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Investor psychology: Is stock market crashing?

18 May 2015 - {{hitsCtrl.values.hits}}

“One of the reasons people hate politics is that truth is rarely a politician’s objective but election and power are.”
- Cal Thomas

The struggle for power might provoke certain individuals to project an incorrect perception to society. Some of these perceptions might even hold an adverse effect on the economy and society. If you are a vigilant investor, you would have come across certain groups misinterpreting the current momentum in the Sri Lankan stock market as a ‘crash’ and thereby implying economic downturn. Hence, it is important to delve into the performance of the market based on factual facts and negate such baseless allegations.

Stock market is ‘not’ crashing
A stock market crash is a concept that is loosely used by people due to their ignorance. Hence, it is important to clearly define this concept. A stock market crash is a significant drop in the total market. In most cases, it results from a burst of a bubble. It creates a situation where the majority of investors are trying to flee the market at the same time and consequently incurring massive losses. Attempting to avoid more losses, investors during a crash engage in panic selling, hoping to unload their declining stocks onto other investors. Panic selling contributes to the declining market, which eventually crashes and affects everyone.
As stated above, a market bubble is followed by a crash. It is similar to the relationship between clouds and rain. Bubbles are like clouds and market crashes are like the rain. Thicker the clouds or the bigger the bubble, the harder it rains.
A classic example is the crash of the New York Stock Exchange in 1929. It destroyed US $ 14 billion in shareholder value and the crash in 1987 on the same exchange wiped out some US $ 500 billion of shareholder value. Based on the aforementioned definition it could be suggested that even the Colombo Stock Exchange faced a similar phenomenon during 2008 and 2011/2012.The market went down by 41 percent in 2008.
These examples highlight the intensity of the term ‘market crash’. It is apparent that the current market conditions can by no means be equated to the phenomenon stated above. If the threshold for a market crash is so low, what would the aforementioned examples be referred as? The problem lies in the terminology used.

Markets move in ‘cycles’

As we know, markets move in cycles. Market cycles are defined as trends or patterns that may exist in a given market environment. Hence, market fluctuations are inevitable. Accordingly, the stock market is currently experiencing a slight drop in prices. It is a part of the cycle.
The investor community usually sees opportunities in market fluctuations. They buy when the prices dip and sell when the prices rise. As Warren Buffet once said investors should be able to look at market fluctuations as their friend rather than an enemy. Investors should profit from folly rather than participate in it.
The All Share Price Index (ASPI) has dipped by only 0.6 percent (40.0 Points) for the current year, while the S&P Sri Lanka 20 Index that captures the performance of fundamentally strong stocks recorded a negligible drop of 0.9 percent (39.0 points).
It is important to question how a 0.6 percent drop in the market could be defined as a crash. If a negligible drop in the market is termed as a crash, what would the 41 percent drop in 2008 be called? It is important to reiterate that the market is not crashing. It is simply cyclic movement of stock prices.
This should ideally be an opportunity for investors to rebalance their portfolio by purchasing shares at attractive valuations.
Investing patterns of foreign investors support this argument. They continue to remain focused on the market. Even though the market has recorded a slight negative growth, the foreign investor contribution to the total market turnover is recorded as 31.0 percent. Foreign investors have purchased shares for the value of Rs.31.8 billion and have sold shares for the value of Rs.26.0 billion during the year, creating a net foreign inflow of Rs.5.8 billion. Net foreign investment of Rs.5.8 billion within five and a half months is impressive and indicates the preference of foreign investors to hold on to their portfolios.
This argument could be further strengthened by inferring in to the growth of net foreign investment. The first five and a half months in the year 2014 recorded a net foreign inflow of Rs.262 million. Accordingly, the net foreign investment has grown by 2,100 percent for the current year as against the same period in 2014.
You will also notice that S&P Sri Lanka 20 Index has decreased by only 0.9 percent during the year. It signals that the market continues to be backed by fundamentally strong stocks. A market that is fuelled by stocks of this nature is usually expected to have a more accurate price discovery mechanism, which is vital for efficient markets.
As stated earlier, a market crash is a result of a market bubble. In the Sri Lankan context, bubbles are mostly fuelled by overtrading penny stocks and overreliance on credit. It is important to note that the market surveillance of the Securities and Exchange Commission of Sri Lanka has revealed that noteworthy incidents of this nature are not recorded. This observation negates the baseless argument of a market crash.
The smooth function of a stock market will require confidence of investors and organisations. Two Initial Public Offerings (IPOs) were recorded for the current year. The market was able to attract only three IPOs by May 13, 2014, in spite of the positive growth experienced last year.
Investors enter the market to obtain capital gains and dividends. The dividend yield has remained at 2.1 percent since 2014, indicating that stock market returns are still lucrative. Attractiveness is expected to increase amidst falling interest rates.
The downward momentum in the market is not limited to Sri Lanka. India is experiencing a robust growth. Yet, it is interesting to note that both the National Stock Exchange of India (NSE) and Bombay Stock Exchange (BSE) have recorded growth of 0.7 percent and 0.6 percent, respectively. This price movement can be attributed to market cycles. Even the Karachi Stock Exchange has dipped by 0.6 percent. Vibrant economies such as Vietnam and Thailand have also experienced negative growth for the current year. Short-term fluctuations in the market cannot be misinterpreted as a market crash or economic downturn.

Markets are driven by ‘external factors’

According to the Elliott Wave Theory, market cycles are a result of investors’ reacting to external factors. He found that the swings of the mass psychology always showed up in the same repetitive patterns.
Accordingly, the political ideology of citizens and the political state of affairs in a country could affect the psychology of investors. This would be reflected in price movements. Historically, market volatility increased during pre/post elections in Sri Lanka as well as during political transition. Thus, this particular trend helps us to understand the current market momentum.
The presidential election that concluded early this year paved the way for political transition and Sri Lanka is also expected hold parliamentary elections in the near future. In such state of affairs, it is natural for the market to experience relatively slow momentum. This could not be interpreted as a crash.
It could be postulated that the market would once again experience an upward trend once the election is held and the government spells out its policies.
The relationship between politics and equity markets is witnessed even in developed markets. Experts believe that the parliamentary election in the UK that concluded last week would have had an impact on the equity market. It was interesting to note that the FTSE 100 Index experienced volatility and short-term market fluctuations during this period.
The prices decreased since the beginning of May 2015 and reversed upward after the Conservative Party was re-elected on May 7, 2015 (Chart 1). One could also argue that the price movements would have been slightly different if the UK witnessed political transition. The aforementioned phenomenon could be explained further if we look at a longer time horizon (Chart 2). Stock prices showed an upward trend until April 2015 and the trend reversed there on. The market witnessed a negative trend until May 7, 2015 and once again bounced back.
The aforementioned factual information reveals that the Sri Lankan stock market is not crashing. The slow momentum and a slight dip in the market can be attributed to the current political environment. We should not forget that we experienced political transition and it is natural for this shift to be reflected in the psychology of the masses. The current trend in the market is expected to reverse once the political state of affairs falls into place.

A ‘lie’ can run round the world before the ‘truth’ has got its boots on
Citizens should take responsibility for their statements and be mindful about what they say in public. It is advised that people share their opinions based on factual information. On the other hand, investors should act wisely and never accept anything at face value. Perhaps you would miss out on valuable investment opportunities if you blindly accept what others say.
“What you don’t see with your eyes, don’t witness with your mouth.”
Jewish Proverb

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Investor psychology: Is stock market crashing?

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