AN ANALYSIS OF THE INTERRELATIONSHIP AND IMPACT OF STOCKMARKET, MICRO AND MACROECONOMIC FUNDAMENTALS ON STOCKPRICING IN NIGERIA

ABSTRACT

Since the Dutch Tulip Mania of the 1630s, cycles of bubbles and bursts in stock markets have become commonplace across the world, hence, this has gained a reasonable academic attention. However answers as to what causes a particular market crash remains context-specific and in most cases, weakly related to the overall question of what causes stock market crash and how it can be prevented. Consequently, the question of what causes a particular market crash remains context specific which has to be answered for all dips in the stock market. Recently, Nigeria Capital Market took a plunge downwards in March 2008 after more than four years of consistent super performance. As is the case in many other African countries, thus far, explanations are hardly empirics supported. As a result, specific drivers of the markets given the peculiarities of poor capitalization, weak underlying economic base and open capital accounts remain unexamined. This study employs three approaches with two data sources with two data sources – one primary (analyzed using charts and tables as well as estimates from a censored logit model) and the other secondary (analyzed using error correction model incorporating macroeconomic indicators) to examine the relationship between Nigeria Stock market and economic fundamentals with a view to determining their impact on stock valuation. We estimated two equations. The first equation showed the relationship of a long run all share price index with major indicators in the economy and the second showed a relationship of the actual value of the all share price index with same set (augmented set) of indicators. The results from the two data sources significantly corroborated each other. The findings largely indicate disconnect between economic fundamentals and stock pricing. We explored the implications on the economy and proffered solutions.

CHAPTER ONE

INTRODUCTION

1.1      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 1719 – 1720 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 ¹5, 048.62, 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 ²$5 trillion in market value of technology companies between March 2000 and October 2002. 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 pessimisms 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 hardly does anyone ever do 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.

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 ³Great 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. Osinubi and Amaghionyeodiwe (2002) observed that the securities industry today is characterized by rapid growth and filled with complexities. New instruments such as equity options, stock index futures and a host of other derivatives are being traded throughout the world. The core of all these activities is the stock market. The stock market, widely described as a barometer of any nation’s economy, provides the fulcrum for capital market activities and it is a leading indicator of business direction. An active stock market may be relied upon to measure changes in the general economic activities using the stock market index (Obadan, 1998). A robust stock exchange not only promotes economic growth, but predicts it.

Indeed, there are several benefits that follow the existence of a robust capital market in a country. Claessens and Glen (1995) list a number of such benefits, most of which define it as critical in the development process. For example, the market remains a veritable source of long term capital for growing businesses, government social investment among others. A well-managed stock market leads to diversification of investment and the market provides opportunity to domesticate wealth. In other words, the Market is a tool for holding back capital flight. Privatization, regularly used as instrument for increasing the stake and participation of the private sector in the economy, also cardinally depends on the stock market. The successful implementation of the divestiture programs under structural adjustment programmes in many African countries owes large to the growing importance of the stock market.....

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Item Type: Project Material  |  Size: 75 pages  |  Chapters: 1-5

Format: MS Word  |  Delivery: Within 30Mins.

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