‘Equity Rout’

On Monday, August 5, 2024, global financial markets experienced a significant shake-up, following a series of unfavourable economic events, mainly from Japan and the United States (US). The case of Japan was quite interesting, and in fact, worrying to market watchers. 

The Japanese Nikkei 225 index, the benchmark index on market performance, recorded its steepest decline since 1987, dropping over 12 per cent of its value. The shock to investors could be felt across many other countries too.

In the US, the disappointing job market report for the month of June, coupled with the spillover effects of the sideways walk of the stock market in Japan led to the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite, the various market performance indexes, all suffering significant losses. The S&P 500 for example, fell by over three per cent on August 5, its worst day since the 2022 bear market.

There was a lot of media interest in the way the equity market had suddenly experienced a significant dip after months of relative stability. In fact, the Financial Times (FT)  newspaper based in the United Kingdom described the development as “equity rout”. And indeed it was, but the market has corrected, somewhat, in the past week, leading to a return to bullish sentiments again.

I followed the events keenly too, as most media channels— radio, television and the various online portals— devoted some time to discussing the developments in global stock markets.
Following the events, I also felt the need to explain how the stock market works and why events of this nature do occur, will occur and therefore cannot be wished away.

With that stated, let me take you back to the April 27 edition of this column, in which I explained in detail how the stock market works. In fact, that edition had the title “How the Stock Market Works” and in part I explained as follows: “Here, you are buying shares and bonds, and sometimes other ‘exotic’ instruments, including futures and options contracts. But broadly, a listed company enjoys share price appreciation when market sentiments about its performance and outlook is positive.

If the company is deemed to be well run with good profit potentials, bargain-hunters would be happy about the potential share price appreciation and capital gains through dividend payment.

So a bargain-hunting investor, who already holds shares of a company doing well, can decide to cash in when the share price increases or buy more to hold in anticipation of better profit growth in the future. In all of this, it is the potential and current performance [of the company] that drives the value of the listed company”. So, in the stock market, we trade in shares and more!

The next consideration is this: Why do unfavourable events, such as geopolitical tension, have an impact on stock market performance?

The plain truth is that when countries are locked in any form of dispute, whether from an economic or political standpoint, there is no peace. It doesn’t necessarily have to be about fighting—bow, arrows or a machine gun—, but when countries cannot trust each other it breeds grounds that adversely affect economic activities.

Take the case of a major oil producer, for example. If country A is a major oil producer and it is at war, the situation will affect the production of the commodity. And as you know, oil is an important commodity to our well-being. It is used in the power industry and at home too we have a very useful need for oil, and all its derivatives, including keeping our cars on the road.

Therefore, when you hear of geopolitical tension that involves a major oil producer it should be an issue of concern because if the situation escalates and supply lines are cut, and demand is held constant, prices are likely to go up.

Yes, prices will go up, and that will define everything that we do. That is the sad reality because price dominates everything in our lives to the point where we have reduced everything to commodity status, and we have given it a price. Even love can have a price! Cruel, but true.

So the listed company on the stock market, while enjoying price appreciation because of the supply restriction with demand assumed to be constant, will move the market index positively. If there was a drop in the price, the market index, if all other prices are held constant, will drop the market index too.

Now, I have made mention of indexes up there, so to explain how the stock market index works, I am going to use the benchmark FTSE 100 London Stock Exchange ( LSE) index. The FTSE 100 index was created in 1984 by the LSE and the early players in the futures and options market as a barometer of the UK stock market, with companies’ pure stock market capitalisations dictating weightings within the index.

A total of 100 stock symbols were created, and these listed companies represent some of the blue chip companies in the world. At the close of trading every day, the value of the index is determined by the strength of the day’s activities, that is, the number of price gains and losses recorded, of course influenced by the weights. So, if the market is deemed bullish it means there were some good price gains with a considerable turnover, and a bearish market is the opposite—very sluggish.

So, that is why sometimes you hear of bear and bull run when it comes to the description of the performance of the stock market. Information is key in stock market performance and within the context of the efficient market hypothesis, the assumption is that at all material times listed share price reflects all known information about the stock.

But are markets always efficient? That’s a topic for another day. The takeaway today, however, is that stock markets are influenced largely by information—negative or positive.