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Re: preventing stock plunge



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1. I think the concept of stocks and shares, their impact on the economy  can
be understood by starting from looking at how a person saves. Traditionally,
there were not many alternatives other than buying gold, or land. (Of course,
in the traditional economies, there were cultural practices like a person who
has earned substantial crop requiring to do some Puja and call all villagers
for feast and  other charity-oriented acts, which took care of a portion of a
person's surplus, though not everything was rosy with tradition.)As the
economy developed, a need arose for heavy investments for industrialization.
That is how companies started getting formed and they started borrowing from
banks and financial institutions. Other than borrowing from Banks, which
requires thorough scrutiny of their records by  the bankers and mutual
acceptance of the loan terms,  public companies have other option of raising
resources from the public. It is to sell the  company's shares, by public
issue (or by giving 'warrants' or rights to existing shareholders),  which in
effect, increases the equity. The net worth of  a company is  the value of the
shareholders' ownership and is equal to 'Assets minus Liabilities'. The ratio
of debt to networth represents the ability of the company to raise resources
from others in relation to its ownership value. This is called the leverage of
the company. Bookvalue of stock is the networth per share.
2. Now, the share market is just like any other market, say, a vegetable
market. Buyers want to buy and sellers want to sell and everyday large number
of transactions take place. There are brokers who act on behalf of buyers or
sellers and who offer to buy or sell on behalf of the clients. Now, just like
price of any commodity, there is  demand and supply mechanism operating.
People have their own notions of value of each share based on their own
assesments, insights, advertisements and feedback . People make their own
decisions based on  their assesment of 1. Risk factor 2. Liquidity factor and
3. Return, not necessarily in the same order. People consider how easily the
instrument could be encashed in time of need, upto what period it is
'locked-up' and so on. Some who want to give least importance to risk factor
and highest priority to return may go for high-yielding but risky investment
options. . Those who want safety first may go for National Savings
Certificates issued by Post offices.While the supply of financial instruments
is governed by the need to sell on part of the existing holders for whatever
reasons, the demand is governed by people's assesments of a particular share
of a company considering the three factors as above. Now, just like any other
market, there is a point where the demand curve meets the supply curve and
that is the equilibrium price of that particular share. Now, suppose, for a
company, such market price is more than its bookvalue. To take an example,
suppose the bookvalue is Rs 10 per share, but the market value is Rs 15 per
share, and suppose the company has a networth of Rs 100 crore. It means the
company has 10 crore shares. Suppose the company requires purchasing new
machinery and needs capital. The company can consider issuing another 10 crore
shares at the rate of Rs 15 per share. If it is able to ensure public
subscriptions, or sell its shares, it means the assets and networth each has
risen by Rs 150 crore, while the liabilities remained the same. Thus the
networth has now become 100 plus 150 i.e. 250 crores. The company has thus
reduced its 'leverage', which means, in future, it could raise debts from
financial institutions if need be, relatively more easily. With 20 crore
shares now, its bookvalue has become 250/20 i.e. Rs 12.50. Thus, by going
public at the appropriate time, the company has not only raised resources but
also increased its bookvalue.  Thus, a buoyant financial market, where the
prices are higher than bookvalues of companies, stimulates growth in the
economy by attracting investment in certain sectors. Conversely, if the
financial market is low, it means the market equilibrium price of a company's
share is lower than its bookvalue. If that happens, company will not feel
encouraged to go for public issue, even if there is a genuine need for
acquiring new machinery. If the trend continues, it may lead to a situation,
where the company may decide to increase the bookvalue per share by buying
back its shares from the public, by dishing out cash. (Suppose the bookvalue
now is Rs 10 per share, the company has a networth of Rs 100 crore in our
example and market value is Rs 5 per share. Company can decide to buy back
4crore shares available with public by spending Rs 20crore. Assets and
networth both reduce by Rs 20 crore. Networth now becomes Rs 80 crore and
number of shares is now 10 minus 4 i.e. 6 crore, making the bookvalue 80/6
i.e. Rs 13.33 per share. Thus bookvalue increased from 10 to 13.33, and the
company has increased its leverage, thereby making it more difficult for being
able to obtain loans from banks) But the company had to spend cash to achieve
this, by foregoing any real investment need for new machinery. Another
alternative that can happen in an economy in such a situation is that big
companies may find it easier to acquire or take over smaller companies by
purchasing their shares, without having to invest in new machinery or
equipment. Both these alternatives have an adverse impact on the overall
growth of the economy. Thus a market with falling share prices spells problems
for the performance of the economy. Now it is also true that a well-performing
economy with reasonably controlled inflaion and low unemployment rate would
naturally lead to a growing share market. And a poorly performing economy has
many consequences, with people not earning enough to be able to invest, those
having some thing to invest not able to find attractive and safe avenues for
investment, and thus leading to  poor stock market. Thus, it seems like a kind
of chick-and-egg situation as to which causes which. But, I guess, a sound
economy is a pre-requisite in the long run for growing stock market.
3. The crucial difference between the financial market and any other commodity
market is that a share is just a document, representing a promise of a
particular kind of performance. You are 'free' to determine and evaluate the
likely future performance promises of the company. There is a possibility that
the promises may be kept and you may get fantastic returns. There is also a
possibility that you may lose your amount invested, but that is it: you will
not lose more than what you have invested. Thus you have agreed on taking a
certain amount of calculated risk.  Of course this is all within the overall
framework of public disclousures a company has to follow, as per guidelines of
SEBI. Now, the Stock exchange indices are basically a measure of extent of
transactions in a particular day by comparing with  cumulative performance.
Overall changes in the index denote the buoyancy or otherwise of the
investors. The share market regulator, i.e, SEBI regulates the market by
controlling certain minimum requirements on part of the brokers, prescribing
margins, and so on, attempting to influence likely decisions of major players
like Foreign Institutional Investors, domestic financial institutions like LIC
and so on. Now, there can be a number of reasons for fluctuations in the
capital markets, ranging from performance of specific sectors,tax rates,
fiscal and monetary policies affecting the aggregate savings for investment,
international business cycles, i.e. fluctuations in growth and recession from
time to time, with no particular periodicity, Court orders affecting growth of
particular sectors,  assesment of expectations of various players, global
financial situation, domestic political situation, and all other factors
affecting individual assesment of 'return, risk and liquidity' on part of the
investors.
I think it is necessary that SEBI  basically ensures that the transactions are
based on fair degree of transparency and individual companies adhere to basic
standards and accouting principles, in order to ensure a level playing field
in the sense that nobody should be in a position to artificially jack up or
manipulate stock prices and the prices be strictly responding to a number of
voluntary sellers and voluntary buyers. There is also a great long-term need
for regulatory organizations like Registrar of Companies to be transparent,
fair and open in enforcement. Similarly credit-rating agencies need to be
absolutely professional.  But, other than that, I am not sure if there is a
need to take any measures to 'prevent a plunge', as plunge is as natural as a
boom and essentially the stockmarket reflects the condition of the economy in
the long run, notwithstanding short term fluctuations.
4. Now, coming to the query on energy based currency, I am not  clear on how
such idea could be practically implemented, as lot of theory still needs to be
sharpened and tools made sophisticated so that it does not make the system
more cumbersome. Perhaps, what one should aim is to progressively ensure
greater accountability and enforcement of environmental standards. If law
enforcement is done rigorously, perhaps the fiscal and monetary policies will
be better tools to guide the economy. The Capital markets automatically play
secondary role in influencing investors' decisions. In order to make 'energy
based currency a reality', many more preparatory jobs will have to be done,
like first building up a translation of various databases, like, for example,
the economic survey, or reports of State Domestic Product from rupees to
energy-units and subject them to detailed scrutiny and interpretation, which
is not going to be an easy task. Therefore I think it is too premature now to
think of stockmarkets and energy-units. I hope this meets some of the points
raised and I welcome others to participate/ add.

"Komaragiri, Param (Param)** CTR **" wrote:

> ... relevance of a stock market crash,
> stock 'points' they frequently say in a market plunge,
> what exactly happens in a stock trade ? is the value
> attributed to each stock too virtual? Is it going to whither away
> when energy based currency if at all becomes a reality?
> ...
> How do we ideally prevent a stock plunge to save an economy?
>
> Parameswar
>
>


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