Study About Fluctuations In The Stock Market
Share or stock market also at times called as equity market in recent times has evolved beyond anyone’s expectations. The equity market is a public entity including the network of economic transactions for the purpose of the trading of a firm’s stock and derivatives at an agreed price. Normally these stocks and derivatives are listed and traded in a stock exchange where the stocks are exchanged over the counter of the firm’s stocks. These stock markets are for the public where they can buy or sell trading stocks of the companies which can be considered as a giant auction. Though historically the concept of stock or shares by means, where outsiders or public gets associated through contributions exists since 12th Century. But it’s only in the 17th Century that stocks started trading publically in Europe. The Dutch East India Company was the first start here, and it does to counter British East India Company. Amsterdam stock exchange is thus believed to first exchange or company to start trading in stocks and bonds. A few decades ago, the parties to a world stock market were mostly individual investors like businessmen. Over a period of time, these markets are dominated by largely by institutionalized buyers and sellers like banks and financial institutions, insurance companies, hedge funds, mutual funds etc. As a result, there were some improvements in market operations in the Indian stock market. The Government of India has fixed some exorbitant fee marked for institutionalized investors and comparatively low fee for small investors. According to the Wikipedia research, the size of the world stock market has become about $40 trillion by the end of 2008. So one can imagine as to how the stock market is really achieving overwhelming response from the public.
In order to identify and understand the fluctuations in the stock market, one has to get a complete idea about the operations in the stock market. Every day in the stock market, the opening price for each and every stock being traded in an exchange is determined and normally such a price is same as that of the closing price of the stock in the previous day of the market. However when the market was closed in the previous day, if a significant incident happens to a company, then the specialist market makers in the exchange will adjust the opening bid and offer prices slightly by bringing a balance between the buy and sell orders happened prior to the market opening for the particular day. Even minor mistakes being committed by the market makers in striking the balance will result into fluctuations in the stock market.
Moreover, the main reasons for the market fluctuations in the stock market are caused by an imbalance between demand and supply conditions theoretically. The stock market always tries to achieve a balance between demand and supply culminating into fluctuations in the individual and the overall market stocks as well. If a particular stock has more buy orders than the sale orders, then the price of that stock will go up and vice-versa. Further the market timing also leads to fluctuations in the stock market. It is very important in case of institutional investors to choose the best time to buy or sell as they deal with large blocks of shares. Institutional investors normally indulge in after-hours trading as a result of which they are in a better position to estimate and to understand the potential fluctuations in the next day’s trading. Similarly the insider-trading reports, news releases about the firms’ earnings and other important financial details, global economic conditions, Government’s policies etc lead to fluctuations in the stock market of any country. Even the long swings in the payment of dividends to the shareholders will proportionately result into the long swings in the stock prices of that particular company (Robert B. Barsky, J. Bradford De Long, 1992).
Impact of economic factors on stock markets
The stock market being the dynamic component of world market is determined by a number of factors, both economic and non-economic. It is very important for a potential investor to understand and analyze these factors before taking any decision. There are different multi-factor asset pricing models like Arbitrage-based model, Arbitrage Pricing Theory etc, apart from the traditional model called Capital Asset Pricing Model. According to these models, the stock prices and stock returns are dependent on economic variables (Opfer and Bessler, 2004). Normally, the price of any commodity, may be stock or others, is determined by the free play of the market forces called demand and supply. Based on this principle, one can explain that the main economic factors affecting the stock market are the demand for and supply of the concerned stocks and derivatives. Even as per the Efficient-Market Hypothesis (EMH), profit margins and dividend payments offered by a company influence its stock prices in the market. Other economic factors include inflation, interest rates, political conditions, foreign trade, global macro-economic activities (Alexis Writing, 2010), share buy-back and stock-split activities of a company, unemployment, Gross Domestic Product, industrial development etc.
Impact of sentiments on stock markets
In spite of economic factors, sometimes the stock market seems to react irrationally to non-economic factor like investor sentiment. Investors and their sentiments are persuaded by press releases, rumors, mass panic etc. If the market is influenced by such psychological factors, prices will subject to ups and downs affecting the market in the future also. Market predictors and behaviorists claim that investors often behave emotionally and irrationally while making the decisions which will lead to incorrect pricing of stocks (George N Root, 2006). Several research studies explain that there exists a strong relationship between stock prices in the market and the investors’ sentiments (Black, 1986; De Long, Shleifer, Summers and Waldmann, 1990; Barberis, Shleifer and Vishny, 1998; Daniel, Hirshleifer and Subrahmanyam, 2001). According to De Long et al. (1990), investors can be categorized into sentiment-free rational investors (arbitrageurs) and extraordinary sentimental irrational investors. The latter group of investors affects the pricing mechanism in the stock market. Their psychological perception and the sentiments even affect the liquidity, future and growth of the capital market. It will decide whether a public issue would be fully, over or under-subscribed (Michael. S. Ogunmuyiwa, 2010). According to the empirical studies being conducted since early 20th century, investors’ sentiments can be measured either directly through surveys or indirectly by depending upon the sentiment related objective variables (Lee, Shleifer and Thaler, 1991; Neal and Wheatley, 1998; Brown and Cliff, 2004). One can conclude that the sentiments of the investors are very crucial in the determination and the anticipation of the stock market crisis (Mohamed ZOUAOUI, Geneviève NOUYRIGAT & Francisca BEER, 2010). Even different grades of sentiments will affect different types of stocks at different levels (Malcolm Baker and Jeffrey Wurgler, 2007).
Introduction to the Indian Stock Markets
A Stock Exchange or a Stock Market is the place where potential investors meet for buying or selling their shares or other securities. Initially a company issues shares in primary market for the first time. Once it is complete, the further trading is done in a stock exchange after getting listed. At present, there are two major stock exchanges viz., Bombay Stock Exchange (established in 1875) and National Stock Exchange (established in 1992) along with the other 20 stock exchanges. The history of stock exchanges in India can be dated during British Rule when the first stock exchange was established in 1850 with a community of brokers. The main difference between these two key entities is that BSE is not completely automated as that of NSE. However the number of stocks listed in BSE is almost double to that in NSE. However by the end of 2009, NSE has become the third largest stock exchange in the world in terms of transaction volumes and amounts. Surprisingly, it is the known fact that till 1980, there was no measure for calculating the ups and downs in the stock prices of the market. During 1992, BSE has introduced stock index called SENSEX which was renamed as BSE-100 Index in 1996. However now in almost all the major stock exchanges, dollar-linked indices are being implemented electronically.
Manifold number of banks, financial intermediaries, insurance companies, corporate companies, mutual funds, individual investors etc participates in the Indian stock market. Indian stock market has been experiencing tremendous changes and developments in its secondary market for equity since 1992. It is based on the following key ingredients for its quality maintenance in operations:
Electronic order book
Lack of counter-party risk
Since then the behavior of stock markets is matter of deep study and concern to all the investors and financial researchers. All investors including brokers try to pick up the clues put forward by the financial research companies Reuters, Financial Times, Moody’s etc and make the investment accordingly for short term or long term financial goals. There are many companies which solely focus on researching and publishing the economical data which would influence the market trend in coming days, months or probably years depending on industry types and investors.
The spread of stock market with popularity and technology of buying online stocks has envisaged the more involvement of the common man, which has further precipitated the investments through stocks. At the moment, even after existence of financial researchers and forecasters the market seems to be deceiving all at many time regularly. And for all these sea saw effects had been termed by media as the sentiments based derivatives. The common investor seems to be scratching the relation between deep researches based financial forecast and the relation between sentiments and financial data where sentiments seem to playing a stronger role.
In view of the above, in the current research, an effort is made to highlight the gaps in understanding of the stock market factors which generally drive it and would provide more appropriate investment decisions by investors.
Aims and objectives of the Study
To identify and analyse the impact of sentiments of investors on the share market prices and returns
To identify the key factors affecting the stock market returns
To understand the causes for the fluctuations in the share market
To analyze the risk component involved in the fluctuations of the stock market
To discuss how the market sentiments affect the stock market returns
To suggest measures to the investors for the rational decision-making before investment
Significance of the Study
Financial professionals always have an eye on the impact of investors’ psychology and sentiments on the stock returns in the financial markets. The media constantly discusses and analyses the effect of investors’ mood on stock market movements. Mr. Daniel Kahneman stated in his speech on ‘Psychology and Market’ at Northwestern University in 2000 that ‘If you listen to financial analysts on the radio or on TV, you quickly learn that the market has a psychology. Indeed, it has character. It has thoughts, beliefs, moods, and sometimes stormy emotions’. As per the empirical research, it is established that there is a strong relationship between stock returns and the investors’ sentiments. But, still, some behaviorists believe that more than market sentiments, it is economic factors that influence the stock market returns. In this context, it is believed that this study which concentrates on the impact of market sentiments, in particular, on the share market provides an extension to the existing literature on the same.
Limitations of the study
Organization of the paper
REVIEW OF LITERATURE
Meaning, definition and explanation of Sentiments
According to the market makers and behaviorists, investor sentiment is basically an attitude, feeling or a belief of an investor about the price movements of securities in the market. It is based on emotion only rather than reason. One can explain that rising prices and the falling prices of the securities indicate bullish and bearish market sentiments respectively. Market sentiment, on the other hand, is the overall prevailing attitude of the whole investment community about the price fluctuations in the security market. Investor sentiment is not justified by the facts rather it is a belief about the risk involved in the investment. However, it is empirically proved that only those companies which are younger, more volatile, unprofitable, non-dividend paying, distressed or with high growth potential are most prone to investor sentiment (Malcolm Baker and Jeffrey Wurgler, 2007, 129-151). But risk-free securities like bonds, gilt-edged securities etc are least subjected to investor sentiments. Based on the sentiments, investors can be categorized as Rational Traders (sentiment-free) and Irrational Noise traders. Rational traders assess the prices of the assets accurately. On the other hand, irrational noise traders show either too much optimistic or pessimistic tendencies for the evaluation of the assets which leads to mispricing of the securities.
There are indicators for the measurement of investor sentiment which specify the positive (bullish) and the negative (bearish) tendencies and also the long and short positions of the securities in the market. Normally the fluctuations in the exogenous sentiments of the irrational traders and the limit to arbitrage from the rational (sentiment-free) investors are responsible for the mispricing of the securities in the stock market (De Long et al., 1990).
Mohamed ZOUAOUI, Geneviève NOUYRIGAT and Francisca BEER (2010) suggest two different approaches to measure investor sentiment. They are Explicit Sentiment Proxies and Implicit Sentiment Proxies. In the former, investor sentiment can be derived through the direct surveys asking the stock market participants about the future economic and the market conditions. These surveys are to be conducted on a regular basis and ultimately the overall sentiments of all the investors are to be aggregated and compiled. Under these proxies, different varieties of sentiment indicators have been suggested by behavioral researchers. Consumer confidence surveys are the major survey based sentiment indicators (Bram and Ludvigson, 1998). However while using these surveys, care should be taken while framing the questions so that the exact and entire content of the information should be well captured (Baker and Wurgler, 2006). Even though, consumer confidence surveys are the popular and useful investor sentiment indicators, these surveys also become failures because of inaccurate responses from the potential investors (Campbell, 2003),lack of understanding about the questions (Betrand and Mullainathan, 2001) and the involvement of personal biases (Grooves, 2006). Instead of Consumer Confidence Surveys, application of SENTIX and G-MIND (as per the publication of the Centre for European Economic Research) as sentiment indicators is very popular in Germany. But these surveys are applicable only for short time periods. Therefore by keeping in view the loopholes involved in these Proxies, it is found out that it is better to use market variables as Implicit Sentiment Proxies instead of Explicit Sentiment Proxies.
Second important approach for the measurement of investor sentiment is Implicit Sentiment Proxies. Under this approach, sentiments are indicated through indirect measures like price movements, patterns of trading and other market variables. Different researchers have suggested different indicators as implicit sentiment proxies. Among them, the aggregate trading volume is a sutable proxy for investor sentiment (). Normally when the investor sentiment is high, then even the aggregate trading volume also increases thereby increasing the investor sentiment further. So investor sentiment and the aggregate trading volume are dependent on each other. Another sentiment indicator under this approach suggested by Frazzini and Lamont (2008) and Indro (2004) is net fund flows. If the investor sentiment is high, then he/she is interested in investing in more mutual funds so that net fund flows increase (Brown and Cli, 2004). According to Baker and Wurgler (006), IPO Returns and the IPO activity are the important Implicit Sentiment Proxies. Loughran and Ritter (1995) opined that the companies utilize the stock market fluctuations led by investor sentiments for the correct timing for the issuance of their IPOs. In Germany, mostly the number of IPO activities per month and the IPO returns are the most common proxies for indicating the investors’ sentiments. Similarly, sometimes even the debt-equity ratio also serves as the indicator of the investor sentiment. During high levels of investor sentiment, the equity is overvalued (Baker and Wurgler, 2000). So when the sentiment is high, companies prefer to issue equity but not debt instruments to the market and vice-versa. Further, Dennis and Mayhew (2002) suggested the put-call ratio as another important proxy for investor sentiment. In case of higher performance of certain stocks, the number of calls bought is higher than the number of puts bought resulting into lower put-call ratio (Brown and Cli, 2004) and vice-versa.
Introduction to risk-taking
Risk is the possibility that the desired action or activity leads to a desired outcome within a speculated time period. The losses that occur because of undesired outcomes can be considered as ‘risks’ associated. While explaining the concept of risk, Warren Buffett (1980) indicated ‘Risk comes from not knowing what you're doing!’. Normally, all the efforts of human beings carry some component of risk, the level of which is ranging from more to less. The risk involved in an investment is the probability of achieving the desired return. It indicates the discrepancy between the actual return and the expected one on the original investment. Risk not only includes the negative outcome (expectations exceeding the actual returns) but also positive outcome (actual returns exceeding the expectations). Risk of an investment can be measured statistically by calculating the standard deviation of the past returns of the investment. The risk can be reduced through the process of hedging. Hedging is the process of reducing the level of risk associated with an investment by purchasing or selling another investment. It indicates a position under which the loss and the risk exposure involved in one security investment is offset by another investment based on the price fluctuations.
Theoretically, it is known fact that the more the degree of risk, the more the investor achieves long-term return. So risk and return are directly proportional to each other as against the belief of some investors that greater return is possible through minimum risk. Risk leads to the exogenous ups and downs in the stock market, foreign currency devaluations, fluctuations in the investors’ sentiments, substantial changes in the inflation and the interest rates and even lot of economic changes.
Most of the people in India regard themselves as risk-takers and challenge-takers. They claim that they are very much willing to take risk. But their ability to take such a risk is very crucial rather than their willingness to take risk. The situation of the investors should allow them to handle some risk. Therefore risk taking is the combination of the investor’s willingness to take risk and his/her ability to take risk. The willingness of an investor to take risk depends on his attitude, upbringing, values, knowledge about the stock market and the financial products etc. Some of the cognitive reaserchers stated that demographic factors, personality traits, attitude towards money and the socio-economic status of the investors affect their willingness to take risk (Carducci and Wong 1998; Roszkowski 1996; Sulloway 1997; Carducci and Wong 1991; Grable and Joo 1999; Grable and Joo 2000). According to Roszkowski and Snelbecker (1990) and Levin et al. (1986), even the situational factors influence the willingness of the investors to take risk. John E. Grablea and Michael J. Roszkowskib (2009) stated that the mood of the investor also influences the willingness to take financial risks.
But the ability of an investor to take risk depends upon his/her stability to withstand with the worst loss situations. However pride, over-confidence and the desperateness hinders the ability of an investor to take risk. According to the Wikipedia,
Risk = Probability of Event Occuring X Impact of Event Occuring
The risk taking of an investor is determined by various market related and individual related factors. As per the literature survey, it is evident that risk tolerance of an investor depends upon gender differences also. Women investors are less likely to invest in risky securities when compared to male investors (McDonald, 1997; Kahn, 1996 and Richardson, 1996). Women are equally capable with that of men in terms of performance but are less confident, less aggressive and more cautious towards investment (Hudgens and Fatkin, 1985; Hollander, 1992). Bradd Libby (2010) proved that one’s willingness to take risk depends upon the age also. For example, older people are risk-avoiders when compared to young and middle-aged investors (Brown 1990; Bakshi and Chen 1994; Grable 2000). Even literature shows that education, home ownership, number of dependents, financial knowledge and income level of the investors influence the risk tolerance. It is also evident that the investors having higher incomes and net assets seem to take more risk comparatively than others (Cicchetti and Dubin 1994; Lee and Hanna 1991; Riley and Chow 1992; Schooley and Worden 1996; Shaw 1996; Sung and Hanna 1996).
One cannot conclude that taking and handling risk is beyond one’s expectations and potential. If the investor manages to take calculated risk as per his/her ability and the awareness about the outcome, the return can be as per the expectations. Ultimately the risk-taking capacity of an investor depends upon his/her psychological traits measured in terms of intelligence, personality, attitudes and values (Carducci and Wong 1998; Wong and Carducci 1991 and Zuckerman 1983).
Relating risk to stock markets
The potential investors in the stock market always try to achieve higher returns on their investments. While investing in the stock market for the first time, investors should be aware of all the different types of risks involved. They also have to understand and analyze their willingness and the ability to take risks. They should be familiar with the market related and psychological factors influencing the risk tolerance towards the investment in a particular stock.
In the modern period, www sources enable the investors to invest in the stocks online and also to enable the financial information about the market. Investors have the direct access to the purchase and sale of securities online without depending on the stock brokers. Investors have been experiencing that the level of returns in the share investment is higher than that of the other types of investments. Moreover, stocks are very much liquid in nature as and when an investor wants to sell off his/her securities, securities can be sold easily without any delay.
However there are several risks involved in the investment of stocks. First of all, investor has to understand the fact that no guarantee will be provided by either the company issuing the stock or the Government towards the certainty of the stock returns. Every investor has to bear the entire risks involved in the probability of achieving expected returns on the stocks. The Government provides only the protection to the investors against mal-practices in the stock market operations. No investor can predict the stock market situation and the market can go up suddenly and even comes down with the same pace. Therefore the investor has to understand the market completely and take his own decision but not going by the advices of the friends and relatives who may not be having the complete awareness of the market. If the investor participates in the equity portion of the total capital of a company, then the company pays its employees, creditors, suppliers and the Government first and out of left-over balance, if any, stock holders are paid. Another important risk involved in the stock market investment is lack of awareness and the information about the financial status of the company and the market conditions. In stock market, it is evident that the more the risk an investor take, the more the return that he/she gets in the long term promising at least 10-15% (Michael James, 2010). It is the known fact that risk on a security sometimes goes beyond the control of the investors also. Only the thing is that the investor has to choose the best security as per his risk level ranging from conservative to aggressive.
Normally, first-time investors will go for getting services from stock market counselors who will provide the tips and guidance for the identification of suitable stocks as per their risk levels. Even such counselors provide the accurate market related information. But in case of day-trading, even the counselor may guide the investors in an improper fashion.
If the investor hits the stock market on a right time with a very good awareness and the understanding of the market, it is sure that he/she will be a successful investor in the market with reasonable risk, as possible. Investors should not be in a hurry about the higher returns in a short-term while investing in stock market. Even the stock investors can employ risk management strategies like diversified portfolio investment to minimize the risks and thereby losses. Through diversified portfolio, the loss on one security can be mitigated with the profit on another. Similarly the investor has to follow the market trend lasting for a month or so and then has to identify the suitable stocks so that stocks’ position is aligned as per the trend.
Impact of economic factors on the stock markets
Stock markets are very much speculative and cannot be predictable. The market is very dynamic and active but the stocks are very volatile. Before going for any investment, an investor has to perform a complete market survey for the past, present and the future time periods for different types of securities. Manifold number of kaleidoscopic factors affects the prices of the stock market as discussed below. Such factors can be categorized as economic and non-economic factors. Indeed there are two popular single factor and multi-factor theories viz., Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (ATP) explaining that economic factors play an important role on the stock market returns (Opfer and Bessler, 2004).
Several researchers have suggested different economic factors that influence the stock market returns. As per the Efficient-Market Hypothesis (EMH), factors like outlook for margins, profits or dividends affect the stock market returns. There is a reasonably good relationship between stock market returns and the macro-economic variables like unemployment, inflation etc (Gertler and Grinols, 1982). According to Chen et al. (1986), the economic factors like the spread between the long and short interest rates, expected and unexpected inflation and industrial production are responsible for the fluctuations in the stock market prices.
According to the research done by Flannery and James (1984) at United States, it is found out that there is a significant relationship between the interest rates prevailing in the market and the security returns. Even the inflation rate is empirically studied as a significant factor responsible for the stock market prices predictability (Spyrou, 2001). As per his literature, stock market returns and the inflation are negatively related with each other. Similarly the other key economic factors affecting the stock returns are company's size, dividend yield, price volatility of energy, money supply, exchange rates and industrial production index (Babar Zaheer Butt et al., 2010: 583-593). Further according to Mazhar Islam M (2003), stock market returns are very sensitive to the industrial production in the long term and the short term, as well. Cognitive behaviorists, Mukherjee and Naka (1995) opined that even long term government bond rate and the call money rate are equally responsible for the stock return volatility.
Based on the literature survey on the economic factors influencing the stock market returns, the following factors can be finalized on the whole which an investor has to keep in mind.
Demand and Supply
The price of any stock is dependent on the free play of the market forces viz., demand for and the supply of it. If the demand for a particular stock is very high, then the price of the stock also rises and vice-versa. Similarly, if the supply of a particular security is high, then the price of that security will go down and vice-versa. If a large number of shares of a company is idle and no investor is interested in purchasing such shares, then obviously the price of such stock falls substantially. In such a case, if the investor, out of emergency, needs to sell off his/her shares, then he/she has to accept the lower price only having no other option. So, one has to be very careful while deciding about the security investment.
Apart from the demand and supply conditions, another major contributor to the fluctuations in the stock market is the market capitalization rate of the company. Market Capitalization, often called as market cap, is calculated by multiplying the share price with the number of outstanding shares. Outstanding shares are those which have been authorized, issued and fully paid by the investors. Market cap indicates the overall public opinion about the company’s net worth and therefore is an important economic factor in the determination of the status of the stock market. So an investor should not go by the price of the stock alone before going for investment. He/she has to understand and analyze the market cap also.
This is an another important economic factor that compares the stock prices with the earnings of the company and gives an investor a fair picture about the market conditions of the stock. Such comparison is reflected in earning/price ratio. If the ratio is greater than 1, it means that the earnings of the company exceed the stock price. In such a case the stock becomes undervalued and vice-versa. But there is a greater potential for such an undervalued stock to get its prices rise in the near future.
Inflation and Interest Rates
Interest rate is the major weapon in the hands of the Central Bank to control the money supply in the economy which in turn also affects the prices of the commodities and the currency, as well. Even the interest rates affect the earnings of the company and its stock prices, as well. For example, if the interest rates are high, the company cannot borrow more money for its expansion programmes which seriously affecting its earnings. If there is any fluctuation in the earnings of the company, its stock prices will be on decreasing trend. Investors will be interested in investing in a particular economy as per their perceptions and beliefs about the increase or decrease in the currency prices. If the prices increase, automatically, it may lead to inflationary tendencies in the economy. The higher the inflation rate, the more the weaker is the value of the country’s currency. Both the higher inflation and deflation rates result in the decrease in the values of stock prices. It is because, even though investors mostly favor the deflationary situation in the market, they perceive the deflation as an indication for a weak economy (Robert Rimm, 2010).
Trade Flows and Political conditions
Even the investment flows to the host country from the foreign countries influence the stock return volatility. If imports are more than the country’s exports, the value of the country’s currency gets devalued which in turn leads to stock market fluctuations and vice-versa. Even if the economic conditions in foreign countries are poor, foreign trade gets affected adversely culminating into the reduction in the companies’ revenue and income. It is already understood that the earnings of a company and its stock prices in the market are directly proportional to each other. If the negative situations in the country’s political scenario like political instability exist, then there is a lot of instability in the stock market returns too.
Performance of the industry
Sometimes an investor has to consider the performance of the overall industry because market conditions have a same/similar impact on all the companies in the industry. If the performance is good, the stock returns will increase automatically. However, there is an exception to this logic. The stock prices of a particular company increase out of the bad news about its competitor-company belonging to the industry.
Introduction of new products/markets
If a company introduces a new product to the existing market or the existing product to the new market, then its earnings increase resulting in the increase in the stock prices of the company in the market. Mostly this factor is very sensitive in case of shares of pharmaceutical companies.
Buy-back of shares
Such a buy-back of shares by a company will result in the decrease of the supply of the securities in the market. According to the law of demand and supply, such decrease leads to the increase in the stock prices. In the stock market, share buy-back is considered as a confidence booster for the investors.
If the investor guesses that the company is going to announce dividend on its stocks, then there is a possibility of the hike in the stock prices. But after the announcement of the dividends, there is even a chance for the drop in the stock prices as the investors investing after the announcement of dividends are not entitled for those payments.
Upgrades or Downgrades of market analysts
Generally if a market analyst downgrades the financial position of a company after some important news about the company, the stock prices which are in the downward trend already, will fall further consequently.
The high level of unemployment results in the lower consumer spending. As a result, the earnings of the companies fall having a negative impact on the stock prices in the market. On the other hand, the low level of unemployment leads to the positive impact on the stock prices.
The sock prices of the company being taken-over by another company will go up as the company is being taken over at premium. On the contrary, the stock prices of the company taking over the first company will drop. However if the investors perceive that the company acquiring the first company shall increase its earnings in the near future because of acquisition, there is a chance for the rise in its stock prices.
Gross Domestic Product (GDP)
It is the overall economic output of all the goods and services being produced in the host country. Market makers frequently observe the conditions of GDP in the economy and take the investment decisions accordingly. For example, if the GDP is higher, consumer spending is high leading higher production and thereby further earnings to the company. Then the stock prices of the company are also in the upward trend.
Impact of sentiments on stock markets
Even though researchers concentrate on the economic factors as the most influencing factors of stock market returns, there are some non-economic factors also that play a vital role in the stock pricing and volatility. Several researches indicate that psychological factors of investors explained by the term ‘Investor Sentiments’ result in extreme stock price movements. Such sentiments affect the investor’s portfolio selection and asset management (Barberis, Shleifer, and Vishny, 1998 and Baker et al, 2006). If an investor receives positive news about a company, then he will be motivated to buy more shares in the company resulting in the stock prices to soar. On the contrary, if he/she receives unfavorable news, he will react aggressively towards the market immediately. That means the stock prices in the market get affected adversely. Similarly, market makers and the investors closely watch each and every movement of the stock operations of the insiders (insider trading) like CEO, CFO or COO of a company. Such observation certainly will leave some news about the financial status of the company. Accordingly, investors’ sentiments are created having an extreme impact on the stock market volatility.
The extreme positions of investor sentiments lead to substantial devaluations in the stock prices resulting in even some errors in the stock prices also (Brown and Cli, 2004). Even it is proved empirically that investor’s sentiments influence the large stocks of companies and not only small stocks (Brown and Cli, 2004). The trading strategies being implemented by market makers are influenced by stock price fluctuations and market bubbles led by investor sentiments mostly (Baker and Wurgler, 2006 and Fisher and Statman, 2000). Normally the emotional extremes of the investors like over-optimism, over-pessimism, over-confidence etc affect the stock market volatility. For example, if an investor commits some amount in the stock based on the over-confidence rather than rational prediction about the markets in future, chances are more for such an investor to run into losses. It is proved that most of the extreme losers in the stock investment are those investors who are over-confident (De Bondt and Thaler, 1985). Investors can be confident but not over-confident. They have to utilize their past experience for assessing the profit performance of the company. Similarly, optimism of investors makes them to under-estimate the possibilities of poor performance of the companies. In this content, a small example is relevant. In U.S.A during the late 1990s, investors have shown exogenous optimism towards IT companies as a result of which investors have experienced drastic failure in the identification of risk of chasing the IT companies and the probability of losing money in their investments (Wen-Chen et al, 2005).
There is another behavior of investor’s sentiments on stock markets called ‘Regret’ (Shefrin and Statman, 1985, Kahneman and Tversky, 1979 and Odean, 1998). As per this, when the market prices of their stock investments are low, investors usually keep the stocks with them only even for a longer period until there is upward trend in the prices. That means, they show the behavior of regret and sell only those stocks having positive returns and retain those having negative returns. This is because of their psychological fear of getting losses. This behavior affects the stock market fluctuations. Further, investor sentiments lead to conditional market volatility and excess returns in the stock market (Lee at al, 2002). Some of the empirical studies even show that if a small company announces the decision about stock split and if the investors sentiments are very high in the market, then such ammouncement leads to high volatility and low profitability in the stock market (Keunsoo Kim & Jinho Byun, 2010: 687-719)
Several researchers have introduced different measures for assessing the investors’ sentiments. However most of those measures are very much debatable. For instance, one of such measures is Closed-End Fund Discount (CEFD). CEFD is the difference between the Net Asset Value (NAV) of the mutual fund and the market value of the same. As per this measure, if the size of the discount is small, bullish tendencies arise in the stock market and if it is large, bearish conditions will blow out. Such a measure calculates the sentiments of small investors. But it is still doubtful and not empirically proved that this measure provides an accurate measure of small investors’ sentiments. However, some researchers have provided accurate measures. Investor sentiments can be measured by using consumer confidence as a proxy (Schmeling, 2009). Hengelbrock, Theissen, and Westheide (2009) have developed a poll-based measure called the SENTIX Index to assess the investors’ sentiments. Baker, Wurgler and Yuan (2009) have conducted an excellent international study on six stock markets and found out that there exists a negative relationship between investor’s sentiments and the aggregate stock market returns in future. Similarly, investor sentiments may sometimes lead to under-pricing of an IPO also (Oehler, Rummer and Smith, 2005). According to Pring (1991), the bullish sentiment index is the correct measure for investor’s sentiments. This index is the ratio between the number of bullish newsletters and the total number of newsletters. Other measures for investors’ sentiments are dividend premium, trading volume, investor’s survey, trading of retail investors etc.
There are different categories of stock indexes like S&P 500, Dow Jones Industrial Index, Nasdaq (USA), ASX100, ASX (Australia), Nikkei 225 (Japan), Euronext 100, Euronext 150 (Europe Union), DAX and TECDAX (Germany), FTSE 100, FTSE All Shares, FTSE Techmark (United Kingdom) and NSE Nifty (India) to explain and guess the future stock price movements affected by investor sentiments. In view of the above explanation and literature, it is very important that investor’s sentiments cannot be ignored while understanding the stock market price movements and thereby identifying the stock returns. Based on this, proper suggestions should be provided by the stock counselors to their clients.
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