Stock Market = Gas balloon - Keeps drifting upwards unless acted upon by external unbalanced force

Stock market is like a gas balloon, it tends to drift up slowly unless there is an external unbalanced force trying to pull it lower.

The above statement has a strong message in it which can act as a double edged sword. Before understanding the legitimacy and the sensibility of it, let us explore the various participants in the stock market and understand how prices move.

a.       Mutual Funds

Many of the mutual funds have a mandate to allocate a fix sum of capital into equity and hence no matter what the price is, they would buy into it as long as funds are flowing into it. Besides, they cannot short sell markets and hence are net buyers only. Hence from this side, we have net buyers coming in at every price in a stable environment.

b.      Investors

The investors include various players like pension funds, mortgage funds, insurance companies, NBFCs, Banks etc. They generally have surplus funds and are in the game for a long horizon. They also allocate ever increasing capital into equity funds despite increasing valuations. The only option they have is to decide on capital allocation between various asset classes and in a stable environment, most of them end up being on the buy side only despite any valuations.

c.       Retail investors

This is a very interesting phenomenon and really funny to analyse sometimes. A retailer investor always invariably enters from the buy side only as he feels the prices may go up further. They end up being bullish not just because of their own understanding but also on understanding of various traders who are always bullish in a bullish market. So most times, they are also net buyers in a stable environment.

d.      Traders

They are the only ones who can be net buyers or sellers during a particular phase but most times, they would avoid going against the general market sentiment and hence will not sell into the market unless there is a dampener to the gas balloon. Hence they are net buyers too..!!

So in a stable environment, even if the companies are not performing exceptionally well or there has been over stretched valuations or any other reason, stock markets will still keep going up unless there is a dampener coming from macro-economic factors or political factors or some other areas. The only argument against this is that investors can allocate capital amongst asset classes. That is true, but the general investor sentiment is that allocate more capital to equity when environment is stable and less to debt. This ends up creating a self fulfilling prophecy in which more and more allocation keep pushing the equity market higher.

So it is very common to see over stretched valuations during stable times and this over-stretching can keep on increasing until there is dampener.

The stock market rally in USA in 2013 is the most perfect example of it. Most companies have not shown exceedingly exceptional performance results nor have they been able to do extra-ordinarily different from what they did last year but still the equity market has rallied more than 50% and most analysts still say that the market can be bought into.!

So the next time, you see a huge stock market crash, don’t fear, as the gas balloon has come lower, look for the opportunity to hold onto it and wait for the dampener to go away and enjoy the drift higher ever after..!!