We all are well aware that equities are volatile, that is they change prices and valuations frequently. In the short term the reasons could vary widely, ranging from news headlines to events and speculative forces. But these do not prevail and fundamentals always become the drivers.
What are some of these that we should be aware of? Firstly, it is proven that stock prices follow earnings growth. When investors are optimistic on earnings growth, prices move up and vice-versa. Hence markets moved up in spite of the pandemic because investors anticipated profits of businesses to grow and they did. But they do not go perfectly in lock-step; they generally move ahead in anticipation (mostly) and some (a smaller proportion) in retrospect. The charts below show how the Nifty’s movements can be related to aggregate earnings growth of the Nifty 50 companies.
The second critical driver is flows. When the flows are large, signifying high interest in buying, prices get driven up easily, and when there is an exodus, prices fall as easily and sometimes with greater ferocity. The different rates could be because fear is a greater driving emotion than greed!
Flows need to be seen with a global context because money is allowed to move freely for investments across borders. Global liquidity has been on an upswing ever since 2008. Liquidity infusion by central banks began with the need to support the economy post global financial crisis and has been increasing with the same mission ever since. Measured easily as the increase in the Fed’s balance sheet which was at USD 3 trillion post GFC, it has jumped to USD 8 trillion post pandemic.
Liquidity looks for profitable investment and hence markets globally have benefitted by this excess liquidity. Domestically, the table shows how inflows and outflows have affected the market.
Flows in turn are affected by sentiment in the short term and earnings growth in the long term. Fear of how the pandemic would weaken economies drove flows in the last year and still continue to be a factor. Another factor that forms part of the decision-making process is currency, which in turn depends on interest rates and inflation. Hence the strength or weakness of the USD is a prime determinant. A weak dollar benefits emerging economies, and so does a higher risk appetite. We have seen evidence of this in the last few months. The course of these flows to emerging nations can change if the USD strengthens due to higher interest rates and investors believing then that the USD offers a higher risk adjusted return.
All these factors together get reflected in the market pricing, valuations and of course volatility. There is a volatility index called the VIX that reflects the fear or complacency of investors. The chart illustrates how the index was at a high during the pandemic, reflecting fear and falling to lows on confidence that things can be managed and will be ok.
T. Srikanth Bhagavat
Managing Director & Principal Advisor
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