Well, my purpose of discussion in this post is not about credit rating agencies or its functioning, rather I wanted to discuss some of the behavioural issues associated with the credit ratings and its impact of stock prices/valuation.

Although securities markets are said to be informationally efficient, it means that any new piece of information is absorbed into the security’s prices quickly, according to the efficient market hypothesis (EMH). And securities are given credit ratings on the basis of fundamentals, i.e., the information that is already available in public domain. Then, how come a credit rating for any security, when released, has a sizable effect on market? Doesn’t there involve some behavioural phenomena?

We all know that this is not a generalized case where all the information reflected in credit ratings are public. Of course, there are cases when the market did not have all the information that are exclusively available to a credit rating agency.  Then, it should ideally have significant impact on markets when credit rating decisions are released.

It has been observed that the impact on the markets can vary significantly from time to time as may not be consistent. Such news can be used by traders to test either the upside or downside of the markets. Once traders can successfully drive the market to one side, herding usually follows.

One of the experts was of opinion that most of the information being in public domain, yet the rating has an advantage as they are subject to some major concerns as follows:

(a)    Credit rating agency decisions are structured form of study different from the information available in public domain which might  be difficult to analyze for any individual;

(b)   Such reports include specific parameters as applicable for the respective industry;

(c)    Credit rating agency’s decisions involve detailed analysis of historical information, which may be again beyond scope for any investor;

(d)   Present and future courses and directions of the concerned organization are discussed in details;

(e)    Business risk, beta and other parameters including peer comparison not only with the benchmarked company(-ies), but also with others in the industry, are analyzed;

(f)    Last but not the least, management skills and profitability are emphasized is credit rating reports.

It is true that there is subjectivity involved in credit rating agencies; hence, these reports are not completely free from psychological biases. Behavioural finance has become an integral part of finance and financial decisions. Take a note of it!!

The impact of sporting events on stock prices have already been captured in several recent research studies. A finding in these studies shows that stock prices react sharply to team performance in big sporting events, and when it comes to an event like the Cricket World Cup, the impact would be certainly significant, for sure. Many argue that a sporting event is a non-economic phenomenon and, as such, stock price will not be affected. However, behavioral finance theorists suggest that large sporting events affect the sentiments of viewers (who are/might be simultaneously investors) resulting in upwards or downwards “mood swings” in the stock market, which are subsequently reflected in stock prices.

The basic conceptual framework in such studies involving the impact of mood swings on stock prices draws on the psychology literature which integrates economics, finance, and psychology to assess the impact of mood fluctuations on the decision making process. The pioneers of this line of research in behavioral economics and behavioral finance use the term neuroeconomics to refer to the science of using brain activity to infer investor decision making processes, and subsequently using this concept to explain stock market systems. As far as the relationships between sporting events and stock prices are concerned, the economic research in this field is relatively new. Ashton and Gerrard (2003) studied the impact of the performance of the English soccer team on the FTSE 100 index based on all matches played by the team during January 1984 to July 2002 and found that good performances by the national soccer team was followed by good performances in market returns. This phenomenon is attributed to two issues: either there may be a feel-good factor with national sporting success engendering greater confidence about the future, and/or given the increasing commercial importance of international tournament finals, an efficient stock market is expected to revise the potential economic benefits to be derived from the favorable results of national soccer team.

Edmans and Garcia (2007) examined the effect of cricket matches and their outcomes on stock market sentiment as part of a broader study considering the outcome of a range of sporting events on stock markets in several countries. The magnitude of the loss effect, and its concentration in Western European countries with developed stock markets, suggests that investors may obtain large excess returns by trading on these mood events, for instance, by shorting futures on both countries’ indices before an important match to exploit the asymmetry of the effect. However, the events we cover do not occur with enough frequency to justify a portfolio fully dedicated to trading on them. Moreover, because the effect seems to be particularly strong in small stocks and involves shorting, even traders who face low transaction costs would find it challenging to take advantage of the price drop. Our principal contribution is not to identify a profitable trading strategy, however, but to document that mood can have a large effect on stock returns. In light of our findings, this paper significantly expands the existing evidence linking mood to asset prices.

Taking this issue further (and in the context of the title of this write-up), Mishra and Smith (2010) examined the impact of India’s performance in one-day cricket international matches on the Indian stock market and found an asymmetric relationship between the performance of the Indian cricket team and stock returns on the Indian stock market. While a win by the Indian cricket team has no statistically significant upward impact on stock market returns, a loss in cricket match generates a significant downward movement in the India stock market. They also found that when Sachin Tendulker (one of the India’s, rather World’s most popular cricketer) plays, the size of the downward movements in returns is higher.

Well, let’s now check if the performances of the Indian cricket team in the ongoing ICC Cricket World Cup 2011 matches have any (significant) impact on stock returns in Indian stock markets. The above graph shows the movements of stock returns of two major indices in the Indian stock market, namely the Sensex (the Sensitive Index of the Bombay Stock Exchange, BSE) and the S&P Nifty (the 30 stock index of the National Stock Exchange, NSE). In order to analyse the impact of the Indian team performances on the stock returns, I drew the schedule and results from here.  When you see the return movements in the above graph, you notice that on 21st February, 2011 (Monday) [immediately after the Indian cricket team won its first match of this tournament against Bangaldesh held on 19th feb. 2011, Saturday in Dhaka], returns shook up swiftly from negative (-1.60%) to positive (about 1.20%) in both the Sensex and the Nifty. After the second match with England played in Bangalore on 27th Feb. 2011 (Sunday), the market reacted somewhat neutrally or even downwards in case of the Nifty. If you remember the outcome of that match, it was tied between India and England. Here again, the outcomes support the hypothesis that results of a major sporting event affects stock returns in short term. This phenomenon is evident from the outcomes of the matches the Indian cricket team played and won on the 9th, 20th and 24th of March, 2011, when stock returns reacted positively to the winning results of the domestic team. The returns on the next days of the matches won by the Indian team have been upwards in all these cases, the strongest reaction of all was seen on 25th March 2011 match (after the day when Indian team played against Australia, and won awfully and Indian team entering the semi-finals of the ICC Cricket World Cup 2011). The stock returns on that day in the Sensex and the Nifty both was about 2.5%. It is interesting to note that the Australian team was knocked out of the Cricket world cup tournament after three successive victory, and also that in the Semi-finals, India is going to play a mouth-watering match with its war-like competitor Pakistan after a long time. The cricket match between these two nations have always been much much more than just a cricket match.

Although the stock returns send positive signals after most of the favourable outcomes of the Indian cricket team in this tournaments, we cannot ignore the fact that the stock returns did not behave in a way it did after most of matches the Indian cricket team won in this mega event. After a match on 12th March 2011 when South African team won a match against India, the stock returns show upward movements next day. Similarly, the stock returns on days after some of the matches show a trend contradictory to the above-mentioned hypothesis [see return movements on 10th March 2011: India vs. Netherlands (09-03-2011, Delhi); and  14th March 2011: India vs. South Africa (12-03-2011, Nagpur)].

So, what can be said about the relationship between financial nerves and sporting blood of the country? Since the above discussion is not based on any statistical or economic analysis, nothing as such a concrete association between the stock returns and cricket match outcomes is found. I have just tried to observe a possible relationship between these two things, on the basis of a simple tracking of the results of cricket matches played by Indian team in the current Cricket world cup and the return movements in Indian stock indices during that period. Research involving more solid and analytical approach and sophisticated econometric techniques is required to establish any meaningful relationship between stock returns and Indian cricket team performances. Till the time, enjoy the ongoing ICC Cricket World Cup 2011!!

This morning when I was surfing across the major stock indices across the world for their level of heights (I repeat heights!!!) they achieve nowadays, I just came across this issue. Consensus can be a phenomenon not only among politician in particular and human being in general, but also among the stock indices. Check the stats given in the below picture:

You can see that almost all indices are moving in consensus; at a decline of about (-) 1.20%+ something!! Though it is obvious that Indian indices have always been following the US indices and also other major global indices, but can we say that indian market almost imitate global markets, NASDAQ and NIKKEI in this case? It seems that market efficiency is at its peak. Okay, you might be wondering if stock markets are following the Efficient Market Hypothesis (EMH), isn’t it? (Drumbeats please!!! )

As you watch throughout the day, most of the stock indices seem to act in unison. In case of Indian stock market where two major indices namely BSE Sensex and NSE S&P Nifty50 are more or less moving in unison. It seems awfully odd that investors around the country are all making independent decisions to buy or sell at the exact same time in sufficient quantities to cause a price movement in both indices at EXACTLY the same moment in time. But is this valid for cross-border scenario also?

Is this market manipulation? If not, what “magic event” occurs that causes all indexes to change direction at the same time? This seems to be a good issue to start with for may finance researchers (including me!! He..he..he..!!).

For those who are not aware of the fundas of WPI,  I would like to tell them that the Wholesale Price Index or WPI is the price of a representative basket of wholesale goods. Some countries use the changes in this index to measure inflation in their economies, in particular India – The Indian WPI figure is released weekly on every thursday and influences stock and fixed price markets. But, the Wholesale Price Index focuses on the price of goods traded between corporations, rather than goods bought by consumers, which is measured by the Consumer Price Index. The purpose of the WPI is to monitor price movements that reflect supply and demand in industry, manufacturing and construction. This helps in analyzing both macroeconomic and microeconomic conditions.

Following graphical trend projects the movements in WPI during April 2005 and December 2010 on a month-to-month basis.

The next graphical representation shows the fluctuation in inflation during January 2005 and January 2011. Don’t you think people are exaggerative while relating inflation to rising food prices or oil prices on a stand alone basis? Inflation has, obviously relation to loads of other factors. Each factor might be unique in its characteristics and impact on the macroeconomic indicator.

We often tend to overreact to the economic indicators, more interestingly, much more beyond what we could understand with our skills and knowledge. People have many myths about inflation in particular and in economics and finance in general. Here you can get to read about a Rediff article about the Eigth myths about inflation. I hope now you would feel like more informed about inflation, isn’t it?

Keep exploring and expanding the boundaries of your knowledge!

Sensex returns have remained very fluctuating (read negative) over a period. Let’s have a overview of returns yielded by the Sensex:

A week                          -1.60%

A month                      -7.60%

3 month                      -13.90%   and

6 month                        -1.90%

Essentially, the market (Sensex in the present case) has given positive returns over a long period over one or more years.

1 year                                9.80%

2 year                             84.30%

3 year                                6.60%      and

5 year                              74.30%.

30 days, 50 days, 150 days and 200 days moving average of the Sensex are 20,142.90, 19,478.48, 18,166.38, and 17,820.28 respectively. The index closed last week down at a level of 17,728.61. Now, shall we go ahead with the proposed factors seemed to have been influencing stock returns, one by one briefly.

If we are talking about the company fundamentals, they are not changing everyday unlike their stock prices! It is expected and justified that stock prices fluctuate around the announcements relating to concerned companies. These announcements may include quarterly and interim financial results, major business deals like M&A, big contracts, clients acquisitions, etc., but such events do not happen on a regular basis. So, it is obvious that these factors do not factor in stock fluctuations every time any stock price moves up or down. Earning per share (EPS), Price-earning ratio (P/E Ratio), and market cap are, of course, some of the best things to observe for any stock market investors. These factors do change with several factors underlying it.

Demand and supply of any stock do matter a lot with respect to its movement over the index. This fundamental rule of economics holds good for the equity market as well. The price is directly affected by the trend of stock market trading. When more people are buying a certain stock, the price of that stock increases and when more people are selling he stock, the price of that particular stock falls. Now it is difficult to predict the trend of the market but your stock broker can give you fair idea of the ongoing trend of the market but be careful before you blindly follow the advice.

News is undoubtedly a huge factor when it comes to stock price. News here means the news coming from all the media, be it print, electronic, or whatever. Though news come from across a lot of sources. They may be good or bad, true or just plain rumor, cooked or raw; its the quality of the news and the investors’ capabilities to exploit them that matters to a significant level.  Positive news about a company can increase buying interest in the market while a negative press release can ruin the prospect of a stock. Having said that, you must always remember that often times, despite amazingly good news, a stock can show least movement. It is the overall performance of the company that matters more than news. It is always wise to take a wait and watch policy in a volatile market or when there is mixed reaction about a particular stock.

All these factors altogether along with some more implied factors make investors change their positions and thereby moving the market way too frequently. These implied factors might be the underlying psychological biases such as heuristics, over- or under-confidence, (in)ability to handle or factor into the complex financial information (though it may be equally applicable to simple information also). Understanding these all factors certainly helps investors take informed financial/trading decisions and keep the markets more efficient and reflect the real values of stocks listed on the indices.

Suppose that an investment analyst discover an investment scheme that could really make money out of stocks. (S)he has two choices: either publish his/her technique in financial press such as the Wall Street Journal, the Economic Times, the Business Line and so on (in print media), the ET Now,  the NDTV Profit and so on (in e-media) and win fleeting fame; or keep his/her secret technique secret and use it to earn millions  of Rupees. Most investors/analysts would choose the second option (Obviously!! Isn’t it?), which present us with a conundrum.

Only investors/analysts who find that an investment scheme cannot guarantee abnormal returns will be willing to report their findings to others. Hence the notion of Efficient Market Hypothesis (EMH) is doomed here only. It is evident that successful investment strategies are not being reported to the public, only those which do not provide investment rewards are available to the mass investors. This is a problem in “selection bias“; the outcome we are able to observe have been preselected in favour of failed attempts. Therefore, we cannot fairly evaluate the true ability of portfolio managers to generate winning stock market strategies.

Adapted from: Investments (BKM), 7th ed.

Why was the interest rate hike expected? Primarily because core inflation (non-food) has been rising and 6 rate hikes in 2010 had little effect in cooling off prices. It’s been a matter of mass debate that food inflation has almost gone out of control, and the Indian housewife is at her wit’s end trying to put nutritious food on the table within the family budget.

If 6 previous rate hikes haven’t managed to control inflation, will the 7th (1st in 2011) fare any better? That is a good question, and the RBI Governor knows it. He took pains to explain to the media that his choices were limited. Inflation needs to be controlled, otherwise high prices of essential commodities will increase input costs for India, Inc. That would affect bottom lines and may slow down expansion and capital expenditure. The severe crack in Hindustan Unilever’s stock price (on 25th of January 2011) is a clear example of investor nervousness. Not only HUL, but the entire market seems to follow the correction mode.

The immediate impact of raising interest costs too much at one go would be resulting in increase of borrowing costs and it might hurt the growth prospects of Indian companies. The RBI has chosen the middle path of a gradual increase in interest rates. If inflation continues to rise, another round of rate hikes may be inevitable (So, be prepared!!). Already, the RBI Governor has relaxed the target core inflation rate to 7% from the earlier 5.5%. There lies the first clue to the market’s fall today. So far, the RBI and finance ministry officials have been making positive noises about controlling inflation through monetary measures coupled with the ‘base effect’ of higher inflation in the year gone by. This was the first official admission that things haven’t worked and aren’t going to work (at least in very near future) as planned.

The second point worth noting here is the unambiguous message that the RBI Governor sent to the commercial banks: Curb lending and increase deposit rates. That may be music to the ears of retirees who stay far away from the stock market and depend on fixed income avenues. Fixed deposit rates at banks will hit the double-digit mark soon. What is meat for retirees is poison for stock market investors. The combination of higher interest rate with lending curbs will throw a spanner in the works of India’s growth story.

Rate-sensitive stocks took a beating today, and don’t be surprised if the stock market cracks further after the Republic Day holiday. As small investors, there are a couple of things they should adopt as their actions.

(i) Don’t panic and sell off everything. But if you are in profit in second rung stocks, book some or all of it.

(ii) Prepare for a bigger correction by making a list of fundamentally strong stocks that offer some Margin of Safety. Let the correction play out.

The next positive trigger may come when the Union Budget will be put forth on the Parliament table. Be alert of your emotions, if possible buy then..

For many small investors, it is not economical to continuously monitor the market. These investors use orders to represent their interests when they are not paying close attention to the market. Institutional investors who usually arrange their own trades have an advantage over individual/small investors who use orders to express their intentions/beliefs/sentiments about the market. The former can respond to market conditions as they change. The later, therefore, must anticipate such changes and, to deal with them, write contingencies while placing their trade orders/making trading decisions.

Trade orders adequately represent investors’ sentiments in general even when market conditions change. When trade orders fail to do so, institutional investors cancel their trade orders and submit new instructions promptly, but individual/small investors are not so active in responding to such situations. It is, therefore, unlike individual investors, institutional investors are able to take advantage of the changing market conditions. Individual investors therefore must carefully specify their intentions/sentiments when they use orders to trade or make trading decisions.

The Blog-Health-o-Meter™ reads This blog is doing awesome!.

Crunchy numbers

A Boeing 747-400 passenger jet can hold 416 passengers. This blog was viewed about 1,600 times in 2010. That’s about 4 full 747s.

In 2010, there were 18 new posts, growing the total archive of this blog to 20 posts. There were 20 pictures uploaded, taking up a total of 7mb. That’s about 2 pictures per month.

The busiest day of the year was December 15th with 49 views. The most popular post that day was About the BFR.

Where did they come from?

The top referring sites in 2010 were papers.ssrn.com, facebook.com, google.co.in, mail.yahoo.com, and yandex.ru.

Some visitors came searching, mostly for behavioral finance research, behavioral finance phd, behavioural finance in india, behavioural finance research, and behavioral finance.

Attractions in 2010

These are the posts and pages that got the most views in 2010.

About the BFR December 2009
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Empirical Research Studies January 2010

Readings for a PhD Student August 2010
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Resumé August 2010

Does Imposing Fine Influence Students’ Behaviour? A Case for Academia November 2010
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