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STOCK MARKET ANALYSIS
LET THE STOCK MARKET CRASH
By Agwu Kalu
By Agwu Kalu
I am neither a Professor of Stock Market nor the Chairman of a big corporation. I tried my hand on Financial Management and never fully made it ending up in the realm of Financial Policy. However, I can lay small claims to knowledge of how the markets work and behave. It is for this reason I am making these observations.
I want to talk about stock market crash and what leads to it. Before then, let us take a look at fundamentals. In developed markets, fundamentals play a key role. Without taking the position of the DG of the Stock Exchange, I can tell you for sure that the most direct influence on a stock's price is a change in the economic fundamentals of the business. Do not forget we are still talking about developed markets.
When the revenues and profits of a quoted business whose stocks are traded at the stock exchange are on a steep upward trend with no indication of letting off, one can expect to see the stock price rise as investors bid up this attractive company in their drive to won a piece of the cake.
Conversely, if the profit picture is flat or, worse, declining with no positive change in sight, traders and investors alike are likely to abandon the stock and the price heads only in one direction - south!
In our stock market, fundamentals do not exist in analyzing price movements. What usually counts are "bonus", "dividends", "rights issue" or/and "public offer" Most of my friends do not agree with me. If we believe in fundamentals, why should leave stocks like Nigerian Breweries, UACN, PZ Cussons and go chasing Afroil, Dunlop, Grommac Industries as if they just struck oil and will be selling it at $200 a barrel?
Okay, enough about fundamentals. I was going to talk about stock market crash. A theory is developed that explains how the stock market can crash in the absence of news about fundamentals, and why crashes are more common than frenzies.
A crash occurs via the interaction of rational and naive investors. Naive traders believe in a simple (but reasonable) statistical model of stock prices: that prices follow a random walk with serially correlated volatility. They predict future volatility adaptively, as a weighted average of past squared price changes, using their irrational methodology.
From time to time, the rational traders/investors sharply lower their demand for stocks, causing prices to fall below fundamentals. This raises naive investors' assessment of future volatility. Since naive traders are risk averse, their demand for stocks falls and this leads to market crash.
Unfortunately, our market will not crash, for the wrong reason. Not because of market forces, but due to negative government intervention. Where on earth does the government fix stock prices? The same meddlesome intervention that took place in the foreign exchange market is being replayed in our stock market. The annoying aspect is that our so-called regulators support this unsettling intervention.
If the government wants to intervene in the stock market, they should look at the other world markets and see how they go about it. But because they can't see, I'll help.
In the U.S., for example, the Federal Reserve lowered its discount rate in August last year and allowed banks to put up as collateral all sorts of things private investors wouldn't touch. According to economist and market strategist Edward Yardeni, of Yardeni Research, these collaterals included everything from low-rated debt to boat loans.
The Federal Reserve changed the direction of the discount rate only 15 times during the last 33 years, and stock prices have mounted a sustained rally every time they reduced them. This tells us something - that the discount rate is very powerful. In times of crisis it helps by allowing banks to borrow against collateral considered too risky for most investors. The banks can then reloan the money to consumers, businesses, or investors, helping overcome a liquidity crisis such as what we are experiencing today.
If there were no liquidity crises, why would there be so much urge to sell stocks to the extent that almost all the stocks open lower at the market every day?
While there are no guarantees in the markets, the fact that stock prices have increased during previous reductions in the discount rate doesn't necessarily mean they will rise every time the government lowers its discount rate.
The Federal Reserve's Open Market Desk monitors the rate at which banks loan each other funds. Do we have that here?? When this amount goes higher than the Federal Reserve's goal - whatever it is - the central bank moves to put more money into the market. Can Charles Soludo do that?
How it does it is that it agrees to buy government Treasury bonds from its primary dealers - big banks like Goldman Sachs and Citigroup. To make the purchase, it deposits money from the sale - sometimes as much as $35 billion - with dealers, who in turn lend the funds on the open market. The agreement is essentially a substantial short-term loan by the Federal Reserve. The move increases the money supply and drives interest rates down.
In Korea, the government's intervention in the stock market took the following form:
- Facilitating the inflow of good firms into capital markets
- Supporting family-owned companies
- Providing incentives for listings
- Listing state-owned enterprises (SOEs)
Broadening the demand base of capital market products
- Fostering institutional investors
- Fostering investment of provident funds
- Stabilizing stock prices
Developing capital market infrastructure
- Building sound regulatory frameworks
- Establishing an efficient stock exchange
- Designing an efficient and effective tax system
These measures involved a Narrow Scope which looked into: Measures associated with transaction costs (Securities transaction tax, commission fees, transaction fees); Measures associated with aberrant demands (Margin requirements, credit guarantee, substitute securities); Measures to directly change the supply and demand of stocks (Suggestions of direct purchase/sale or expansion/reduction of stock purchase quota, expansion/reduction of the scope of institutional investors and principal account) and Price Limit System.
On a Broad Scope the intervention looked into Pursuit of stock price stabilization by expanding the market base and liquidity through stock market growth-mainly done through legal reforms.
I am not intelligent enough or even competent to suggest ways of effectively intervening in this market but if in my dream I become a president, I'll ask banks and insurance companies to plough 15% of their private placement and public offer returns into the stock market. The same will go for pension funds and mortgage institutions with varying degrees of commitment.
I will remove all price restrictions. Although price limit system has its advantages like preventing extreme price volatility, it nevertheless hampers the occurrence of efficient price discovery.
The Governor of the Central Bank, Directors General of the stock exchange and the SEC will proceed on compulsory leave, and in their place will be ECONOMISTS who know what they should do.
Stock brokers will be better capitalized than N2b, perhaps N10b. They should be able to stabilize the market by buying up or selling stocks on the floor of the exchange rather than buying IPO's and then coming to sell on the floor at very huge profits.
I will remove all limits on price movement, knowing and believing we have rational traders. Since the majority of the traders in our stock market are naïve and risk averse, there will always be pressure for them to sell at the earliest sign of shock. This will lower the market's risk-bearing ability leading to a near crash. Anticipating this, a rational trader has no alternative but to bid up prices on the day of the crash. Unlike other explanations of market crashes, this mechanism is fundamentally asymmetric: the price of stocks cannot exceed fundamentals, so frenzies or bubbles cannot occur.
Transaction costs and listing requirements will be greatly lowered. The other day, the exchange or SEC reported an income of several billion naira, from doing what when investors are losing money by the day. Trade alert will vanish like a candle in the wind and financing of politics from the capital market will be a thing of the past.
Now here come the reasons why our stock market is headed for a well-deserved crash. The first reason is that stock prices rose too high within such a short time.
Although there are two big factors that determine stock prices - economic value and investors' emotion. Stocks are worth something, and whenever the going price goes too far above or too far below fair value, the fair-value price exerts a magnetic pull on the going price until the going price reverts to the mean (the fair-value price). Emotional investors can for a time push stock prices wildly above or below fair value. The economic-value price always prevails in the end, but it can take some time for this to happen. Like we are experiencing in Nigeria today, most people believe that the market has over-corrected. Emotional prices have been known to remain in place for 10 years or even a bit longer.
With price earning ratio as high as 80, a price crash of major proportions becomes inevitable.
The second reason why stock prices are crashing is that people grew weary of the deceptions needed to keep prices from falling hard.
It's because stock investing is primarily an emotional endeavor and only secondarily a rational one. When stock prices are high, investors want to be told that that's not a problem. Experts primarily concerned with maintaining their popularity with investors are generally willing to tailor their message to respond to customer demands. A lot of big lies have been told about stocks for a long time now and the appeal of looking at stock investing in honest ways is now leading crashing stock prices.
The third reason why our stock market is crashing is that we got ahead of ourselves in our economic expectations.
When we all spend more, the wheels of economic growth turn faster. But the artificial spinning of the wheels of commerce brought on by inflated stock prices cannot last. Telling tall tales about the value of our stock portfolios is a temporary fix to our economic troubles.
The longer the temporary fix continues, the more dependent we become upon it. Eventually, we can't keep things going forward even with the benefit of the artificial stimulus. At that point, things begin to slip into reverse.
The correction of the artificial push becomes a big artificial obstacle to economic growth. The economic downturn caused by a loss of confidence in high stock prices becomes a cause of even lower stock prices, which becomes a cause of even lower economic growth. And so on. The happy cycle of higher stock prices and faster economic growth becomes an unhappy cycle of lower stock prices and slower economic growth once the tipping point is reached.
The fourth reason why shall experience stock market crash is that some economic or political event took place which served as a plausible justification for a crash.
I am saying this because politicians came up with this idea of Independent Power Project - IPP, that put several billions of naira into their pockets without doing anything. In fact the more they didn't do, the more they got. That explains why almost all the IPOs and private placements were over-subscribed by the tune of several trillion naira, even when you want to sell pure water.
What actually happened was that too much (bad) money started chasing too few stocks, which saw worthless stocks at a PE ratio of almost 100.
The last reason I believe our stock market is crashing is that that''s what it is supposed to do.
After the rains comes the dry spell. It's a cycle.
That explanation of why stocks crash probably sounds glib if you are one of those who lost large amounts of accumulated wealth in the big price drop. I apologize for sounding glib.
There's a point to my simple and straightforward explanation, however. The true reason why stocks crashed really is that the price drop is part of a natural cycle. The "experts" who are more concerned with being popular than with telling it straight misled you. I cannot get you your money back. The best that I can do is to tell you the true simple and straight story so that you can avoid having this sort of thing happen to you again.
Extreme bull markets like we experience a few months ago are not a good thing. They are a deception. Deceptions hurt people. You are one of the people who got hurt. You are a victim of the most out-of-control bull market.
Don't give up on stocks. That would be a mistake. Stocks are a wonderful asset class.
All that you need to give up on is the fantasy view of stock investing that depends on sentiments rather than fundamental analysis. There's a good chance that a return somewhere in that neighborhood is going to continue to apply in the future.
When you see returns going far above that, know that something is up. Know that things have gotten out of hand and take some money off the table. Then you won't get burned when the natural and inevitable cycle of stock prices that has always applied in the past applies again in the future.
Stock prices go up, stock prices go down. Change your stock allocation accordingly, and you won't find yourself asking the next time we all experience this natural and inevitable cycle why stocks crashed.
I want to talk about stock market crash and what leads to it. Before then, let us take a look at fundamentals. In developed markets, fundamentals play a key role. Without taking the position of the DG of the Stock Exchange, I can tell you for sure that the most direct influence on a stock's price is a change in the economic fundamentals of the business. Do not forget we are still talking about developed markets.
When the revenues and profits of a quoted business whose stocks are traded at the stock exchange are on a steep upward trend with no indication of letting off, one can expect to see the stock price rise as investors bid up this attractive company in their drive to won a piece of the cake.
Conversely, if the profit picture is flat or, worse, declining with no positive change in sight, traders and investors alike are likely to abandon the stock and the price heads only in one direction - south!
In our stock market, fundamentals do not exist in analyzing price movements. What usually counts are "bonus", "dividends", "rights issue" or/and "public offer" Most of my friends do not agree with me. If we believe in fundamentals, why should leave stocks like Nigerian Breweries, UACN, PZ Cussons and go chasing Afroil, Dunlop, Grommac Industries as if they just struck oil and will be selling it at $200 a barrel?
Okay, enough about fundamentals. I was going to talk about stock market crash. A theory is developed that explains how the stock market can crash in the absence of news about fundamentals, and why crashes are more common than frenzies.
A crash occurs via the interaction of rational and naive investors. Naive traders believe in a simple (but reasonable) statistical model of stock prices: that prices follow a random walk with serially correlated volatility. They predict future volatility adaptively, as a weighted average of past squared price changes, using their irrational methodology.
From time to time, the rational traders/investors sharply lower their demand for stocks, causing prices to fall below fundamentals. This raises naive investors' assessment of future volatility. Since naive traders are risk averse, their demand for stocks falls and this leads to market crash.
Unfortunately, our market will not crash, for the wrong reason. Not because of market forces, but due to negative government intervention. Where on earth does the government fix stock prices? The same meddlesome intervention that took place in the foreign exchange market is being replayed in our stock market. The annoying aspect is that our so-called regulators support this unsettling intervention.
If the government wants to intervene in the stock market, they should look at the other world markets and see how they go about it. But because they can't see, I'll help.
In the U.S., for example, the Federal Reserve lowered its discount rate in August last year and allowed banks to put up as collateral all sorts of things private investors wouldn't touch. According to economist and market strategist Edward Yardeni, of Yardeni Research, these collaterals included everything from low-rated debt to boat loans.
The Federal Reserve changed the direction of the discount rate only 15 times during the last 33 years, and stock prices have mounted a sustained rally every time they reduced them. This tells us something - that the discount rate is very powerful. In times of crisis it helps by allowing banks to borrow against collateral considered too risky for most investors. The banks can then reloan the money to consumers, businesses, or investors, helping overcome a liquidity crisis such as what we are experiencing today.
If there were no liquidity crises, why would there be so much urge to sell stocks to the extent that almost all the stocks open lower at the market every day?
While there are no guarantees in the markets, the fact that stock prices have increased during previous reductions in the discount rate doesn't necessarily mean they will rise every time the government lowers its discount rate.
The Federal Reserve's Open Market Desk monitors the rate at which banks loan each other funds. Do we have that here?? When this amount goes higher than the Federal Reserve's goal - whatever it is - the central bank moves to put more money into the market. Can Charles Soludo do that?
How it does it is that it agrees to buy government Treasury bonds from its primary dealers - big banks like Goldman Sachs and Citigroup. To make the purchase, it deposits money from the sale - sometimes as much as $35 billion - with dealers, who in turn lend the funds on the open market. The agreement is essentially a substantial short-term loan by the Federal Reserve. The move increases the money supply and drives interest rates down.
In Korea, the government's intervention in the stock market took the following form:
- Facilitating the inflow of good firms into capital markets
- Supporting family-owned companies
- Providing incentives for listings
- Listing state-owned enterprises (SOEs)
Broadening the demand base of capital market products
- Fostering institutional investors
- Fostering investment of provident funds
- Stabilizing stock prices
Developing capital market infrastructure
- Building sound regulatory frameworks
- Establishing an efficient stock exchange
- Designing an efficient and effective tax system
These measures involved a Narrow Scope which looked into: Measures associated with transaction costs (Securities transaction tax, commission fees, transaction fees); Measures associated with aberrant demands (Margin requirements, credit guarantee, substitute securities); Measures to directly change the supply and demand of stocks (Suggestions of direct purchase/sale or expansion/reduction of stock purchase quota, expansion/reduction of the scope of institutional investors and principal account) and Price Limit System.
On a Broad Scope the intervention looked into Pursuit of stock price stabilization by expanding the market base and liquidity through stock market growth-mainly done through legal reforms.
I am not intelligent enough or even competent to suggest ways of effectively intervening in this market but if in my dream I become a president, I'll ask banks and insurance companies to plough 15% of their private placement and public offer returns into the stock market. The same will go for pension funds and mortgage institutions with varying degrees of commitment.
I will remove all price restrictions. Although price limit system has its advantages like preventing extreme price volatility, it nevertheless hampers the occurrence of efficient price discovery.
The Governor of the Central Bank, Directors General of the stock exchange and the SEC will proceed on compulsory leave, and in their place will be ECONOMISTS who know what they should do.
Stock brokers will be better capitalized than N2b, perhaps N10b. They should be able to stabilize the market by buying up or selling stocks on the floor of the exchange rather than buying IPO's and then coming to sell on the floor at very huge profits.
I will remove all limits on price movement, knowing and believing we have rational traders. Since the majority of the traders in our stock market are naïve and risk averse, there will always be pressure for them to sell at the earliest sign of shock. This will lower the market's risk-bearing ability leading to a near crash. Anticipating this, a rational trader has no alternative but to bid up prices on the day of the crash. Unlike other explanations of market crashes, this mechanism is fundamentally asymmetric: the price of stocks cannot exceed fundamentals, so frenzies or bubbles cannot occur.
Transaction costs and listing requirements will be greatly lowered. The other day, the exchange or SEC reported an income of several billion naira, from doing what when investors are losing money by the day. Trade alert will vanish like a candle in the wind and financing of politics from the capital market will be a thing of the past.
Now here come the reasons why our stock market is headed for a well-deserved crash. The first reason is that stock prices rose too high within such a short time.
Although there are two big factors that determine stock prices - economic value and investors' emotion. Stocks are worth something, and whenever the going price goes too far above or too far below fair value, the fair-value price exerts a magnetic pull on the going price until the going price reverts to the mean (the fair-value price). Emotional investors can for a time push stock prices wildly above or below fair value. The economic-value price always prevails in the end, but it can take some time for this to happen. Like we are experiencing in Nigeria today, most people believe that the market has over-corrected. Emotional prices have been known to remain in place for 10 years or even a bit longer.
With price earning ratio as high as 80, a price crash of major proportions becomes inevitable.
The second reason why stock prices are crashing is that people grew weary of the deceptions needed to keep prices from falling hard.
It's because stock investing is primarily an emotional endeavor and only secondarily a rational one. When stock prices are high, investors want to be told that that's not a problem. Experts primarily concerned with maintaining their popularity with investors are generally willing to tailor their message to respond to customer demands. A lot of big lies have been told about stocks for a long time now and the appeal of looking at stock investing in honest ways is now leading crashing stock prices.
The third reason why our stock market is crashing is that we got ahead of ourselves in our economic expectations.
When we all spend more, the wheels of economic growth turn faster. But the artificial spinning of the wheels of commerce brought on by inflated stock prices cannot last. Telling tall tales about the value of our stock portfolios is a temporary fix to our economic troubles.
The longer the temporary fix continues, the more dependent we become upon it. Eventually, we can't keep things going forward even with the benefit of the artificial stimulus. At that point, things begin to slip into reverse.
The correction of the artificial push becomes a big artificial obstacle to economic growth. The economic downturn caused by a loss of confidence in high stock prices becomes a cause of even lower stock prices, which becomes a cause of even lower economic growth. And so on. The happy cycle of higher stock prices and faster economic growth becomes an unhappy cycle of lower stock prices and slower economic growth once the tipping point is reached.
The fourth reason why shall experience stock market crash is that some economic or political event took place which served as a plausible justification for a crash.
I am saying this because politicians came up with this idea of Independent Power Project - IPP, that put several billions of naira into their pockets without doing anything. In fact the more they didn't do, the more they got. That explains why almost all the IPOs and private placements were over-subscribed by the tune of several trillion naira, even when you want to sell pure water.
What actually happened was that too much (bad) money started chasing too few stocks, which saw worthless stocks at a PE ratio of almost 100.
The last reason I believe our stock market is crashing is that that''s what it is supposed to do.
After the rains comes the dry spell. It's a cycle.
That explanation of why stocks crash probably sounds glib if you are one of those who lost large amounts of accumulated wealth in the big price drop. I apologize for sounding glib.
There's a point to my simple and straightforward explanation, however. The true reason why stocks crashed really is that the price drop is part of a natural cycle. The "experts" who are more concerned with being popular than with telling it straight misled you. I cannot get you your money back. The best that I can do is to tell you the true simple and straight story so that you can avoid having this sort of thing happen to you again.
Extreme bull markets like we experience a few months ago are not a good thing. They are a deception. Deceptions hurt people. You are one of the people who got hurt. You are a victim of the most out-of-control bull market.
Don't give up on stocks. That would be a mistake. Stocks are a wonderful asset class.
All that you need to give up on is the fantasy view of stock investing that depends on sentiments rather than fundamental analysis. There's a good chance that a return somewhere in that neighborhood is going to continue to apply in the future.
When you see returns going far above that, know that something is up. Know that things have gotten out of hand and take some money off the table. Then you won't get burned when the natural and inevitable cycle of stock prices that has always applied in the past applies again in the future.
Stock prices go up, stock prices go down. Change your stock allocation accordingly, and you won't find yourself asking the next time we all experience this natural and inevitable cycle why stocks crashed.
Copyright © 2008 Anadal Technologies Limited. All Rights Reserved.
Last modified: October 19, 2008
Last modified: October 19, 2008