Do changes in Stock prices cause Recessions?

QUESTION NO.51

Do changes in Stock prices cause Recessions?

INTRODUCTION

WHAT IS STOCK?

The term stock is also use to mean the ownership shares of a corporation .for example, an owner of a corporation will have a stock certificate which provides evidence of his or her ownership of a corporation’s common stock or preferred stock in accounting there are two common uses of the term stock. One meaning of stock refer to the good .the owner of the cop ration’s common or preferred stock is known as stockholder.

Stocks Basics: What Causes Stock Prices To Change?

Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.

Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.

That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don't equate a company's value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding. For example, a company that trades at $100 per share and has 1 million shares outstanding has a lesser value than a company that trades at $50 that has 5 million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million = $250 million). To further complicate things, the price of a stock doesn't only reflect a company's current value, it also reflects the growth that investors expect in the future. The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn't going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Wall Street watches with rabid attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company's results surprise (are better than expected), the price jumps up. If a company's results disappoint (are worse than expected), then the price will fall.

Of course, it's not just earnings that can change the sentiment towards a stock (which, in turn, changes its price). It would be a rather simple world if this were the case! During the dotcom bubble, for example, dozens of internet companies rose to have market capitalizations in the billions of dollars without ever making even the smallest profit. As we all know, these valuations did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators. Some you may have already heard of, such as the price/earnings ratio, while others are extremely complicated and obscure with names like Chaikin oscillator or moving average convergence divergence

What is Recession?

A recession is a decline in a country's gross domestic product (GDP) growth for two or more consecutive quarters of a year. A recession is also preceded by several quarters of slowing down.

What causes it?

An economy which grows over a period of time tends to slow down the growth as a part of the normal economic cycle. An economy typically expands for 6-10 years and tends to go into a recession for about six months to 2 years.

A recession normally takes place when consumers lose confidence in the growth of the economy and spend less.

This leads to a decreased demand for goods and services, which in turn leads to a decrease in production, lay-offs and a sharp rise in unemployment.

Investors spend less as they fear stocks values will fall and thus stock markets fall on negative sentiment.

So, why do stock prices change? The best answer is that nobody really knows for sure. Some believe that it isn't possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price extremely rapidly.

STOCK MARKETS & RECESSION

The stock market and economy of the country are interrelated. People think that if the stock market is showing a downtrend, then the economy also shows a downtrend. But there is no strong evidence to prove this. Rather the stock market show what investors believe is the state of a country's economy. So realize that the index of the stock market is just a price which fluctuates according to the demand and supply theory.

The basic rule in economics states that if the supply increases, the price automatically decreases. For instance, if the manufacturing of the automobiles has increased, then the prices of automobiles are sure to decrease. When we apply the same theory to the stock market, as the company increases its stocks, the price of the stock should decline. And, if the stock prices decline, then the economy should fall. But this is not seen in the economy and added to this the new stocks are issued when the economy is growing. This is mainly because when a company makes money from the stock market, it uses that money to grow its business. Hence, the economy grows.

The inherent value is used to evaluate the stocks and this influences the investors to sell or buy stocks. The inherent value is determined by the total expected earnings which a company makes in a specific. It is based on the reality that the value of the dollar tomorrow will not have the same value that is has today. If the investors start believing that it is time for recession, they will think that the earnings of the company will reduce. This reduces the inherent value and the stocks are sold. And this leads to downtrend in the market.

The relation between the stock market and the economy is not logical. In the general terms if the Y happened before Z, we think that Y caused Z. The stock prices fall because the investors think that the economy may fall and therefore, sell the stocks. So it is not the economy which is affecting the stock prices or the stock prices that is affecting the economy, it is the thinking of investors which is affecting the indices most of the times.

Investors usually depend on the macroeconomic situations to buy or sell the stocks. And the investors are right about the downtrend of the economy. But they apply this strategy in stock market before there is any visible downtrend in the economy. And, this makes people think that recession is caused due to the market.

The belief that the stock market drives the economy is due to an error in logic. Generally we think that if A came before B that A caused B. In this case, the expectation of a decline in the economy causes the stock market to decline today. Or in logical terms, A came before B, because the expectation of B caused A. It' also important to realize that it's not the expectation of future economic changes that is causing changes in stock prices. It's the fact that people are acting on these expectations. If investors bought and sold stocks based on astrological factors or Barry Bonds' current homerun total then these would be causing the price of stocks to change. In a situation like that, it would seem that the stars are causing the price of stocks to change; the economy would have nothing to do with it.

It is because a large number of investors act on this inherent value principle that the economy tends to follow the stock market. Investors are constantly watching macroeconomic variables to try and determine when the next downturn in the economy will happen. Investors are often right when they predict the future growth rate of the economy. As a result, they often sell off their shares before the economy goes into a decline making it look like the stock market is causing a recession. In reality the causality runs the other way because the two things that causes price to change are changes in supply or changes in demand.

CONCLUSION

From the above we can state that it is always not necessary that the stock prices cause recession. There are other factors which are discussed about, which causes recession too. There are many reasons which cause a company’s stock prices to fluctuate. But it doesn’t mean that its changes will cause recession in the economy. If one company loses then other company gain, as the investor will invest in the company which is providing them good return, so the money keeps on circulating in the stock market itself. When a company makes money from the stock market, it uses that money to grow its business. Hence, the economy grows.

Submitted by:-VIKAS KASHYAP

Submitted to:- Prof.Gurdeepak Singh

MBA1-'C'