AN ANALYSIS OF THE INTERRELATIONSHIP AND IMPACT OF STOCK MARKET, MICRO AND MACROECONOMIC FUNDAMENTALS ON STOCK PRICING IN NIGERIA
ABSTRACT
Since the Dutch Tulip Mania of the
1630s, cycles of bubbles and bursts in stock markets have become
commonplace across the world, hence, this has gained a reasonable
academic attention. However answers as to what causes a particular
market crash remains context-specific and in most cases, weakly related
to the overall question of what causes stock market crash and how it can
be prevented. Consequently, the question of what causes a particular
market crash remains context specific which has to be answered for all
dips in the stock market. Recently, Nigeria Capital Market took a plunge
downwards in March 2008 after more than four years of consistent super
performance. As is the case in many other African countries, thus far,
explanations are hardly empiric s supported. As a result, specific
drivers of the markets given the peculiarities of poor capitalization,
weak underlying economic base and open capital accounts remain un
examined. This study employs three approaches with two data sources –
with two data sources – one primary (analyzed using charts and tables as
well as estimates from a censored logit model) and the other secondary
(analyzed using error correction model incorporating macroeconomic
indicators) to examine the relationship between Nigeria Stock market and
economic fundamentals with a view to determining their impact on stock
valuation. We estimated two equations. The first equation showed the
relationship of a long run all share price index with major indicators
in the economy and the second showed a relationship of the actual value
of the all share price index with same set (augmented set) of
indicators. The results from the two data sources significantly
corroborated each other. The findings largely indicate disconnect
between economic fundamentals and stock pricing. We explored the
implications on the economy and proffered solutions.
CHAPTER ONE
1.0 INTRODUCTION
1.1 Background to the Study
The occurrence and existence of bubbles
have gained reasonable academic attention (examples include, Froot and
Obstfeld, 1992; Allen and Gorton, 1993; Biswanger, 1999; Chen, 1999;
Abreu and Brunnermeier, 2003). The existence of stock market bubbles and
crashes dates back to the 1600s. The Dutch tulip mania of 1630’s, the
South Sea bubble of 1719 – 1720 and more recently, the internet bubble,
which peaked in early 2000, are some notorious cases (Abreu and
Brunnermeier, 2003). Time and again, both pundits and market makers have
had difficulty correctly foreseeing the direction of the market even in
the medium term. For example, when on March 10, 2000, the
technology-heavy NASDAQ composite peaked at 15, 048.62, very few
expected what was to follow the next couple of months. Even though such
high movements were quite contrary to the trends in the rest of the
economy (particularly given that the Federal Reserve had raised interest
rates six times over the same period and that the rest of the economy
was already beginning to slow down), the fall still caught many analysts
and stakeholders unprepared. The bubble burst that followed (generally
known as the dot-com bubble crash) wiped out about 2$5 trillion in
market value of technology companies between March 2000 and October
2002. Many other (nontechnology) stocks followed in the wave of weak
confidence in the market and lost values. A number of reasons have been
given for that particular market crash, but as in many other times, such
reasons often relate to market-specific occurrences and are weakly
related to the overall question of what causes stock market crash and
how these can be prevented.
Consequently, the question of what causes
a particular market crash remains a context specific one that must be
answered for all dips in the market. Investors sometimes, albeit
temporarily, show excessive optimisms and pessimisms which end in
pulling stock prices away from their long term trend levels to extreme
points. Just before a major burst, experience has shown, the market will
always look so promising and attract some late comers who are also
somewhat new and inexperienced in the business.
Unfortunately, they are the most
vulnerable in crisis times. However, even for the more mature investors,
there is evidence that following the market is a very demanding job and
hardly does anyone ever do a perfect job of correctly predicting its
direction. In particular, the cause of bubbles remains a challenge to
most analysts, particularly those who are convinced that asset prices
ought not to deviate strongly from intrinsic values. While many
explanations have been suggested, it has been recently shown that
bubbles appear even without uncertainty, speculation, or bounded
rationality. For instance, in their work, Froot and Obstfeld (1992)
explained several puzzling aspects of the behavior of the United States
stock prices by the presence of a specific type of bubble that they
termed “intrinsic bubbles”. Bubbles are often identified only in
retrospect, when a sudden drop in prices appears. Such drop is known as a
crash or a bubble burst.
To date, there is no widely accepted theory to explain the occurrence
of bubbles or their bursts. Interestingly, bubbles occur even in highly
predictable experimental markets, where uncertainty is eliminated and
market participants should be able to calculate the intrinsic value of
the assets simply by examining the expected stream of dividends.
Clearly, the existence of stock market bubbles is at odds with the
assumptions of Efficient Market Theory (EMT) which assumes rational
investor behaviour.
Often, when the phenomenon appears,
pundits try to find a rationale. Literature show that sometimes, people
will dismiss concerns about overpriced markets by citing a new economy
where the old stock valuation rules may no longer apply. This type of
thinking helps to further propagate the bubble whereby everyone is
investing. Economic bubbles are generally considered to have a negative
impact on the economy because they tend to cause misallocation of
resources into non-optimal uses. In addition, while the crashes which
usually follow bubbles are momentous financial events that are
fascinating to academics and practitioners, they often destroy large
amount of wealth and cause continuing economic malaise. For investors,
the fear of a crash is a perpetual source of stress, and the onset of
the event itself always ruins the lives of some. Foreign portfolio
investments are withdrawn and/or withheld in order to service domestic
financial problems; prospects of reduced foreign direct investment are
bound to affect investor confidence and the economic health of countries
with market crash. In addition, a general credit crunch from lending
institutions for businesses requiring short-and-long-term money may also
result and a protracted period of risk aversion can simply prolong the
downturn in asset price deflation as was the case of the 3Great
Depression in the 1930s for much of the world and the 1990s for Japan.
Not only can the aftermath of a crash
devastate the economy of a nation, but its effects can also reverberate
beyond its borders and beyond the time of its occurrence. Market
reversals and the damage they inflict tend to leave deep-seated memories
and emotional scars that are not easily healed with the passage of
time. Clearly, crashes (i.e. bubble burst) occur immediately after
market tops. The problem now arises as to what perennial parameters
should be used to measure the cutting edge of “boom harvest” to avoid
unforeseen future market crash. Osinubi and Amaghionyeodiwe (2002)
observed that the securities industry today is characterized by rapid
growth and filled with complexities. New instruments such as equity
options, stock index futures and a host of other derivatives are being
traded throughout the world. The core of all these activities is the
stock market. The stock market, widely described as a barometer of any
nation’s economy, provides the fulcrum for capital market activities and
it is a leading indicator of business direction. An active stock market
may be relied upon to measure changes in the general economic
activities using the stock market index (Obadan, 1998). A robust stock
exchange not only promotes economic growth, but predicts it.
Indeed, there are several benefits that
follow the existence of a robust capital market in a country. Claessens
and Glen (1995) list a number of such benefits, most of which define it
as critical in the development process. For example, the market remains a
veritable source of long term capital for growing businesses,
government social investment among others. A well-managed stock market
leads to diversification of investment and the market provides
opportunity to domesticate wealth. In other words, the Market is a tool
for holding back capital flight. Privatization, regularly used as
instrument for increasing the stake and participation of the private
sector in the economy, also cardinally depends on the stock market. The
successful implementation of the divestiture programs under structural
adjustment programmes in many African countries owes large to the
growing importance of the stock market.
Despite the considerable contributions of
stock markets to the economy, Adjasi and Yartey (2007) observed that
the rapid development of stock markets in Africa does not mean that even
the most advanced African stock markets are mature. African stock
markets are small, illiquid, with infrastructural bottlenecks and weak
regulatory institutions. Even though markets are gradually adopting
electronic systems, there are still substantial African stock markets
which trade manually and use manual clearing and settlement. Similarly,
most markets do not have central depository systems, whilst some markets
still have restricted foreign participation. Such bottlenecks slow down
trading and induce inactivity.
The Nigeria stock exchange shares in a
number of these problems. Specifically, it remained weak for many years
after which it experienced some kind of growth but which was not steady.
The Exchange, which started as Lagos Stock Exchange in 1960, was
renamed ‘Nigeria Stock Exchange’ in 1977. But developments in the market
go much earlier than that. The existence of the market can be traced to
1946, when the Ten-year Development Plan (1946-55) local loan ordinance
was promulgated (Osinubi and Amaghionyeodiwe 2002). However, after
nearly 20 years of formalization and change of name to Nigeria Stock
Exchange, the market remained largely rudimentary like other markets in
Africa. For ten years from 1986 up to the end of 1996, companies from
the stock market raised a cumulative of only N32 billion. In 1996, the
value of new issues amounted to N5.8 billion a significant part of which
was foreign portfolio investment (Emenuga, 1998). However, following
the reemergence of democracy into Nigeria in 1999, the market rebounded
significantly. Both awareness and participation in the market soared.
Beginning in 2004, the market witnessed unprecedented boom, peaking in
2007 with the banking sector recapitalization that led to massive
capital hunt by banks. As banks constitute more than 50 percent of the
market, there was massive boom in the market. Unfortunately the boom did
not last. By 2008, the US mortgage-induced global crisis hit the
Nigerian economy and flattened the little gains made in the market over
the 5 years prior to it.
Several authors have given reasons for
market fluctuations and crashes in Nigeria and other places (e.g.
Anyanwaokoro, 1999). Likewise, many have outlined options for mitigating
them. Adjasi and Yartey (2007) for example, believe that macroeconomic
stability, well developed banking sector, transparent and accountable
institutions, automation, promotion of institutional investors and
strengthening regulation and supervision are necessary preconditions for
promoting efficient functioning of stock markets in Nigeria and Africa
at large. However, it has to be borne in mind that the market crash was a
strong reminder that the magic wand for understanding and solving the
problem of bubbles and bursts in markets is yet to be found. It equally
was a reminder that no market in the world is immune to crashes and that
the so-called rule of new markets that can grow indefinitely does not
hold yet for any emerging market. As in other market crashes, it is safe
to assume that several factors played together in the Nigerian market
crash. But which of these is the chief cause and what is the probable
channel of impact is not known. This is partly what this work intends to
research into.
1.2 Statement of the problem
Recent events seem to indicate that the
Nigerian capital market is in no way exempted from the proven
imperfections in financial markets throughout the world. While the
market has been growing since the turn of the 21st Century, the banking
consolidation seemingly led to a flurry of activities in the market that
culminated in sharp increases in the values of a majority of stocks in
the Nigerian stock exchange. Stock price movements were strong and
investments in the stock market yielded superior returns relative to
other channels of investment in the country. It became fashionable to
join the investment train. With a growth of about 74.5 percent in 2007,
the Nigerian stock market was acclaimed one of the World’s fastest
growing markets and was an all-investors’ toast. Investor confidence was
very high and market capitalization peaked at N12.6 trillion as at the
first week of March, 2008.
Multiple returns, particularly in capital
appreciation were reaped by a number of investors and market awareness
was at an all time high as at the end of 2007.
However, the trend changed significantly
beginning in the second week of March 2008. The market began to slide in
both capitalization and all share indices. For instance, market
capitalization of the 303 listed equities, which had opened on January
1, 2008, at N10.180 trillion and later appreciated to N12.395 trillion
as at March 2008, suffered its highest fall in the 48-year history of
the Nigerian Stock Exchange, depreciating by N3.223tn or 32 per cent to
N6.957tn by the year end. The all-share index (indexed in 1984 at 100)
which had risen to 66,371 as at March 5, 2008, equally dropped
drastically by the end of the year. Every indicator in the stock market
has continued to slide down (NSE, 2009). The Nigerian market crash came
even before the rest of the world joined in what has now come to be
accepted as a global economic recession. While the crash in the price of
quoted shares on the Nigerian Stock Exchange started in March, those of
the United States started in August and some other developed countries
followed later in October. Even though the US real estate crisis had
already set in, there was no clear evidence of strong relationship or
that it could be the factor driving the fall of prices in the Nigerian
stock market. This indicates that changes in the global economy may not
be enough explanation for the challenges that faced the Nigerian capital
market and calls for further enquiry into the causes. Nonetheless, the
decline that was witnessed in the Nigerian capital market cannot be
separated from the worldwide financial crisis that has continued to hit
hard on global stocks. Needless to say, this development is worrisome.
Investor confidence waned in the market and other economic activities
like consumption and investment may have been seriously affected.
Already, some structural changes in investment (portfolio readjustments,
decrease in overall investments,etc) are already going on and many
investors are channeling resources to the money market, real estate and
other alternative investment destinations (Obayelu, 2009). Given these
trends, some analysts, investors and other stakeholders are already
predicting that the market may be headed for a complete crash (Nduwugwe,
2008).
As in many other stock markets under the
same circumstances, there have been competing arguments over the cause
of the crash. There have also been several explanations ranging from
plausible to ridiculous. While some believe the market has always been
over-valued and is undergoing self-correction indicating that the
reduction in share prices will be permanent, others see the correction
as temporary (Nduwugwe, 2008, Nwachukwu, 2009). This difference in
perception also arises because of divergent views on what exactly is
driving the fall in market value of shares. While it is believed in some
quarters that share prices rose faster than both market and other
economic fundamentals, some see the Nigerian stock market as not having
even grown up to its fundamentals and so still having opportunities for
further growth, indicating that the correction is very temporary.
But clearly, very little empirical
analyses support most of these explanations. It is evident that there
has been little research into the real causes of the challenges facing
the Nigerian stock market. There seem to be more opinions than empirical
evidence as to the cause of the market changes. On the whole, while the
Nigerian stock market has received comparatively less critical research
than some of its developed market counterparts, the current crisis in
the market has received even far less critical evidence-based
assessment. Many years down the line of market booms and bursts,
critical assessment of what drives the Nigerian capital market and the
range of roles macroeconomic policies can play to support the market is
still weak. The danger in this is that policy positions may not
adequately mirror the actual and/or fundamental causes of the problem.
In addition, probability of future recurrences is higher if the
underlying causes of the problems are not unearthed. This research work
sets out to systematically study the market with a view to understanding
the different roles of market fundamentals and bubbles in the
determination of stock pricing and market movements. The critical
measure of market activity used in the study is the all share price
index.
1.3 Objectives of the Study
Given the above, the primary objective of
this research is to provide empirical evidence on the causes of the
recent stock market crisis in Nigeria. Specifically, the study intends
to
- Find out whether the movements in stock prices over the last couple of years (particularly since from 2004) follows fundamentals in the economy or merely reflect speculative (and other) bubbles. In other words, examine the relationship between stock market valuation and macroeconomic fundamentals in the country;
- Assess the causes of the recent crisis in the Nigerian stock market;
- Evaluate investor confidence in the market given these recent activities and occurrences.
1.4 Research Questions
Our research questions for this study are as follows:
- Does valuation of stock prices in the Nigerian stock market adequately reflect the underlying fundamentals of both firms’ performance and overall economic activities in the country?
- What is the root cause(s) of the recent crisis in the Nigerian stock market?
- To what extent did the recent happenings in the stock market affect investors’ confidence?
1.5 Research Hypotheses
William (2006) stated that hypothesis is a
specific statement of prediction. It describes in concrete (rather than
theoretical) terms what you expect will happen in your study. Our
hypotheses for the study are as follows:
- Nigeria stock market is not driven by economic fundamentals.
- The recent crisis in the Nigerian stock market is not caused by ill-adjusted stock prices.
- Investor confidence was not affected by the recent crisis in the Nigerian stock market.
1.6 Scope and Limitations of the Study
Scope
The research covers firms quoted on the
Nigerian Stock Exchange. Using monthly data from January 2004 through
December 2008, this study is primarily concerned with the impact of
selected indicators on the movement of prices and will not delve into
reverse causality i.e. the impact of the recent crisis on other major
macroeconomic variables like inflation, output growth, etc.
Limitations
Impediments to effective empirical studies in Nigeria are:
- Availability and access to reliable data;
- Finance;
- Time.
To circumvent some of the limitations stated above, the following applied:
- Data disaggregating techniques e.g. interpolation with risk of some level of bias in the estimates.
- Varying sources of data. However, because of envisaged comparability difficulty under the circumstance, we exercised great care in data evaluation so as to as much as possible ensure thoroughness.
- We also made attempts to maximize available resources including time to make the final output of this research qualitative.
1.7 Significance of the Study
This study has both academic and practical (policy) significance as follows:
- Contribution to the literature particularly on the determination of developing countries’ stock markets and causes of stock market crises with particular concentration on Nigeria;
- Strong referral point for further research in the future on the subject matter;
- Influence policy on the stock market and inform on the relative roles of firm level fundamentals as well as market regulation and macroeconomic management in the determination of market movements;
- Beneficial to all aspects of the population as it evaluates trends in the market and relate these to important economic goal posts in a meaningful, logical, and empirical way;
- Investors, policymakers and other stakeholders will find work in this area very useful;
- Current and relevant to a large array of other audience – government and all players in the Nigerian economy – for varying purposes.
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