How would you explain how a stock price goes up 10% in a single day and drops 10% the next day?
Why do stock prices move so frequently and dramatically even within a very short time?
Investment experts and theories will tell you that stock prices are driven by underlying fundamentals.
Then how would you explain that a stock price goes up 10% in a single day and drops 10% in the next day? Do the fundamentals keep changing by 10% in consecutive days in such ways?
Similarly, you will often notice that the major global stock market indices such as the S&P 500 change more than 2-3% in a day.
If the stock market prices are driven by the underlying macroeconomic fundamentals, then would it sound okay to you if I say the gross domestic product (GDP) of the USA has changed 2-3% in a single day following a 2-3% change in stock market indices?
Consider the recent movement of stock prices: S&P 500, the most widely used measure of the US stock market performance, rose more than 30% in the last five months since it hit the bottom in March this year.
And the S&P BSE Sensex, a common gauge of the Indian stock market, surged more than 30% in the last six months this year.
Also, the Dhaka Stock Exchange's broad index DSEX rose more than 25% in the last three months after the withdrawal of the general holidays.
The stock markets in many countries including Bangladesh have started roaring when the world economy is taking a bath in deep recession.
How do you connect the disconnect between the fundamentals and the stock market?
In reality, stock value, not the price, is driven by underlying fundamentals.
You might think that value and price are identical. But there is a big risk in assuming so.
When you are assuming value and price to be the same, you are thinking that the market is perfectly efficient and every investor is rational. But in reality, neither the market is efficient nor is the investor rational.
Price is something that you pay, and value is something that you receive when you pay the price.
You can observe the price in the market which keeps fluctuating. You find the value as the present value of the future cash flow of the firms.
If the fundamentals of the firms get stronger, expected cash flows and value get higher, too.
But does that value perfectly get transmitted to price? If it were the case, then there would never be bubble-burst, overvaluation, and undervaluation.
What is the transmission channel from value to price?
The most obvious channel is the supply of money and the opportunity costs of the fund.
If the supply of money is tight and its opportunity cost (interest rate) is high, then despite strong fundamentals and higher value of the firms, the price may remain low for a long time.
Similarly, if there is an oversupply of money in the market and the opportunity cost of fund is low, then the price might overshoot the value.
The latter case may explain why stock markets around the world are roaring when the economy is taking a major blow from the pandemic.
To cushion the damaging effects of Covid-19, central banks and governments around the world are running a stimulus programme, with an expansionary monetary policy, by injecting new money and cutting interest rates at an unprecedented rate.
So, a part of the money, lured by my higher expected return, is coming to the stock market and fueling the share price.
Another transmission channel from value to price is the market sentiment which is the average expectation of the market participants about the future direction of the economy, confidence in the market microstructure, and governance.
If the market sentiment gets stronger, more people invest in the market and prices go up.
Similarly, if the sentiment gets shaky, it leaves a damping effect on the prices, widening the gap between prices and underlying value.
Since late 2017, DSEX lost more than 30% even though the real GDP of Bangladesh grew more than 7% in the fiscal year (FY) 2017-18 and FY19.
Similarly, DSEX has gone up by more than 25% in 2020 even after a considerable drop in GDP growth this year.
Then how do you connect the disconnect between the strong growth in macroeconomic fundamentals and the fall in stock market indices and vice versa?
You can connect this dot through value to price transmission channel.
When Covid-19 hit the economy, the government and the Bangladesh Bank took many stimulus programmes which resulted in an expansion in the money supply and a big drop in overall interest rate.
Given the fact that financial institutions are sitting on piles on money and not extending credit due to the high risk of borrowers' business in an uncertain time and returns on alternative investment (bank deposits) are relatively low, part of the excess money is being channelled to the stock market, helping the untapped value transmit to price.
Also, the overhaul of the Bangladesh Securities and Exchange Commission leadership has boosted market sentiment. Supply of money, low-interest rate, and positive market sentiment altogether helped the market valuation level unwind and transmit to price.
But why does stock price fluctuate so frequently, unlike other asset prices?
The stock price depends on the underlying value.
Value depends on underlying fundamentals such as growth in sales, profit margin, condition on the overall industry, and the macroeconomy.
Even though underlying fundamentals and values do not change frequently, then why does the price do so?
The answer lies in the value to price transmission channel which is affected by day to day market sentiment, changes in monetary, fiscal, and economic policy that affects the supply of money, its opportunity costs, and average market participant's confidence in the market.
This means even you have picked up the right stock which is reasonably undervalued, still, you might not profit from it in the short to medium term and will be exposed to price fluctuations as the value to price transmission channel might not work or take a long time to adjust.
Also, when you invest, try to get a sense of how value to price transmission channel works in particular markets and factors affecting the transmission channel and how it will affect your investment if it takes a long time to work in addition to fundamental analysis of the firms.
Md Sajib Hossain, CFA is a Fulbright Scholar at Syracuse University, USA and also an assistant professor at the Department of Finance, University of Dhaka.