Disclosure: The article was first written on Sunday, November 21, 2010 at 11:45pm. It reflects the writer's personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.
Why do we need stock indices?
Have you ever wondered why we need a stock index? It took me quite a while to understand what a stock index is and why we need it. Everyday a number of stocks go up and a number of stocks go down. The index is a mathematical calculation used to understand whether the market as a whole went up or went down. The popular indices that we have in Bangladesh (DGEN DSI) are “market capitalization” weighted indices which means that they put more importance to the price movement of larger companies rather than smaller ones. This is exactly why you see the index move by a greater amount when large caps like Grameenphone or the “banking sector” moves.
The index gives us a benchmark to compare our returns with the market returns. For example if I say that I made a 100% returns in 2010, it might sound super impressive. But given the fact that all stocks on average increased by close to 100% in 2010 it sounds quite normal because I barely beat the market. Furthermore, the additional information that corporate earnings would probably increase by a maximum of 25% makes the situation even riskier.
The conclusion from the above discussion is that I can only be considered a good fund manager/investor if I can consistently get a return above the market indices. Now comes the bad part. The indices that are available to us (DGEN, DSI etc) are absolutely incorrectly calculated. So, there is no way we can compare performances. Until and unless the calculation is corrected, we cannot compare our performances.
Stock market cycles and long term average returns
Whatever I write I tend to come back to macroeconomics somehow. The economy usually moves in cycles. So sometimes you have a situation when the economy is growing strongly, unemployment is low, inflation starts picking up etc (so Interest rates also start rising). Then we also have the other extreme when the economy is in a recession, unemployment is high, prices start falling (deflation) and interest rates are low. In between there are transition periods.
Similar to economic cycles, stock markets also move on cycles. Usually we see stock market cycles move in a similar pattern to the economic cycles but it is not necessary that this will happen every time. During periods of bull runs the investors are highly optimistic and are willing to pay a high price for shares and hence the market P/E ratios are high. The strong faith in the market brings stock prices to such a high level that is far beyond their stocks “intrinsic value” (true value). So naturally the next phase is the bearish one when stock prices steadily fall and the panic button starts ringing causing investors to sell shares even at high losses. So suddenly, despite the blind faith in the market the investors lose a lot of money causing their confidence in the market to fall down to tatters. This is the period when market volume falls to extremely low levels and most stocks trade at bargain prices. It usually takes quite some time for the confidence in the market to come back.
The reason I took so much time to explain these cycles is to explain that ultimately capital market performances are driven by macroeconomic performance. When the macro economy performs well, the corporate earnings improve and thus stock prices increase. However, there should be some sort of uniformity between these variables. Many a time stock prices move far ahead of earnings (like in 2010 stock prices in Bangladesh increased by around 90% while earnings growth would be around 20-25%) which is why we see some sort of correction (I am referring to fall in stock prices).
The interesting thing that we notice is that stock markets tend to overreact on both positive and negative news. When earnings were growing 20-25% stock prices grew 90% and when the correction should have been 10-15% they might fall by 20-25% or even more.
The part which most people overlook is that, if you take a 5-10 year period the average return you get should more or less be similar to the growth of earnings. I have used some dummy numbers to show the stock market returns for 5 years over two different scenarios.
Scenario 1 (Prices moving ahead of fundamentals and then subsequent correction):
65%, 100%, -30%, 0%, 10%.
Scenario 2 (Steady and stable increase in price and earnings):
20%, 20%, 20%, 20%, 20%.
You might be surprised (Some of you may not though) that the returns under both these situations are identical at the end of the fifth year. However, under scenario 1, there are many other adverse impacts. I can think of a couple of them at the moment
1.People might lose faith in the stock market for a prolonged period of time. We saw that after the 1996 stock market crash in Bangladesh.
2.Equity financing will become less attractive because they will get lower price for their shares (far below true value).
All of this suggests that a steady and sustainable growth in stock prices backed by “core” earnings growth is much better compared to a boom and bust. But reality is that the world is not a textbook full of theories but a place where people’s emotions have more (probably way more) importance than rationality and logic. So, we will continue to experience such ups and downs in the stock market. And in such a market to judge our performance we should not look at absolute returns but compare our returns with the broad market index.
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