Bulls, Bears & Fools

It seems everybody is obsessed with the stock market these days.

Recent media reports have been trying to raise caution, with reason, about the current bullish trend in the Dhaka Stock Exchange (DSE).

Much of financial news media focuses on the behavior of stock market prices, so perhaps it’s understandable that people believe that stock market prices are a reflection of real economic performance. However, one thing must be made abundantly clear: the stock market is not, repeat not, the economy (sometimes referred to as the “real” economy) and vice versa. The DSE is not necessarily a barometer of the state of our economy, nor does either one necessarily dictate or inform the other. There is no direct cause and effect relationship between the two. In fact, most of the time, the relationship between the two is at best unpredictable and cannot be reasonably ascertained.

This has important implications for policy makers, market managers, and individual investors. For policy makers, there needs to be a clear appreciation between policies that stimulate the economy and policies that stimulate the market. Even developed nations have made muddled policy decisions by conflating the two.

It is worrying to see journalists, analysts, policy makers, and university professors sometimes muddying the issue rather than clarifying it, getting us all caught in a further web of confusion.

In a developed economy with established and accessible capital markets, one could tentatively hold the proposition that stock market movements may be a leading indicator of what the economy might do in the future since stock prices are determined by supply and demand forces that are dictated by large numbers of informed people who are essentially making a bet on the future performance of a company in the context of the real economy. Therefore, the general stock index of the DSE, the DGEN, is an indicator of the expectations of financial capital, but it moves up and down for a variety of reasons, the majority of which often have nothing to do with the profitability or productivity of the underlying enterprises represented by the stocks (e.g., international trade forces like garment export quotas, etc.) or economic forces like the price of oil.

But we don’t have a developed economy. And our stock market is comparatively small, with a handful of companies that probably account for the majority of the stock turnover each day. Therefore the price movements of a few companies lead to large swings in the aggregate index of the DSE. I’m guessing that the top 10 or 20 companies, or certain volatile sectors like banking or construction, might account for as much as 50% of the turnover on an average day. Furthermore, most of the trading volume is probably due to institutional investors (e.g., banks) looking to get rid of excess capital liquidity. I have no data on this, just a gut feeling.

Also, while I again don’t have the hard data to prove it, I would venture a safe guess that the publicly traded corporate sector (i.e., those that have floated shares on the market) contribute significantly less to national income than the non-corporate sector. By which I mean: agriculture (which contributes upwards of 25% of our GDP and involves 70% of our population), retailers, wholesalers, the service and hospitality industry, the so-called “informal” economy, etc. In fact, I’m guessing that if our entire publicly traded corporate sector were to vanish overnight, strictly speaking, our economy would lose very little income.

Except, of course, the knock-on effects on certain people’s individual wealth (and therefore consumption) and psychology (e.g., confidence) would be disastrous. But that has nothing to do with stock market prices per se, but has to do with the loss of employment and income of many people. In the end, we should ask what percentage of Bangladeshi households have any investment or exposure in the stock market? How many people actually own shares? How many people actually have their savings linked to stock market performance? Again, I don’t have the hard data, but I would venture it’s a very low number.

Sometimes it is argued that stock market activity reflects investor confidence which in turn impacts actual, real investment in the economy. But again, I would venture that the hard data would show very little correlation between the movement in stock market prices and the actual investment in our economy over the last decade or so. The current rally in the stock market, after all, is a very recent trend.

In a developed and well-functioning economy that has a developed and responsive capital market, you could also argue that the stock market helps channel private savings into the economy, i.e., when companies use the stock market to raise capital to fund investment in machinery, employment, growth, etc. But again, how many people channel their savings into the stock market, how many companies are listed on the bourse, and how much does the publicly traded corporate sector contribute to our national income? I may be entirely wrong, but my gut feeling is that it’s not much when compared to our total savings. I would guess most of our savings are in government bonds, bank savings accounts, insurance and provident funds, and cash stuffed in mattresses and our grandmother’s almirahs. I could again be wrong.

Clearly, smart investors should tread carefully when stock prices start exceeding the underlying fundamental value of a stock (i.e., financial statement data other than the trading patterns of the stock, e.g., cash flow, return on assets, capital management, etc. that determine the intrinsic value of the stock).

But you can’t characterize stock market activity as “abnormal” or “unhealthy”. The market simply is what it is. In fact, booms and busts are rather “normal” and to be expected, and such vigor in market capitalization and trading activity might even be an indicator of good healthy markets.

If one were to grossly oversimplify finance, it could be said that finance comes down to two basic and primary concepts:

1. The time value of money
2. The greater fool theory

The first, simply put, is that a taka today is worth more than a taka tomorrow (since you could invest that taka today and earn a return on it by tomorrow). The second concept, again simply put, is that investors can ride a wave of market optimism and invest in questionable securities in the hopes of finding a “greater fool” who they can sell it to in the future.

I’m not sure about the sophistication of our average investor (the few that there are), but I suspect our current speculative bubble (and it most probably is a speculative bubble) is due to (a) a surge in new and unsophisticated investors chasing perceived high returns without understanding how the market or valuation works, (b) large institutional investors trying to divert excess liquidity from what they perceive as our other sagging economic sectors, and (c) the greater fool theory.

Of course, the bullish rally will continue as long as everyone keeps believing in greater fools (and maybe become fools themselves). And of course, the bubble will certainly burst one day, it’s inevitable. One can only hope that when the music stops, everyone finds a chair.

Regardless, appeals to rationality and fundamental analysis are probably going to fall on deaf ears. The least of the reasons being that people aren’t always rational and most don’t bother analyzing what little fundamental data is available to us in Bangladesh. Markets have always been prone to “irrationality” and speculation. There is plenty of bad news about our economy without having to resort to the kind of alarmist and obscurantist coverage of the stock market as given by our mainstream media. The media should not only cover the potential reasons for why we’re in a bubble, but maybe try and prepare the general public for what happens when such bubbles burst. For in the end, while a handful of people make gains during a rally, almost everyone suffers repercussions from a crash.

I’ve made many claims here in this longish post, and unfortunately without much hard data to my credit. However, I will make one last proposition. You should only be mildly concerned about the state of our real economy just because a few investors are acting in an “irrationally exuberant” manner in the stock market. The “real” economy depends on a lot more than just the returns on financial capital in the stock market.

The time to start worrying is when real signs of economic activity start to slow down, like construction of new apartments, when your corner shop starts closing, or if all of a sudden our myriad and near-identical shopping malls stop selling so much of whatever it is they sell all day. To be fair, that is increasingly evident, let’s not forget that our declining exports, declining local investment, deteriorating law and order, sagging investment climate, etc. are causes for real concern. Most Bangladeshis and the current government should worry less about the stock market and worry more about managing and reforming the real economy with sound policy that provides incentives for productive investment in our economy.

Failing that, maybe in the end we will all be made the greater fools.

-Bf