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Your Personal 10-Point Survival Guide for Stock Market Katrinas

29 may 2006 - Markets - Editor

Who can claim to have no interest in the stock market? Mainstream media certainly subscribe to survey findings that most 21st century humans are driven largely by passion to accumulate ever-growing personal net worth! Pick up any newspaper or magazine of your choice, or browse through scores of channels and stations, and you will surely encounter news of stocks that you should have bought!

The stock market, like every path that leads to hidden treasure, is paved with thorns! Hearts are notorious for changing rhythm and even pausing altogether for seconds at least, on receiving electric impulses from brains besotted with news of downturns, crashes and bears. Though modern medicine is ready with drugs and devices to help cardiac muscle recover from news of set-backs in the stock market, it does no harm to approach the danger with a set of planned contingent actions born in the professional practice of Financial Management.

Expert post-mortems of the stock market crashes of 1929 and 1987 yield varied conclusions since the number of possible causes are so high. It is always tempting to apportion blame, and this can cloud judgment. Nevertheless, it is vitally important to know when to expect a significant downturn in valuation, because everyone would like to avoid enduring losses of financial substance which threaten our plans and security.

Here are 10 points which can help investors navigate through most storms that can hit a stock market at any time:

  • Warning signs: Severe and prolonged downturns are often preceded by rapid fluctuations. Market capitalization plummets, only to recover in days if not hours. Big bears are flexing muscles and it is time to seek refuge in solid shelters of the blue chips! The latter will not escape punishment, but the effects will be transitory, with steady recovery in time.


  • State of the economy: Large and rising deficits in government budgets, imbalances and major shifts in money supply, aggression in global politics and the terms of international trade, inclement weather and imbalances between supply and demand of strategic goods and services, are precursors of trouble in any stock market. Every investor cannot learn econometrics, but trends in the Gross Domestic Product, employment and inflation may be used as ready measures of economic health. Trends in consumer spending also display general confidence in the state of affairs of a nation.


  • Basel II: Bank liquidity and their abilities to meet surges in commitments with fluidity, are important indicators of a sound national economy. Bank failures are known to accelerate stock market crashes. Though US banks are not fully committed to the international norms of Basel II, the principles of prudent cash management is something for stock market investors to watch with great care.


  • The global scenario: Stock markets outside the United States have an advantage in that they tend to follow trends of the New York Stock Exchange (NYSE). However, the underlying reasons for dramatic downturns at the NYSE may often lie in unstable and confrontational relationships between countries. This is especially the case when the United States is directly involved. We may expect the stock market to fare poorly whenever the United States appears to lose control over the course of international events.


  • Misdemeanor: Since stock market values depend so heavily on psychological factors, every breach of trust by managements, politicians and regulators is received with a most bearish sentiment. No one would like to risk their assets with people whose credentials are suspect. Every instance of malfeasance has the potential to trigger a fall in stock market values, especially if it is detected relatively late.


  • Excessive speculation: Highly leveraged transactions, delays in settlements and feelings that people have begun to take risks they cannot afford, all act as pivots on which every stock market can call. Reasonable margins and transparent controls on speculation herald stock market value appreciation.


  • National governance: Monetary policy, law and order, an effective system of justice, budgetary discipline, provision of productive labor and stable relations with neighbors are key issues which affect investor sentiments. These factors straddle the domestic scene and international financial institutions as well. Funds from abroad travel to economies that are judiciously and rationally governed. Corrupt and restrictive regimes can trigger flight of capital to other countries. Governments that run up large and run-away deficits do not augur well for prospects of the stock market.


  • Skepticism and uncertainty: These are cardinal warning signs. Social unrest, deep divisions on matters of national concern, a hesitant and tentative government and conflicting rumors about developments in the immediate future are all signs that market valuation could decrease and stay that way for at least the medium-term. Some of these sentiments are reflected by free media, but there is generally no alternative to stay close to ground zero in trading circles.


  • Price to earnings: Expectations of business performance and realization of actual returns influence market capitalization significantly in terms of both upward valuation and in causing bearish behavior as well. Investors have short memories when it comes to action. They reward excellent business results and superior returns on investments with enthusiasm and generosity, but are repelled by unmet expectations, and sell stocks with venom!


  • Inherent values at the micro level: just as some members of a stock market may perform below par even in the best business environment, there are professionally managed companies which can weather the most turbulent downturns with calm and ease. Thus a crash at the stock market can be a rare opportunity for some of the best long term investments. Technical knowledge of business appraisal therefore stands sanguine investors in good stead when trading conditions are depressed and unfavorable.

Cyclical trends in valuation of the stock market are probably inevitable. Analyses of time series data can only serve limited purposes, because the history of investment shows a random occurrence of major discontinuities. A stochastic interpretation of any current economic environment, keeping major development of the past in view, can yield reasoned forecasts of possible future outcomes. Such a rational approach, based on relevant facts, can help investors survive and even prosper when the going gets tough.

 


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