People buy shares in a company mostly for the dividends that they will pay; the higher the dividend they expect to receive per share the more attractive the share is and so the higher the price they are willing to pay. Because dividends are paid out of profits it follows that the higher the price of the share the greater the profit people must be expecting the company to make. Share prices or indices based on them are therefore an indicator of the future profits that the market expects the company or the economy as a whole to make. This is the rationale for using share price indices as an indicator of an economy’s future buoyancy. But a number of caveats need to be borne in mind.
First, there are a number of share indices and they do not always show the same picture. For example the much quoted FTSE100 is a weighted average of the 100 companies listed on the London Stock Exchange with the highest market capitalization (share price times the number of share outstanding). The FTSE250 is a weighted average of the next 250 companies with the highest market capitalization. Many of the companies in the FTSE100 are international companies whilst those in the FTSE250 are more UK based. Not surprisingly then their behaviour can differ and over the last decade or so has done so quite markedly. This is especially true recently – the FTSE100 contains a high proportion of mining, oil and banking companies which have performed notably poorly.
Second, if everyone came to expect wages and the prices of all goods to be 10% higher in all future years than they had previously thought then they would expect nominal profits to be higher by 10% too. Consequently expected nominal dividends would be jump by 10% and so would conventional share indices. In other words, conventional share indices are nominal variables which are likely to rise and fall with changes in expected inflation. Conventional share indices should therefore be deflated by a price index to obtain an estimate of the expected ‘real’ future buoyancy of the economy.
Thirdly, the composition of share indices changes over time – for example, the less successful companies will drop out of something like the FTSE100 as other companies overtake them in size. This “selection bias” means that this index – or any other such index – can give a falsely rosy impression of the performance of shares over longer periods.
And fourthly, since what drives share prices are expectations of future profits rather than actual future profits, it is possible that share indices can give an entirely misleading picture of the economy’s true prospects.