Thursday, September 18, 2008

Why Do Stock Markets Crash?

Stock markets crash because investors have arrived at a state of disbelief in their investment valuation as evidenced by the collapse of banks. There is a double whammy.

Normally, stocks are properly valued with respect to their investment prospects based on real sector activities such as doing research and producing goods and services and selling them. If they believe that a 10% pa rate of return is reasonable, then a p/e of 10x is reasonable. If they want a 8% pa rate of return, then a p/e of 12.5x. This is assuming a fairly stable and steady stream of income which can only be got from a big corporate which has been in business for sometime - not your young upstart with lots of speculative promises.

There is a chance for stocks to be overvalued when companies make overblown forecasts of their prospective profits with expectations of mega projects. A lot of these things are hot air.

There is a more insiduous mechanism at work. When real businesses are bad and banks have too much deposits, they tend to lend to consumers for the purpose of cars and houses. Real estate is excellent investment for banks because it represents solid collateral - better than a mere good cashflow project. But when banks begin to lend big time to the property sector, you know that the fundamentals of the economy are weak and asset inflation and speculation is going to be main game in town.

As bank loans grow, their prospective income grows and their share prices rise. The stock market index climbs and investors become excited and poured their hard-earned savings into the market - better, they invest and speculate in the market on credit - which could be good for the loan books of banks again. The banks and the stock market enjoy a fruitful conspiracy...

Until the bank customers start having problem repaying. The cycle reverses. Banks collapse, their earnings collapse, and stock prices collapse.

What does one do when this happens. Somebody once said that fortunes are made in bloodbaths. Buy low, sell high. But know your stocks first.

It is high time that we de-focus the discussion of economic policy based on the stock market. Let the stock market die. Focus on building proper businesses. R&D, investments, meet market demand. Do some real work - rather than trying to pull easy cash from the zero-sum stock market.

We have suffered too long from misguided politicians who think that stock market speculation represents the healthy of the economy.

In a perfectly well-managed private sector with a strong balance sheet and careful investment, there is no need for a stock market. In an imperfect world, the stock market is the joker in the pack.

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