Factors Influencing Stock Prices In Indonesian Stock Exchange

There are many definitions of stock with different point of view. Bernstein states that stocks are partial ownership of company’s assets which are subordinated with debt (Bernstein, R. 2002). Stock is a device that implies an ownership position in a company and signifies a claim on its proportional share in company’s assets and profits. Only certain companies have stock called corporation. Limited partnership and Sole proprietorship do not issue stock (WebFinance, Inc., 2010). According to Vernimmen et al. (Vernimmen et al. 2009, p. 527), “A stock or a share is a security that is not redeemed.? The investment can only be recognized through disposal and whose revenue flows is uncertain.

Corporations need financial resources and this required resources usually come from ordinary or common stocks, preferred stocks, and medium to long term lenders or debenture holders. Common stock is everlasting capital for the corporation. The owners who invest in this type of stock are called ordinary or common shareholders and any profit retained after paying debenture interest will be distribute to them called dividend. Preferred stocks are issued to public in order to acquire capital and these stocks have rights to specified yearly fixed percentage dividend on the paid-up capital. Preferred stocks are less common in stock market (Anandarajah, Aseervatham, and Reid 2005). The following are the characteristics of common stock and preferred stocks: (Scott et al. 1999).

Preferred Stock

A hybrid security which has similar characteristics to bonds and common stocks.

It is similar to bonds in its dividends which are limited in amount.

It is similar to common stocks in that it has no fixed maturity date, dividends are not deductible in terms of tax purposes, and non-payment of dividends will not cause bankruptcy.

Common Stock.

Common stock shares imply an ownership in corporation which does not have maturity date and exists as long as the firm does.

Stock exchange is an organization which helps connection between potential buyers and potential sellers of stocks. Stock exchange can be physical place, network of computers, system of telephone link, etc. A stock market is a place where stocks can be purchased and sold (Samuel, J.M., Wilkes, F.M., and Brayshaw, R.E. 1996). Most of countries around the world have stock exchanges. The number of stock exchanges around the world is growing significantly. Based on continents, stock exchanges around the world can be divided into 6: Africa, Asia, Europe, Middle East, North America, and South America. Indonesia Stock Exchange called IDX is one of the stock exchanges in Asia (Stock Exchanges Worldwide Links, n.d., 2010).

Principally, there are 2 advantages are obtained by investor who buying or having stocks in stock exchanges (Indonesia Stock Exchange, 2007):

Dividend.

Dividend is sharing profit awarded by a company because of holding stock for a relatively long period until ownership term is in period where an investor is recognized as shareholder who has right to get dividend.

Capital Gain.

Capital gain is the difference between selling price and buying price acquired from trading activities.

Those advantages cause investors choose stocks as an attractive alternative than put their money in fixed deposits that have low interest rates (Chuan, 2004).

Basically, investors who buying or having stocks will also have some risks (Indonesia Stock Exchange, 2007):

Capital Loss.

Capital loss is a situation when an investor is selling the stocks at lower price than the buying price.

Liquidity Risk.

A company with shares held by public is declared for its bankruptcy by the Court. Shareholders or investors will have the last priority of claiming their rights after all liabilities are fulfilled. The rest of the company’s wealth will be shared proportionally to the shareholders. Shareholders will not obtain anything from the liquidation if there is no rest left.

The overall price movements of common stocks of corporations traded on stock markets are called stock market price indexes. Corporate stockholders will get benefit from company through dividends and have right to vote in company. Investors’ capital gains and losses will affected by increasing and falling of stock prices (Frumkin 2000). Norman (Frumkin, N. 2000, p. 277) states that “The dividend yield, which is the rate of return on a share company stock, is a company’s annual cash dividend percentage of company’s annual stock price.?

Nowadays, the price of stocks in Indonesia Stock Exchange is changing rapidly. The average price of stocks in Indonesia Stock Exchange increased significantly (approximately 20%) during 2006. The average price decreased approximately 19% during January 2008 and declined again approximately 16% during March 2008. The significant change of stock prices in Indonesia Stock Exchange is caused by external environmental factors or macroeconomics factors (Frensidy, B. 2008). There are many external environmental factors that impact financial system including stocks. Those factors are economic growth, inflation, exchange rates, interest rates, etc (Evans, et al. 2000).

Many investors lost their money because of the significant change of stock prices in Indonesia Stock Exchange. Investors lost their capital because they sell their stocks at lower price than the buying price (Indonesia Stock Exchange, 2007). By analyzing external environmental factors, investors can predict the future price of stocks more accurately. To minimize the risk or capital loss, investors have to understand external environmental factors influencing stock prices in order to make correct decision whether they have to buy, sell, or hold the shares. The research will identify external environmental factors which have significant influence on stock prices and explain the relationship between those factors and stock prices in order to accomplish that goal.

Objectives, Research Question, and Research Hypotheses

The objectives of the research are:

To identify the variables of external environmental factors influencing the stock prices in Indonesia Stock Exchange.

To analyze the influence of external environmental factors on stock prices in Indonesia Stock Exchange.

Based on the objectives, the research questions are as follow:

Which external environmental factors influence stock prices in Indonesia Stock Exchange?

How does external environmental factors influence on stock prices in Indonesia Stock Exchange?

Based on the research question, the research hypotheses are built up:

External environmental factors encourage the change of stock prices in Indonesia Stock Exchange.

External environmental factor have strong correlation with stock prices in Indonesia Stock Exchange.

Scope

This research study will focus on external environmental factors influencing the stock prices in Indonesia stock exchange, which will be explained more briefly in chapter 2 literature reviews. Some external environmental factors influencing stock prices are applied to explain the correlation between external environmental factors and stock prices in Indonesia Stock Exchange. The analysis of what kind of relationship (positive or negative) between external environmental factors and stock prices will also be clarified in this research.

The literature reviews will consist of some external environmental factors which influence stock prices especially in Indonesia Stock Exchange. A survey will be performed in order to collect data about the change of several external factors and stock prices in Indonesia Stock Exchange. Based on collected data, a model will be offered to analyze the relationship between stock prices and external environmental factors.

Lastly, this research will be limited and focused on the following:

The research is only focused on JSX composite index or (Indonesian: Indeks Harga Saham Gabungan, IHSG).

This research is only focused on external environmental factors which influence stock prices.

The data collection period of this research is 5 years from 2005 to 2009.

Chapter 2

LITERATURE REVIEW

Literature Review of External Environmental Factors and Stock Prices in Indonesia Stock Exchange

This chapter will summarize external environmental factors which influence stock prices. Factors and frameworks will be appeared by joining and integrating adopted theories. Lastly, the major external environmental factors influencing stock prices in Indonesia Stock Exchange will be provided in this chapter.

Categories of Stocks and Types of Orders

In the market, there are various names of stocks that refer to different categories of stocks (Chuan, 2004):

Figure 2.1 Categories of Stocks

Source: adapted from Chuan, 2004

Blue Chips refer to stocks that are steady with good fundamentals.

Undervalued Stocks refer to stocks which are well-established by companies with solid balance sheet. Such stocks are generally unnoticed by investors, traded with small volume, and receive little reporting from media and analysts or experts.

Growth Stocks refer to stocks which are established by recognized companies that have high growth sectors and their business are predicted to enlarge quickly over the coming years. Such stocks are generally traded with higher PER (Price Earnings Ratio) even though they lack of history of strong earnings base. While companies show continual rise in their earnings, the price of these stocks will increase.

Penny Stocks refer to stocks that have small capitalization and traded bellow one dollar.

Small-Cap Stocks refer to stocks that have very few issued shares and traded in low price at stock market. Such stocks are usually not bought by foreign institutions and funds. Small-Cap Stocks have some risks as follow:

Smaller companies tend to less flexible to major crisis because they are less diversified and more prone to market shocks and monetary crisis.

Trading volumes are low and less liquid. Therefore, investors may not find the buyers in stock market when they want to sell the stocks.

Small-Cap Stocks are more sensitive to news and rumors.

There are 3 types of orders used in the buying and selling of stocks as follow (Chuan, 2004):

Market Order

Market order is an order to buy or sell stocks instantly at the best current price. For example, investors place market order to sell AAA shares. It means investors buy AAA shares at current offering price.

Limit Order

Investors which place limit order will set a certain suitable price to buy or sell a particular stock.

Stop Order

Stop order is an order to buy or sell the stocks that are traded at certain price level immediately. This certain price level is known as stop price. For instance, investors place stop order to buy AAA shares at $5.00. If AAA shares begin to trade at $5.00, the order becomes market order and broker will buy shares at the best current price. In terms of selling stop order, the order is placed bellow current price to help investors decrease their possible losses and keep their profit.

Timing and Stock Investment

Investor would discourage when the price of their stocks decreased significantly after they had bought the stocks or to be trapped in market crash after they had invested their money in the stock market. Good timing is the most crucial factor for investors in stock market. Even the best stocks will become useless investments if investors buy them at wrong time (George, A. 2008). The major problem is good timing cannot be determined easily because stock market is influenced by large amount of factors and events that are beyond prediction. Investors have to understand factors influencing stock price and involve some insight to determine good timing whether they have to buy, sell, or hold their stocks (Chuan, 2004).

In stock investment, price is mechanism by which practically all goods and services are exchanged. In this case, price has strong power or price is a king because price will determine whether stocks become excessively expensive or inexpensive (George, A 2008). The price of stocks tends to increase when there are more buyers than sellers in stock market. Buyers are tense in stock market based on expectation of future price increase. There are some signals which make buyers believe that future stock price will increase (Chuan, 2004):

Positive indication from market trend.

Rumors in stock market.

Information concerning better earnings prospects for company.

External Environmental Factors Influencing Stock Prices

There are several external environmental factors influencing the uptrend or downtrend of stock prices in stock market. Those external environmental factors are:

Worldwide stock market.

Local economy.

Political factor.

Inflation.

Foreign Exchange Rates.

Interest Rates.

Commodity Prices.

Worldwide Stock Market

The performance of world economy will have effect on local economy or Indonesian economy due to globalization. The worldwide economy especially US, China, Japan, and Singapore economy will help to enhance Indonesian economy because those countries are major trading partners of Indonesia (CIA, 2010). Therefore, positive economic performance of those countries will give favorable result for Indonesian Stock Market (Chuan, 2004).Indonesian stock prices get significant impact from US, China, Japan, and Singapore stock prices. JCX composite index or IHSG obtain significant influence from worldwide stock market especially DJIA (Dow Jones Industrial Average), Nikkei 225, Hang Seng and Strait Times. Investors always look at those stocks before and during trading stocks in Indonesia Stock Exchange.

Export partners and import partners of Indonesia will affect local economy and price of JSX composite index in Indonesian Stock Exchange (Samsul, M. 2006). For example, JCX composite index in 7 May 2010 decreased significantly (71.29 points or 2.54%) because of the decrease of worldwide stock market. Dow Jones Industrial Average decreased 407.05 points or 3.75%, Nikkei decreased 331.1 points or 3.1%, Hang Seng decreased 213.12 points or 1.06%, and Strait Times decreased 6.7 points or 0.59%. The decrease of worldwide stock market had significant influence on Indonesian stock prices (Meryani, A. 2010).

Figure 2.2 Indonesia Export Partners 2009

Source: adapted from CIA, 2010

Figure 2.3 Indonesia Import Partners 2009

Source: adapted from CIA, 2010

Local Economy

GDP or Gross Domestic Product is regularly used as an indicator of economic performance of the country. Brux (Brux, J.M. 2008, p. 351) states that “Gross Domestic Product (GDP) is defined as the market value of all final goods and services produced in the economy in a given time period (usually one year).? There are two different types of GDP as follow:

Nominal GDP.

Nominal GDP is GDP that determined at current prices or actual prices of a particular year.

Real GDP.

Real GDP is GDP which adjusted for inflation.

GDP is generally used as indicator of standards of living in a country. If GDP is high, there is an assumption that economy in a country is doing well and this country has high standards of living. When GDP is growing, there is an assumption that economic activity in a country and standards of living are rising (Brux, 2008).

When GDP of a country shows positive growth, it is usually followed by positive trend in stock market. Therefore, GDP is often used by investors to estimate turning points of their stocks and to time their investment.GDP growth and other economic data are published in newspaper. When investors read this information, investor should know how to use the information wisely. For instance, when banking sector is predicted to perform badly, investors should leave out banking stocks in their stock investment. This information will help investors to choose their stocks and make correct decision whether they have to buy, sell, or hold the shares. When economic condition in a country is good, stock prices generally tend to increase. However, investors have to be careful because it is also a sign that good days are numbered. Economy which is growing too fast will be difficult to maintain its growing or to be sustained (Chuan, 2004).

Political Factor

Stock price can be affected by regional, national, and international political situation. Political crisis usually will have negative impact in stock market trends. Stock prices generally will drop significantly because of political crisis (Chuan, 2004).

Inflation

According to Hook (Hook, J.A. 2003, p. 110), Inflation is “A condition in which the economy experiences a continuous increase in the average price level of all goods and services.? The price of certain goods and services may decrease but the average price of all goods and services increases. Financial service industries and banking are influenced significantly by inflation (Hook, J.A. 2003). Inflation can also be defined as a state that has continuous increase in prices of goods and services. Inflation will increase the cost of doing business because price of goods and services increases significantly. Therefore, it is expensive to do business during inflation and profit margins of business will decrease due to higher price of raw materials, rentals, etc (Chuan, 2004).

Potential earnings of companies will determine the demand for a stock. Therefore, potential earnings of many companies generally decreased during inflation period due to the lower demand for stock. The lower demand for a stock will cause the decrease of stock prices in stock market. Investors should look at the growing of inflation and sell their stocks before inflation happens. Investors can use commodity prices and interest rates as indicators of inflation trend. When commodity prices and interest rates are rising, those factors indicate the coming of inflation. Investors should have carefulness to enter the stock market (Chuan, 2004).

Foreign Exchange Rates

Taylor, F. states that foreign exchange rate is the ratio which is used to convert one currency into another. Most countries around the world have their own currencies released by certain official agency which is called monetary authority or central bank. Currency is medium of exchange which is used to buy goods and services (Taylor, F. 2003).

According to Philip (Philip et al. 2000), there are types of exchange rate system as follow:

Flexible Exchange Rates.

Flexible exchange rates system is an exchange rate system which the value of currency is permitted to react to market forces without any intervention by central banks or monetary authority.

Fixed Exchange Rates.

Fixed exchange rates system is an exchange rate system which associate countries agree to fix the value and changes only occur under certain particular condition. This exchange rate system can reduce uncertainty from international trade and support long term investment in international trade.

Managed Floating.

Managed floating is an exchange rate system which currency is allowed to respond to market changes but central banks are allowed to interfere in order to protect the value of the currency especially when central banks believe that depreciation is only temporary.

“Stock-Oriented? models of exchange rates which also known as portfolio-balance approaches view exchange rates as equating demand and supply for certain assets especially stocks and bonds. Financial assets are valued by present values of future cash flows, expectations of relative currency values have significant role in price movements especially for internationally held financial assets. Therefore, stock prices are influenced by exchange rates movement (Ajayi and Mougoue, 1996).

JCX Index or IHSG gets significant influence from the fluctuation of USD/IDR exchange rate. USD/IDR indicates how many IDR (Indonesia currency) per US dollar. The decrease of IDR currency in term of US dollar is generally followed by the decrease of several Indonesia stock prices such as Telkom, ASTRA International, Bakrie Telecom, Kalbe Farma, etc (Sihombing,G. 2008). Figure 2.4 shows that the fluctuation of USD/IDR exchange rate is very high. Therefore, Indonesian investors should look at USD/IDR exchange rate as consideration in trading stocks (Yahoo, 2010).

Figure 2.4 USD/IDR Exchange Rates from 2005 to 2010

Source: Yahoo, 2010

Interest Rates

Frumkin (Frumkin, N. 2000, p. 190) states that “Interest is the cost of borrowing money, and interest rates are the price of money.? Interest rates which refer to yields are the annualized percentage that interest is of the principal of the loan.

Interest rate is a good indicator of inflation trends because of its role as regulatory device to monitor the inflation trends. If interest rate increases, the cost of borrowing money will become higher and more expensive. Investing and developing business will be more expensive. Therefore, the economic growth is decrease and the inflation is under control. Besides as an indicator of inflation trends, interest rates also affect stock market and have significant influence in stock prices.

When interest rate in a country is low that indicates stable or low inflation rates, stock market generally shows its positive trends and has tendency to be more active. Many investors prefer to put their money on other investments rather than put their money in bank deposits due to lower fixed interest rate. Investors will obtain lower return from bank deposits than return which comes from other investments especially stocks or shares.

In addition, the cost of borrowing money becomes cheaper and this makes investors advance their additional borrowing for investment. Therefore, low interest rate will give positive impact to stock market in terms of rising stock prices. Investors have to be more careful when there is news about increasing interest rates. Investors should look at the change of interest rates regularly because of the impact of interest rates on their stock prices (Chuan, 2004). Increasing interest rates will give a negative effect on many companies which have large debts or loans because of the rising of cost of borrowing. The profit of the companies and ability to grow will decrease. When the profit of companies decrease, stock prices generally becomes less attractive and their stock prices decrease. When interest rates become high, investors usually react in two possible outcomes as follow (Mladjenovic, P. 2009):

Investors may sell some of their stocks to pay their interest loans or debts. If many investors sell their stock, it will give negative effect on stock prices. Stock prices tend to decrease because there are more sellers than buyers in stock market.

Higher interest rates may cause investors swap change their investment from stocks to bonds or bank deposits which offer higher return.

In Indonesia, interest rate decisions are decided by Central Bank of Republic of Indonesia. Indonesia interest rates dropped significantly over the years that can be seen in figure 2.5. The decrease of interest rates will attract more investors to invest their money on stock market (Trading Economics, 2010).

Figure 2.5 Indonesia Interest Rates from 2006 to 2010

Indonesia Interest Rate

Source: Trading Economics, 2010

Commodity Prices

Basic commodities which are required in the production process of most goods and services are good indicators of inflation trends. Those commodities are oil, rubber, steel, etc. When the prices of those commodities increase, the cost of goods and services will also increase. Therefore, when the prices of most commodities increase, it may be an indication of inflation. Investors should have carefulness to enter the stock market. Besides as an indicator of inflation trends, commodity prices especially oil prices also affect stock market and have significant influence in stock prices (Chuan, 2004).

Higher oil prices will have significant impact on stock market returns especially the aggregate effect of stock prices. Higher oil prices may cause the rising of production cost which will give great forces on industry equity returns. In oil exporting countries, higher oil prices will increase profits from oil, gas, coal, and vary resources industries. Higher oil prices may cause the rising of stock prices especially for oil exporting countries which depends on relative significance of the industries (Chen, A. H. 2008).

JCX composite index or IHSG gets significant influence from the fluctuation of oil prices. For instance, the price of oil in early 2008 increased significantly to US$ 147 per barrel and then decreased drastically to US$ 36 per barrel. The price of JCX composite index followed the fluctuation of oil prices. In the early 2008, JCX composite index increased to IDR 2800. At the end of this year, JCX composite index decreased to IDR 1100 (more than 100%) because of the decrease of oil prices. Indonesian stock prices generally follow the fluctuation of oil prices. When the oil prices decrease, stock prices usually also decrease and otherwise. Therefore, Indonesian investors should look at the movement of oil prices as consideration in trading stocks (Sidarta, W. 2010).

Research Framework

Stock price in Indonesia Stock Exchange is the main axis in the research framework. The potential external environmental factors which influence stock price are:

Economic factors.

Economic factors consist of worldwide stock market (DJIA, Hang Seng, Nikkei, and Strait Times), local economy (GDP), inflation, interest rates, exchange rates (USD/IDR exchange rates), and commodities prices (oil price). Interest rates and commodities prices have correlation with inflation because the movements of those factors are indicator of inflation trends.

Political factors.

Stock price can be affected by regional, national, and international political situation such as political crisis.

All of those potential factors will become consideration factors for Indonesian investors in order to make correct decision whether they have to buy, sell, or hold their stocks. The research framework can be seen in figure 2.6.

Figure 2.6 Research Framework

POLITICAL FACTOR

ECONOMIC FACTORS

STOCK PRICE

(JCX Composite Index or IHSG)

INTEREST RATES

INFLATION

OIL PRICES

EXCHANGE RATES

(USD/IDR)

LOCAL ECONOMY (GDP)

WORLDWIDE STOCK MARKET

(DJIA, NIKKEI, HANG SENG, STRAIT TIMES)

Source: The Researcher

Summary

The research topic in this study is An Empirical Study of Factors Influencing Stock Prices in Indonesia Stock Exchange. The report consists of introduction, literature review, and reference. Chapter 1 introduction identifies background of the research, objectives of the research, research question, research hypotheses, and scopes. Chapter 2 literature review provides knowledge and theories that are related to research topic. Summary and explanation of external environmental factors which influence stock prices will be provided in this chapter. At the end of this chapter, the author provides research framework in this report. Factors and frameworks will be appeared by joining and integrating adopted theories. Lastly, references show the sources of all information used in this research.