Why are stock markets volatile?

There has been unprecedented volatility in the domestic markets last month. In India, all major market indices lost over 20 percent from their highs (mid-cap and small-cap stocks were the worst hit in this correction). Intraday volatility was also quite high in the markets. There were many days when the Sensex recorded more than 1,000 points (above five percent) intraday swings. The main reason for the correction seen in markets last month is negative news inflows from the US and world economy front.
The rise and fall of share prices (market direction) depends on various market forces. In fact, the factors that affect stock markets have increased significantly over the last one decade due to globalisation and technological advancements. Volatility is an important consideration while computing risk, and hence, the returns expectations from investments in the market.
These are some market forces that directly or indirectly drive the stock market volatility.
Volatility due to global factors
One of the major factors that is driving market volatility globally in the last few months is the recession in the US, and hence world economy. This negative news was triggered by the US sub-prime crisis. Recently, the credit issues and the losses reported by major financial institutions in the US again triggered negative sentiments in US markets and the fear percolated down to markets worldwide. According to analysts, there is a growing concern that the depth of credit issues is still unknown and not quantified.
Many leading financial services companies in the US have revised their top line forecasts downwards. There is a strong feeling in the market that the US economy will go through a recession phase this year. Since the US is the largest economy in the world, people are not clear about its impact on the world economy and markets.

The US dollar is weakening against all major currencies in the world (Euro, Canadian dollar, Australian dollar, Japanese yen etc). Crude oil prices have reached around USD 100 per barrel. This is another sentiment dampener in the global markets.
Domestic factors
In the past correction phases, the domestic markets had been the biggest out-performers compared to other Asian markets due to foreign funds inflows. But in the recent correction (January 2008), foreign institutional investors (FII), took out USD 3.2 billion dollars from the domestic markets. We have seen sharp downfalls in the markets. Momentum mid-cap and small-cap stocks were the biggest losers in the markets.
The rupee has seen a sharp appreciation of 12 percent in the last one year or so. This has made a lot of our exports go uncompetitive with respect to other global competitors.
Many local events made the market react quite strongly in the past. For example, the Securities and Exchange Board of India’s (SEBI) proposal on restriction of further investments through the participatory notes (PN) route created panic in the domestic stock markets in October last year
We have seen large IPOs draw out huge amounts of liquidity from the market. From a maturity point of view, the domestic markets have come a long way in the last 10 years, but still the market lacks maturity in comparison to large global markets.
What should you do?
The question is what should investors do? Practically, if you look at the issue, you are not much-impacted by the US sub-prime crisis and export’s contribution to India’s GDP is also not very large. The Indian economy today is the second-fastest growing one in the world. India’s real GDP grew at an average rate of more than eight percent per annum over the last three years.
According to projections made by the Reserve Bank of India (RBI), the Indian economy will grow at a healthy rate of around 8-8.5 percent this year. Also, due to a slowdown globally, plenty of foreign funds and companies are looking at investments in India. Therefore, it is advisable for investors to hold on to their investments, looking at the long term.
Many large-cap blue chip stocks are trading at attractive valuations (around 30 percent lower than their peaks). Investors should look at investing in blue chip and quality mid-cap stocks only and abstain from investing in small-cap stocks where the risk is quite high due to lack of adequate information. Nobody can predict the market direction (up or down) in the short term but considering the overall scenario, one can say that the India growth story is pretty much intact.

ref :http://economictimes.indiatimes.com/Financial_Times/Why_are_stock_markets_volatile/articleshow/2768660.cms

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