Stock exchange developments: Why such a big fuss? When stock exchanges around the world tumble, they make headlines. One wonders whether it is all fuss for nothing or whether one should be really concerned. In an ever financially integrated world, what happens on international stock exchanges such as the Dow Jones, the NASDAQ and the FTSE, among others, can indeed influence everyone’s life, not just the super rich! When investors buy shares they do so on the understanding that the money they are forking out will entitle them to future returns in the form of dividends and / or capital gains. Therefore, how much they are willing to pay for a share in a particular company depends on the growth prospects facing that company. Accordingly, brighter expectations of higher dividends and / or upbeat expectations about the future share price movements trigger an immediate increase in demand for that company’s shares. This translates into an immediate rise in the share price, turning into a self-fulfilling prophecy. By the same logic, falling share prices imply the opposite. They are interpreted as a sign of negative things to come. Outright pessimism and downward reassessment of future prospects lowers the current demand for shares resulting in sell-offs. In the financial jargon this translates into a switch from a bullish to a bearish market. Falling share prices can create a domino effect on the whole economy. Firms may delay their future investment plans as more pessimistic sales forecasts would not make some projects financially viable. At the same time, tumbling share prices reduce the company’s own collateral, limiting to an extent its ability to borrow to finance investment projects. Lower investment translates into a lower stock of capital in the economy with a detrimental impact on the country’s future growth potential. Share price movements do not affect only businesses but also consumers. On one hand, falling share prices, particularly if compounded by high volatility, create more uncertainty, which consumers might react to by cutting their spending. This impact is further magnified by the fact that, people who actually own the shares whose price has declined, experience a reduction in their wealth. Overall, this translates into depressed consumption levels in the economy. So if lower share prices can exert such negative effects, does it mean that higher share prices are always a bonanza? Unfortunately this is not the case. If over a prolonged period of time, share prices keep rising at a much faster pace than would be justified by economic fundamentals, say the genuine rather than perceived (or hoped for!) future profitability of the company, this translates into a financial bubble. The latter happens when share prices reach levels considered to be too expensive when compared to the future returns that they are expected to generate. Such a situation may persist for a long period of time but at some point the wake up call will arrive. Investors will realise that the prices they are paying for the shares are not justified by the underlying company fundamentals. Investors then try to offload their holdings of shares, triggering a sell-off, with a consequent drop, possibly abrupt, in share prices. It is indeed difficult for policy makers to judge developments in stock exchanges, as both the ups and downs have their potential positive and negative side-effects. There is so much to comment on, and unlike physics, things are more open to debate and contrasting views. After all, trade takes place on stock exchanges because different investors have different expectations about the future. Ex-ante, both the buyer and the seller expect to make a gain. Ex-post it may be a different matter!
Posted on: Wed, 19 Jun 2013 19:19:57 +0000
Trending Topics
Recently Viewed Topics
© 2015