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How to analyze the stock market
1. How to analyze stock market?
Stock markets are barometers of the economy. It is expected that the markets and their indicators, in
the form of indices, reflect the potential of the corporate listed on them and, in the process, the
direction and health of the economy. If a countryās economy is performing well and expected to grow at
a 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 before
analyzing 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 Wise
assessment and then finally analyzing the Company or the Stock.
GLOBAL ECONOMY
INDIAN ECONOMY
SECTOR WISE
COMPANY/STOCK
2. GLOBAL ECONOMY:-
Markets across the world are seeing a lot of short term volatility mainly driven by news and events in
the global markets. The countryās capital market is increasingly influenced by global developments
because 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 of
losses due to sub-prime crisis in USA, speculation over interest rates cut by FED, rise in global
commodities prices, fluctuation in global crude oil prices etc. These are some fundamental reasons why
global markets, especially the Indian stock market behave in a volatile manner based on developments
in global markets.
Indian companies are getting involved in exporting their products to global markets, raising funds by
listing on foreign stock exchange. The percentage revenue of Indian companies coming from foreign
markets is growing year over year. Therefore, share price movements of these companies are more
likely to be affected by the development in world economy. So analyzing global economy is something
vital.
INDIAN ECONOMY:-
India is the second fastest growing economy in the world. It is one of the most attractive destinations for
business and investment opportunities due to huge manpower base, diversified natural resources and
strong macro-economic fundamentals. Also, the process of economic reforms initiated since 1991 has
been providing an investor-friendly environment through a liberalized policy framework spanning the
whole economy.
Though the global financial crisis have affected the Indian equity and foreign exchange markets at
present, the macroeconomic brunt of the meltdown is not much, due to the overall strength of the
domestic demand and the largely domestic nature of its investment financing. Also 60% of Indiaās GDP is
dependent upon domestic market.
There are some economic parameters which affect the Indian Economy and there by the stock markets
such as monetary policies, fiscal policies, governmental expenditure towards infrastructure & lastly
confidence among consumers to spend more and generate demand for the goods & services for
stimulated growth. All such economic indicators not only measure/analyze the present performance of
an economy but also help in predicting and forecasting its future growth prospects.
3. We can broadly classify the above said parameters in to two:-
A) Monetary Parameters
B) Fiscal Parameters
The Monetary Policies regulates the supply of money and the cost and availability of credit in the
economy. 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 can
increase or decrease the supply of currency as well as interest rate, carry out open market operations,
control credit and vary the reserve requirements.
Letās 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. The
most important feature of a money market instrument is that it is liquid and can be turned over quickly
at low cost and provides an avenue for equilibrating the short-term surplus funds of lenders and the
requirements of borrowers. The call/notice money market forms an important segment of the Indian
money market. The funds located through the money market can be utilized to provide financing for the
purchase of securities that can be added to the portfolio of the investment firm, or as a resource that
will cover the margin accounts of the firmās clients.
B) CRR & SLR ā CASH RESERVE RATIO & STATUTORY LIQUIDITY RATIO:-
CRR, or Cash Reserve Ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain
with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and
secondly 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 their
Statutory Liquidity Ratio (SLR) requirements. The government securities (also known as gilt-edged
securities 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 secondary
market.
C) OPEN MARKET OPERATIONS:-
An open market operation is the principal tool of implementing monetary policy by which a central bank
controls its national money supply by buying and selling government securities, or other financial
instruments in order to expand or contract the amount of money in the banking system. When the
Government sells securities to the public, it absorbs money from the economy. There is, thus, a
reduction in money supply. Later, when it spends, the money flows back to the system, resulting in a net
nil effect. When the RBI enters the secondary market for the purchase or sale of securities, it does so to
implement its monetary policy. Thus, if it wants to have an expansionary policy, it may buy securities,
injecting money into the system.
4. D) REPO AND REVERSE REPO:-
Simply the operations whereby RBI injects liquidity in the system are termed as āRepoā, and whereby
the Central Bank absorbs liquidity are termed as āReverse Repoā. REPO or repurchase agreement or
ready forward deal is a secured short-term (usually 15 days) loan by one bank to another against
government securities. Legally, the borrower sells the securities to the lending bank for cash, with the
stipulation 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 as
collateral for a cash loan at a fixed rate of interest. In a repo, the borrower agrees to immediately sell a
security to a lender and also agrees to buy the same security from the lender at a fixed price at some
later date.
Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are
always happy to lend money to RBI since their money are in safe hands with a good interest. An increase
in Reverse repo rate can cause the banks to transfer more funds to RBI due to these attractive interest
rates. It can cause the money to be drawn out of the banking system.
Now letās move on to governmentās fiscal parameters:-
Fiscal policies may be defined as a deliberate change in government revenue and expenditure to
influence the level of national output and prices. For instance, at the time of recession the government
can increase expenditures or cut taxes in order to generate demand. On the other hand, the
government can reduce its expenditures or raise taxes during inflationary times. Fiscal policy aims at
changing aggregate demand by suitable changes in government spending and taxes. The Fiscal Policy
can 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 DEFLATION
Simply put, inflation is a rise in prices of several items over a period of time. It is measured through
various indices and each provides specific information about the prices of items that it represents. The
index could be the Wholesale Price Index (WPI) or the Consumer Price Index (CPI) for specified
categories of people like agricultural workers or urban non-manual employees. Each of the indices is
created in a specific manner with a certain year as the base year and they consider the price change
over a year. An index used for measuring inflation comprises several items having different weight age
and 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 low
inflation need not always be good for equity markets, as the impact will differ for companies and sectors
across 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. Deflation occurs "when prices are declining over time. This is the opposite of inflation; when the
inflation 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, either
ways, over a period of time.
B) GDP GROWTH
The Gross Domestic Product (GDP) or Gross Domestic Income (GDI) is one of the measures of national
income and output for a given country's economy. It is the total value of all final goods and services
produced in a particular economy. GDP is widely used by economists to gauge the health of an
economy.
The growth in nominal GDP matches that of the corporate performance year after year and hence there
is a fair degree of co-relation between Stock market & GDP. This may be due to the fact that the GDP of
the 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 is
assumed that the stock market follows suit. In the long-run, the economy goes through cycles of
recovery, peak, slowdown, and depression. Stock markets also exhibit similar cycles. Hence, if India's
GDP 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 the
economy has a bearing on the share prices but the health of the stock market in the sense of a rising
share price index is not reflective of an improvement in the health of the economy.
C) FDIās & FIIās
FDI is defined as āinvestment made to acquire lasting interest in enterprises operating outside of the
economy of the investor.ā Foreign direct investment has become the major economic driver of
globalization, accounting for over half of all cross border investments. Companies are rapidly globalizing
through FDI to serve new markets and customers, map out their value chains in the most efficient
locations globally, and to access technological and natural resources
On the other hand, FII is used to denote an investor, who invests money in the financial markets of a
country different from the one in which that investor is incorporated. So, if you as an Indian decide to
invest in the US stock markets, it is an out-bound foreign institutional investment. Similarly, suppose a
rich American millionaire invests in the Indian stock markets, it would be termed as in-ward FII.
FIIās are supplementing volatility in Indian market. This is what is happening in current scenario. The
Indian market is interdependent on global markets like U.S., Europe and other Asian markets. This was
the same that happened in current scenario, U.S. and other market meltdown slotted in direct impact
on 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 investorsā sentiments that FIIs are tracked so closely. It would not
be prudent to drive away foreign investors from investing in our country because for a developing
country like us, itās very important to drive foreign investors to our country.
6. D) FOREX RESERVES
Foreign Exchange Reserves (also called FOREX reserves) in a strict sense are only the foreign currency
deposits and bonds held by central banks and monetary authorities. Foreign exchange reserves are
important indicators of ability to repay foreign debt and for currency defense, and are used to
determine credit ratings of nations. Coming to the economics of forex reserves, they are basically held
to achieve a balance between demand for and supply of foreign currencies, for intervention, and to
preserve confidence in the country's ability to carry out external transactions.
While analyzing the potential cost or benefit of holding such reserves it is pertinent to always keep in
view the objective of holding reserves which include maintaining confidence in monetary and exchange
rate policies, enhancing the capacity of the central bank to intervene in forex markets, capacity to
absorb shocks in times of crisis and, above all, provide market confidence to indicate that the economy
is well-placed to meet all external obligations and, of course, the security of backing domestic currency
by external assets.
The country also benefits by using the excess forex reserves to repay its liabilities and also use a part of
its 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 are
affected by the volatility of other market. Particularly the returns of the stock market are sensitive to the
returns as well as the volatility of foreign exchange market. On the other hand returns in the foreign
exchange 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 of
returns in stock market.
E) RUPEE ā DOLLAR RELATION
The appreciation and depreciation of dollar against rupees will have huge impact on Indian economy. It
will have direct impact on the export sector, as little appreciation would give huge income on the
contrary a slide would count huge loss. A rise in the Rupeeās value against the Dollar would mean that
our goods would be more expensive in Dollar terms, which may reduce our sales abroad. Alternatively, if
the Dollar price of our goods is kept fixed, the corresponding Rupee realization would be less. Either
way, our export earnings may suffer. This has already affected the bottom lines and share prices of
some of our software companies. The same may happen to other export industries, especially in the US
market. On the import side, however, the Rupee cost of oil and other goods (whose prices may be fixed
in 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 higher
risk. This means that the Indian government, companies and individuals will have to pay more for the
money they borrow: in other words, higher interest rates. A major problem with a falling rupee is that it
will increase the Indian government's burden of repaying and servicing foreign debt. Another problem is
that it might discourage foreign institutional investment from pouring funds into the Indian markets.
7. Indian companies which could borrow from the overseas markets at cheaper rates to finance their import
and export needs will also be badly affected.
F) IIP DATA
IIP number or data is a measurement which represents the status of production in the industrial sector
for a given period of time compared to a reference period of time. IIP number is one of the best
statistical data, which helps us to measure the level of Industrial activity in Indian Economy. IIP data is a
simple index which provides information about the growth of different sectors of our economy like
mining, electricity, Manufacturing & General. The IIP index reflects the growth in Indiaās industrial
activity and excludes all kinds of services.
Index of Industrial Production (IIP) is an abstract number, the magnitude of which represents the status
of production in the industrial sector for a given period of time as compared to a reference period of
time.
Indian stock markets are very sensitive to IIP Numbers. A better IIP number would show a positive
growth 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 generally
concentrate on stocks but forget about the importance of sector. Stocks sectors are helpful sorting and
comparison tools. This is extremely helpful, since one of the ways to use sector information is to
compare how your stock or a stock you may want to buy, is doing relative to other companies in the
same sector.
If all the other stocks are up 11% and your stock is down 8%, you need to find out why. Likewise, if the
numbers are reversed, you need to know why your stock is doing so much better than others in the
same sector ā maybe its business model has changed and it shouldnāt be in that sector any longer.
Letās 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. Why
such Sector diversification is needed in LONG-TERM investment?? Sector wise Diversification is needed
in long-term investment as the investor is willing to wait & hold the portfolio for a longer-duration of
time or until his pre-set targets are achieved. This long-term investment can span across few years or
even more. During such times, in this constantly changing environment, various sector of the economy
come into bullish trend & diminish from the sight time-n-again. The trend keeps changing among various
sectors depending upon various internal and/or external conditions elated to the economy in general.
8. Like, for example, currently in the bearish situation, FMCG and Pharmaceuticals sectors has shown
better resilience due to their operation in the space of inevitable consumption of goods/services. Even
in bearish times, people wonāt stop consuming Medicines or People wonāt stop bathing with soaps. At
the most, they may downgrade using expensive soaps with less expensive ones. But, they wonāt stop
absolutely using it .Similarly, before this bull run, we saw how liquidity made a rush towards Commodity
stocks, including Metal stocks. Now, that bullishness has disappeared for the time being, due to
concerns of slowdown in world economy. So, meaning to say... Commodity trend came & went by. It
may 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 in
opposite direction, as we witnessing right now - bear phase. No investment is a sure thing. Any
company, howsoever strong in any & every way it may be, can have serious problems that are hidden
from investors. Even the most financially sound company with the best management could be struck by
an uncontrollable disaster or a major change in the marketplace, such as a new competitor or a change
in technology. The same thing applies to SECTOR specifics also & most of them are also governed by the
LAW OF SEASONALITY. The trend keeps changing.
COMPANY:-
Finally comes analyzing the Company. To analyze a company one need to do both fundamental analysis
and technical analysis.
Fundamental Analysis:-
This type of analysis of a business/company involves analyzing its financial statements and health, its
management and competitive advantages, and its competitors and markets. The analysis is performed
on historical and present data, but with the goal to make financial projections. There are several
possible objectives:
to calculate a companyās credit risk,
to make projection on its business performance,
to evaluate its management and make internal business decisions,
to make the companyās stock valuation and predict its probable price evolution.
Prediction of how the company/stock will move, normally for the longer term, is based on its
fundamentals and valuation. Fundamental analysis is the process of looking at a business at the basic or
fundamental financial level. This type of analysis examines key ratios of a business to determine its
financial health and gives you an idea of the value its stock. Many investors use fundamental analysis
alone or in combination with other tools to evaluate stocks/company for investment purposes. The goal
is 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. Price to book ratio
Return on equity/investment
Debt/equity ratio
Dividend yield ratio
Technical 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 are
used, the study of charts of past price and trading action is primary. It maintains that all information is
reflected already in the stock price, so fundamental analysis is a waste of time. Trends āare your friendā
and sentiment changes predate and predict trend changes. Investorsā emotional responses to price
movements lead to recognizable price chart patterns. Technical analysis does not care what the āvalueā
of a stock is. Their price predictions are only extrapolations from historical price patterns.