The Share Market and The Reality Check

The Share Market and the Reality Check
Arun Kumar
CESP/SSS, JNU.
The Tribune, September 13, 2007.

The Stock Market in India has been going through a roller coaster. After rising sharply for a few months and reaching a peak on July 24 (Sensex, 15,869), it started fluctuating. It dropped sharply on July 27 (542 points), August 1(615 points) and then on August 16 (643 points). These have been the biggest 3 falls but there have been others, like on August 21, 2007 (438 points). The investor is breathless not knowing which way to go. Some, like the SEBI chief have argued that there is nothing to worry or the Finance Minister has reiterated that the economy is doing well (implying, nothing to worry). The investor is sought to be convinced that the fundamentals of the economy are good and that there is no need to panic.
It is clear that the crisis has hit suddenly, something even the FM or the RBI were not able to anticipate. The recent RBI Report in July made no mention of any such possibility. If those with all the economic intelligence at their command, could not read the coming events, can the investor do better? All this is reminiscent of occurrences in the last 16 years when many have lost heavily. Can the assurance that the fundamentals are good be believed? Two important points need to be kept in mind.
First, the stock market is not always directly linked to the fundamentals of the economy. If it was, with the fundamentals being good, as the Finance Minister and the experts say, why the repeated sharp fall? Compared to the July 24 peak on August 21, 2007, it was down by 12%. Now it is recovering.
The stock market is essentially based on short run expectations. Some expect it to rise and buy to make a gain (the bulls) while others expect it to fall so they sell to make a profit (the bears). At any given time, there are bulls and bears operating to keep the market in equilibrium. If no one is buying (no bulls), the market would collapse as happened on the manic Monday last year. If there are no sellers (no bears) the market would rise sharply. Further, a bull in the morning may be a bear the afternoon. The positions keep switching because of the changing expectations. If the market has risen sharply, some begin to expect it to fall and turn bearish and vice versa.
Short term factors, like, a CBDT circular, the news of FII withdrawing or instability of government move markets. Long term features of the economy and politics also have a bearing but these signals are read in the immediate context and often there are over reactions. For instance, what would be the effect of reservations on the corporate sector or whether the left front is going to push the UPA government harder in the context of the nuclear deal?
What role do the economic fundamentals play? The stock market reflects the health of the corporate sector but they constitute 30% of the output of the economy. Indirectly, this may also reflect the health of the overall economy but often not. Till July 24, when the market rose sharply, it was unaffected by the growing social unrest in the country, increasing criminalization, rising unemployment or the farmers committing suicide. Currently, the declines are due to the failure of the sub prime loans market in the USA which has little to do directly with the Indian economy or its fundamentals.
Even if the fundamentals are important there is no particular level of the stock market indices that is commensurate with a given level of the fundamentals? There is no one to one correspondence between the two. The Harshad Mehta induced boom in 1992 was co-terminus with a sharp decline in the rate of growth of the economy. Similar was the case during the Ketan Parikh induced boom. Yes, the economy has grown at about 8% in the last three years. Does that justify a 250% rise in the stock market indices? The corporate sector profits have risen sharply by about 30% but even that does not justify the rise.
In effect, the sharp rise in the indices has meant that the market has been going out of sync with reality. Consequently, average returns on the stocks have been falling. Why do the investors still invest? Because of the expected capital gains. In a bull market, it is the expected capital gain that drives investments. This is an unstable situation. If the rate of rise of the market slows down, the rate of return falls and the investors start turning into bears. The market tends to reverse gear. The big players with their analysts, control over chunks of stocks and association with brokers are able to see the signs and retrieve some of their positions. Usually in a boom, greed brings in small investors and they are the ones to suffer the losses when the market falls.
The market mostly consists of the big fish. According to published data, in 2004-05 only 1,40,000 individuals bought shares worth more than Rs. 1 lakh – a mere 0.00001 % of the population. Public holding of the shares of the stock markets is hardly a few per cent. Over 80% is held by the big investors. Thus, the small investors are marginal to the market and they tend to get locked in. The losses for the big investors are mostly on paper. The higher valuation during the boom reverses when the market falls but the original capital is usually intact and they periodically book profits.
The second issue is that in times of turbulence, no one is able to predict the market given the uncertainty, the manipulations by the big investors and insider trading. In the case of the sub-prime market collapse, the Federal Bank of the USA was also caught off guard. After the event, many now argue that the bomb was ticking but few predicted it, certainly not the Federal Bank. Indian markets are getting affected because some FIIs are withdrawing money to shore up their US operations which are the more important ones for them. In this situation where do the fundamentals of the Indian economy enter the picture?
In most situations of decline of the stock markets even the finance ministry cannot predict what will happen (otherwise it would take corrective steps). What it usually does is to put pressure on the financial institutions, like, on public sector banks and insurance companies to support the market to prevent a drastic fall. No wonder, the public financial institutions suffer in the process (as happened earlier to the UTI which collapsed). This may be taking place now also.
This is the key to the problem of the Indian small investors. Today, the government’s economic performance is judged by the rise in the stock markets. The Ministry has signaled to the operators that they can be bulls without worry since the ministry would send signals to the right places to support the market, if it falls. The ministry has been favouring the market by diluting capital gains tax and eliminating the dividend and the wealth taxes. But these are precisely the instruments that used to keep speculative activity in check. In their absence, boom and bust are bound to be aggravated. To be successful, one has to successfully predict what the majority will do - know the minds of the FIIs and those indulging in insider trading. No small investor with a little bit of savings can easily do this, so the stock market is not for them.
What the government does not seem to factor in is that the speculative activity in the stock market affects other investments adversely. We need investments in agriculture, small scale industry and physical infrastructure but if one can make money in the short run then why invest in the real economy and get a return much later? A steady market is better all around than a volatile one but the present policies are an anti-thesis of this.
In brief, the US sub prime market, liquidity problems, political turmoil due to the Congress - Left disagreement on the nuclear issue are important to explain the stock market instability but the reality check is the speculation induced by the policy makers to gain brownie points with finance capital.

nuramarku@gmail.com.