Explainer: What is dragging the stock market lower?

The Sensex closed just above the 37,000-mark after it fell by 463 points on August 1, whereas the Nifty was down by 138 points and closed at 10,980, hitting a new five-month low.

Overall, close to 600 BSE stocks hit 52-week low. In this explainer, we take a look at the factors that are driving the stock markets down.

Why are stock prices crashing?

Going by the commentary of company managements in their earnings calls, the slowdown in the economy appears to be getting worse. You are seeing a severe demand contraction in most industries, notably auto. This is hurting the earnings of companies.

Is the market over reacting? Usually they are known to over react in good times as well as bad?

Other than a handful of Nifty stocks, which have risen sharply, the rest of the market has been under pressure for some time now. So the downtrend in prices has not happened overnight.

Investors were hopeful of an earnings recovery in the June quarter. That does not seem to be happening. Worse still, most companies are saying that they do not have any visibility for at least two more quarters.

Yes, the market could be over reacting, but then as the stock market saying goes: Bhav bhagwan che (price is everything)

Are there any other factors, other than a depressed earnings outlook, that is hurting market sentiment?

Credit is getting tighter. Given some defaults by companies on their debt paper in the last few months, banks and mutual funds have become wary of lending. This has pushed up borrowing costs for everybody. Of course,  companies with a good credit rating are still getting money, but others are having to offer higher rates.

Many promoters have raised money by pledging shares. Till some months back, it was relatively easy for promoters to find borrowers. Not any longer. If stock prices fall further, many promoters will have to either repay a part of what they have borrowed against their shares, or deposit additional shares with their lenders to make up for the loss in value. If they are unable to do either, the lenders will dump the shares to recover their money.

So is costly debt aggravating the problem?

Definitely. Unlike problems in the equity market, where the value is notional (paper wealth), problems involving debt are real. We are talking about real institutions having lent money by borrowing from individuals in the form of deposits/bonds, and then lending to companies. A debt collapse will hurt much more than an equity collapse.

How are institutional investors looking at the market?

Foreign funds have turned negative over the last month and have been selling more than what they have been buying. That has mainly to do with the additional tax that many foreign funds will have to pay following the Budget proposal to raise the surcharge for wealthy individuals and trusts. Many foreign funds are structured as trusts.

So far, domestic mutual funds have been getting steady inflows through systematic investment plans. But some investors have been discontinuing theirs SIPs as returns for more than one year have now turned flat, or even turned negative.

Reduced inflows into mutual funds is a big risk for the market, because that is what has helped the market to absorb the selling by foreign institutional investors.

Mid and small cap stocks are available dirt cheap. Is it a good time to buy them?

Yes, many stocks are available for half the price or even less, compared to their prices 12-18 months back. But that does not automatically make them cheap. You will need to check their track record before taking a call. If you recall, many auditors of listed companies have resigned in the last few months because they did not have the confidence to certify the financial numbers. Yes, quite a few companies have been fudging their books to ensure a good valuation for their shares. But that is becoming increasingly difficult as regulators are tightening the screws on auditors as well as companies.

So should I not buy anything at all?

In fact, this is the time you should be putting money in the stock market. As mentioned earlier, be watchful of what you are buying. If you are not confident of buying stocks directly, invest through mutual funds. Do not discontinue you mutual fund SIPs. Remember, you can never catch the top or bottom of the market. But if history is any indicator, buying in times of panic usually has yielded good results a few years down the line.