The Dynamics of Equity Price in Markets: Is it Real?

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Delhi-based Tarun takes a hard look at the dynamics of equity price in the markets, in the weekly column, exclusively in Different Truths.

There are great stories of wealth creation through equity markets. Often, we hear of celebrities like Warren Buffet, who is followed the world over for his stock investment abilities, or even our own Rakesh Jhunjhunwala. Most of the people still frown on equity markets as being a waste of time and resources, or even being harmful. I try to explore a bit more on this aspect.

The equity markets are a method of providing funding to the company. The equity provides a right to ownership and hence profits of the company, but not to interest payment of the company. Whatever profits the company saves after payment of interest, depreciation, and taxes, is available for distribution to equity shareholders. This distribution is known as the dividend. If the company retains those profits for further business development, then the net worth of the company increases.

The companies’ stocks are listed on stock exchanges, like, the Bombay Stock Exchange, or National Stock Exchange in India. They can be sold and bought there, subject to the Exchange rules. Now, notice that the companies’ products and services are not sold on the stock exchanges. Only their ownership in terms of equity units of small denomination, changes. That means the people dealing in the products and services of the companies are different than the people dealing in the shares of the companies.

The price of a stock depends on two factors – the earnings of a company, and the investible funds of the economy. The price of a stock increases when a company is able to grow its earnings, and it also increases, when the investible funds of the economy increase. Let’s see what increases these two factors.

A company increases its earnings in many ways. Some of the factors that increase them are the right management, a great product, a great business plan, competitive advantages along with supportive government policies. Now, judging whether a company would be able to increase earnings over the years sustainably, is not an ability for an average investor. One needs to have either a natural flair for it or one has to acquire it studiously. A person like Warren Buffet has said that he doesn’t buy shares, but businesses. That is, he doesn’t buy shares to trade them, but buys running businesses, which look promising to him, and holds them for a very long period of time.

The other factor is liquidity. When interest rates go lower, the availability of funds increases. Since the people are unable to get returns on fixed deposits, they tend to invest in equity markets to get the returns. Since the interest rates in much of the western world right now are zero, the equity markets keep on going up, as more and more money is poured into equity markets. This liquidity is a tricky thing. In 2008, the subprime mortgage market in the USA crashed. The liquidity collapsed as a result. The stock markets went down in a spiral because of that. After that, liquidity has gone back up, so stock markets are going up again. Will the liquidity crash again? A million dollar, or possibly more, question.

So, if an investor has to judge so many things-the management quality, the product, the business plan, the liquidity, and then invest, is it easy? The simple answer is no. Still, there are so many people indulging in stock investing. There are newspapers devoted to their coverage, there are business channels that continuously beam tips to buy and sell stocks. There are occasional headlines of a black day in stock markets when markets crash. This is all an unreal kind of world, one created by the modern-day industrial revolution. The financial markets are divorced from real economies, as we are seeing worldwide, at least in the short run. India’s GDP growth may be coming out less, yet, because of the wonders of liquidity, the stock markets continue to go up. Similarly, in the USA, or other countries, the GDP growth can’t be directly linked to the stock market growth, because of the liquidity factor.

A word about psychology is very important here. There are statistical tools to analyse stock prices. There is a proper course, a respectable one in the USA, which teaches those tools. They pertain to margin trading of stocks, which is a highly risky system. It is because of this that a stock moves up or down about 20% in a single day, giving the delusion of big money being lost or made. Actually, the psychology of an investor is very important, and one has to be aware of the extremes of emotions stock markets are capable of generating, before investing.

Let me give you an example. In the 1990s, LTCM was a fund formed with two Nobel Prize winners as directors, and lots of toppers of USA universities. It managed to earn above-average returns on investments for three years, prompting it to take more and more risk, and eventually, it earned a loss so huge, that the Federal Reserve Bank had to step in to save it. That happened probably because the earned profit made the company so overconfident, that it overshot the risk mandate it originally had.

So, should we disregard stock markets altogether? This is an important question, which I shall answer in my next column.

©Tarun Gupta

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Satyam Shivam Sundaram defines the belief and philosophy of Tarun Gupta, a Delhi-based businessman, with a passion for learning. He tries to locate the common thread in all learning – as Einstein identified energy as the base thing – and find creative, interdisciplinary solutions to problems, with special focus on economics. Behavioural economics is his special interest, which encompasses emotions as well as economic choices when identifying problems and the solutions.