The Direction of the Stock Market

Ooi Kok Hwa did a critical analysis of what is a stock market crash in THE STAR today. He also touch on the analytical tool called the Fractal Market Hypothesis (FMH).

To paraphrase him:

“A crash is a sudden and abrupt drop in prices. Appearing random, it is the consequence of previous price movements. A crash will be severe if a lot of ‘noise traders’ who know nothing about the stock market, continue to participate and risk their money on stocks.”

In a situation when investors are cautious and aware of the risks they are facing when they take positon in the stock market, then any crash that occurs will be short-lived and less severe. Smart investors will not take undue risks. We assume most investors are “smart” and will not over extend their resources. We also believe punters are getting more ‘savvy’ these days with sundry analytical tools and expert services to help them along. Smart trading behaviour is indicated when trading volume shrinks as the market drops and picks up as the market goes up.

Edgar E. Peters in his book entitled Fractal Market Analysis: Applying Chaos Theory to Investment and Economics, proposed using Fractal Market Hypothesis (FMH) to explain the impact of liquidity and investors’ investment horizons on stock market behaviour.

According to FMH, liquidity is one of the main factors contributing to market stability. A market will remain stable when there are a lot of investors with different investment horizons. This is a very pertinent point.

The investment horizons can be divided into short-and long-term. Long-term investors are mainly fundamental investors whereas short-term investors are mainly traders, speculators and technical analysts.

Stock prices are mainly dependent on supply and demand. Hypothetically, a market will remain stable whenever these two groups hold different views. A market will remain flat or stable when long-term investors buy and short-term investors sell or vice-versa. When these two groups share the same view, we would have either a bull or a bear market.

A bear market will occur when the economic fundamentals deteriorate or the market is overvalued and long-term investors stop participating in the market. This backdrop which lacks positive news will equally be unattractive for short-term investors to trade in.

So looking at the local investing climate currently, we have seen the fall of stock prices in Shanghai.The local market was in cautious trading mode during this period and had held quite well through this small crisis and so we can leave that behind us now.

Then there are some other valid concerns which will affect the direction of the market. These include the fear of the slowing down of the U.S economy and the strengthening ringgit chiefly its impact on our exports and industrial production. We also have an ‘X’ factor–the potential general elections poser.

Given the low interest rate regime and the perception that inflation is eroding away ringgit power, the possibility of a movement of smart money from fixed deposits into mutual funds, the stock market, property and bonds remains valid. It is this liquidity flow that will eventually move mutual funds, feeder funds and the local stock market.

Mr Ooi is of the opinion that in Malaysia, it is the day traders, smart investors and institutional investors which have been moving the market with an average daily trading volume of about one billion. He believes there are not many noise traders in the current market.I tend to agree with him here. My take is there are many fund managers out there timing their buying and selling.

Our market will move up if long-term investors believe that our economy will continue to grow stronger. Official statistics once corroborated by international broking houses and analysts, will stir up long-term fundamantal buyers such as pension funds. They will buy for the long haul.At the same time, positive news will spur buying interest from short-term traders and this will add to market activity and trading volume.

If investors generally believe the market can go higher and fundamentals remain intact, the market will go up driven by liquidity. If you believe in the FMH, then our market will likely resume its uptrend as long-and short-term investors start buying stocks again. A superbull may be on the cards.

For the moment, the general elections rumour contimues to be strong and this is helping to catalyse the market to move upwards.

Heartsong