Sensex surges 500 points: When money is easy, stocks will party

The simple truth that busts all myths about making money on the market was evident today when the Indian stock markets took off vertically. Around mid-morning, the Bombay Stock Exchange Sensex was up by over 500 points - all for the simple reason that the US Fed declined to taper down its bond-buying programme in the foreseeable future. Ben Bernanke has chickened out of taking on the risk of finding out what will happen if he reduces liquidity. This is an indirect confirmation that liquidity is key.

What does the Fed’s monthly bond purchase of $85 billion do? It increases liquidity. And where does the increased liquidity go? Usually into assets - shares, gold, et al.

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This is really the secret of making money on the stock market: look for liquidity surges and ebbs. When it surges, stocks go up. When it declines, markets move down. It is true as much of stocks as onions. The money chasing an asset decides prices in the short run.

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Long-term fundamentals like demand and supply are important, but the only fundamental that matters in the short run is liquidity.

Will stocks rise or fall from here? I don’t know. But the answer will depend on liquidity. Don’t be fooled into thinking that somehow all the bad news about growth or inflation or CAD is all gone.They are still around. But bulls will be bulls when they smell money.

Here are 10 things to remember about stock markets and the explanations given about them.

#1: The three fundamental driving forces of stocks are these: liquidity, liquidity, liquidity. It is liquidity, or lack of it, that drives prices up or down. Liquidity simply means the amount of money available to chase stocks. When the amount falls, markets fall; when it rises, stocks rise. If there are no changes in liquidity, the markets will not move.

#2: What is true for the market may not be true for individual stocks. If liquidity is what drives entire markets and indices, liquidity varies from stock to stock. What we call fundamentals - a bullish or bearish view of a stock - essentially means that liquidity will change in favour or one stock or the other, assuming the total quantum of money available for investment in stocks remains the same. This is why pension funds are crucial for market direction. Assuming the total workforce keeps on increasing, the money available for market investment keeps rising, driving up stocks. When populations age, this corpus starts shrinking. This is why Japan’s stock market has not recovered since the 1990s. The Nikkei recovered this year under PM Shinzo Abe primarily because the Bank of Japan is busy printing money - liquidity again.

Stock fundamentals create a reasoned climate for changing the direction of liquidity towards (or against) one stock. Fundamentals do not raise prices changes in the direction of liquidity. If people want to sell Tata Steel and buy TCS, it means the liquidity available has changed direction. The market as a whole may not rise in this event driven purely by stock fundamentals.

#3: A corollary of the liquidity paradigm is this: when you are not sure of liquidity, go for stock-specific investment. If we assume that there is always some amount of money going into stocks or between stocks, when liquidity stagnates or falls, people will opt for what they think are stocks with sounder fundamentals. This changes liquidity in favour of some sectors, and away from others. This is also why some stocks are called defensives (food, FMCG) and others growth stocks (which respond to broader liquidity conditions faster).

#4: Macroeconomics is important for broad movements. The US Fed’s statement on continuing money cheap is a clear pointer to continued liquidity. If Ben Bernanke stops or reduces bond buying when the economic outlook improves, it means less injection of artificial liquidity, and less money available for boosting asset prices. But that time is some distance away.

#5: Liquidity is impacted by the market’s relative preferences for stocks based on their future outlook - as determined by the market’s influencers. Sectors, stocks or an entire genre of stocks that are unrelated to each other - as in large-caps, mid-caps, etc - can rise or fall depending on the flavours of the season. During volatile and uncertain times, large caps may be preferred; but in more settled times, mid- and small-caps may be the talk of the town. But it is liquidity that matters ultimately.

#6: Short-term market movements are less reliable than long-term ones. What Ben Berkanke or Raghuram Rajan say about markets will impact short-term movements . But the market’s direction is finally determined by what people do rather than what central bankers say. Stocks rise and fall everyday - but this happens because people move from one stock to another when overall liquidity, or money chasing stocks, is the same. This is why at constant liquidity, a flood of IPOs or disinvestment may tank markets - people sell the stocks they hold to buy the new equity.

#7: The stock market is impacted by other asset markets, too. Investors put their money into a variety of assets - from stocks to commodities to real estate to bonds or currencies whatever - so when real estate is falling, liquidity may shift to stocks or bonds or other assets that investors think will rise or fall less. The recent fall in gold may have helped trigger the shift of liquidity from gold to bonds or stocks. But the US Fed’s decision yesterday to continue bond buying pushed gold up once more. Money flows from one asset class to another depending on relative outlook. However, if there is a general surge in liquidity, all assets could surge simultaneously.

#8: Interest rates and stocks have an inverse relationship. When rates fall, stocks which represent better cash flows tend to get rerated upwards. This is why the markets watch the RBI’s monetary policy show closely.

#9: The ultimate triggers are greed and fear: markets fall when fear reigns; they rise when greed hold firm. Right now, most markets are ruled both by fear and greed, but the balance is tipping towards greed, as the US Fed chickened out of tapering its bond buying. The markets could turn either way depending on whether economic optimism returns or ebbs. The short-term fear of a reduction is easy money - which Ben Bernanke’s statement has allayed - is waning. But if growth prospects improve, the old concerns about a liquidity taper will be back. And the markets will weaken.

#10: Don’t depend too much on expert advice. The only people who make big money on the markets are those who take the trouble to learn themselves. The rest are cannon fodder for the experts. I am not saying you can’t benefit from expert advice, but the truth is even experts can’t know how the markets will behave beyond the short-term. If they did, they would not put this information to benefit you when they can make use of it themselves. Altruism is in short supply when it comes to market advice.

(This is a slightly modified version of an earlier article on the same subject. Read the earlier version here ).