One is normally encountered with the question of what moves the stock market? It’s a valid question too. If one is venturing on a long journey such as investing it is important to know what will take market forward or backward.
For an investor in debt, gold or real estate it is not necessary to have these queries. In case of debt, the investor is more interested in the credit rating of the instrument and then the returns which are relatively assured. In case of gold, investors in the shinning metal do it with an intention of holding it for a long time. For real estate, the investor is happy with early monthly rentals as real estate property sooner or later moves higher, that is assuming that the purchase is meant as an investment and not as a place of residence.
But when it comes to stock markets or individual stocks an investor would like to be certain of what are the factors that will drive it. Given the high volatility, it is better to know the risk that is involved before embarking on the journey.
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We shall look at the factors that drive stock markets.
Demand-supply: One common factor that drives all asset classes and goods that are sold in the marketplace is demand and supply for the particular good. So is the case with the market. Supply and demand determine the way the stock price or overall market moves. If there are few buyers, irrespective of the fundamentals the stock will not move. This is what happens in a bear market. Complete chaos and disbelief result in few buyers despite strong fundamentals. At the same time at the peak of a bull market, there is a huge demand for many stocks.
Fundamentals: Perhaps the biggest reason that attracts smart money and foreign investments in the country or company is fundamentals. If a company or the economy has strong growth prospect will have no problem in attracting money. Everyone wants to ride a winner. Same is the case with investing in markets.
Money follows where there is a potential to earn and gets out of areas where growth tapers or there is a slow down. The growth of the overall economy results in individual companies also growing with it. This is a lethal combination which results in markets moving higher. But growth also brings with it a higher expectation from the participants.
During results season we have seen companies being hammered even when they miss market expectation marginally. Same is the case with the economy. If the overall economic growth is met or is short by even a decimal point we have so-called experts and economists coming out of the woodwork predicting their doomsday philosophy.
But the underlying fact is that growth is one of the biggest parameters that decide the direction of the market over the long term. There can be short-term blips in the movement but the long-term direction of the market is decided by overall growth.
Liquidity: There is no point having a vehicle with a high horsepower if one does not have enough fuel to run it. For stock markets, the fuel is liquidity or availability of funds. Funds can come from a retail investor, domestic mutual funds or foreign investors. Drying up of funds results in lower liquidity which makes it easier for manipulators to play the market according to their liking.
Nonetheless, liquidity is one of the important factors for big investors. Getting in the market is easy, it’s the getting out which requires enough liquidity. While liquidity provided by retail investors and domestic mutual funds is good, the big money and boost to the market comes from foreign investors.
Foreign investors bring in their money to a country in various forms. Some would invest in the debt market trying to cash in on the interest rate differential in their country and those abroad. Second are the ones who invest in businesses. Foreign Direct Investment (FDI) or Private Equity firms are the modes of investing directly in businesses. Such investment not only helps corporates grow but also create more jobs and is beneficial for the overall economy. In case the company is listed entity shareholders and investors benefit from such a move.
Finally, foreign money also finds its way directly in the market. For India, till recently foreign money was the biggest reason for market movement. There was a strong correlation between foreign money flow and market direction. But since demonetization domestic investments have replaced foreign money as the main source of market investment.
This, however, does not mean that foreign money does not play an important part in the market movement. As Indian money kept under the mattress dries up and enters the mainstream, Indian markets will once again have to look at foreign flows for directions.
Nearly a fifth of market capitalization in India is held by foreign investors. In the bigger companies, foreign investors are the biggest investors after promoters. Imagine the impact on the market if any untoward development results in money being withdrawn from the market.
While demand and supply can have a medium-term impact on the market direction, growth and liquidity, especially foreign investments are essential for the long-term direction of the market.