Published: October 2nd, 2016
Written By : Ronak Pol
In a press conference on 29th September DGMO Lt General Ranbir Singh announced that India carried out surgical strikes in PoK. Apart from the political storm that this information caused it also sent a few ripples in the Indian stock market.
The political implications of these strikes are already understood by many but there is also a need to understand the reaction on financial markets. Soon after DGMO called for a press conference a sense of panic was visible in the market. As the news unfolded markets started losing ground and continued on a downward spiral. By the day’s end, Sensex had lost nearly 500 points and the index has been sluggish ever since.
If we want to use any Index as a measure of people’s sentiment towards a certain news then it is crucial for us to understand the demography of that index. We also need to understand the way markets treat new information and react to it.
Sensex and Nifty are the two benchmark indices in India but are by no means the only two market indices. For ease of exposition, we will only concentrate on Sensex.
Sensex is an index of 30 companies that are listed on the Bombay Stock Exchange (BSE30) these companies provide a sample of various sectors and are used to calculate the index. The base for Sensex is 100 at 1978-79 price level and the index is calculated on the basis of free float methodology. Sensex is widely regarded as the pulse of the Indian Stock market.
But we also need to acknowledge the fact that a strikingly low amount of Indian population actually trades in the equity market. As Bloomberg reports “Less than 1.5 percent of the population invests in securities, compared with almost 10 percent in China and 18 percent in the U.S. and just 2 percent of India’s household savings are exposed to equity; in the U.S., the long-term average is 45 percent.” This clearly shows that the market exposure of Indian consumers is very low and also a very small fraction of Indian savings are exposed to non-diversifiable market risk. We can also say that the Index is not an accurate depicter of the Indian sentiments when it comes to new Information.
Understanding these facts will go a long way in interpreting fluctuations in the market and drawing conclusions on the Indian sentiments towards surgical strikes.
Information and Indices
A lot can be understood about how people perceive new information based on how the index reacts. But for anyone who is not well versed with the intricacies of how information flows into the market, they should not trust the numbers once the information comes out.
This goes back to our basic understanding of market efficiency (Efficient Market Hypothesis – EMH) and Random walk hypothesis. An implication of the efficient market hypothesis is that future price innovations are unpredictable, i.e. future prices are the forecasted price (today’s price inflated by the discount rate) plus an unpredictable pricing error. Now depending on the accuracy with which analysts are able to predict new information will the current price start reflecting that information. But when the information arrives without any prior warning then the markets react abruptly depending on the adjustment mechanism.
Keeping the technicalities Indian markets have been hit with a massive geopolitical shock and have reacted accordingly – In this case, the stock prices going down.
Does this mean Indians don’t agree with the decision of surgical strikes?
People simplify their understanding of Information flow into a broad sentence – When an information causes stock prices to go up it is good information and when stock prices go down the information is negative. This is as far from the reality as it can possibly get.
What people regard as bad news shareholders might interpret it as good for business and vice versa. For example : When a company in financial distress closes offices and tanks its employees on a massive scale you would interpret this as a bad news but chances are that the stock prices of the company will creep up. Shareholders look at it as lesser recurring expenses for the company and find the decision to be financially sound. It’s the reverse case when there is dividends announcement – chances are that stock prices will actually reflect this news negatively and there are good reasons for this as well. You could also see growing uncertainty by observing the India VIX index which captures volatility in the market. The index spiked soon after new information hit the market.
The point here is – unless you understand the transmission mechanism never judge any information based on the stock price.
Now let me help you interpret why the market went down once the information for surgical strikes came out.
Uncertainty = Not good for business
Uncertainty is almost certainly never good for business. Uncertainty leads to volatility in the markets which causes investors to pull their money from the market, this causes stock prices to fall and markets to go on a downward spiral. Markets remain sluggish until the time uncertainty remains and once investors better assess the situation markets slowly start recovering. This can be observed through market reaction to various situations like Grexit or even the 2008 crises.
This is what we are observing with Indian markets today. A geopolitical uncertainty has caused markets to panic and investors to liquidate their positions. The magnitude of the fall can certainly be an overreaction to the news and we can expect the markets to stabilise in the near future, but markets will recover only when we have a sustained period of political stability. This can take anywhere between one week to one month depending on public sentiments.
This also shows that a war is never good for business. If you think that a war with Pakistan can solve our border disputes with them then your mistaken. A war kills millions of innocent people and almost never gives any solution. We have examples from countries like Syria and Iraq where a period of prolonged war has only gotten worse with time and countless innocent lives have been lost. This does not mean that we should be submissive and not respond to terror threats but we need a more diplomatic approach to this problem. The rise of globalisation has provided us with new firearms in the form of sanctions, USA successfully used these against Russia and if we can rally the entire world behind us to talk about this problem and find a lasting solution – we will not have to fight any more wars.
A lot can be understood by observing market indices but there needs to be a methodical approach and conclusions should only be drawn by taking a holistic view of the context.
In no ways does a fall in Sensex mean that markets do not support surgical strikes, but they certainly associate these strikes with a period of uncertainty. Chances are markets will recover soon – unless there is major crossfire from across the border.We also need to understand that war is not a solution and will only amplify our problems.
Lastly, I would like to pay my respects to the Indian soldiers who are fighting this war for us. We are honoured for your service and pray for your safety on the battlefield.