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Markets reflect the economy

indexSometimes during my casual chats I ask people their view about the economy and most give it a ‘thumbs up’. Then, I ask them their view about the stock market, and most give this a ‘thumbs down’. This, to me, is the epitome of their financial illiteracy.

Generally speaking, the stock market will reflect the economic conditions of an economy. If an economy is growing then output will be increasing and most firms should be experiencing increased profitability. This higher profit makes the company shares more attractive – because they can give bigger dividends to shareholders.

If the economy is forecast to enter into a recession, then stock markets will generally fall. This is because a recession means lower profits, less dividends and even the prospect of firms going bankrupt, which would be bad news for shareholders.

Also, in a period of uncertainty, investors may prefer to buy bonds for the greater security and avoid shares, because of the greater risk involved.

Believing in the economy and not the market is like looking at the mirror and hoping to see some other person in it. The market (in the long run) reflects the economy and nothing but the economy, like a mirror would only reflect your face if you stand before it.

Of course, in the short term, the market falls prey to economic headwinds and tail winds  blowing within, as well as from outside the borders. Price of a portfolio or a single business is dependent on the intrinsic value of the portfolio or the business (raw material, patents and copyright, differentiation, usefulness, uniqueness, loyalty, brand value). This represents the long term value.

But price in the short term is also a function of the demand, which rises and falls because of a flush or a shortfall of funds, respectively. During a shortfall of funds, (the word used is low liquidity in the system) the investors dump their assets, to harness as much liquidity as possible. Naturally, this panic selling makes others (especially uneducated and passive investors) start believing in an impending ‘doomsday’ kind of scenario.

Thus, ‘selling’ gains momentum, as this view about impending disaster spreads like wildfire among investors.

Similarly, prices can march upwards reaching unprecedented and unrealistic levels, on account of excess liquidity and uncontrolled exuberance. The short term volatility that we see in the stock market, is based on such mood swings and does not reflect the intrinsic value of the portfolio of companies, which represent a mutual fund, or the benchmark.

The long term, on the other hand, is entrenched in unwavering assets of our economy, such as:-

  • Size of population
  • Demography
  • State of development of the economy
  • Political stability

As is evident, none of the above attributes (assets) appear to be of temporary nature. Hence, these are termed as ‘fundamentals’ of the economy and these ‘fundamentals’ guide the economy forward, as it tries to attain the next level.

Investors should focus on getting themselves financially educated and invest through the mutual fund route, thus benefiting from the growth potential of our economy. Last but not the least, let’s stop blaming the stock market. The mirror cannot be held responsible for any ugliness or beauty that stands before it. It will only do the job of reflecting it.

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