Bernard Baruch, an American financier and stock investor, once said that the main purpose of the stock market is to make fools of as many men as possible. Quite true, especially for those who fancy themselves expert jockeys confident of riding this wild horse known as the equity market. It is one thing to not be an expert but quite another to dabble in the unknown with blinkers on.
This is a down-to-basics article that presents you with five factors that eventually drive the equity market.
1) Inflation
It is the general rate at which the prices of goods and services rise in a country. In India, the Wholesale Price Index, or WPI, and the Consumer Price Index, or CPI, are the two most popular indicators which represent this rise in price level. As their nomenclature suggests, the former presents the rise in price level of various goods at the wholesale level while the CPI, which is a later addition, is popularly called ‘retail inflation.’
The desired level of inflation differs given an economy’s state of development. In times of economic calm, developed economies experience lower rates of inflation compared to their emerging peers. Sustained levels of moderate inflation are necessary for an economy to grow. However, high inflation is not a desired state of affairs and leads to higher interest rates, which is the next factor to look at.
2) Interest rates
The role of the central bank is to implement a monetary policy that is conducive to growth and employment, manage the country’s money supply, as well as promote stability of the country’s financial system. The bank uses various tools and actions to achieve these goals. One of them is to influence the rate of interest by moving the short-term interest rate, typically the overnight interest rate in the interbank market. Expectations of future short-term interest rates then determine long-term interest rates.
A sustainable level of inflation relieves the central bank of the worry of managing it with a hawk’s eye. This results in an easy monetary policy which yields softer interest rates. These, in turn, lead to banks and financial institutions lowering their own lending rates, thus making it cheaper to borrow. Since deposit rates go down as well, lower interest rates fuel spending and encourage businesses to invest more, which increases the credit growth in a financial system.
If inflation remains persistently high, then the bank will maintain a higher interest rate. A high interest rate is not conducive to growth since it makes borrowing expensive. So consumers will take lesser amount of loans and spending will not be as high. Businesses too will go slow on taking loans to expand and credit growth drops. Let’s look at credit growth.
3) Credit growth
Credit growth represents the demand for loans from the public and private sector and individuals. When credit growth is on the rise, it indicates that businesses are borrowing more and expanding which, in turn, creates jobs and increases revenue and profits.
The rise in credit is crucial for the growth cycle in an economy to set in. This happens as it tends to cause the price of assets such as stocks to increase, thus boosting the net worth of people. And this rise in asset prices gives their owners more wealth which can be used as collateral against which further borrowing can take place. An improvement in the economic outlook helps increase the credit offtake, which, in turn, helps in boosting the economy.
4) Corporate profits
Business can make use of the easy and cheap availability of credit by aggressively investing in their infrastructure and/or upgrading their services. Since cheap loans also make it attractive for consumers to make big ticket purchases today instead of waiting for tomorrow, corporates can see a rise in revenues and profits. Corporate profitability, which is often represented by EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), is a key factor studied by analysts while projecting the performance of companies and assessing their stock’s value.
5) Valuations
As stated above, consistent increase in EBITDA in quarterly results generally means a brighter future for a company. This information is vital for stock analysts who make use of it in their future revenue projections of companies. This further feeds into their models which arrive at a valuation for the firm in question.
Hence, an increase in profits can lead to an upward revision in their stock prices and consistent strong performance further propels the price. If this rising trend is general, then most of the listed companies will see a rise in their stock price. This pushes the broad market stock indicators like the Sensex and Nifty higher. Translation: You make money.
To sum it up, lower inflation leads to lower interest rates. This boosts credit growth and leads to EBITDA margins improving resulting in earnings acceleration.
Equity investing is inherently interesting and can be very rewarding if done judiciously. Though the arena is extensive and the information available may seem daunting to digest, one should not feel put down by the volume of information and technical details. Sometimes, information about key drivers is sufficient to make informed and rewarding decisions. And whenever you’re feeling bogged down, remember what Peter Lynch, the celebrated fund manager and investor said: "Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it."