HISTORICAL TREND IN NSE ASI 70, , , , , , , (10,000.00) Log ASI ASI. Log ASI

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1 Meristem Securities Limited 124 Norman Williams, Ikoyi South/West. Lagos, Nigeria. Tel: Fax: THE NIGERIAN STOCK MARKET CRASH: COMING SOON? In recent times, the Nigerian stock market has witnessed a persistent bull ride, flanked by escalating gurgles and bubbles which some stakeholders say will soon burst!. Despite its miniature stature compared to its counterparts the world over; the Nigerian stock market has proved to be one of the most efficient in terms of profitability as it posted one of the highest annual returns in The implication of a year-end return of 74.8 percent was that all stocks invested in the Nigerian market posted a cumulative of 74.8 percent return on investment during the year. The momentum for stock price movement has grown very strong and investors are now comparing virtually every form of investment to the stock market. Now, joining the investment train is becoming an all-comers affair. Attributable to this surge in investment attitude are the robust reforms experienced in the Nigeria s financial landscape in the last couple of years. For major players in the financial sector such as banks and insurance firms, the stock market has served as a safe haven for scaling consolidation hurdles. Growing in leaps and bounds, the capital market

2 has acted as a veritable fulcrum for the rapidly expanding financial sector. But will the Nigerian stock market bubble burst soon, or will it ever prop? Nobody has ever predicted accurately the when and how of bursts. Just before a major burst, experience has shown, the market will always look so promising and attract some late comers who are also somewhat fledgling. Unfortunately, they are hit the most. The Real Value of the Nigerian Stock Market. The Nigerian capital market is in no way exempted from the proven imperfections in financial markets throughout the world. Investors sometimes, albeit temporarily, exhibit excessive optimisms and pessimism which culminate in pulling stock prices away from their long term trend levels to extreme points. As against fact, the theory of efficient market posits that only fundamental factors such as profits and dividends should drive stock prices so that trade plays little or no role in stock price movements. The overvaluation of the Nigerian stock market seems to be a notion supported by meagre evidence. But common economic sense tells us that the pace of general economic growth should be in tandem with growth of the capital market. This is premised on the fact that stock market booms are an element of the business cycle, with booms typically arising during cyclical recoveries and other periods of rapid economic growth and ending when GDP growth slow. But so many things still need to be unearthed in the behaviour of the Nigerian stock

3 market in recent times. The extraordinary recent levels of Nigerian stock prices, and related expectations that these levels will be sustained or surpassed in the near future, present some critical questions. We need to know whether the current period of impressive feat of the Nigerian stock market will be followed by poor or negative performance in coming years. We need to know confidently whether the surge that brought us here is indeed a speculative bubble an indefensible rise in prices brought on by investors buying behavior rather than by genuine, fundamental information about value. In short, we need to know if the value investors have imputed to the market is not really there, so that we can readjust our planning and thinking. Figure: I HISTORICAL TREND IN NSE ASI Log ASI 70, , , , , , , (10,000.00) Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 ASI Jun-06 Dec-06 Jun-07 Dec-07 Log ASI

4 From historical perspective, there is no doubt the Nigerian Capital market has soared to extremely high levels in recent years. These results have created a sense among the investing public that such high valuations, and even higher ones, will be maintained in the foreseeable future. But figure 1 above looks quite instructive. From a logarithm scale, the index currently appears quite higher than what it should be. If the history of high market valuations is any guide, the public may be very disappointed with the performance of the stock market in coming years. Nigeria Stock Market Bubbles and Breadth Stock market bubble is a type of economic bubble taking place in stock markets when price of stocks rise and become overvalued by any measure of stock valuation. The existence of stock market bubbles is at odds with the assumptions of Efficient Market Theory (EMT) which assumes rational investor behaviour. Behavioral finance theory attributes stock market bubbles to cognitive biases that lead to groupthink and herd behaviour. But, often, when the phenomenon appears, pundits try to find a rationale, so as not to be against the crowd. Thus, 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. The burst of this bubble results in a market crash which is every investor s nightmare. Stock market crashes are

5 momentous financial events that are fascinating to academics and practitioners alike.for traders and 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 of them. There is no numerically-specific definition of a stock market crash but the term commonly applies to steep double-digit percentage losses in a stock market index over a period of several days. Drawing from the above, a stock market crash can be described as a sudden dramatic decline of stock prices across a significant cross-section of a stock market. The Underlining factors in Market Booms and Bursts The Stock Market is an investment roller coaster which rides on four wheels-market fundamentals, psychology, globalization, and the macroeconomy. From the advanced to the least developed of markets, each of these factors commands significant impact on the workings of the stock markets. From the macroeconomic perspective, overall market size is positively correlated with the ability to mobilize capital and diversify risk on an economy-wide basis so that the stock market should grow as the economy progresses. In essence, the stock market reflects both underlying macroeconomic conditions and specific economic policy actions. Higher inflation, for example, would tend to depress stock

6 returns because higher expected inflation would raise long-term interest rates (and thereby raise the rate at which investors discount future dividends). High interest rate may then convince investors to sell stocks which may lead to a fall in the market Investors thinking process exerts significant influence on the stock market that appears consistently ever since the beginning of investing and will continue for centuries to come. One powerful tool for influencing market movement is herding. Usually, aggregate investor psychology at any given time is always behind the reality of stock market. Most times investors respond to price decline and the behaviour of others during the decline, not fundamental economic changes. The effects of macroeconomic policies on stock markets are likely to be influenced not only by domestic regulation but also by globalization and international integration of capital markets. Thus, the efficient operation of stock markets would seem to hinge on both global macroeconomic and regulatory policies, and how well those policies interact with one another. International economic policies, such as capital controls and exchange rate pegs, and financial regulation affect the linkages between domestic economic performance and stock markets. In these decades, international financial markets are highly integrated with significant foreign direct investment across countries of the world

7 Usually, investors value firms stock only as much as they value the firm s present and future earnings The value of the discounted expected earnings stream, which should equal the current price of the stock, has two components. The first is the forecasted future earnings.the second is the interest rate used to discount forecasted earnings streams. This discount rate is the default-free real rate of interest represented by the long-term government bond rate plus an equity risk premium, which is the extra return investors require for holding risky stocks. This traditional discounted earnings model can be used to determine the extent to which the fundamentals justify the level of stock prices. The optimum valuation of stocks is critical to the sustenance of price appreciations whenever they occur. It usually better for stocks to be undervalued rather than overvalue so that market forces ultimately works to create a convergence on value. Overvaluation seems to trigger crashes in most cases. The Nigeria s Stock Market: how soon can the bubble burst? As far as evidence from market crashes around the world can take us, no factor can give convincing reason why markets could fall by an extraordinary degree without any significant prior announcement or change in the world. Since 1996, the largest fall in the NSE All Share index was 16% on the 22nd of Feb, However, the highest appreciation prior to that time was on a day before when the index

8 gained 10%. The next peak moment occurred on the 23rd of January, 1998 when the index lost 10% having gained just 0.25% the previous day. The fear of a stock market crash has never been stronger than it is today. One reason for that is that we ve all been conditioned by at least one or more major stock market crash around the world in our lifetimes and a few mini-crashes and selling panics to boot. These market reversals and the damage they inflict tend to leave deep-seeded memories and emotional scars that are not easily healed with the passage of time. Crashes occur immediately after market tops. The followings signs can be recognized as indications of a market top High valuation level Dividend yield falling below 5% Widespread bullishness Belief that present scenario is different and history will not repeat itself this time. Trumpeting enormous gains to be made in the stock market by professionals and media Rising interest rate Stocks no longer reacting positively to strong earnings Traded volume expanding significantly Excessive speculation among low price stocks. Breakdown/weakening of a large number of blue Traded volume expanding significantly

9 Excessive speculation among low price stocks. Breakdown/weakening of a large number of blue chip stocks Market unable to move higher despite increasing volume Conclusion Market crashes never occur without market tops. The pertinent question here is whether the signs of market tops are prevalent in the Nigerian stock market. Absence of any of the highlighted signs raises substantial doubt about the imminence of a market crash. Meristem Securities Limited weekly market sentiments and its attendant recommendations are prepared based on publicly available information and are meant for general informative purposes. Meristem Securities Limited can neither guarantee the accuracy or completeness of the information as they are an expression of our analysts views and opinions. Meristem Securities Limited cannot be held responsible for any loss suffered by relying on the said information as this information as earlier stated is based on estimates and opinions and is meant for general information purposes and not as solicitation to buy securities and financial instruments Meristem Securities Limited 2008.