Behind the Crash: Analysis of the Roles of Macroeconomic Fundamentals and Market Bubbles in the Nigeria Stock Exchange - PDF

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Behind the Crash: Analysis of the Roles of Macroeconomic Fundamentals and Market Bubbles in the Nigeria Stock Exchange Chioma Chukwuma-Agu Department of Banking and Finance University of Nigeria, Enugu
Behind the Crash: Analysis of the Roles of Macroeconomic Fundamentals and Market Bubbles in the Nigeria Stock Exchange Chioma Chukwuma-Agu Department of Banking and Finance University of Nigeria, Enugu Campus, Enugu Nigeria And Chukwuma Agu Investment and Trade Policy Centre Department of Economics, University of Pretoria South Africa Paper for Presentation at the African Econometric Society Conference, Sheraton Hotel, Abuja; 8 10 July, 2009 JEL Classification : E44, G10, G12, 016 Abstract Using three approaches with two data sources one primary and the other secondary this work aims to show the relationship between stock pricing and behaviour of the stock market on one hand and micro and macroeconomic fundamentals in the Nigerian economy on the other. The primary data was analyzed using charts and figures as well as estimates from a censored logistic model while the secondary data was modeled using an error correction approach. The long run value of the all share price index in the time series model was obtained using a single equation approach that relates the dependent variable to fundamental values of its core explanatory variables. Two equations were thereafter estimated, the first showing the relationship of this long run all share price index with major indicators in the economy and the second showing the relationship of the actual value of the all share price index with same set (or augmented sets) of indicators. The results from both the two sources largely corroborate the other. Data from the primary survey indicate that the key drivers of share prices, particularly for the boom period were neither broad macroeconomic indicators (though such factors as inflation rate and macro instability are noted to affect it) nor key indicators of the health of the firm. Prices were clearly shown to be much above levels that could have been determined by such indicators as posted profits of firms, amounts paid out as dividend and regularity of such dividend payout. In contrast, stakeholders see price setting behaviour as dominant in the market and largely driving stock prices for the boom period. Such price setting behaviour seems to be strongly aided by weak regulatory capacity of key institutions in charge of the market. Reframed as censored logit equations, these same results obtained. Secondary data analysis equally showed that the relationship between actual levels of the all share price index for the period 1990 through 2007 were not driven by expected variables. While its fundamental values are driven by such monetary and relative price variables, actual values are driven by external sector variables and prices. Output was largely insignificant either for fundamental or actual movements in the ASPI. 1. Introduction A. Background to the Study The occurrence and existence of bubbles have gained reasonable academic attention (examples include, Froot and Obstfeld, 1992; Allen and Gorton, 1993; Biswanger, 1999; Chen, 1999; Abreu and Brunnermeier, 2003). The existence of stock market bubbles and crashes dates back to the 1600s. The Dutch tulip mania of 1630 s, the South Sea bubble of and more recently, the internet bubble, which peaked in early 2000, are some notorious cases (Abreu and Brunnermeier, 2003). Time and again, both pundits and market makers have had difficulty correctly foreseeing the direction of the market even in the medium term. For example, when on March 10, 2000, the technology-heavy NASDAQ composite peaked at 5, , very few expected what was to follow the next couple of months. Even though such high movements were quite contrary to the trends in the rest of the economy (particularly given that the Federal Reserve had raised interest rates six times over the same period and that the rest of the economy was already beginning to slow down), the fall still caught many analysts and stakeholders unprepared. The bubble burst that followed (generally known as the dot-com bubble crash) wiped out about $5 trillion in market value of technology companies between March 2000 and October Many other (non-technology) stocks followed in the wave of weak confidence in the market and lost values. A number of reasons have been given for that particular market crash, but as in many other times, such reasons often relate to market-specific occurrences and are weakly related to the overall question of what causes stock market crash and how these can be prevented. Consequently, the question of what causes a particular market crash remains a context-specific one that must be answered for all dips in the market. Investors sometimes, albeit temporarily, show excessive optimisms and pessimism which end in pulling stock prices away from their long term trend levels to extreme points. Just before a major burst, experience has shown, the market will always look so promising and attract some late comers who are also somewhat new and inexperienced in the business. Unfortunately, they are the most vulnerable in crisis times. However, even for the more mature investors, there is evidence that following the market is a very demanding job and no one actually ever does a perfect job of correctly predicting its direction. In particular, the cause of bubbles remains a challenge to most analysts, particularly those who are convinced that asset prices ought not to deviate strongly from intrinsic values. While many explanations have been suggested, it has been recently shown that bubbles appear even without uncertainty, speculation, or bounded rationality. For instance, in their work, Froot and Obstfeld (1992) explained several puzzling aspects of the behavior of the United States stock prices by the presence of a specific type of bubble that they termed intrinsic bubbles. Bubbles are often identified only in retrospect, when a sudden drop in prices appears. Such drop is known as a crash or a bubble burst. To date, there is no widely accepted theory to explain the occurrence of bubbles or their bursts. Interestingly, bubbles occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets simply by examining the expected stream of dividends. Clearly, the existence of stock market bubbles is at odds with the assumptions of Efficient Market Theory (EMT) which assumes rational investor behaviour. Often, when the phenomenon appears, pundits try to find a rationale. Literatures show that sometimes, people will dismiss concerns about overpriced markets by citing a new economy where the old stock valuation rules may no longer apply. This type of thinking helps to further propagate the bubble whereby everyone is investing. 2 Economic bubbles are generally considered to have a negative impact on the economy because they tend to cause misallocation of resources into non-optimal uses. In addition, while the crashes which usually follow bubbles are momentous financial events that are fascinating to academics and practitioners, they often destroy large amount of wealth and cause continuing economic malaise. For investors, the fear of a crash is a perpetual source of stress, and the onset of the event itself always ruins the lives of some. Foreign portfolio investments are withdrawn and/or withheld in order to service domestic financial problems; prospects of reduced foreign direct investment are bound to affect investor confidence and the economic health of countries with market crash. In addition, a general credit crunch from lending institutions for businesses requiring short-and-long-term money may also result and a protracted period of risk aversion can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders and beyond the time of its occurrence. Market reversals and the damage they inflict tend to leave deep-seated memories and emotional scars that are not easily healed with the passage of time. Clearly, crashes (i.e. bubble burst) occur immediately after market tops. The problem now arises as to what perennial parameters should be used to measure the cutting edge of boom harvest to avoid unforeseen future market crash. This study is about market bubbles and crash in the Nigerian capital market. Beginning in 2004, the market witnessed unprecedented boom. This boom lasted till the beginning of 2008 and a crash ensued one which was sustained till the end of the year. The market crash was a strong reminder that the magic wand for understanding and solving the problem of bubbles and bursts in markets is yet to be found. It equally was a reminder that no market in the world is immune to crashes and the so-called rule of new markets that can grow indefinitely does not hold yet for any emerging market. As in some of the bubbles and crashes of earlier years and other climes, a number of reasons could be responsible. But which of these is the chief cause and what is the probable channel of impact is not known. This is partly what this work intends to research into. B. Statement of the problem Recent events seem to indicate that the Nigerian capital market is in no way exempted from the proven imperfections in financial markets throughout the world. While the market has been growing since the turn of the 21 st Century, the banking consolidation seemingly led to a flurry of activities in the market that culminated in sharp increases in the values of a majority of stocks in the Nigerian stock exchange. Stock price movements were strong and investments in the stock market yielded superior returns relative to other channels of investment in the country. It became fashionable to join the investment train. With a growth of about 74.5 percent in 2007, the Nigerian stock market was acclaimed one of the World s fastest growing markets and was an allinvestors toast. Investor confidence was very high and market capitalization peaked at N12.6 trillion as at the first week of March, Multiple returns, particularly in capital appreciation were reaped by a number of investors and market awareness was at an all time high as at the end of However, the trend changed significantly beginning in the second week of March The market began to slide in both capitalization and all share indices. For instance, market capitalization of the 303 listed equities, which had opened on January 1, 2008, at N trillion and later appreciated to N trillion as at March 2008, suffered its highest fall in the 48-year history of the Nigerian Stock Exchange, depreciating by N3.223tn or 32 per cent to N6.957tn by the year end. The all-share index (indexed in 1984 at 100) which had risen to 66,371 as at March 5, 2008, equally dropped drastically by the end of the year. Every indicator in the stock market has continued to slide down. The Nigerian market crash came even before the rest of the world joined in what has now come to be accepted as a global economic recession. While the crash in the price of quoted shares on the Nigerian Stock Exchange started in March, those of the United States started in August and some other developed countries followed later in October. Even though the US real estate crisis had already set in, there was no clear evidence of strong relationship or that it could be the factor driving the fall of prices in the Nigerian stock market. This indicates that changes in the global economy may not be enough explanation for the challenges that faced the Nigerian capital market and calls for further enquiry into the causes. Nonetheless, the decline that was witnessed in the Nigerian capital market cannot be separated from the worldwide financial crisis that has continued to hit hard on global stocks. Needless to say, this development is worrisome. Investor confidence waned in the market and other economic activities like consumption and investment may have been seriously affected. Already, some structural changes in investment (portfolio readjustments, decrease in overall investments, etc) are already going on and many investors are channeling resources to the money market, real estate and other alternative investment destinations. Given these trends, some analysts, investors and other stakeholders are already predicting that the market may be headed for a complete crash. As in many other stock markets under the same circumstances, there have been competing arguments as to the cause of this development since the start of the crash. Explanations as to its cause have ranged from the very plausible to the downright ridiculous. While some believe the market has always been over-valued and is undergoing self-correction indicating that the reduction in share prices will be permanent, others see the correction as temporary. This difference in perception also arises because of differences in understanding of what really is driving the fall in market value of shares. While it is believed in some quarters that share prices rose faster than both market and other economic fundamentals, some see the Nigerian stock market as not having even grown up to its fundamentals and so still having opportunities for further growth, indicating that the correction is very temporary. But clearly, very little empirical analyses support most of these explanations. It is evident that there has been little research into the real causes of the challenges facing the Nigerian stock market. There seem to be more opinions than empirical evidence as to the cause of the market changes. On the whole, while the Nigerian stock market has received comparatively less critical research than some of its developed market counterparts, the current crisis in the market has received even far less critical evidence-based assessment. Many years down the line of market booms and bursts, critical assessment of what drives the Nigerian capital market and the range of roles macroeconomic policies can play to support the market is still weak.the danger in this is that policy positions may not adequately mirror the actual and/or fundamental causes of the problem. In addition, probability of future recurrences is higher if the underlying causes of the problems are not unearthed. This research work sets out to systematically study the market with a view to understanding the different roles of market fundamentals and bubbles in the 4 determination of stock pricing and market movements. The critical measure of market activity used in the study is the all share price index. C. Objectives and Relevance of the Study Given the above, the primary objective of this research is to provide empirical evidence on the causes of the recent stock market crisis in Nigeria. Specifically, the study intends to Find out whether the movements in stock prices over the last couple of years (particularly since from 2004) follows fundamentals in the economy or merely reflect speculative (and other) bubbles. In other words, examine the relationship between stock market valuation and macroeconomic fundamentals in the country Assess the causes of the recent crisis in the Nigerian stock market Evaluate investor confidence in the market given these recent activities and occurrences Make recommendations on ways of avoiding or minimizing the negative consequences of such occurrences in the market in the future. It is our conviction that this study has both academic and practical (policy) significance. The study will contribute to the literature particularly on the determination of developing countries stock pricing and causes of stock market crises. Thus, it aims to add to the body of knowledge on the Nigerian stock market (which presently is relatively small) and point the way for more enquiry into the subject for future studies Besides, the issue under consideration in the work is one which is very current and relevant to investors, policymakers and other stakeholders in the Nigerian economy as it evaluates trends in the market and relate these to important economic goal posts in a meaningful, logical and empirical way. It particularly aims to influence policy on the stock market and inform on the relative roles of firm level fundamentals as well as market regulation and macroeconomic management in the determination of market movements. II. A Review of Related Literature Theoretical Review 1. Stock Valuation and the Theories of Investor Behaviour According to Koller et al (2005), to examine the behavior of the stock market, one must first distinguish between what drives market valuation levels (such as market-value-to-capital ratios) and what drives total return to shareholders (TRS), which are primarily the market fundamentals. They state that market valuation levels are determined by the company s absolute level of longterm performance and growth, that is, expected revenue and earnings growth and return on invested capital (ROIC). TRS is measured by changes in the market valuation of a company over some specific time period and is driven by changes in investor expectations for long-term future returns on capital and growth. Their work showed that the relative market value of a company as measured by the market-value-to-capital ratio is determined by the company s growth and its spread of ROIC over the weighted average cost of capital (WACC). Okafor (1983) classifies approaches to stock valuation under three broad headings: Fundamental Approach, Technical Approach and Efficient Market Approach/Efficient Market Hypothesis (EMT). The fundamentalists lay emphasis on real variables like dividends, earnings etc. They therefore conduct four major forms of analysis as follows - analysis of general economic 5 conditions, industry analysis, company analysis and financial analysis. The assumptions on which the fundamentalists operate are that every asset has an intrinsic value; the intrinsic value of every security is reflected by its market price and basic economic facts about a firm determine the intrinsic value of securities issued by it. The technicians reject the notion of intrinsic values on securities. Rather they study market conditions in general and price movements in particular. By implication, the technicians rely heavily on the market forces for determination of prices of securities. Dow Theory is perhaps the most popular tool of technical analysis. The theory upholds that all price actions comprise three contemporaneous movements the primary movement, the secondary movement, and the minor movements. Charting techniques, which involves the use of graphs, and non-charting techniques, which involves other analytical procedures other than charts are other tools used in technical analysis. The Efficient Market Hypothesis, on the other hand, is a modern development in security valuation. The theory holds that stocks are always in equilibrium and it is impossible for an investor to always beat the market. Consequently, the market is said to always be efficient implying that it adjusts to prices quickly and in an unbiased manner after the arrival of important news or surprises. Proponents of this theory are of the view that there are more pundits than there are stocks. There is parity to precision of their assessment as more analysts follow each stock in a given industry. Hence the price of stocks adjusts almost immediately to reflect any new developments. Generally, there are three forms or levels of market efficiency. The weak form efficiency which holds that prices reflect all past information such as information in last year s annual reports, previous earnings announcements, and other past news. The semi-strong form efficiency which holds that The semi-strong form of efficient market states that all public information, both past and present is reflected in asset prices and The strong form efficiency which holds that prices reflect all public an
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