Thursday, 10 November 2011

Factors Driving Asset Prices

It is probably easy to earn money or work for money then to take care of the earned money or to invest money or to make money grow or importantly make our money work for ourselves. There is lot of mis-conceptions about investments and different asset classes like equities, bonds, commodities, real estate or investment avenues like direct equity, mutual funds, fixed deposits, bonds, real estate funds etc. I believe investments are more of common sense approach as possible because investments are finally common sense thing rather than any algorithm or arithmetic model. In this article I just cover the equities, how the markets behave and what are the factors which affect them.

There are 5 major forces which affect the price of equities (or for that matter any freely tradable thing like bonds, gold etc) and they are as follows:

1)       Economic Factors
2)       Monetary Factors
3)       Fundamental Factors
4)       Technical Factors
5)       Psychological factors

I believe these five are the major forces which affect stock (and many other markets) at different points of time. However, the interaction and influence of each factor is different at different points of time. Now, let us discuss each of these factors in some detail:

1)       Economic Factors: Macro economic factors would be very important in the initial stages of an investment cycle. We have to know whether we are within a structural bull or bear market which can be determined with the help of macro economic factors. For example, currently we are within a structural bull market but a cyclical bear market where certain macro economic factors like inflation, GPD growth, fiscal deficit etc have deteriorated. However, we have to note that equity investments can’t be done based on macro economic factors because stock market is the barometer of the economy and hence it around 6 to 9 months in advance predicts the macro economic factors. Therefore, as far as macro economic actors are concerned, we have to invest in stocks when the situation moves from worst to bad and not wait till it turns good because by then the stock prices might have rallied substantially from their bear market lows.

2)       Monetary Factors: This is another important factor which affects equity prices as monetary factors or interest rates have a primary effect on equities through affecting the corporates bottomlines through interest and finance costs, affecting equity valuations through change in discount rate and competing for the same investible surplus of the investor. For example high interest rates are one of the biggest enemies of equities because it is likely to result in fall in corporate earnings through increased interest costs, reduction in equity valuations (like P/E multiple) through increase in discount rate and making available less investor surplus for equities as it makes debt attractive. An investor cant wait for all monetary factors to become good before buying – he / she has to invest when he / she believes interest rates are close to peak or will slightly rise because that is the time when the worst as far as this factor is concerned has played out. Currently, we might not be totally there but somewhere close to there.    

3)       Fundamental Factors: These are the fundamental reasons on which stock prices and valuations should ideally be, these are the factors on which an entrepreneur or the owner will value his / her own business enterprise. The major fundamental factors are earnings, sales, cash flow, book value, enterprise value, dividends etc. Fundamental analysis is very important for stock picking but rarely helps us in achieving above average market performance. This is because a business might be good fundamentally but the stock need not perform that well at that point of time. And also the fundamental value assigned to a business keeps on fluctuating. For example, over the past 1-year, there were lot of buyers when the BSE Sensex was around 21000 or 18x P/E multiple and few buyers when it was around 16000 or 13x P/E. Costly can become costlier and cheap can become cheaper! So, fundamental valuations are like pendulum, they swing from one extreme to another making equities from very cheap to extremely costly. When the markets are going up it seems that it will keep going up and up but in those times of euphoria we have to remember that “however long a tree may grow it will not touch the sky” and similarly when stocks are crashing down we feel depressed as if there is no bottom but in those depressing times we have to remember that at certain price it will become so cheap on earnings and dividends that somebody will just buy the whole company or business itself. Infact, most of the recent bear market bottoms of the past 2 decades in India have happened in single digit P/E (7 to 10x) and hence the current P/E of 13 or 14x does not automatically mean that the market is at the bottom. Talking about DCF, I have seen many analysts taking pride in doing DCF analysis and “sum-of-the-part” valuations. Theoretically, DCF is very right and I also love to do it – but I hardly attempt to do it practically. This is because how can some analyst sitting in an AC office in a place like Mumbai predict the future cash flows of a company producing something many miles away for so many years into the future? How can somebody calculate the “discount rate” when few months back no analyst or economist was predicting such a phenomenal increase in interest rates? If somebody can’t predict interest rates 6 months down the line with reasonable accuracy then how can it be done 5 years down the line with reasonable confidence? Again, how can somebody predict the market risk premium and the beta with so much confidence when these things are dynamic and changing constantly. How can somebody get the “terminal value” of a business many years or decades in future when the management itself might not be knowing it. When somebody can’t predict the prices of commodities (which are raw materials for some companies while finished goods for others) and interest rates with reasonable confidence how can they predict the earnings and cash flows of a company many years down the line? What majority of the analysts do is that they first decide the target price of a stock and then accordingly change the different variables in the DCF model to get that price! Hence, fundamental factors are of paramount importance in stock market investments but with the caveat that they will not help in getting above average market returns unless combined with other factors.

4)       Technical Factors: Actually speaking, technical analysis begins where fundamental analysis ends. After we fundamentally decide “what” to buy, then we have to technically see “when” to buy and also to sell. Technical analysis is very logical and can give very good insights into price behavior but unfortunately here also most of the analysts do it in a stereotype manner and first decide on what they want and then try to justify how it will come. Market never moves on the basis of what any person wants but on the basis of what it wants to do and where it wants to go. There are different technical tools like moving averages, trendlines, price and volume oscillators, Bollinger bands, candle stick patterns, Elliot wave etc the detailed explanation of all these is beyond the scope of this article but if we study the markets (charts) very closely then infact “it starts talking to us” and gives us signals as to what it wants to do and where it wants to go.

5)       Psychological Factors: Last but certainly not the least, psychological behaviour is perhaps the most important factor in the investment world which separates the successful investor from the novice one. Because here we don’t want to know what we think is right but try to guess what the other thinks is right and even more what other thinks about what others might be thinking is right. And whatever may be our investment style like fundamental approach or technical analysis, we have to actually in practice follow that. I will give one example to explain this point. For example, an investor thoroughly does fundamental analysis on a company and concludes that it is worth Rs.150 while the current market price of the stock is Rs.100. Then he / she goes and buys on that basis. Suppose tomorrow for no fault of the company or deterioration in its business environment but only because of market crash, the stock falls to Rs.75. Then whatever analysis that investor might have done – his / her faith will get shaken. How many of the so called fundamental analyst still have the guts to hold the stock and believe that it is worth Rs.150 in the long term. The same can be true with technical analysis. Hence whatever may be our investment method, the important thing is to follow it and be psychologically strong and sound to do it. I quote Sir John Templeton over here who said that ”to buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward” – this quote explains psychological analysis in a nutshell.

The confluence of all the above factors determine the price of stocks or for that matter any easily tradeable liquid investment. To end I quote the great economist Mr. John Maynard Keynes who once commented that “there is nothing so disastrous as a rational investment policy in an irrational world” and the legendary investor Mr. Warren Buffet said that “stock market is a place where people with money meet people with experience, the people with experience get the money while the people with money gain experience”. Happy Investing!


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  2. Very nice and informative post as in market risk is directly proportional to reward but through proper risk identification an individual can work in proper manner. Equity tips