would enable you to enjoy an array of other services such as Member Rankings, User Groups, Own Posts & Profile, Exclusive Research, Live Chat Box etc.. 
Home
The Stock Market - Only a Correction by R.M.B.Senanayake.
The stock market decline accelerated the week before last and some expected the worst predicting a market crash. But last week after the brokers met the president the market improved and price indices climbed as he promised to do away with credit restrictions. Presumably the forced selling will stop. But will the brokers cause another bubble? They say a market crash and a bubble are like a cloud and rain. You can have clouds without rain but you can’t have rain without clouds; bubbles are like clouds and market crashes are like the rain. Historically, a market crash has always arisen from a bubble and the thicker the clouds or the bigger the bubble, the harder it rains.
There can be no rain without clouds and similarly there can be no market crash unless there is also a bubble. But a market crash is not the same as a market correction. Market corrections are comparatively small being about 5% or so while a crash is much higher. The week before last, the All Share Price Index as well as the Milanka Price Index fell by a little over 5%. This could be considered as a market correction provided the market does not continue to fall as investors panic and sell.
What then is a bubble?
A bubble takes place when the stock prices move far above their intrinsic values or market fundamentals. It arises in the first place because investors or the large majority of them have become speculators. An investor bases his decision to buy a stock only after examining the fundamentals of the company and considering whether the price of the stock is such as to provide him a reasonable return on his investment. The returns from a stock are the dividends and theory has it that the price of a stock should reflect the sum of the discounted values of the dividends which will be paid by the company in the future.
One way of considering whether the stock is worth the price is to look at the dividend yield which is the dividend divided by the market price of the share. If the dividend yield is low the stock may be considered as overpriced. Investors look at another ratio called the Earnings Per Share and its inverse the Price Earnings Ratio. Our market PER was as high as 25 (it means that it will take 25 years to repay the investment by way of dividends if the level of earnings remain the same) when the stock market boomed in 2010. It fell to 15.1 but rose to 16 after the president agreed to remove the restrictions on credit.
What caused the bubble?
Why did the stock prices go up so high? It is because the participants in the market had become speculators and traders rather than investors. While the investor buys low and sells high the speculator buys a stock when it is moving up ( or sells a stock when it is declining hoping to buy back later at a reduced price) and takes profit when it has gone still higher. He may help the upward movement along by deliberately buying up the available quantity of the particular share in the market, expecting others to follow him. Others follow him on the herd instinct. This is helped along by brokers circulating rumors about how good the share is and how much it will move up.
There are allegations that a group of high net worth individuals deliberately pushed up the prices of certain illiquid stocks where the supply in the market at a given time is small and can be cornered. If a speculator corners such small supply he could drive its price up well above its intrinsic value. This seems to have happened and the Securities Exchange Commission apparently found such allegations credible and has investigated them.
The SEC also fixed price bands which prevented a stock from increasing above its upper band. Despite it however stocks moved up and up. But as the price shoots upwards the original speculators who hold the share will sell. But there must be buyers to buy them at these high prices. As the share price rises above its intrinsic value there will be fewer and fewer buyers. But those who bought the share originally hoping it would rise would then find it difficult to sell the shares at a profit since they bought high. There have to be new buyers who are themselves expecting the share to rise some more. But such new buyers will be fewer as a share rises in price way above its intrinsic value.
Credit driven bull market
The brokers gave credit to market participants. They seem to have given credit lavishly ignoring the necessity for equity which any prudent lender would want. There was the 50% margin rule under which a client could only borrow up to 50% of the value of his share portfolio. When the market value of the share portfolio falls the broker was expected to raise a margin call and ask the client to top up the value of his portfolio in cash. Brokers seem to have ignored these prudential limits and provided credit liberally. So with such credit the clients bought into high priced shares expecting their prices to move up further and give them a profit.
But as the supply of new clients dries up the high prices are not sustainable. Then when the brokers were required to stop credit by the Securities Exchange Commission the supply of new speculative buyers dried up instantly. It is then that the prices of the shares began to fall as the brokers had to insist on cash settlement by T+5. (Trade day plus 5). The market was suddenly converted into a cash market. When clients did not pay on T+5, the brokers had to force sell their shares and the market came down.
The SEC had also required brokers to clear debtors who had exceeded the 50% margin value of their portfolios. Brokers had to call upon their clients who were in debt to them to pay up. If they failed to pay up they would have to force sell their shares on which they had a lien. But when broker firms force sell to cover margin requirements or to comply with the SEC rule then the market has to come down. This constitutes the bursting of the bubble.
The Crash of 1929 in USA
The Great Depression of 1929 in USA was preceded by a stock market crash in Wall Street. Subsequently a Committee of the U.S Congress which investigated the crash uncovered evidence that the brokerage firms were giving unlimited credit and investors were buying on credit and reselling to obtain a profit. Many investors had turned out to be speculators rather than long term investors.
It is not known how much credit the broker firms extended to clients and how much of their debts are non-performing. Broker firms themselves are poorly capitalized and when they give unlimited credit they are really creating new money far above their liquid assets. When new buyers were induced to buy overpriced shares on the basis of rumors about their performance or other likely price sensitive events such as a take-over or a new investment by the firm, the whole scenario replicates a pyramid or Ponzi scheme. A bubble is built up on hype and it bursts when new buyers who hold for the long term dry up because the prices are too high. Then the high prices are not sustainable and they begin to decline.
A stock market which bursts can harm not only the individual investor but the economy at large. The stock market collapse of 1929 led to dole queues, soup kitchens and bank collapses. A similar crash took place in Japan in 1990 which led to years of stagnation in the economy. So it is right not to allow a bubble to form. The crash in the Golden Card Credit Company led to contagion which affected several other companies of the Ceylinco Group and to a run on other registered finance companies.
Cheap money the
underlying cause
A huge influx of money has entered the market through individual retail investors who have no understanding of economics or company fundamentals. They bought shares not as long term investors but as speculative traders. They were encouraged by the brokers to buy and sell rather than hold for the long term. The availability of unlimited credit allowed clients to buy beyond their financial capacity - over-leverage. The brokers promoted such trading since they earned commission on business volumes generated.
A crash is a significant drop in the total value of a market, almost undoubtedly attributable to the popping of a bubble, creating a situation where in the majority of investors are trying to flee the market at the same time and consequently incurring massive losses. Attempting to avoid more losses, investors during a crash are panic sellers, hoping to unload their declining stocks onto other investors and cut their losses. Hopefully there may not be panic selling now but prices may decline some more. An orderly correction is needed.
http://www.island.lk/index.php?page_cat=article-details&page=article-details&code_title=40385
The stock market decline accelerated the week before last and some expected the worst predicting a market crash. But last week after the brokers met the president the market improved and price indices climbed as he promised to do away with credit restrictions. Presumably the forced selling will stop. But will the brokers cause another bubble? They say a market crash and a bubble are like a cloud and rain. You can have clouds without rain but you can’t have rain without clouds; bubbles are like clouds and market crashes are like the rain. Historically, a market crash has always arisen from a bubble and the thicker the clouds or the bigger the bubble, the harder it rains.
There can be no rain without clouds and similarly there can be no market crash unless there is also a bubble. But a market crash is not the same as a market correction. Market corrections are comparatively small being about 5% or so while a crash is much higher. The week before last, the All Share Price Index as well as the Milanka Price Index fell by a little over 5%. This could be considered as a market correction provided the market does not continue to fall as investors panic and sell.
What then is a bubble?
A bubble takes place when the stock prices move far above their intrinsic values or market fundamentals. It arises in the first place because investors or the large majority of them have become speculators. An investor bases his decision to buy a stock only after examining the fundamentals of the company and considering whether the price of the stock is such as to provide him a reasonable return on his investment. The returns from a stock are the dividends and theory has it that the price of a stock should reflect the sum of the discounted values of the dividends which will be paid by the company in the future.
One way of considering whether the stock is worth the price is to look at the dividend yield which is the dividend divided by the market price of the share. If the dividend yield is low the stock may be considered as overpriced. Investors look at another ratio called the Earnings Per Share and its inverse the Price Earnings Ratio. Our market PER was as high as 25 (it means that it will take 25 years to repay the investment by way of dividends if the level of earnings remain the same) when the stock market boomed in 2010. It fell to 15.1 but rose to 16 after the president agreed to remove the restrictions on credit.
What caused the bubble?
Why did the stock prices go up so high? It is because the participants in the market had become speculators and traders rather than investors. While the investor buys low and sells high the speculator buys a stock when it is moving up ( or sells a stock when it is declining hoping to buy back later at a reduced price) and takes profit when it has gone still higher. He may help the upward movement along by deliberately buying up the available quantity of the particular share in the market, expecting others to follow him. Others follow him on the herd instinct. This is helped along by brokers circulating rumors about how good the share is and how much it will move up.
There are allegations that a group of high net worth individuals deliberately pushed up the prices of certain illiquid stocks where the supply in the market at a given time is small and can be cornered. If a speculator corners such small supply he could drive its price up well above its intrinsic value. This seems to have happened and the Securities Exchange Commission apparently found such allegations credible and has investigated them.
The SEC also fixed price bands which prevented a stock from increasing above its upper band. Despite it however stocks moved up and up. But as the price shoots upwards the original speculators who hold the share will sell. But there must be buyers to buy them at these high prices. As the share price rises above its intrinsic value there will be fewer and fewer buyers. But those who bought the share originally hoping it would rise would then find it difficult to sell the shares at a profit since they bought high. There have to be new buyers who are themselves expecting the share to rise some more. But such new buyers will be fewer as a share rises in price way above its intrinsic value.
Credit driven bull market
The brokers gave credit to market participants. They seem to have given credit lavishly ignoring the necessity for equity which any prudent lender would want. There was the 50% margin rule under which a client could only borrow up to 50% of the value of his share portfolio. When the market value of the share portfolio falls the broker was expected to raise a margin call and ask the client to top up the value of his portfolio in cash. Brokers seem to have ignored these prudential limits and provided credit liberally. So with such credit the clients bought into high priced shares expecting their prices to move up further and give them a profit.
But as the supply of new clients dries up the high prices are not sustainable. Then when the brokers were required to stop credit by the Securities Exchange Commission the supply of new speculative buyers dried up instantly. It is then that the prices of the shares began to fall as the brokers had to insist on cash settlement by T+5. (Trade day plus 5). The market was suddenly converted into a cash market. When clients did not pay on T+5, the brokers had to force sell their shares and the market came down.
The SEC had also required brokers to clear debtors who had exceeded the 50% margin value of their portfolios. Brokers had to call upon their clients who were in debt to them to pay up. If they failed to pay up they would have to force sell their shares on which they had a lien. But when broker firms force sell to cover margin requirements or to comply with the SEC rule then the market has to come down. This constitutes the bursting of the bubble.
The Crash of 1929 in USA
The Great Depression of 1929 in USA was preceded by a stock market crash in Wall Street. Subsequently a Committee of the U.S Congress which investigated the crash uncovered evidence that the brokerage firms were giving unlimited credit and investors were buying on credit and reselling to obtain a profit. Many investors had turned out to be speculators rather than long term investors.
It is not known how much credit the broker firms extended to clients and how much of their debts are non-performing. Broker firms themselves are poorly capitalized and when they give unlimited credit they are really creating new money far above their liquid assets. When new buyers were induced to buy overpriced shares on the basis of rumors about their performance or other likely price sensitive events such as a take-over or a new investment by the firm, the whole scenario replicates a pyramid or Ponzi scheme. A bubble is built up on hype and it bursts when new buyers who hold for the long term dry up because the prices are too high. Then the high prices are not sustainable and they begin to decline.
A stock market which bursts can harm not only the individual investor but the economy at large. The stock market collapse of 1929 led to dole queues, soup kitchens and bank collapses. A similar crash took place in Japan in 1990 which led to years of stagnation in the economy. So it is right not to allow a bubble to form. The crash in the Golden Card Credit Company led to contagion which affected several other companies of the Ceylinco Group and to a run on other registered finance companies.
Cheap money the
underlying cause
A huge influx of money has entered the market through individual retail investors who have no understanding of economics or company fundamentals. They bought shares not as long term investors but as speculative traders. They were encouraged by the brokers to buy and sell rather than hold for the long term. The availability of unlimited credit allowed clients to buy beyond their financial capacity - over-leverage. The brokers promoted such trading since they earned commission on business volumes generated.
A crash is a significant drop in the total value of a market, almost undoubtedly attributable to the popping of a bubble, creating a situation where in the majority of investors are trying to flee the market at the same time and consequently incurring massive losses. Attempting to avoid more losses, investors during a crash are panic sellers, hoping to unload their declining stocks onto other investors and cut their losses. Hopefully there may not be panic selling now but prices may decline some more. An orderly correction is needed.
http://www.island.lk/index.php?page_cat=article-details&page=article-details&code_title=40385
Last edited by rijayasooriya on Sun Dec 04, 2011 9:27 am; edited 1 time in total (Reason for editing : title corrected and writer's name added.)
