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Stock Market Theory

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The Indian Stock Market

The stock market in India is part ofthe larger Indian Securities Market.

Above everything is the Indian

Economy. Therefore, economics is

important.

Where does the stock market fitinto the great Indian economic

scene?

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EconomicsI

FinanceI

Investment

/ \

Tradeable Non-tradeable

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Hybrid

Secondary

Primary

Equity

Hybrid

Secondary

Primary

Debt

Tradeable Investments

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The Primary / New Issue /IPO Market

Companies need capital for:

starting anew

expansion

diversification

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The Primary / New Issue / IPO Market

Capital is raised by:Public issue by prospectus

Book built public issues

Offer for sale

Private placement

Rights issues

Bought out deals

ESOPs

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The Primary / New Issue / IPO Market

As a rule, avoid IPOs, because blindinvesting in IPOs is investment withouta strategy.

Most IPOs are bunched together in abull market when it is good for thecompanies to sell their shares rather

than for investors to buy them.The track record of the promoters is

possibly the most important criterion

for investing in an IPO.

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The Stock Market

World stock markets have a

history of more than 350years.

Indian stock markets have ahistory of almost 200 years.

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Securities Market History

In 12th century France, there wereofficials called ‘courratier dechange’ who were concerned with

managing and regulating the debtsof agricultural communities onbehalf of the banks.

Because these men also tradedwith debts, they could be called

the first securities brokers.

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In the late 13th century, commoditytraders in a French town called

„Bruges‟ gathered inside the houseof a man called Van der Bourse

and in 1309 they institutionalised

this hitherto informal meeting placeinto what came to be known as the

„Bruges Bourse‟.

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In 1351, the Venetian governmentoutlawed the spreading of rumours

intended to influence the price of

government securities. In the middle of the 13th century, Venice

bankers began to trade in government

securities. Pisa, Verona, Genoa, Florence also began

trading with government securities during

the 14th

century.

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The Dutch later started joint stockcompanies, which let shareholders

invest in business ventures and get a

share of their profits or losses.

In 1602, the Dutch East India

Company, issued the first shares onthe Amsterdam Stock Exchange. It

was the first company to issue stocks

and bonds.

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Why Is Stock Market History of

Vital Importance?“No statement is more true and

better applicable to Wall Streetthan the famous warning of

Santayana: “Those who do not

remember the past, arecondemned to repeat it.”

- Benjamin Graham, „The Intelligent Investor‟

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Benjamin Graham (1894 – 1976)

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History of the London Stock

Exchange

Started life in the coffee houses

of late 17th century London.

Quickly grew to become the

city‟s most important financial

institution.Is a major world stock exchange

even today.

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LSE – Historical Highlights

1698 – Stock dealers are expelled fromthe Royal Exchange for rowdiness andstart to operate in the streets and coffeehouses nearby, in particular, Jonathan‟sCoffee House in Change Alley.

1698 – John Castaing begins to issue“at this office in Jonathan‟s CoffeeHouse” a list of stock and commodityprices called “The Course of theExchange and other things.”

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1720 – The wave of speculative feverknown as the „South Sea Bubble‟ bursts.

1748 – Fire sweeps through Change

Alley, destroying most of the coffeehouses, but they are subsequently

rebuilt.

1761 – A group of 150 stock brokers and

jobbers form a club at Jonathan‟s to buy

and sell shares.

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1773 – The brokers erect their ownbuilding in Sweeting‟s Alley with adealing room. This is briefly known as“New Jonathan‟s”, but members soonchange the name to „The StockExchange‟.

1801 – On 3rd March, business opens on

a formal membership subscription basis.On this day the first regulated exchangecomes into existence in London and the

modern stock exchange is born.

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1802 – The exchange moves into anew building in Capel Court.

1812 - The first codified rule book iscreated.

1836 – The first regional stock

exchanges open in Manchester andLiverpool.

1854 – The stock exchange building

is rebuilt.

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The painting that followsshows the trading hall of

the London StockExchange sometime in

1847

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The painting that followsshows the trading hall of

the London StockExchange sometime in

1891

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1914 – World War I breaks out and thestock exchange is closed for about 5months.

The Stock Exchange Battalion ofRoyal Fusiliers is formed. Sixteenhundred volunteer, four hundred neverreturn.

1923 - The exchange receives its owncoat of arms with the motto. “Dictum

Meum Pactum” (My word is my bond).

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1939 – World War II breaks out. Theexchange is closed for the first 6days. It is closed for one more day in

1945 due to damage from a V2rocket. Trading continues in thebasement.

1972 – Queen Elizabeth II opens theexchange‟s new 26 storey buildingwith its 23,000 sq. ft. trading floor.

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1973 - First female members areadmitted to the market.

1973 – Eleven British and Irish

regional exchanges amalgamate withthe LSE.

1986 – Deregulation of the market

known as the „Big Bang‟. Ownership of member firms by an

outside corporation is allowed.

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All firms become brokers / dealers,able to operate in a dual capacity.

Minimum scales of brokerage are

abolished. Individual brokers cease to have

voting rights.

Trading floor abolished. Computerisedtrading and dealing via computer andtelephone from separate dealing

rooms commences.

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The exchange becomes a private limitedcompany under the Companies Act,

1985.

1991 – The governing council of theexchange is replaced by a board of

directors drawn from the exchange‟s

executive, customers and users.

1995 & 1997 – Faster and better trading

and settlement systems are introduced.

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2000 – The exchange transfers its role as listingauthority for the U.K., to the Financial Services

Authority (FSA).

2000 – Shareholders vote to become a public

limited company, London Stock Exchange,

PLC.

LSE shares list on the LSE itself in July.

2003 – Derivatives business division of the LSEstarts.

2004 – LSE moves to brand new headquarters

close to St Paul‟s Cathedral in London.

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New York Stock Exchange

The origin of the NYSE can be tracedto 17 May 1792, when the Buttonwood

agreement was signed by 24 stock

brokers outside 68 Wall Street in NewYork, under a buttonwood tree.

On 8th March 1817, the organisation

drafted a constitution and renameditself as the „New York Stock &

Exchange Board.‟

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NYSE – Historical Highlights

In 1863, the name was shortened to thepresent „New York Stock Exchange.‟

From July to November 1914, the

exchange was closed due to the outbreakof World War I, but after that it reopened tohelp the war effort by trading bonds.

On 16th September 1920, a bombexploded outside the NYSE building onWall Street in a terrorist attack, killing 33and injuring 400. The culprits were never

found.

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On 24th October 1929, there was theBlack Thursday Crash.

On 29th October 1929, selling

intensified leading to Black Tuesdayand the start of the Great Depression.

In the 1930s, the focus was on stock

market regulation and investorprotection. Many important pieces ofsecurities legislation were passed.

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Commissions became fullycompetitive on May 1, 1975. NYSEmembers used to call it „May Day‟.

They must have thought it was aCommunist conspiracy rather thanthe laws of economics at work!

The concept of circuit breakers andcontrolled stoppages of trading wereconceived, after the 554 point drop in

the DJIA on 27th

October 1987.

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Today, trading halts for an hour,two hours or the rest of the day,

if there is a drop of 10%, 20% or

30% respectively in the DJIA.

The NYSE was closed from 11th

to 17th September 2001,following the 9/11 terrorist

attacks.

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Why bother about stock

market history?“There is nothing new in

the markets, only thehistory you haven‟t

read.” - Larry Swedroe

(US investment advisor)

F

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From

The Native Share & StockBrokers‟ Association

to

The Stock Exchange, Bombay

to

BSE Limited

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The Stock Exchange, Bombay

An informal group of approximately 22 stockbrokers used to trade under a banyan tree

opposite the town hall of Bombay from the

first half of the 19th century.

In 1875, this informal group organised itself

into the „Native Share and Stock Brokers

Association‟.

The BSE is the oldest exchange in Asia.

The Tokyo Stock Exchange is the second

oldest established in 1878.

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BSE – Historical Highlights

A brokers‟ hall was inaugurated inJanuary 1899.

After World War I, the BSE was

shifted to an old building near theBombay Town Hall.

In 1928, the plot on which the BSEbuilding now stands was acquiredand a building was constructed in1930.

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BSE – Historical Highlights

Sir Phiroze Jeejeebhoy waschairman of the BSE from 1966 to

1980 and was the visionary behind

the current, 28 storey building. In 1995, the system of manual

trading by open outcry was replaced

with a computerised trading system

called the „Bombay Online Trading

System‟ or BOLT.

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The Stock MarketThere are 25 „recognised‟

stock exchanges in India, but

all except the BSE and NSEare virtually defunct.

Stock market investment wasan esoteric art until the mid-

1970s

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The Stock Market

Foreign Exchange Regulation Act(FERA), 1973.

The Dhirubhai Ambani / Reliance

Industries factor.Several booms, recessions and

scams since 1975.

With liberalisation, the Indian stockmarkets have achieved worldstandards, commencing from 1991.

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The Stock MarketSEBI and the age of regulation

Computerised / screen based trading

Clearing Corporations and theguaranteeing of trades

Dematerialisation

Internet trading

Rolling settlements, currently T+2

Derivatives

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The Stock MarketGovernment support to the spread of theequity cult:

Dividends on equity shares are tax free in

the hands of the recipients even thoughthere is a 16.995% dividend distribution taxpayable by the companies.

Long-term capital gains tax exempted on

equity, although there is STT at 0.125% onall delivery based transactions.

Short-term capital gains pegged at 10.3%

with STT.

Th St k M k t

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The Stock Market

Exemption of all financial investments,including equity, from wealth tax.

Holding period of equity & equity mutualfunds for long-term capital gains eligibility

is 1 year as opposed to 3 years for non-financial assets.

Abolition of stamp duty on demat

purchases. Minimum market lot is 1 under the demat

regime.

Stock lending

f f S

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Definitions of a Stock Exchange

A stock exchange is an organisedmarket for purchase and sale of second

hand listed and permitted corporate and

government securities.SCRA, 1956: Any body of individuals,

whether incorporated or not, constituted

for the purpose of assisting, regulatingor controlling the business of buying,

selling or dealing in securities.

Economic Functions of a

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Stock Exchange

Ready market for existingsecurities

Evaluation of securities „Res tantum valet quantum vendi

potest‟ – A thing is worth only

what someone else will pay forit.

The market is always right!

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Evaluation of Securities

“We have seen much more moneymade and kept by „ordinary people‟

who were temperamentally well suited

for the investment process than bythose who lacked this quality, even

though they had an extensive

knowledge of finance, accounting and

stock market lore.”

- Benjamin Graham, „The Intelligent Investor ‟

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For the common equity investor…

In the short run, thestock market cannot

be analysed.

In the long run, it neednot be analysed!

E i F ti f

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Stock Exchange

Safeguards for investors through investor grievanceredressal mechanisms,arbitration, ensuring market

integrity, effective marginingsystems and active andpassive intervention measures.

E i F ti f

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Stock ExchangeRegulation of company

managementCapital Formation

Facilities for trading,settlement, arbitrage, hedging

and speculation

S

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Stock Market Animals

Stock Market „animals‟can be classified into 2major categories:

Operators, andPlayers

O t i th St k M k t

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Operators in the Stock Market

In the modern, screen basedtrading environment, stock marketoperators would be:

Stock Brokers, employees orassociates authorised to operateonline trading terminals.

Professional Dealers includingday traders logging in throughinternet terminals or remote

terminals.

O t i th St k M k t

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Operators in the Stock Market Stock Market operators can be classified

into 2 major categories – Operators andPlayers

In the modern, screen based trading

environment, stock market operators wouldbe:

Stock Brokers, employees or associatesauthorised to operate online tradingterminals.

Professional Dealers including day traderslogging in through internet terminals or

remote terminals.

O t i th St k M k t

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Commission Brokers

Jobbers

Financiers

Specialised dealers in govt. securities,odd lots, spot transactions anddebentures

Arbitrageurs

Floor Brokers

To get an insight into how the stockmarket actually works, let us considerthe operators in the old days of manual

trading:

O t i th St k M k t

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Commission Brokers

Jobbers: A jobber is a super

specialist. He generally deals in just

one share. He does not entertain

clients. He is an independent,

professional operator. He wouldalways be willing to give a two way

quote for the security in which he is

jobbing.

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The Trading Floor

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ACC

TISCO

RELIANCE

L&T

The Trading Floor

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Example of an actual trade in thedays of manual trading:

Lets assume the commission broker

has an order to purchase 500 sharesof Tata Steel for his client.

He enters the trading floor and

proceeds to the Tata Steel tradingcounter where he establishes eyecontact with the Tata Steel jobber.

O t i th St k M k t

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He yells at the jobber “500 Tisco”.Please note that the commissionbroker does not disclose to the jobber

if he is a buyer or seller.The jobber quotes, let us say, “500/501”.

This means the jobber is prepared to

buy 500 Tisco at Rs 500/- and sell 500Tisco at Rs 501/- per share. Thedifference of Re 1 is called the jobbingmargin or the jobber‟s turn.

O t i th St k M k t

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If the commission broker finds the ratereasonable, he yells “taken” and thedeal is done.

If the next commission broker buys, letus say 1000 shares of Tisco, at thesame rate of Rs 501/- and the broker

after him buys 750 shares at the samerate, what is the message that is beingconveyed by the market to the jobber ?

Is demand more or supply more?


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Obviously, demand is more. When demand

is more, prices rise.

Therefore, when the next commission

broker approaches, the jobber will change

his quote to “501/502”.

If sustained buying continues, the quotes

may increase to 502/503, 503/504,

504/505, 505/506 and so on, until in the

perception of the jobber, selling emerges

which is approximately equal to the buying.

O t i th St k M k t

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If at say, 505/506, selling is greaterthan buying in the perception ofthe jobber, the prices will start

declining to 504/505, 503/504, etc.Jobbing is an extremely skillful and

risky operation. Good jobbers

could execute between 60 and80 transactions per minute, inshort bursts of intense trading.


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The objective of the jobber is to havea nil position in securities at the end

of the day. In other words, if he has

purchased a total of 1 lakh shares,he would endeavour to sell 1 lakh

shares. If he operated for a margin

of Re 1/- per share, his net profit

would be Rs 1 lakh at the end of the

day

Players on

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Players on

the stock market

InvestorsSpeculators

I t t V S l ti

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Investment Versus Speculation

Investment: is the purchase of anasset for the conservation of wealthand the increase of wealth, with the

emphasis on the conservation ofwealth.

Speculation: is the purchase of an

asset for the conservation of wealthand the increase of wealth, with theemphasis on the increase of wealth.

In estment Vers s Spec lation

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Investment Versus Speculation

To sum up,Investment is safe speculation.

Speculation is hazardous investment.

Who is a speculator?

Generally, someone who goesagainst an investment time horizon.

Investments Versus Speculation

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Investments Versus Speculation

Short-term speculation Vs long-terminvestment

100____102____104____106____124

1st Jan 3st Jan 28th Feb 31st Mar 31st Dec

Senseless speculation Vs „Sensible

speculation‟

M k T i

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Mark Twain

There are two times in a man‟s life

when he should not speculate:

when he can‟t afford to,

and when he can.

Mark Twain (1835 1910)

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Mark Twain (1835 – 1910)

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“The market can stay

irrational longer thanyou can stay solvent.”

- John Maynard Keynes

John Maynard Keynes

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John Maynard Keynes

Types of speculators

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Types of speculators

First-time winners – mistakingluck for expertise!

The roller coaster riders – winsome, lose more than some!

Slow losers – bleeding to death

„Stake all at the top‟ suckers

Short-term „investors‟

The lesson from internet trading

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The lesson from internet trading

Terrance Odean, a finance professorwho studies investor behaviour, foundwith his colleagues, that most

internet traders actually lost moneyeven during the tech bubble of 1998-2000. systematically buying and

selling the wrong stocks. The morethey traded, the worse theyperformed. The average survival timefor day traders was about six months.

Stock Market Malpractices

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Stock Market Malpractices

Kerb TradingWash Sales

Cornering

Rigging

Insider Trading: When a person

privy to unpublished, price-sensitiveinformation, plays the market with a

view to enrich himself.

Causes of Price Fluctuations

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Text book causes: Demand and supply

Supply of credit (Bank Rate)

Actions of domestic and foreigninstitutions, mutual funds, underwriters

Merits and performance of individual

companies

Trade cycles

Speculation


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Causes of Price FluctuationsText book causes (contd.):

Sympathetic fluctuations

Government policies and political factors

Actions of derivatives operators Cornering, rigging, rumours, insider trading

Actions of regulators

Technological innovations

Amalgamations, mergers, takeovers,

acquisitions

The Real Cause of

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Daily Price Fluctuations

Sentiment

Understanding market behaviour /

sentiment:Human beings are basically irrational.

They are guided by emotions, impulses,

instincts, prejudices, wishful thinking,hopes, fears, desires, almost

everything, except logic and reason.

Crowd behaviour

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Crowd behaviour Stock Market operators and players are all

part of a crowd.

Crowd behaviour is very different fromthe behaviour of individuals who make

up the crowd. A crowd never reasons or thinks. It is always

swayed by emotions.

Emotions being extremely contagious,sweep through the crowd, sometimespropelling it in one direction and sometimesin another.

Crowds always over react

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Crowds always over-react

Therefore, crowds are never moderatein their approach.

They are always given to extremes of

behaviour.The crowd associated with the stock

market is the sum total of the operators

and players who perform any marketrelated action on a given day.

This crowd always over reacts.

Results of over-reactions

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Results of over-reactions

The over reaction of thestock market crowd results

in either pushing stockprices to unrealisticallyhigh levels or sendingthem crashing toundeservedly low levels.

Greed Fear & Hype

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Greed, Fear & Hype

Greed Vs fear syndrome:Greed is the most prevalent

emotion in a rising market.Fear takes over in a falling

market.Hype adds fuel to the fires of

greed and fear

The Greater Fool Theory

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The Greater Fool Theory envisionsa world in which there is a suckerborn every minute.

These suckers exist only to buyyour investments at a higher pricethan you paid for them.

Therefore, you can pay any price,so long as others are willing to paymore than your price.


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There is no reason, only masspsychology, in the world of thegreater fool theory.

It‟s perfectly all right to paythree times what something is

worth, as long as later on, youcan find some innocent to payfive times what its worth.


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“Stocks are bought onexpectations – not on

facts.”

Old Wall Street proverb: “No price is too high for abull or too low for a bear.”

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Understanding market

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Understanding market

behaviour / sentiment

“Nothing sedates rationality

like large dosesof effortless money.”

- Warren E Buffett

Warren Buffett

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Warren Buffett

Understanding Market Behaviour /

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g

Sentiment:

“In individuals, insanity israre. But in groups,

parties, nations andepochs, it is the rule.” - Friedrich Nietzsche

Epoch: the beginning of a distinctive period

in the history of anything

Friedrich Wilhelm Nietzsche (1844 – 1900)

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( )

Greed Fear & Hype

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Greed, Fear & Hype

“The four mostexpensive words in the

English language are,„This time its different‟.”

- Sir John Templeton

Sir John Templeton

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Sir John Templeton

Greed Versus Fear

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Greed Versus Fear

“We simply attempt to be fearfulwhen others are greedy,

and to be greedy only whenothers are fearful.”

- Warren Buffett

Mistakes

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Mistakes

Basic human irrationality, pluscrowd behaviour, plus over-

reactions, plus

Greed, plus fear plus hype, result

in mistakes.

“Every time a share is bought orsold, somebody, somewhere

has made a mistake.”

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Daniel Kahneman

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Daniel Kahneman

The idea that any single

individual without extra

information or extra marketpower can beat the market is

extraordinarily unlikely. Yet themarket is full of people who

think they can do it.

Daniel Kahneman

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Daniel Kahneman

Real Causes of Long-term

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Equity Price Movements

The one reliable truth of equityinvestment is that in the long run, the

market always goes up.

The rate of growth of equity investmentscomfortably exceeds the rate of inflation.

The long-term rate of return on stock

market investment is the total of the

dividend yield and the long term rate

of earnings growth.

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Cumulative annualised returns of different asset classes(1985 - 2006) Source: CLSA

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(1985 - 2006) Source: CLSA

17.9

11.3

10.4

7.2

6.8

0 5 10 15 20

Equity

G Sec

Bank FD

Gold

Inflation (% Annualised returns)

Real Causes of Long-term Equity

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Price Movements

That is why probably the only

equity measuring tool that a

common investor needs to knowabout is the price earnings ratio.

„P‟ = Price = Market Price „E‟ = Earnings = Earnings per

share (EPS)


P i M t

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Price Movements

When you divide the market price „P‟ bythe EPS „E‟, you get the Price / Earnings

Ratio or P/E Ratio.

The P/E ratio indicates how much the

stock market is prepared to pay for every

Re 1/- of corporate earnings per share.

P/E ratios of individual stocks may vary

widely and can be erratic and unreliable.

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114

Price Movements

Historically, P/E ratios of the BSESensex and NSE Nifty have

fluctuated between 10 on the lower

side and 22 on the higher side.

The P/E ratio of the Capital Market

2,000 has fluctuated between 9 onthe lower side and 20 on the higher

side.

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Source: Research of Sundaram Mutual Fund

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Understanding Market

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Behaviour / Sentiment:

That is why Benjamin

Graham stated that in the

short run, the stock market

is a voting machine and in

the long run, it is a

weighing machine.

Benjamin Graham (1894 – 1976)

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Thank you!

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