LIQUIDITY DRIVES THE MARKET ALWAYS

THREE THINGS THAT DRIVE THE MARKETS : LIQUIDITY, LIQUIDITY AND LIQUIDITY

Don’t be fooled. Explanations are what we get when something happens unexpectedly. They are seldom fully valid.

When the Sensex and Nifty suddenly tanked a week back or surged yesterday, everybody was thrashing about for explanations. Some saw it as a response to Prime Minister Modi's strong personal message pro growth. Others saw it as a response to domestic bad news as well with both State Bank of India and Tata Steel reporting mixed results, and Bhushan Steel coming under a cloud following alleged bribery and misrepresentation of facts.

 

Don't be fooled. Explanations are what we get when something happens unexpectedly. They are seldom fully valid.

 

Here are ten things to remember about stock markets and the explanations given about them.

 

1: The three fundamental driving forces of stocks are these: liquidity, liquidity, liquidity. It is liquidity, or lack of it, that drives prices up or down. Liquidity simply means the amount of money available to chase stocks. When the amount falls, markets fall; when it rises, stocks rise. If there are no changes in liquidity, the markets will not move.

 

2: What is true for the market may not be true for individual stocks. If liquidity is what drives entire markets and indices, liquidity varies from stock to stock. What we call fundamentally a bullish or bearish view of a stock essentially means that liquidity will change in favor of one stock or the other, assuming the total quantum of money available for investment in stocks remains the same. Stock fundamentals create a reasoned climate for changing the direction of liquidity towards (or against) one stock. Fundamentals do not raise prices, changes in the direction of liquidity does. If people want to sell Tata Steel and buy TCS, it means the liquidity available has changed direction. The market as a whole may not rise in this event driven purely by stock fundamentals.

 

3: A corollary of the liquidity paradigm is this: when you are not sure of liquidity in general in the market, go for stock-specific investment. If we assume that there is always some amount of money going into stocks or between stocks, when liquidity stagnates or falls, people will opt for what they think is stocks with sounder fundamentals. This changes liquidity in favor of some sectors, and away from others. This is also why some stocks are called defensives (food, FMCG) and other growth stocks (which respond to broader liquidity conditions faster).

 

4: Macroeconomics is important for broad movements. The explanation that Modi's statement triggered the spike yesterday has validity only in the context of liquidity. If he focusses on growth then the economic outlook improves, it means more injection of liquidity, and more money available for boosting asset prices. However, there is also the counter-point: since Growth will start only with concrete policy decision and stability and only if the Indian economic outlook improves, the liquidity-driven stock surge will have to look more closely at industry fundamentals to decide where to invest. In short, artificial liquidity will fall, and long-term liquidity will rise as the economy generates more jobs, more incomes, and more money for investment.

 

5: Liquidity is impacted by the market's relative preferences for stocks based on their future outlook as determined by the market’s influencers. Sectors, stocks or an entire genre of stocks that are unrelated to each other as in large-caps, mid-caps, etc - can rise or fall depending on the flavours of the season. During volatile and uncertain times, large caps may be preferred; but in more settled times, mid- and small-caps may be the talk of the town. But it is liquidity that matters ultimately.

 

6: Short-term market movements are less reliable than long-term ones. What Modi today or Raghuram Rajan say about markets today will impact short-term movements. Congress, for example, claimed yesterday that the markets had read Modi wrong but the market’s direction is finally determined by what common people do rather than what politicians say in the long-term. Stocks rise and fall everyday but this happens because people move from one stock to another when overall liquidity money chasing stocks is the same. This is why at constant liquidity, a flood of IPOs or disinvestment may tank markets because people sell the stocks they hold to buy the new equity. This is also why large market players are keenly watching the retail participation in the current market rise.

 

7: The stock market is impacted by other asset markets, too. Investors put their money into a variety of assets from stocks to commodities to real estate to bonds or currencies whatever so when real estate is falling, liquidity may shift to stocks or bonds or other assets that investors think will rise or fall less. The recent fall in gold may have helped trigger the shift of liquidity from gold to bonds or stocks. Money flows from one asset class to another depending on relative outlook. However, if there is a general surge in liquidity, all assets could surge simultaneously.

 

8: Interest rates and stocks have an inverse relationship. When rates fall, stocks which represent better cash flows tend to get rerated upwards. This is why the markets watch the RBI’s monetary policy show closely.

 

9: The ultimate triggers are greed and fear: markets fall when fear reigns; they rise when greed hold firm. Right now, most markets are ruled both by fear and greed a sort of midway point. They could turn either way depending on whether economic optimism returns or ebbs. The short-term fear is about a reduction in easy money which is why Raghuram Rajan's statement spoiled the markets (FII Sentiment). But if growth prospects improve, greed too could return.

 

10: Don’t depend too much on expert advice. The only people who make big money on the markets are those who take the trouble to learn themselves. The rest are cannon fodder for the experts. I am not saying you can’t benefit from expert advice, but the truth is even experts can't know how the markets will behave beyond the short-term. If they did, they would not put this information to benefit you when they can make use of it themselves.

Remember altruism is in short supply when it comes to market advice.