I had started this post in May this year and it had remained in a draft state ever since. The topic I intended to cover has been covered in the post I made in reply to Ritwik today, so there is no reason to complete this one. But I liked the start I had made. Here it is, broken links, outdated information and all.
The saying goes that “In the kingdom of the blind, the one-eyed man is king”. To contest the saying, H G Wells wrote a short story titled “The Country of the Blind“. It describes the travails of a sighted man who stumbles into a valley of blind men and tries to use the advantage his eyes give him. He fails because the country has been organized in such a way that his eyes give him no advantage at all.
I have been for long wondering which of these competing visions (oops) is true. The Indian stock market tells me that Wells was right. Via Sepia Mutiny I came across a post on Fortune’s blog “Riding the Elephant” which says that India’s investors lack sophistication. The post has generated a lot of predictable jeers both on Sepia Mutiny and on Fortune. But I think that the essential point is true. There is no reason at all for the Indian stock market to go up or down 20% in response to a 2-3% change in the US market. It just does not make sense.
I once participated in a simulated stock market. The simulated companies in that game never paid any dividends. They only announced profits. When I asked why, I was pointed to the Miller Modigliani dividend irrelevance theorem, which claimed that it made no difference whether a company paid dividend or not. That is because when a company made good profits, the price of the stock would rise, and what money an investor would have made, he could make by booking profits.
In reality, the game went quite differently from what the organizers had intended. At first, stock prices did go up when “good” news was announced and down when “bad” news was. But soon, people realised that “good” and “bad” were just words, and that there was no money backing those words. So some people started placing sell orders on the “good” news to book profits from the rise of share prices, and buy orders on the “bad” news, because the price was going to be low. Within 30 minutes, the market had lost any linkage with the fundamentals of this simulated economy, and was going up and down entirely based on “market sentiment”.
I must point out that all the participants in this game were MBA students, all of whom had some grounding in basic capital market theory.
Something similar happens in the Indian stock markets. There are two ways to invest in the market. You can look at the company, find out what profits it is expected to make, and discount those profits to find the expected share price. The alternative is to ignore the fundamentals all together and treat the market like a casino.
As in any casino, the players, on an average lose money. In an actual casino, it is the casino that makes money. One obvious group that makes money in the Indian stock markets would be the manipulators, but I strongly suspect, with no real evidence, that the other group is the genuine investors.