Before panicking, it is important to know that it is important not to panic. Things are just getting really crazy out there. As a recent example, the Canadian statistics agency announced one day that the Canadian economy had done unexpectedly better at creating jobs and the Canadian government announced that it would buy $25 billion of good quality bank mortgages to encourage Canadian banks to lend more freely, not because the banks were weak. The market response at the time….. stocks down… $Cdn down….
Another example? Consider the experience of the maker of the Blackberry, Research in Motion. The company announces massive increases in sales and huge increases in profits, albeit slightly less than expected. Then in early October, they also announce yet another new and very cool product. The market reaction…. The stock is down 50% over the past month. That’s just crazy when you consider the company has $1.5 billion dollars in cash reserves. That means the company can have $100 million dollar losses (which aren’t going to happen) for 15 years and still not be bankrupt. Even Apple would be bankrupt if that happened. Now is not the time to judge based on what you see. Best advice… Sign up for meditation classes.. Take up jogging… Or just get drunk…. Check back in a month or so.
Everything you see in the markets and the subsequent reactions may not be a good way to judge where things will go in the end. The things that are clear are that Europe is going into recession and so is the USA. Understand the underlying fundamentals and stick with what you know. As for everything else, no one really knows for sure.
As a Canadian economist put it, making economic forecasts in this environment is like trying to estimate the value of your home when your kitchen is on fire. Who really knows?
Sunday, October 19, 2008
The Two-Way Interconnectedness of Markets
Far too many conclusions are being made based on comparing stock indices. While these indices give an indication of how a particular stock market is performing, different indices for different stock markets are not directly comparable. Furthermore, stock indices no longer give a clear indication of how domestic investors see the future profit potential of companies that are primarily dependent on the economic performance of the domestic economy.
First of all, the nature of companies that form each index dictates the degree of volatility experienced by that index. This is particularly clear when comparing the Dow Jones Index of the NYSE and the Bovespa Index of the Sao Paulo Stock Exchange. More than half of the 30 companies that form the Dow Jones have historical betas below 1.0 and none above 2.0. There are none forming the Bovespa index under 1.0 and many have historical betas over 2.0. There are also linkages between markets that need to understood. Companies included in the Bovespa Index and forming about 66% of that index also trade as ADRs on the NYSE. That means that their stock prices and the index itself will feel the impact of US investor sentiment.
Secondly, the veil of aggregating index values also obscure indications of where individual companies actually see their future long term growth coming from. I think if you look at investor-focused material from Dow Jones companies, you will find that many report that their greatest business growth potential comes from emerging markets. In fact, the global nature of these companies likely reduces their overall investment risk rather than increase it.
The end result is that stock indices are far more interlinked than most actually realize and I wonder if we are getting a magnification of the real impact on emerging market economies through the normal volatility of individual stocks and the flight to safety by American and European investors.
Having said that, the conclusion is not that emerging markets will be spared but that economies and equity markets remain interconnected more rather than less. However, the relationship is much more two-way that many assume. That is, in addition to the negative impacts of the downturn in American and European economies spreading to the rest of the world, the positive impacts of rapid economic growth in emerging markets also flow back to the American and European markets.
First of all, the nature of companies that form each index dictates the degree of volatility experienced by that index. This is particularly clear when comparing the Dow Jones Index of the NYSE and the Bovespa Index of the Sao Paulo Stock Exchange. More than half of the 30 companies that form the Dow Jones have historical betas below 1.0 and none above 2.0. There are none forming the Bovespa index under 1.0 and many have historical betas over 2.0. There are also linkages between markets that need to understood. Companies included in the Bovespa Index and forming about 66% of that index also trade as ADRs on the NYSE. That means that their stock prices and the index itself will feel the impact of US investor sentiment.
Secondly, the veil of aggregating index values also obscure indications of where individual companies actually see their future long term growth coming from. I think if you look at investor-focused material from Dow Jones companies, you will find that many report that their greatest business growth potential comes from emerging markets. In fact, the global nature of these companies likely reduces their overall investment risk rather than increase it.
The end result is that stock indices are far more interlinked than most actually realize and I wonder if we are getting a magnification of the real impact on emerging market economies through the normal volatility of individual stocks and the flight to safety by American and European investors.
Having said that, the conclusion is not that emerging markets will be spared but that economies and equity markets remain interconnected more rather than less. However, the relationship is much more two-way that many assume. That is, in addition to the negative impacts of the downturn in American and European economies spreading to the rest of the world, the positive impacts of rapid economic growth in emerging markets also flow back to the American and European markets.
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