Why Does the Stock Market Move up and Down? Part -1

why-does-the-stock-market-move-up-and-down-part-1

We have seen that the fundamentalist approach to investment requires us to buy a share when its price is down and sell it when it is high. This statement may give rise to sceptical question such as what if it does not go down in the first place and secondly what if it does not go up after it had gone down. These are valid questions to be posed and l have indeed been so asked many times. This chapter will therefore examine the question of why a share (and the market as a whole) moves up and down at all. We shall start by examining the short and medium term situation.

WHAT DETERMINES SHORT AND MEDIUM TERM STOCK MARKET LEVEL?

As we shall see in the second half of this chapter, over the long run, the stock market is fairly rational. Over ten, twenty or more years, economic factors determine the prices of shares. However, over the shorter term, the market is less driven by economic considerations but rather more by the psychological perceptions of the stock market players. As we have seen, stock market players can be rather tickle in their evaluation of shares. It is this fickleness in their evaluation of shares which causes so much short term fluctuations in the prices of shares.

Why Are Share Prices So Fickle?

Shares are just like any other commodity in a free market situation. The price of a share depends on the supply of and demand for shares. If there is a high demand for shares and restricted supply, its price will go up. Conversely, if there is limited demand but a great deal of supply, its price will go down. In this way, shares are just like any other commodity, for example, fresh fish. If the weather is stormy, there will be less supply of fish and its price will go up. If the catches are good, the price will go down. Ultimately, there is nobody in this world who can control the freemarket price of a share. The largest banks in the US tried to stop the stock market collapse in 1929 and even all their combined wealth could not change the course of history The beginning of l985 brought what looked like a repeat of the futile 1929 attempt to change the direction of the market to the Asian stock market. The Ministry of Finance tried very hard to push up the Stock market but again to no avail.

The major reason why share prices fluctuate With such case is that shares are but one of the many forms of investments which are available to the investors. The same money that is used to buy share. can be used to buy houses, land, kept in fixed deposits or held in cash form. (The potential investors can also decide to spend it rather than put it aside.) All the other investments, like shares, provide a return to the investors. Investors choose to invest their savings in shares because they believe that shares Will provide them with superior return compared with other forms of investments. Once they become convinced that the other forms of investment will provide better return, they will desert stock market in droves and shift their money elsewhere. Once this takes place, share prices will fall.

Unfortunately, there are two extra factors which cause share prices to be even more volatile than most commodities. First, unlike fish, the Supply of shares is relatively fixed in the short run. There can be no sudden appearance of new issues just because the demand for shares is good. This restriction of supply leads to extreme price fluctuations which are common to all stock markets. In addition, large share price movements tend to feed upon themselves. What do I mean by “tend to feed upon themselves?” Let us look at it this way. What will happen if the whole country develops a sudden interest in putting money in fixed deposits? The answer is that there is likely to be little long-term effect. Chances are that if the banks are faced with a huge deluge of money in fixed deposits, they will lower the fixed deposit interest rate. This will reduce the return obtainable on fixed deposit and some investors will turn to other forms of investment, and the demand for putting money into fixed deposits will return to normal. Notice that if there is a great deal of demand for putting money into fixed deposits, the return on fixed deposits drops, thus reducing the demand for this form of investment. The money market therefore has a built-in stabilizing feature.

But this built-in stabilizing feature is missing from the stock market Let us consider what would happen if a high demand suddenly develops (caused by, say, a sharp decline in interest rate). Since the supply of new shares is very much restricted, the high demand will drive up the price of shares. What happens to the return (on paper) of the existing share investors’ Their return goes up because the higher share prices provide them with an unrealized capital gain on top of the dividend return they have been getting. At the same time, those people who are interested in investing in shares become even more interested because they now perceive that the return on share investment has become greater than what it was previously. One has to think about this carefully. It is as if the banks will increase the fixed deposit interest rate in the event of an unexpected increase in demand for fixed deposits. That action will surely create an even greater demand for fixed deposits. This is in effect what happens in the stock market. An increase in demand creates a higher return to the existing share investors (and the return expectation of potential investors) which stimulates their interest to purchase more shares and this tn turn, lifts the prices even further thus creating even more interest. It is this special mechanism of the stock market which causes share prices to go up to the most extreme level once a bull market has taken hold.

In every bull market, the prices of shares rise to a most unreasonable level but what causes the rise to eventually stop and then reverse direction? Why is it that a bull run cannot go on forever, sucking in ever more money and rising higher and higher? Two things prevent an infinite rise in the stock market. First, the amount of money available in any country is finite. As the bull market proceeds, more and more of the country’s savings is sucked into it and eventually the people involved simply run short of money. Second, the price rise typically experienced in a bull market would result in quoted companies having such absurd market value that eventually, even the dimmest investor can see that this rise cannot go on forever. Pressure to sell and play it safe therefore develops and eventually this pressure to sell will overcome the opposite desire to buy. An example will make this principle clear.

At the height of the 1973 bull run, Oversea-Chinese Banking Corporation – OCBC was selling at $50 per share. We should stop and think for a moment what this actually means. At that point in time OCBC had 60 million shares and this put a market value of $3,000 million on the whole of OCBC. This figure is so large that it defies imagination for it is larger than a quarter of the gross national product of Singapore of 1972. At the price level of the time, one lot of OCBC was worth two terrace houses. Does this make any sense if you were to consider the fact that two terrace houses would have provided you with an annual rental income of around $4,000 while one lot of OCBC gave you about $100 in after-tax dividend? This is so obviously nonsensical that many wise investors cashed in their shares and the shares of OCBC began to drop. Once the price of a share start to drop, the opposite effect from that which takes place on the way u) goes into action. The drop in price means negative return (i.e. a loss) for the investors. The negative return would mean that the share is now less attractive. There is therefore a decline in demand. Given that the supply is fixed, the reduced demand would mean a lower price They thus begin to lose faith in it and more and more investors chow; to opt out before they lose even more money. The pressure to sell eventually becomes a flood and the share’s price would drop precipitously. In the case of OCBC, it eventually lost over 90 per cent of in market value.

The longer a bull market persists and the greater the size of the rise, the more people will be sucked in. Towards the end of a bull market share prices move up almost solely as a result of this “jumping on the bandwagon” effect rather than for any economic factor. Similarly, the rapid initial decline after the end of a bull market is also largely due to psychological and emotional factors.

However, the stock market is not manic all the time. Speculative mania takes place but infrequently. Not all stock market rises develop into a full scale bull market nor do all stock market declines degenerate into a slump. For much of the time, the demand and supply factors are more or less in balance. A big movement in one direction may be countered by an equally big one in the opposite direction. It is only occasionally that a powerful push in a single direction without any corrective influence which leads to a proper bull market developing. Stock markets move up and down much of the time without any resemblance to the maniacal phase. What then determines the demand for shares under normal circumstances? I believe there are three things of importance which have an effect on the market. They are:-

(a) The return on alternative investment(s);

(b) The optimism or pessimism of the market regarding the future trend of the economy and the market;and

(c) Non-economic factor(s).

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