How to understand the market crash

We live in an interconnected and interdependent world. The Indian stock market is not a lone Jack falling sharply; Many Jills come stumbling after. Stock indices around the world are in decline, compared to the end of 2021.

The US S&P 500 fell 9.8% in the first week of May from its level on December 31, 2021. The Nasdaq Composite was down 17.1%, and that includes all stocks on that exchange, indicating that the decline in stock prices is broad-based

The Shanghai Composite fell 16.3%, the Shenzen Composite 25.7%. The euro zone index fell 13.3%. The Korean Kospi fell more than 10%. Some markets such as Malaysia and Indonesia managed to maintain their levels and grow, although Japan’s Nikkei 225 fell 6.9%. Morgan Stanley’s Emerging Markets Composite fell more than 13%, two percentage points more than the drop in developed markets.

It can be comforting to know that we have company in misfortune. That still doesn’t explain why it all falls apart. An important factor is the withdrawal of monetary and fiscal policies from their expansionary and extra-accommodative stance adopted to cushion the impact of the pandemic on businesses and ordinary people.

Then, the war in Ukraine and efforts by the West to punish Russia have increased levels of uncertainty and inflationary forces, adding to downward pressures on economic growth and stock prices.

In theory, the price of a stock represents the current value of its potential future earnings. In practice, that value is modified by a variety of additional factors. These include liquidity inflows in search of assets to buy for the best possible returns; liquidity outflows in a rush to get out of assets that may no longer be the best bet for returns; expectations of future growth and changes in interest rates; and expectations of turbulence in the markets due to policy changes or adverse political events.

Extremely low interest rates on bank deposits and government bonds can persuade savers to transfer their funds to the stock markets, adding to the investable capital available to buy stocks. This process can and does take place on a global scale.

When policy rates in Europe and Japan were so low as to be zero or negative, it made sense for capital to look to the emerging world for equity assets that offered significantly higher rates of return, even after adjusting for the risk involved. .

Low interest rates don’t drive up stock prices simply by increasing the supply of funds, leaving debt to chase higher returns on stocks: low rates also drive up stock prices directly, via the discount rate lower value used to calculate the present value of future income. $110 in a year is worth $100 today, using a discount rate of 10%. $110 in a year is worth $102.8, if the discount rate is reduced to 7%. The more the discount rate is reduced, the greater the net present value of a future gain. Stock price is the total value of a company’s future earnings, discounted by each year’s earnings to get the net present value. When interest rates are close to zero, as they were in advanced economies until recently, stock prices rise because of the small discount rate used to calculate the net present value of the future stream of income.

Now that central banks have started to raise rates, the opposite trend has begun. Money that had flown out of debt in search of higher equity returns is flowing back into debt, and that liquidation is depressing share prices. Furthermore, as central banks raise policy rates, the discount rate for estimating the net present value of the return on equity rises, further depressing equity prices.

When the US Fed, the largest central bank, whose policies determine the cross-border flows of the largest savings reserves, raised its repo rate by half a percentage point on May 4, the entire interest rate structure of debt instruments in the US rose.

As government bond yields rise, and even if the spread over the yield of this risk-free instrument (the risk premium) on other debt remains unchanged, everything rises to match the change. However, this spread over government bond yields does not remain constant when risks to growth or inflation become apparent. The spread on Treasuries has widened in the US and in other markets as well.

To cushion the impact of the pandemic, some $15 trillion of additional liquidity was created. Now this overworking of money printing machines has stopped. Sucking excess liquidity into the system has not yet started on a large scale. When that happens, share prices should fall further.

The price-earnings ratio or P/E is a good measure of how healthy a stock’s valuation is. Suppose a bond offers a coupon of $100 is priced at $1,000; the price-earnings multiple of this asset is 10. But this is a constant rate of return, which would not increase.

A company may become increasingly profitable and its share price may rise to reflect this increased profitability and offer capital gains. If a company’s future growth prospects are particularly bright, investors would tolerate a much higher P/E and buy a stock at a price that, if invested in safe bonds, would offer much higher and guaranteed returns, and should have been the sensible thing. investment option. So we have, in the recent past, public issues of companies that were sporting a P/E of even 1,000. Investors were happy to take advantage of such offers, with the expectation that the company would quickly improve its profitability and start generating higher returns. Think Tesla, think PayTM.

The P/E of the US S&P 500 was 19.1 on January 1, 2019. It had reached an incredible 35.96 on January 1, 2021, in the midst of the pandemic when economic activity was really low . The reason was that easy liquidity flooded the markets and individual credit accounts.

After the rises in policy rates and the wave of global uncertainty in the wake of the war in Ukraine, money is pouring out of risky assets (stocks in general and stocks in emerging markets in particular) and rushes into the supposed safe haven of US government captivity. On May 11, 2022, the P/E of the S&P 500 had dropped to 19.89.

Sensex P/E had risen above 30 in the recent past, and is now down to a more realistic 22. The flight of foreign portfolio capital has helped to reduce share prices. FPI’s outflow has far exceeded inflows for the entire current year, and FPIs have cumulatively taken out more than $20 billion in 2021. By 2017, they had put in more than $70 billion. During 2019-21, FPI net inflows exceeded $40 billion. These are not large numbers relative to the full market valuation, which, in any decent economy, would be about the same magnitude as GDP. But most stocks are not traded, and FPI money plays an important role in the trading volumes of key stocks that move market indices and is enough to make prices go up and down.

Right now, the risk to global growth from the fallout from the Ukraine war, high energy and food prices, is compounded by the withdrawal of additional accommodative monetary policy in the rich world to make global capital flee. of emerging markets.

The additional liquidity created by the rich world’s central banks will not be recovered all at once: it will take years to sell the assets back to private investors. The liquidity that still circulates will need high-yield avenues. India remains a potential destination. Serious work to ensure strong governance, including social coherence and peace, stable macroeconomic fundamentals, and compelling growth potential can bring markets back to growth, at a more sustainable pace.

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