Wednesday, June 6, 2007

What triggers a downfall in the market?

AS a result of China's higher-than-expected economic growth of 11.1% and fear of possible further interest rate hikes in China, regional markets, including Malaysia, fell sharply last Thursday.

This was the second time after Chinese New Year (CNY) that a drop in Chinese stock prices rattled the markets across Asia.

According to Lee In Ho in his study on Market Crashes and Informational Avalanches, there are four stages in a market crash. They are boom, euphoria, trigger and panic.

Under the boom stage, the market will normally have a main theme that excites everyone about stocks.

In Malaysia, several positive measures under the Ninth Ma- laysia Plan got investors excited about the construction and property sectors. At this stage, this is seldom a bubble as companies continue showing good corporate results. A bubble will be created at the euphoria stage. The unjustified extrapolation of future earnings and the revision of higher target prices by research analysts can cause overconfidence in companies’ future performance.

A bubble will start to take shape when the general public reacts to this overconfidence. An irrational exuberance will occur when market prices and expectations about future values are far beyond the fundamentals of the companies.

However, no one will know when the rise will stop. A market will resume its upward trend until something triggers the downfall.

Usually, the stock prices get higher and steeper just before the market crash.

At the trigger stage, private information will reach a threshold that triggers other traders to alter their behaviour. At this critical situation, when almost everyone is at irrational exuberance, any event can trigger the market to tumble.

In January 1994, our stock market put the blame on former finance minister Tun Daim Zainuddin for saying that he had sold all his shares because prices had reached dangerous levels.

Until now, nobody can really understand the main reason behind the sharp plunge on the Shanghai Index right after the CNY.

According to some fund managers in China, the selling was mainly due to investors panicking when they noticed that their friends were selling stocks.

A famous researcher in behavioural finance, Robert Shiller, conducted a survey by asking institutional and individual investors what was in their mind during the stock market crash in 1987. One conclusion he drew was that the crash was due to people reacting to each other with heightened attention and emotion.

Investors seemed to follow what other investors were doing. As a result of action and reaction, a feedback loop was created when everyone had a simultaneous reaction to common stimuli.

A market crash is described as a process that corrects a public belief that is inconsistent with the current distribution of private information. The severity of a crash will depend on whether the market is filled by “new generation” investors or experienced traders.

“New generation” investors do not know anything about the stock market but are greedy and want to get quick money from it. A market will not crash if it has experienced traders who know how to control risk and when to cut losses.

However, if a market is filled by “new generation” investors with no holding power and do not know when is the right time to sell a stock, any sharp drop in prices could result in panic selling. At this panic stage, the fear of further drops could cause big fall in prices.

When will the stock market crash again?

My usual answer for this question is the stock market will not crash as long as you continue to worry about when it will crash. The market will crash at the time when you least expect it to happen. Investors should remember that the market always performs beyond your expectations.

We should not be too worried about when the market will crash. Instead, we should consistently review our portfolio and sell those stocks whose prices have gone beyond their intrinsic value

Source: TheStar

No comments: