The Real drivers of Stock Market
“Price is what you pay and value is what you get.” - Says the incredible genius of value investment, Mr. Warren Buffett. But have you tried to identify the factors which drive the price of a share and make the scrip overvalued or undervalued? Well, you would find n-number of factors like Revenue, Profitability, Management, Asset Base, Leverage in micro level and GDP, inflation, interest rate Industrial Production, foreign exchange rate, political stability etc in the macro front, which affects the movement of the stock price. But practically, one can club all these factors in only three broad categories namely Earnings, Liquidity and Sentiment (ELS factor) which determine the direction of the stock market. Let’s try to understand them one by one.
Earning: The rationale behind the valuation of any share is the earning prospects of the company. Most of the time you will find the stock prices surge with strong reported earning and also plunge due to dismal earning show. At times you would also find some stocks going exorbitantly high with no such significant earning level. This happens when the investors are very upbeat about the future earnings prospects of the company (not the current earning). Of course there is no surety that the expectations of the investors from the company would be fulfilled. The perfect example of this would be the dot com boom and crash between1995-2000. Just before the crash (i.e. March-2000) the average P/E of dot com companies has touched 32.6x (P/E’s at that level had not been seen since September 1929). This was because everybody was upbeat about the growth and earning potential of these companies and that was the reason for these high valuations. For example, online grocer WebVan.com, a company that never turned a profit, had a market cap of $1.2 billion at the height of the Dot‐com Bubble. At last the investors has realised that these dot com companies are not going to give a profit which they had anticipated. Then, it is really very difficult for market to sustain that high valuation without any earnings and finally the market crashed. The crux of the matter is, a company should generate a sustained growth in Earning Per Share (EPS) in order to create value for the shareholders as the best judge of the financial performance of any company is the EPS. This is why the preferred multiple of any analyst, irrespective of industry, is the P/E multiple.
Liquidity: Liquidity means the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. In stock market it is dependent on the amount of money which has been pumped in or out of the market. In India, the money flows to stock market is dominated by Foreign Institutional Investors (FII). From the year 2000 to 2007, the FIIs have poured Rs. 2,46,600 cr in equity market and the benchmark index- SENSEX surges from 3,972 to 20,286 during the same period. With the start of global economic melt down in 2008, the same FII’s net investment was (-52, 987) cr in Indian equity market and SENSEX plunges from its all time high of 21,206 to 9,647 level by the end of 2008. Again in the calendar year 2009 and 2010, FII’s net investment was 2,16, 690 and with this SENSEX bounced back to a level of 19,459 from the lows of 2008. The year 2011 was not good for the Indian equity market as the market lost 25 percent of value during the year. This made it one the major underperformer in the emerging market. During the period the net investment by FII was (-2,812) cr. Since Dec-2011 till date, there is a unidirectional movement of the market which is purely due to heavy buying by FIIs. So form the above facts and figure one can rationally argue that Indian Stock Market is completely liquidity driven which has been supported by FIIs.
Sentiment: Sentiment in stock market is referred to the General feeling or tone of a market. There are basically two types of sentiment- bullish and bearish. One can say that Earrings and Liquidity determines the sentiment. Have you tried to understand what turned the perfect Bull Run in India upside down to a Bear Run with the revelation of subprime mess in USA? Has the fundamental of all the Indian companies deteriorated overnight? What happened when Satyam announced its $1.3billion Maytas acquisition plan? What happened when SEBI announced its curb on Participatory Notes on 16th Oct 2007? In all these cases, you will find the investor’s sentiment turned bearish with in no time. Unlike Earnings and Liquidity, you can not quantify the Sentiment. But yet it has tremendous impact on Stock Market Movement.