Many readers have asked a very pertinent question, viz., "why
the stock prices are not reflecting the economic reality?" It is a common
knowledge that the outbreak of COVID-19 pandemic and consequent socio-economic
shutdown has caused extensive damage to
After pondering over this question for many days, I have reached
the following conclusions:
All financial assets (Bonds, Equity, MF Units, Derivatives etc.)
have two clear 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 any underlying business or
asset.
- 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 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 the 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 etc.), 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 etc. The price at which the stock is trading on the stock
exchanges would be least of his concern.
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 day to day basis would be least of his
concern.
- 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 intent of selling these securities at a higher price at some point in future, he is a trader, dealing in securities as commodities. He is concerned with the day to day market price of the security.
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 the 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 shut down, credit freeze etc.) significantly
impact the market prices. The day to day prices usually have little or no
connection with real economy.
In 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.
Similarly, 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. I
wonder how could someone be termed as an investor or lender if I have
absolutely no control over the security or asset I am buying or the entity I am
lending to?
Also, consider if a fund manager tells you that I will interest
in these five businesses and hold it for next 20years regardless of the market
price of their stock, and charge you 2% every year for holding stock on your
behalf. 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.
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 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 realized less money because
supply was more than demand on that particular day.
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.
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