Death, taxes and stock market crash

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Death, taxes and stock market crash
« on: January 04, 2011, 09:25:22 PM »
Death, taxes and stock market crash
   Abdullah A Dewan
  In the USA, we say, something that is guaranteed in life is “death and taxes”. For stock market investors, I added a guarantee of a third event – “stock market crash”. No one knows exactly when death will strike and the same applies to stock market crash.

Last Sunday’s (December 19) crash which plunged the DSE General Index by 551 points or 6.72 percent at the close of a four-hour trading session. In money terms, market capitalization was slashed 5.5 percent, which amounts to a loss of Tk 18,871 crore.

Before the bleeding stopped, distressed investors took to the street – one that is reminiscent of the 1996 crash that also followed street uprising. The impoverished little guys set fire on wood and paper in front of the DSE building, blocked the traffic and intoned their platitudes of angry slogans demanding actions against the top brasses of the premier bourse and market regulators including the BB governor.

Let us examine a few critical issues: Who to blame for the crash? Answer: Mostly the euphoric investors. Should the regulators take some blame? Yes—mostly for their inexperience and lack of understanding that you tighten the rope and make the knot before the rope is tightening too thin -- nearing its breaking point.

My understanding is that you don't change the rules in the stock market when the market is overheating. If you do, market will have a free fall and you will be blamed. Let the market take the nosedive -- the so called correction -- on its own and then you intervene cautiously trying to stabilise it slowly so that the swings are not too painful to the distraught investors.

Investors should take the lopsided responsibility because no one promised them a smooth and happy ride to riches betting in the stock market. Thy lost sight of the obvious signals weeks before the crash that the market is overheating and a crash is looming. My November 7 article in this column underscored such an eventuality. Like everyone else, I read these market overheating signals from published reports.

On October 31st, when reporters asked about the stock price surge, finance minister MA Muhith observed, “I’ll not say that it’s over-heated, it’s little bullish though. However, we’re constantly taking steps to stabilize it”. One such step was Bangladesh bank’s move to enforce 15 percent capital requirement by banks. In that piece, “Is the stock market approaching a crash?” I wrote: “Muhith’s remarks seem to reflect some pent-up apprehensions as though the market could face a major setback anytime now.” Besides, there was other signals unfolding as the market was forming a speculative bubble.

In its attempts to cool down the market from further overheating, BB through its November 4 memo initiated a move to stop commercial banks' unauthorized investment in stocks. On December 2, BB instructed all commercial banks to recover sector targeted loans (purchase of industrial goods and commodities) that were diverted to stock market by January 15. According to BB’s investigations, such irregularities were quite rampant. There were allegations that different banks emptied their vaults to channel funds to the stock market.

Such widespread investigation of banks by BB was its first. Banks in a bid to make quick profit looked to the share market like the general investors. Concerned businessmen and economists in different forums have cautioned about the fallout of such reckless behaviour by banks -- playing in the stock market betting with people’s savings.

In an effort to contain inflation, BB increased the Cash Reserve Ratio (CRR) for banks by 50 basis points to 6 percent. The higher CRR also acts to slow down credit flow to non-productive activities. The BB also issued another directive asking financial institutions to adjust their stock investment exposure to within 10 percent of their total liabilities in the stock market, and the exposure will be calculated based on market price, not cost price. The IMF also advised BB for addressing the overexposure of commercial banks to the stock market.

All these publicly available information were warnings enough to shift investment from stocks to safe assets such as savings account or Treasuries. But the euphoria with share prices was unstoppable as if rising stock prices is an irreversible one way process.

Under inflationary pressure, the investors’ rush to buy stocks is counterintuitive. Washington University economics professor Charles Nelson has studied the impact of price inflation, as measured by the consumer price index (CPI). He devised the following trading rule: “When CPI inflation is on the rise, stay out of stocks; when CPI inflation is on the decline, buy stocks.”

This rule is easily plausible. As inflation increases, central banks increase interest rates to reduce the money supply and slow inflation down: When interest rates are high, cost of borrowing is high, and therefore, there’s less money tiptoeing around. With higher interest rates, investors must be promised higher returns to invest in stocks. This requires stock prices to adjust downward.

In my November 7 piece, I wrote “Any change in the ‘margin loan to equity ratio’ in the middle of market surge would be disastrous.” The SEC changed rules – MRR was decreased and then increased and BB waited much too long to enforce regulations on banks’ operations and unauthorized use of funds in the share market. Big investors saw the signs –sold off their stock holdings leaving the little guys –the ignorant and the euphoric investors impoverished.

One should blame the SEC and the BB only to the extent that they waited too long to enforce regulations. Market was looming to crash regardless -- enforcement of regulations -- when the market was already been oversold -- only hastened the crash. Further deeper corrections will gradually follow as BB keeps steering its anti-inflationary monetary control and higher interest rates policy.

Writer, formerly a BAEC physicist and nuclear engineer, is Professor of Economics at Eastern Michigan University (