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How to analyze the stock market


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How to analyze the stock market

  1. 1. How to analyze stock market?Stock markets are barometers of the economy. It is expected that the markets and their indicators, inthe form of indices, reflect the potential of the corporate listed on them and, in the process, thedirection and health of the economy. If a country’s economy is performing well and expected to grow ata healthy rate, the market is usually expected to reflect that.Indian economy is increasingly exposed to global markets post liberalization in the early 90s. So beforeanalyzing domestic markets one needs to analyze the Global economy.According to us, to analyze the domestic market, one needs to:Analyze Global Economy, then how it affects the Indian Economy and then comes Sector Wiseassessment and then finally analyzing the Company or the Stock. GLOBAL ECONOMY INDIAN ECONOMY SECTOR WISE COMPANY/STOCK
  2. 2. GLOBAL ECONOMY:-Markets across the world are seeing a lot of short term volatility mainly driven by news and events inthe global markets. The country’s capital market is increasingly influenced by global developmentsbecause of the active participation by FIIs and big corporate growing appetite for global borrowings.For example, news/rumors related to economic recession in USA, soft/hard landing and estimation oflosses due to sub-prime crisis in USA, speculation over interest rates cut by FED, rise in globalcommodities prices, fluctuation in global crude oil prices etc. These are some fundamental reasons whyglobal markets, especially the Indian stock market behave in a volatile manner based on developmentsin global markets.Indian companies are getting involved in exporting their products to global markets, raising funds bylisting on foreign stock exchange. The percentage revenue of Indian companies coming from foreignmarkets is growing year over year. Therefore, share price movements of these companies are morelikely to be affected by the development in world economy. So analyzing global economy is somethingvital.INDIAN ECONOMY:-India is the second fastest growing economy in the world. It is one of the most attractive destinations forbusiness and investment opportunities due to huge manpower base, diversified natural resources andstrong macro-economic fundamentals. Also, the process of economic reforms initiated since 1991 hasbeen providing an investor-friendly environment through a liberalized policy framework spanning thewhole economy.Though the global financial crisis have affected the Indian equity and foreign exchange markets atpresent, the macroeconomic brunt of the meltdown is not much, due to the overall strength of thedomestic demand and the largely domestic nature of its investment financing. Also 60% of India’s GDP isdependent upon domestic market.There are some economic parameters which affect the Indian Economy and there by the stock marketssuch as monetary policies, fiscal policies, governmental expenditure towards infrastructure & lastlyconfidence among consumers to spend more and generate demand for the goods & services forstimulated growth. All such economic indicators not only measure/analyze the present performance ofan economy but also help in predicting and forecasting its future growth prospects.
  3. 3. We can broadly classify the above said parameters in to two:- A) Monetary Parameters B) Fiscal ParametersThe Monetary Policies regulates the supply of money and the cost and availability of credit in theeconomy. The Monetary Policy aims to maintain price stability, full employment and economic growth.The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. It canincrease or decrease the supply of currency as well as interest rate, carry out open market operations,control credit and vary the reserve requirements.Let’s take a look into the Monetary parameters:- A) CALL MONEY MARKET:The money market is a market for short-term financial assets that are close substitutes of money. Themost important feature of a money market instrument is that it is liquid and can be turned over quicklyat low cost and provides an avenue for equilibrating the short-term surplus funds of lenders and therequirements of borrowers. The call/notice money market forms an important segment of the Indianmoney market. The funds located through the money market can be utilized to provide financing for thepurchase of securities that can be added to the portfolio of the investment firm, or as a resource thatwill cover the margin accounts of the firm’s clients. B) CRR & SLR – CASH RESERVE RATIO & STATUTORY LIQUIDITY RATIO:-CRR, or Cash Reserve Ratio, refers to a portion of deposits (as cash) which banks have to keep/maintainwith the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free andsecondly it enables that RBI control liquidity in the system, and thereby, inflation. Besides the CRR,banks are required to invest a portion of their deposits in government securities as a part of theirStatutory Liquidity Ratio (SLR) requirements. The government securities (also known as gilt-edgedsecurities or gilts) are bonds issued by the Central government to meet its revenue requirements.Although the bonds are long-term in nature, they are liquid as they can be traded in the secondarymarket. C) OPEN MARKET OPERATIONS:-An open market operation is the principal tool of implementing monetary policy by which a central bankcontrols its national money supply by buying and selling government securities, or other financialinstruments in order to expand or contract the amount of money in the banking system. When theGovernment sells securities to the public, it absorbs money from the economy. There is, thus, areduction in money supply. Later, when it spends, the money flows back to the system, resulting in a netnil effect. When the RBI enters the secondary market for the purchase or sale of securities, it does so toimplement its monetary policy. Thus, if it wants to have an expansionary policy, it may buy securities,injecting money into the system.
  4. 4. D) REPO AND REVERSE REPO:-Simply the operations whereby RBI injects liquidity in the system are termed as “Repo”, and wherebythe Central Bank absorbs liquidity are termed as “Reverse Repo”. REPO or repurchase agreement orready forward deal is a secured short-term (usually 15 days) loan by one bank to another againstgovernment securities. Legally, the borrower sells the securities to the lending bank for cash, with thestipulation that at the end of the borrowing term, it will buy back the securities at a slightly higher price,the difference in price representing the interest. It allows a borrower to use a financial security ascollateral for a cash loan at a fixed rate of interest. In a repo, the borrower agrees to immediately sell asecurity to a lender and also agrees to buy the same security from the lender at a fixed price at somelater date.Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks arealways happy to lend money to RBI since their money are in safe hands with a good interest. An increasein Reverse repo rate can cause the banks to transfer more funds to RBI due to these attractive interestrates. It can cause the money to be drawn out of the banking system.Now let’s move on to government’s fiscal parameters:-Fiscal policies may be defined as a deliberate change in government revenue and expenditure toinfluence the level of national output and prices. For instance, at the time of recession the governmentcan increase expenditures or cut taxes in order to generate demand. On the other hand, thegovernment can reduce its expenditures or raise taxes during inflationary times. Fiscal policy aims atchanging aggregate demand by suitable changes in government spending and taxes. The Fiscal Policycan be used to overcome recession and control inflation.Fiscal policies that need to be looked upon to analyze the stock market include:- A) INFLATION AND DEFLATIONSimply put, inflation is a rise in prices of several items over a period of time. It is measured throughvarious indices and each provides specific information about the prices of items that it represents. Theindex could be the Wholesale Price Index (WPI) or the Consumer Price Index (CPI) for specifiedcategories of people like agricultural workers or urban non-manual employees. Each of the indices iscreated in a specific manner with a certain year as the base year and they consider the price changeover a year. An index used for measuring inflation comprises several items having different weight ageand hence the index moves according to the price changes in these items.To tame inflation, the government usually hikes interest rates. High inflation is not always bad and lowinflation need not always be good for equity markets, as the impact will differ for companies and sectorsacross different time horizons. Inflation is caused by a combination of four factors: 1. The supply of money goes up. 2. The supply of other goods goes down. 3. Demand for money goes down. 4. Demand for other goods goes up.
  5. 5. Deflation occurs "when prices are declining over time. This is the opposite of inflation; when theinflation rate is negative, the economy is in a deflationary period."The stock market normally reacts when there is a significant change in inflation and deflation, eitherways, over a period of time. B) GDP GROWTHThe Gross Domestic Product (GDP) or Gross Domestic Income (GDI) is one of the measures of nationalincome and output for a given countrys economy. It is the total value of all final goods and servicesproduced in a particular economy. GDP is widely used by economists to gauge the health of aneconomy.The growth in nominal GDP matches that of the corporate performance year after year and hence thereis a fair degree of co-relation between Stock market & GDP. This may be due to the fact that the GDP ofthe economy is the collective output of the agriculture, industrial, and services sectors. It can, therefore,be asserted that corporate performance tends to trace GDP growth over the long-term, and it isassumed that the stock market follows suit. In the long-run, the economy goes through cycles ofrecovery, peak, slowdown, and depression. Stock markets also exhibit similar cycles. Hence, if IndiasGDP grows at 10 per cent in one year, the Sensex may not gain a similar percentage during that year.However, the relationship may hold true over the longer-term. It may be stated that the state of theeconomy has a bearing on the share prices but the health of the stock market in the sense of a risingshare price index is not reflective of an improvement in the health of the economy. C) FDI’s & FII’sFDI is defined as “investment made to acquire lasting interest in enterprises operating outside of theeconomy of the investor.” Foreign direct investment has become the major economic driver ofglobalization, accounting for over half of all cross border investments. Companies are rapidly globalizingthrough FDI to serve new markets and customers, map out their value chains in the most efficientlocations globally, and to access technological and natural resourcesOn the other hand, FII is used to denote an investor, who invests money in the financial markets of acountry different from the one in which that investor is incorporated. So, if you as an Indian decide toinvest in the US stock markets, it is an out-bound foreign institutional investment. Similarly, suppose arich American millionaire invests in the Indian stock markets, it would be termed as in-ward FII.FII’s are supplementing volatility in Indian market. This is what is happening in current scenario. TheIndian market is interdependent on global markets like U.S., Europe and other Asian markets. This wasthe same that happened in current scenario, U.S. and other market meltdown slotted in direct impacton Indian market. The FII are taking out the money and the impact is shown on current Indian markets.It is because of the volatile nature of investors’ sentiments that FIIs are tracked so closely. It would notbe prudent to drive away foreign investors from investing in our country because for a developingcountry like us, it’s very important to drive foreign investors to our country.
  6. 6. D) FOREX RESERVESForeign Exchange Reserves (also called FOREX reserves) in a strict sense are only the foreign currencydeposits and bonds held by central banks and monetary authorities. Foreign exchange reserves areimportant indicators of ability to repay foreign debt and for currency defense, and are used todetermine credit ratings of nations. Coming to the economics of forex reserves, they are basically heldto achieve a balance between demand for and supply of foreign currencies, for intervention, and topreserve confidence in the countrys ability to carry out external transactions.While analyzing the potential cost or benefit of holding such reserves it is pertinent to always keep inview the objective of holding reserves which include maintaining confidence in monetary and exchangerate policies, enhancing the capacity of the central bank to intervene in forex markets, capacity toabsorb shocks in times of crisis and, above all, provide market confidence to indicate that the economyis well-placed to meet all external obligations and, of course, the security of backing domestic currencyby external assets.The country also benefits by using the excess forex reserves to repay its liabilities and also use a part ofits reserves to finance the import of capital and intermediate goods and to boost domestic production.The stock exchange and the foreign exchange markets are interlinked. The returns of one market areaffected by the volatility of other market. Particularly the returns of the stock market are sensitive to thereturns as well as the volatility of foreign exchange market. On the other hand returns in the foreignexchange market are mean reverting and they are affected by the volatility of stock market returns.There is strong relationship between the volatility of foreign exchange market and the volatility ofreturns in stock market. E) RUPEE – DOLLAR RELATIONThe appreciation and depreciation of dollar against rupees will have huge impact on Indian economy. Itwill have direct impact on the export sector, as little appreciation would give huge income on thecontrary a slide would count huge loss. A rise in the Rupee’s value against the Dollar would mean thatour goods would be more expensive in Dollar terms, which may reduce our sales abroad. Alternatively, ifthe Dollar price of our goods is kept fixed, the corresponding Rupee realization would be less. Eitherway, our export earnings may suffer. This has already affected the bottom lines and share prices ofsome of our software companies. The same may happen to other export industries, especially in the USmarket. On the import side, however, the Rupee cost of oil and other goods (whose prices may be fixedin dollars) would fall, which may help keep the inflation rate down.What happens if the rupee keeps on falling?As the rupee falls, foreign investors will want bigger returns for their money to compensate for the higherrisk. This means that the Indian government, companies and individuals will have to pay more for themoney they borrow: in other words, higher interest rates. A major problem with a falling rupee is that itwill increase the Indian governments burden of repaying and servicing foreign debt. Another problem isthat it might discourage foreign institutional investment from pouring funds into the Indian markets.
  7. 7. Indian companies which could borrow from the overseas markets at cheaper rates to finance their importand export needs will also be badly affected. F) IIP DATAIIP number or data is a measurement which represents the status of production in the industrial sectorfor a given period of time compared to a reference period of time. IIP number is one of the beststatistical data, which helps us to measure the level of Industrial activity in Indian Economy. IIP data is asimple index which provides information about the growth of different sectors of our economy likemining, electricity, Manufacturing & General. The IIP index reflects the growth in India’s industrialactivity and excludes all kinds of services.Index of Industrial Production (IIP) is an abstract number, the magnitude of which represents the statusof production in the industrial sector for a given period of time as compared to a reference period oftime.Indian stock markets are very sensitive to IIP Numbers. A better IIP number would show a positivegrowth on our Industrial production and share markets would possibly cheer.SECTOR:-Investors tend to underestimate the importance of sector before investing in a stock. They generallyconcentrate on stocks but forget about the importance of sector. Stocks sectors are helpful sorting andcomparison tools. This is extremely helpful, since one of the ways to use sector information is tocompare how your stock or a stock you may want to buy, is doing relative to other companies in thesame sector.If all the other stocks are up 11% and your stock is down 8%, you need to find out why. Likewise, if thenumbers are reversed, you need to know why your stock is doing so much better than others in thesame sector – maybe its business model has changed and it shouldn’t be in that sector any longer.Let’s look why sector analysis is important in stock market?Firstly, to start with, a long-term portfolio needs to be well-diversified in terms of Sector Allocation. Whysuch Sector diversification is needed in LONG-TERM investment?? Sector wise Diversification is neededin long-term investment as the investor is willing to wait & hold the portfolio for a longer-duration oftime or until his pre-set targets are achieved. This long-term investment can span across few years oreven more. During such times, in this constantly changing environment, various sector of the economycome into bullish trend & diminish from the sight time-n-again. The trend keeps changing among varioussectors depending upon various internal and/or external conditions elated to the economy in general.
  8. 8. Like, for example, currently in the bearish situation, FMCG and Pharmaceuticals sectors has shownbetter resilience due to their operation in the space of inevitable consumption of goods/services. Evenin bearish times, people won’t stop consuming Medicines or People won’t stop bathing with soaps. Atthe most, they may downgrade using expensive soaps with less expensive ones. But, they won’t stopabsolutely using it .Similarly, before this bull run, we saw how liquidity made a rush towards Commoditystocks, including Metal stocks. Now, that bullishness has disappeared for the time being, due toconcerns of slowdown in world economy. So, meaning to say... Commodity trend came & went by. Itmay come back once global economy stabilizes & shows some recovery over next few years.Similarly, every portfolio should have 10-20% investment in defensive sectors to over-come the over-aggressiveness of remaining sectors. This would provide cushion of safety when the tide turns inopposite direction, as we witnessing right now - bear phase. No investment is a sure thing. Anycompany, howsoever strong in any & every way it may be, can have serious problems that are hiddenfrom investors. Even the most financially sound company with the best management could be struck byan uncontrollable disaster or a major change in the marketplace, such as a new competitor or a changein technology. The same thing applies to SECTOR specifics also & most of them are also governed by theLAW OF SEASONALITY. The trend keeps changing.COMPANY:-Finally comes analyzing the Company. To analyze a company one need to do both fundamental analysisand technical analysis.Fundamental Analysis:-This type of analysis of a business/company involves analyzing its financial statements and health, itsmanagement and competitive advantages, and its competitors and markets. The analysis is performedon historical and present data, but with the goal to make financial projections. There are severalpossible objectives: to calculate a company’s credit risk, to make projection on its business performance, to evaluate its management and make internal business decisions, to make the company’s stock valuation and predict its probable price evolution.Prediction of how the company/stock will move, normally for the longer term, is based on itsfundamentals and valuation. Fundamental analysis is the process of looking at a business at the basic orfundamental financial level. This type of analysis examines key ratios of a business to determine itsfinancial health and gives you an idea of the value its stock. Many investors use fundamental analysisalone or in combination with other tools to evaluate stocks/company for investment purposes. The goalis to determine the current worth and, more importantly, how the market values the stock/company.The tools of fundamental analysis are:- Earnings per share Price to earnings ratio
  9. 9. Price to book ratio Return on equity/investment Debt/equity ratio Dividend yield ratioTechnical Analysis:-This manner of playing the market assumes that non-random price patterns and trends exist in markets,and that these patterns can be identified and exploited. While many different methods and tools areused, the study of charts of past price and trading action is primary. It maintains that all information isreflected already in the stock price, so fundamental analysis is a waste of time. Trends “are your friend”and sentiment changes predate and predict trend changes. Investors’ emotional responses to pricemovements lead to recognizable price chart patterns. Technical analysis does not care what the “value”of a stock is. Their price predictions are only extrapolations from historical price patterns.