Thursday, March 20, 2008

The valuation conundrum and stock market dynamics

These days as market takes a nosdive suddenly I see a lot of people talking about value, valuations and multiple of sub 14 times etc. and term this as irrational fall. The same arguments of value were also given when the BSE sensex was at 21000+ with a minor difference wherein we talked about valuations and embeded vauations and then tried to justify the rise as a rational rise. I to be honest never understood this kind of thinking and branding stocks in some closet of multiple. Sure valuations are important but the most important thing in any market are three variables liquidity and let's rename the other two variables as X and Y, stock market is no different.

Let's have an economy in which there is one supplier of gold and copper and these are the only two tangible products produced in this economy and the rest of the population has lots of money with them (also let me add exchange of commodities is not allowed: I will explain later how this condition comes to play even in real life for now this condition is our variable X), due to this the copper sells for rupees x and gold sells for rupees 100x. However one fine day all the money is gone. Then it's irrelevant to talk that gold is more valuable than copper they both attract negligible value as there is no liquidity.

Let's slightly tweak this example, so now we replace copper with bread. Whats more valuable after 7 days of hunger 'gold or bread'. So another factor that is extremely important in markets is 'marginal utility': The satisfaction a person recieves from one addtional unit of the good. This is our variable X.

If I have lot's of money in my pocket I would buy 'luxury brands', essentially the same quality of cloth from an expensive showroom with some fuzzy symbol on it. The same happens to stocks, in periods of high liquidity various popular names skyrocket.

Now when a person becomes cash strapped he becomes economical in his spending. The same happens in market he buys businesses that have real cash flows, he starts thinking about PE multiples. So really if one thinks about it, its liquidity that determines the performance of the stocks by controlling the marginal utility the players. I shall continue this article next time by explaining more about the variable X and hence completing the market dynamics.......

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