Whenever stock markets are in the grip of a bull run, there is always chatter about new money pouring into the stock market because of the entry of new investors.

Share Market Live

NSE

While there can be new investors in the stock market, technically there cannot be new money in the stock market because of one of the very basic principles of the stock market.

In its note, the Kotak Securities team of Sanjeev Prasad, Sunita Baldawa and Anindya Bhowmik, have explained some of the concepts and also debunked some of the commonly held beliefs

(The questions have been framed by CNBCTV18.com, so as to put the contents of the Kotak Securities note in context)

Is there something such new money in the stock market?

Secondary stock markets do not have any new money at any point in time or for that matter, no money at all times. There is always a buyer and a seller in any trade and thus, the net sum in the stock market will always be zero. This is true for all times from a nanosecond for a trade to a year to in perpetuity. Of course, there is wealth based on market capitalization of stocks and one can make a lot of money in the stock market if one is lucky and smart (stress is on ‘and’) or lose a lot of money if one is unlucky or unwise (stress is on ‘or’).

Does liquidity/fund flows influence the change in stock prices?

We have long argued that ‘flows’ or ‘liquidity’ (commonly understood as new funds received by institutional funds from retail investors or purchase or sale by overseas investors) do not have any relevance for prices or fair values of stocks. Stock prices move on changes in expectations of the future and the several variables that determine prices (same holds for value) which can be reduced to (1) future cash flows/earnings and (2) cost of capital/equity in a simple DCF framework.

Does money injected into the system by central banks enter the stock market?

Central banks can ‘create’ money but money cannot ‘enter’ the stock market. The various rounds of limited and unlimited QEs (bond purchase programs) pursued by various central banks to finance government deficits indirectly has resulted in a sharp increase in the balance sheet size of the central banks over the past few years. However, this does not mean that some or all of this money ‘went’ into stock markets even though the purchase of government bonds by central banks ‘creates’ money (central bank net credit to government is a source of money).

Why do stock prices surge when central banks cut rates or offer to buy bonds?

The monetary actions of central banks (cut in repo rates, limited or unlimited purchases of all sorts of bonds) are simply their ways to tempt economic participants (corporates, households) to take more risks and thus, revive the economy. Stock market participants tend to correlate a lower risk-free rate* with a lower cost of capital/equity. In our view, the assumption of lower cost of capital/equity in the minds of market participants being linked to lower interest rates is the prime reason for the increase in stock prices (presumably earnings estimates haven’t increased) and not their actions in terms of buying stocks (note, somebody must be selling also).

Is there a correlation between the cost of capital and the risk-free rate?

We are not sure if there is an automatic correlation between the cost of capital/equity and the risk-free rate. In fact, we would argue that the risks to cash flows/earnings of companies would increase in the current economic situation (the extent of change will depend on the type of the company and the sector). This would suggest an increase in the equity risk premium at the same time, which may offset part or all of the reduction in risk-free rates.

* Government bonds are considered as risk-free and hence the rate of interest on them is one of the examples of a risk-free rate