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How to make sense of the market crash


We live in an interconnected, interdependent world. India’s stock market is not a lone Jack who takes a steep fall; Many Jills are coming tumbling after. Stock market indices everywhere are in decline, compared to the end of 2021.

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

The Shanghai Composite was down 16.3%, the Shenzen Composite, 25.7%. The Euro area index was down 13.3%. Korean Kospi was down more than 10%. A few markets such as Malaysia and Indonesia managed to retain their levels and grow, although Japan’s Nikkei 225 was down 6.9%. Morgan Stanley’s Emerging Market Composite was down more than 13%, two percentage points more than the decline for the developed markets.

It can be comforting to know that we have company in misfortune. That still does not explain why everything is coming down. One major factor is the withdrawal of monetary and fiscal policies from their extra-accommodative, expansionist stance adopted to cushion the impact of the pandemic on companies and ordinary people.

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

In theory, the price of a stock represents the value today of its potential future earnings. In practice, that value is modified by a variety of additional factors. These include inflows of liquidity in search of assets to buy for best possible returns; outflows of liquidity in a hurry to exit 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 markets due to policy changes or adverse political events.

Extremely low rates of interest on bank deposits and government bonds can persuade savers to switch their funds to the equity markets, adding to the investible pool of capital available for buying 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 scour the emerging world in search of equity assets that offered significantly higher rates of return, even after adjusting for the risk involved.

Low rates of interest do not push up stock prices merely by increasing the supply of funds leaving debt to chase higher returns in equity: low rates also directly push up stock prices – via the lower discount rate used to compute the present value of future income. 110 a year from now is worth 100 today, using a discount rate of 10%. 110 a year from now is worth 102.8, if the discount rate shrinks to 7%. The further the discount rate shrinks, the greater the net present value of a future earning. The stock price is the total worth of a company’s future earnings, each year’s earning discounted to get the net present value. When interest rates are close to zero—as they were in advanced economies until recently—stock prices go up because of the very small rate of discount applicable to calculate the net present value of the future stream of incomes.

Now that central banks have begun raising rates, the opposite trend has started. Money that had fled debt in search of higher returns in equity is returning to debt, and that sell-off is depressing stock prices. Further, as policy rates are raised by central banks, the discount rate for estimating the net present value of return on equity goes up, depressing share prices further.

When the US Fed, the most important central bank, whose policies determine the cross-border flows of the largest pools of savings, increased its repo rate by half a percentage point on 4 May, the entire structure of interest rates on debt instruments in the US went up.

As the yield on government debt goes up, and even if the mark-up over the yield on this risk-free instrument (the risk premium) on other debt remains unchanged, everything goes up to adjust to the change. However, this spread over government bond yield does not stay constant, when risks to growth or inflation manifest. The spread over Treasuries has been widening in the US and other markets as well.

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To cushion the impact of the pandemic, some $15 trillion of additional liquidity was created. Now, this overworking of the money-printing machines has been halted. Sucking out the excess liquidity in the system is yet to commence on any large scale. When that happens, stock prices should fall further.

The price-to-earnings ratio or P/E is a good measure of how sane the valuation of a stock is. Suppose a bond that offers a coupon of 100 is priced at 1,000; the price-earning multiple of this asset is 10. But this is a steady rate of return, which would not go up.

A company can become increasingly profitable, and its share price can go up to reflect this increased profitability and offer capital gain. If the future growth prospects of a company are particularly bright, investors would tolerate much higher P/E and buy a stock at a price, which, if invested in safe bonds, would offer much higher, assured returns, and should have been the sensible investment option. So, we have, in the recent past, public issues of companies that sported P/E of even 1,000. Investors were happy to lap up such offerings, in the expectation that the company would improve its profitability rapidly and start generating higher returns. Think Tesla, think PayTM.

The P/E for the S&P 500 of the US was 19.1 on 1 January, 2019. It had reached a crazy 35.96 on 1 January, 2021, in the middle of the pandemic when economic activity was really down. The reason was easy liquidity flooding the markets and individual credit accounts.

After hikes in policy rates and the wave of global uncertainty in the wake of the war in Ukraine, money is flooding out of risky assets — stocks in general and stocks in emerging markets, in particular — and rushing into the deemed safe haven of US government bonds. On 11 May, 2022, P/E for the S&P 500 had come down to an earthly 19.89.

Sensex P/E had climbed to more than 30 in the recent past, and is down to a more realistic 22 now. Flight of foreign portfolio capital has helped tamp down stock prices. FPI outflow has been far in excess of inflows all through the current year, and FPIs have cumulatively taken out more than $20 billion in 2021. In 2017, they had brought in more than $70 billion. Over 2019-21, net FPI inflows were more than $40 billion. These are not large numbers in relation to the total valuation of the market, which, in any decent economy, would be roughly of the same magnitude as GDP. But the bulk of the shares are not traded, and FPI money plays a big role in traded 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 of the Ukraine war, high energy and food prices, joins up with the withdrawal of extra accommodation of monetary policy in the rich world to make global capital flee emerging markets.

The additional liquidity created by the central banks of the rich world will not be taken back all at once – it will take years to sell assets back to private investors. The liquidity that still circulates will need avenues of high returns. India remains a potential destination. Serious work on ensuring there is sound governance, including on social coherence and peace, stable macroeconomic fundamentals and compelling growth potential can make the markets grow again, at a more sustainable pace.

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