172@29@17@247!~!172@29@0@53!~!|news|trends|expert-columns-2|decoupling-of-real-economy-from-markets-why-stock-prices-dont-reflect-economic-reality-5311021.html?utm_source=MC_OpeninApp!~!news|moneycontrol|com!~!|controller|infinite_scroll_article.php!~!is_mobile=false
Moneycontrol
Subscribe to PRO at just Rs.33 per month. Use code SUPERPRO
Last Updated : May 25, 2020 03:25 PM IST | Source: Moneycontrol.com

Decoupling of real economy from markets: Why stock prices don’t reflect economic reality

The resilience of stock markets in light of COVID-19 uncertainty has left many market participants perplexed.

The global order arguably has never faced so much uncertainty in the past 75 years of post-WWII period, as it faces presently. The way people work, travel, socialise, live, eat, and communicate are all set for major changes. The global strategic and trade relations face the prospects of a dramatic paradigm shift. In these circumstances, it would be highly imprudent to mark any eventuality as improbable or unlikely. In fact, today nothing looks outside of the realm of possibilities. The "change" is the only certain thing, in these times of increasing uncertainties.

The resilience of stock markets in light of this uncertainty has however perplexed many market participants. The divergence in the stock indices and real economy has raised many questions.

One of the pertinent questions is "why the stock prices are not reflecting the economic reality?" After pondering over this question for many weeks, I have reached some conclusions.

Close

Real economy-stock market divergence is not new

It is important to note that the divergence between real economy and stock markets is not a novel phenomenon. It has perhaps existed ever since the financial market started functioning.

In the past 50 years alone, we have seen multiple instances of such divergence.

For example, consider the period between May 1990 and December 1990.  It was a watershed in the global social, political and economic order. In the seven months, the world changed the most in the post-WWII era. For India also that was a defining period in the post-independence history.

In the global context, some of the key events that took place in those seven months included:

(a) Apartheid ended in South Africa, marking the end of one of the darkest chapters in world history.

(b) The 44-year-old Cold War between two superpowers ended with a treaty to destroy chemical weapons and most of the nuclear arsenal; and the process of USSR dissolution began with the Supreme Soviet of the Soviet Union granting Mikhail Gorbachev special powers to secure the Soviet Union's transition to a market economy. This marked the end of a bipolar world that had divided the world into two camps in the post-WWII era. In the subsequent two decades, the USA would reign over the world as the only super power.

(c) Iraqi forces invaded Kuwait. This was followed by the invasion of Iraq by 34 nations in a joint operation, first of its kind in the post-WWII era. This was followed by a long bloody war between the USA and its allies on the one side and radical Islamic forces on the other side. The war on terror thus started still continues, though many key supporters like Saddam Husain, Muammar al-Gaddafi, Osama Bin Laden, etc. have been neutralised.

(d) The reunification of Germany ended more than four decades of separation of German people, healing the post-war wounds. Strengthening of Germany and the end of Margret Thatcher era in Great Britain marked the reemergence of Germany as a leading power in Europe and paved the way for the Maastricht Treaty formally establishing the European Union in 1993.

(e)The WHO removed Homosexuality from its list of diseases, erasing the centuries' old stigma attached to the practice and giving a new dimension to human rights globally.

In the Indian context also many significant events took place changing the course of Indian politics, economics and social milieu forever. For example,

(i) Mandal Commission report was implemented in India, reserving 49 percent of government jobs for SC/ST and OBC in India. This changed the politics of India forever, marginalising the Congress Party and strengthening the regional parties that contested elections on social justice slogan, not poverty elimination.

(ii) BJP President LK Advani undertook a road trip (Rath Yatra) to mobilise support for the Ram Temple in Ayodhya. The VP Singh government falls, after Advani is arrested in Bihar. The BJP rises as the primary challenger in India's national politics. Six years later Atal Bihari Vajpayee would make the first BJP-led coalition government in India that lasted 13 days.

(iii) Chandrasekhar, a socialist leader becomes the prime minister by default and initiates the transition of Indian economy from a controlled economy to free market economy. The job would be carried forward by the Congress government formed in 1991 and subsequent United Front and BJP governments.

(iv) Massacre and exodus of Kashmiri Pundits in January 1990 was followed by firing by CRPF on the funeral procession of Mirwaiz Moulana Muhammad Farooq in May 1990. These events triggered a long intense terror war in the valley, nearly destroying the heaven on earth, which still continues.

While all these events were occurring, the stock markets globally, including India, were doing rather well disregarding all the turmoil, uncertainty and concerns.

Three decades later, the circumstances are almost similar to the summer of 1990. The outbreak of COVID-19 has completely shaken the global economics, politics, geopolitics and social framework. The things look set to change dramatically. But the global stock markets are again doing rather well.

Why this divergence?

I find that all financial assets (Bonds, Equity, MF Units, Derivatives etc.) have two manifestations - (i) Interest in some underlying business (es) or loan to some underlying business with or without a charge on the assets; and (ii) independent commodity without any regard to the underlying business or asset.

Investor in underlying business

When someone buys equity shares of a company with the intent of acquiring an interest in the underlying business of that company, he is considered an investor in that underlying business.

He may use the services of a stock broker or may buy directly from the company or some other shareholder. Such a person is mindful of the price he is paying for acquiring an interest in the business. He usually would not like to pay much more than what he believes is the fair value of that business, based on various parameters like future cash flows, replacement cost of assets, market leadership (product, technology, brand, accessibility), competitive advantages, etc.

This person would be usually concerned with the performance of the company as reflected by the profitability, cash flows, solvency margins, and sustainability. The price at which the stock is trading on the stock exchanges would be least of his concerns.

Similarly, when a person lends money to a business with the intent of earning a regular fixed income over the predefined term of loan, he is concerned with the liquidity, solvency and viability of such a business during the term of the loan. How the yields on benchmark government security or other corporate securities move on a day-to-day basis would be least of his concerns.

Trader of financial asset as a commodity

However, when a person buys a security which is regularly traded on some platform like stock exchange, or buys units of a mutual fund in which the underlying asset is the security regularly traded on some platform, with the sole intent of selling these securities at a higher  price at some point in future, he is in effect a trader, dealing in securities as commodities. He is concerned with the day-to-day market price of the security.

Traders' and investors' interest diverge

The interest in business of an investor is mostly linked to the real economy. Good businesses will usually do well in a growing economy; and these will do relatively better in a declining economy. Nonetheless, during the down cycles of the economy, growth of most of the businesses will slow down.

However, when we consider financial assets as commodities, the dynamics completely changes.

The day-to-day price of stocks or bonds is determined purely by the forces of demand and supply on that particular day. The factors like storage capacity (margin money or loss bearing capacity) and carrying cost (interest rates, forward premiums, etc.) significantly influence the demand and supply. Temporary demand or supply disruptions (ban on short selling, hike in margins, market shutdown, credit freeze, etc.) significantly impact the market prices. The day-to-day prices usually have little or no connection with the real economy.

Present demand-supply dynamics favours higher prices for financial assets

In the past three months, global central banks have added significant liquidity to the global financial system. This additional liquidity is available at near-zero cost. Naturally, the demand for "securities as commodity" is higher due to higher holding capacity and lower carrying costs.

Where do mutual funds fit in?

It was quite challenging to decide where the investment in mutual fund units by small investors and high net worth individuals (HNI) fit in this two-way classification of financial assets. After weeks of contemplation and intense discussions with various market participants, I have reached the following conclusion. I acknowledge that consensus may not agree with my viewpoint. Nonetheless, I am convinced about this.

Mutual fund units are commodities

When someone buys units of a mutual fund, he has no control over the asset or securities underlying those units. It is the discretion (or decision) of the fund manager (or index manager, in case of ETF) that would decide what would be the asset underlying those mutual fund units.

How could someone be termed as an investor or lender if he has absolutely no control over the security or asset he is buying or the entity he is lending to?

Consider if a fund manager tells the investors that I will buy interest in these five businesses and hold it for the next 20 years regardless of the market price of their respective stocks. For this buy and hold for 20 years he demands a fee of 2 percent per annum.

How many investors would agree to this proposition?

Obviously, when you buy units of a mutual fund, you entrust your money to an expert who has a track record of dealing in "securities as commodity". Your bet is on the jokey (fund manager) and not the horse (underlying securities); because you have no clue about or control over the horse. The jokey is free to change the horse any number of times during the course of the race.

Therefore, basically buying mutual units is also trading in "securities as commodity". The gains and losses from this trade are closely linked to the day-to-day demand and supply equilibrium without any regard to the strength of the ultimate underlying business.

The occurrences in the debt mutual funds in past 12-15 months aptly illustrate this point. A debt mutual fund receives a large redemption request (excess supply) on a day when the liquidity in the market is tight. To meet the redemption obligation, the fund manager sells bonds below fair value causing loss to the unit holder. The company who had issued this bond is working perfectly fine and is fully solvent. This phenomenon can only be explained if we treat MF units as commodity, which realised less money because supply was more than demand on that particular day.

In my view, if the market participants assimilate these two manifestations of the financial assets, it would be much easier to navigate through market cycles and business (economic) cycles.

Vijay Kumar Gaba explores the treasure you know as India, and shares his experiences and observations about social, economic and cultural events and conditions. He contributes his pennies to the society as Director, Equal India Foundation. The views are personal. 
First Published on May 25, 2020 03:25 pm
Sections