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MGT411 GDB 2 Solution Spring 2012

The Case:

Prices of common stock of Cement Manufacturing Association (CMA) are increasing on daily basis. New investors are more enthusiastic in purchasing the CMA’s stock due to the belief that the company’s stock prices will tend to increase more in the days to come. Hence, at present the investment in this stock will be very beneficial for them. So, with the expectation to sell this stock at higher prices in the future could give them huge gain. However, the market analysts keeping an eye on the fundamental value of CMA’s stock are of the view that the stock prices of the company are overvalued, thus not representing their true values. According to these analysts, this stock will not be able to maintain its current trend of price increase in the future and will be forced by the market mechanism to adjust its price to its fundamental value.

 

Requirement:

Considering the above scenario, do you agree that this price hike is beneficial for the country’s economy in general and for the investors in particular? Support your answer with logical reason.

Solution:

An overvalued stock market will be the ultimate goal of every market participants. Everyone from the individual stock investor to the fund managers and government needed an overvalued stock market. Let us examine each and every one of them individually.

From an individual investor point of view, it is certainly not in the best interest for them to have an under-performing stock market. If the stock market persistently under performs other assets, then investors will pull out their investments from the stock market and invest in say money markets if they offer higher rates of return. So in order to prevent investors from pulling out of the market, the insiders and big money will always try to create an overvalued market.
Politicians need an overvalued stock market to gain popularity especially when election is around the corner. When the stock market is strong, no one will benefit more than the politicians. This is because when everyone is making money from the market, no one seems to care how the politicians run the economy even if they run it to the ground. The present government will surely be voted into office again even if there are corrupted to the core. The people who are able to influence the public are too occupied with making money and hence they will have less interest in who is running the country and who is being done to it. All they care is whether the market will continue going upwards.
Mutual funds managers and brokers also want an overvalued stock market because their earnings are based on commissions. Mutual fund manager’s income is based directly on the percentage of the funds valuation. The higher the valuation the more income they will receive. Mutual fund managers need an ever increasing market to keep selling their products to unsuspecting investors by telling them that the market will keep going up and making new highs.
Stock Broking firms too through their brokers always engaged in the so called ‘hyped-up selling’ of shares to their uninformed clients, telling them that every dip is an opportunity to accumulate more shares. This will nonetheless increase their earnings by doing more trades and hence more commissions.
Corporations also need an overvaluation of the stock market. The reason being most of the executives wealth are tied to their stock holdings in the company either through Employee Stock Option Scheme (ESOS) and Stock splits. So it is not in their interest to have a beat down stock market.

 

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