Investor wealth soars as the Sensex scales new highs. Property prices zoom. Gold prices touch new highs. Ever wondered why the prices of stocks, real estate or precious commodities like gold and silver move up or down in such a way? Is there some large conspirator or a conman manipulating the prices?
For our discussion, let us refer to all the above, stocks, real estate or commodities as assets. The prices of all these assets move in a particular fashion. Although the direction of the move or the extent of the same is difficult to identify before the move, we will try and establish some relationship between certain possible reasons and the movement of the prices.
The assets referred above serve some economic purpose and hence derive some value as perceived by the beneficiary or the user of the economic purpose. The perceived value could be obtained in the present or in future. It could also be derived value in some form. Let us elaborate this. Ownership of stocks or equity shares represents part ownership of a business. The economic survival of any business (we are only referring to businesses and not charities or not-for-profit organizations) depends on its ability to generate profits. As long as the business continues to make profits and increase the profits, the perceived value of the business goes up as the share of profit for the shareholder also goes up. Housing property, on the other hand, serves one of the most basic needs – that of providing shelter. Since purchase of a house involves sums larger than the available resources of many households, those who can afford to buy houses can derive rental income from the houses they own (of course, other than the one they reside in). Gold serves another economic purpose, that of acting as a store of wealth. As long as an asset serves some economic purpose, it can be used as an asset for the purpose of investment.
Let us then see the relationship between the value provided by the asset (or stored in the asset) and the price in the market.
The assets transfer hands when there is a willing buyer and a willing seller and they agree on a transaction price. Logically, a buyer would be willing to pay a price that is less than the value perceived by her. On the other hand, a seller would sell only if the perceived value is more than the price. That is the importance of the word “perceived” in all our discussion so far. Let us look at certain examples:
1. A person gets transferred from Delhi to Mumbai. The Mumbai office is located at Nariman Point. Another person from Delhi comes to Mumbai for the same reasons, but has to work out of the office at Thane. All other things being equal, we know that both will put a higher value to an apartment that is closer to one’s work place.
2. A Foreign Institutional Investor (popularly known as an FII) is looking at investing in a market that can deliver higher returns. The options that this FII has are either to invest in developed countries, where the returns are in single digits or to invest in a market like India, where the expected returns could be in double digits. On the other hand, a retired Indian investor with some money to invest may be better off investing in a bank fixed deposit where one-year rate could be as high as 10%. Both the investors would put different values to the same stocks.
3. At the same time, if a company does well in the business and generates good profits by efficient use of capital, investors would be willing to pay a higher price to buy shares of the company. This is like a shopkeeper willing to pay higher price to buy (or higher rental) for a ground floor shop on a busy street with good frontage.
Ultimately the value v/s market price equation can be explained by study of the following:
* Economic fundamentals
* Perceived value of the asset
* Demand v/s supply v/s alternatives
* Availability of money to buy or need of money, which will result into selling
While liquidity rules in short term, fundamentals drive the long-term movement. However, the value v/s price equation gets impacted by either or both liquidity and fundamental factors. Often when the prices move in one direction on account of liquidity or the lack of it, how far the movement goes is difficult to predict. As the famous economist John Maynard Keynes said, “Markets can remain irrational longer than you can remain solvent”.
When that happens the asset becomes costlier than the inherent value as those with money perceive the future value of the asset to be much higher than rationality can explain. It is in such times, in fact at all times, that it is important to understand the basic economics driving the asset prices and the long term behavior of the assets.
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