A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino

This article is dedicated to my friends at RC Mandaluyong.

People normally bear the misimpression that stock markets function as some variant of gambling “casino”.

Never have they realized that stock markets bear a significant financial and economic merit. Any country that desires to adopt some degree of market based economy requires the presence of a stock market. Even in places which are deemed as economically, socially or politically chaotic or unstable such as Iraq, Zimbabwe or Nigeria has an operating stock market.

Basic Function

The stock market operates similar to the markets where we buy our food. Basically both of these markets function as platforms for conducting exchanges between buyers and sellers. The difference is in the products traded. For our “conventional” markets, it is based on comestible stuffs and or other household wares, whereas for the stock market they involve corporate financial securities such as common stock or preferred stocks or Exchange Traded Funds (ETF).

Going deeper, stock markets- as part of the capital markets- often reflect the basic function of money as medium of exchange, unit of account and a store of value.

-they function as a platform to trade financial securities (medium of exchange),

-they serve as a repository of collateral since they represent ownership in companies that are backed by assets and stream of revenues (store of value) and

-they are valued through the pricing mechanism whether these are driven by momentum or emotions, corporate fundamentals or micro/macro economy as “inflation” (unit of account).

Since all financial markets are driven by the price mechanism, the following variables represent as key drivers in ascertaining prices:

-a collective assessment of the fluctuating balance between demand and supply

-accounts for the subjective value judgments by market participants

-signifies the time dimension in shaping for market participants expectations, whether it short medium or long term, and lastly

-primarily influenced by psychological dimensions (such as greed or fear) and cognitive biases (such as overconfidence, anchoring, risk aversion etc.)

And because markets are determined by divergent psychological expectations they result to a variable flux in prices as seen in the tickertape. This is known as volatility.

Yet prices are always set on the margins. What you read on the stock market section in the newspapers account for as prices determined by marginal investors, where daily traded volume represent only a fraction of total shares outstanding or market capitalization, and not the majority owners.

And the resultant price volatility set by marginal investors is what accounts for as the conventional impression of gambling “casino” like actions.

Risk and Uncertainty

The common impression of the public is that price fluctuations or volatility are a function of sheer randomness. And because of the perception of such unpredictability they are deemed to be risky, which adds to the gambling misperception.

But as market savant James Grant says, ``The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price.”

Of course, whether it is stock market or any non-financial enterprise or even public governance the fundamental problem will always be tomorrow’s uncertain outcome. We can’t even be certain if we will see the sun shine tomorrow. As an old saw goes, there is nothing certain in this world except death and taxation.

The point is- the aversion to the stock market is generally not about its unpredictability, but about having an insufficient understanding of how markets operate. To quote, the world’s richest and most successful stock market investor Mr. Warren Buffett, ``Risk comes from not knowing what you are doing.”

Yet if one scrutinizes the market, it can be generally observed that markets rarely operate on random.

This makes uncertainty of the future a measurable component. The same uncertainty is what can be translated to as “risk” or a “state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome” to quote economist Frank Knight.

In addition, compared to a dice toss, or a bet on a lottery, or a horse race which is immediately determined by the end result of one particular event, markets can be distinguished from these high return high risk activities, because they operate as a continuing process.

This makes time a significant contributor to risk assessment.

From the distinguished finance author Peter L. Bernstein, ``Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field.”

Reward Risk Tradeoff

Everyone wants to profit. But in financial or stock markets or in any “market based” entrepreneurship endeavor, profits come by as returns of investments (ROI). In other words, one has to accept some degree of risk in order to generate profits.

Applied to regular business enterprises, this also translates to same dynamics: risk capital has to be deployed, in the expectations of future stream of revenues, which fundamentally determines your return on capital. The difference is that in the stock market as a shareholder, you become a passive investor.

Yet because we are uncertain about tomorrow, there is always the risk of undesirable or adverse outcome in the marketplace.

Again like any entrepreneurial activities, success or failure in the stock market always entail offsetting risks relative to your capital to determine your expected returns. This is what is known as the Risk-Return Tradeoff.

Put differently by understanding and limiting your risk, you can amplify or optimize your returns.

This brings us to the basics of risk identification. Fundamentally, there are 3 major risks to consider;

-systematic risks or market risk- risks to the general stock market such as government policy repercussions as war, protectionism, regulatory overkill, monetary policy mistakes, excessive taxation or risks of an economic recession or risk from bubbles: asset-liability mismatch seen in domestic balance sheets or in currency framework or overleverage in the financial or economic system etc…

-residual common factor risks or risks relative to a specific industry such as industry directed regulations, tariffs, etc... and lastly,

-residual specific risks (e.g. risk relative to a particular stock or company such as profitability, management, labor, inventory, etc…)

This means that once the above risks can be assessed, which correspondingly may determine one’s risk reward profile and subsequently applied to the configuration of a portfolio mix, the much feared losses can be minimized while the profit opportunities optimized.

Let me cite a common example; some financial institutions as banks offer Unit Investment Trust Funds (UITFs). Such investment vehicle essentially accounts for as fiduciary fund generally designed to cater to an investor’s risk appetite. But the portfolio mix is standardized; it is offered in either foreign (US dollar) or domestic (Peso) denominated funds and generally split into a choice of equity, fixed income (bond or money market) or balance fund (50% equity-50% balance).

For an investor of the UITF it means 3 things:

First, passive investment-investment allocation is determined by the fund manager assigned for a particular portfolio distribution. Your risk reward ratio is subject to the fund manager’s risk distribution activities. This means your portfolios performance is also subject to management risk.

Two, since the balance of accepting risk is standardized; a choice of all fixed income (conservative risk taking), balance fund (moderate risk) and equity fund (aggressive), the unforeseen risk is the opportunity cost of being “flexible”. In short, a standardized portfolio could be deemed as rigid.

Lastly, a foreign currency denominated fund means expanding your risk spectrum to include the currency risk or volatility from currency valuations.

However in an actively managed portfolio, you can apply the same risk allocation strategies, but this time, being more malleable to your risk profile and time frame based returns expectations.

Market Cycles

Whether we talk about economics or markets, we always deal with psychology.

It is because people act, based on their perceived values or priorities or guided by incentives, to attain certain desired ends.

Thus, the prevailing social psychology, as reflected in moods and actions, underpins the economic activities of savings-consumption-investment decisions, aside from cycles in the financial markets.

Here is an example of flow of the psychological cycle that drives market and or economic cycles.

Generally speaking, since people as social beings, we tend to act in crowd like fashion. This essentially forges extreme swings from outright optimism to downright depression, brought upon by our base instincts of “fear and greed”.

Applied to the economy we see the same wavelike movement…

Thus, economic trends transit from recovery, prosperity, contraction and recession which defines the general economic cycles, and which are nearly identical with the flow of the public’s social moods or psychology.

And as mentioned earlier, stock markets are likewise driven by crowd psychology. This in essence determines the price actions. And because crowd psychology is shaped by time influences, such invariably leads to trends which determine what is known as the stock market cycles.

The stock market cycle can be identified as bottom, advance, top and decline. In the above, the Philippine Phisix chart since 1980 shows that we appear to be undergoing a second leg of a long term cycle.

Again whether it is the stock market, or real estate or any asset class subjected to price actions, they are all influenced by the general trends of psychology.

The same can be applied to boom-bust cycles.

Boom bust cycles account for as the extreme flow of fund swings to certain industries which are typically manifested or vented on financial markets. Boom cycles are usually fueled by massive credit expansion, overspeculation and euphoria, while the bust cycles are the opposite of boom cycles; credit contraction, massive losses from liquidations, liquidity constraints, retrenchment of economic activities or plain risk aversion.

The present bust in the US, preceded by a boom in its housing industry, is emblematic of this phenomenon.

Speculation and Economic Benefits of the Stock Market

Because we can’t foretell of the future accurately, any act of capital allocation basically represents as speculative activity. But where the difference lies, again, is in the degree of volatility. A dentist may have less volatile flow of patient visits compared to a businessman engaged in distribution of cellphones.

However, most speculative actions in the marketplace are always associated with short term movements. Yet, unknown to most, the speculative component helps increase the liquidity or tradeablity of a security or markets, which essentially produce greater pricing efficiency or reliability of market price signals.

Remember, price signals function as our principal incentives for deciding how to allocate resources which can be seen in the context of saving, investing or consuming.

Finally, there are other economic benefits that the stock market provides to the society:

1. The stock market is a vital part of the process from which we coordinate production. Ideally stock prices should reflect the productivity of business firm aside from market’s discernment of the entrepreneurial judgments concerning future productivity.

2. It competes with the banking sector in determining the degree of mobilization of savings into investment. From a national scale this becomes a formidable channel for economic advancement in terms of efficiency of capital deployment.

3. Unknown to many, stock markets often function as forward indicators, such that they have been known to predict upcoming recessions or prospective recoveries. Thus, movements in the financial and stock markets can give a clue to the transitioning business environment, which should help management or businessmen, in allocating resources or in applying their business strategies going forward.

4. It operates as alternative avenues for fund raising (public listing), intermediation (using shares as collateral for borrowing-lending) or liquidity generation (buying or selling a company).

5. Because the markets operate as an organized platform of exchange, the ease from a market’s liquidity allows companies to save on transaction costs: search cost (matching buyers and sellers), contracting costs (cost of negotiation) and coordination cost (meshing securities of different industries into a single platform), which frees up capital for other usage.

6. Allows wider public participation in the ownership of major companies, which expands the concept of private property ownership.

7. Allows some individuals to save from taxation (e.g. inheritance taxes)

8. Because stock markets function as repository of collateral or store of value, it can serve as protection or safehaven against hyperinflation or a severe form of a loss of purchasing power of a currency.

In the case of Zimbabwe where (hyper) inflation rate has reached an astounding 231,000,000%, its stock market has skyrocketed 960 QUADRILLION percent on a year to date basis as of November 4^th, (All Africa.com) considering more than 5 years of severe economic contraction and 85% unemployment rate. Unfortunately because of some political reasons, the Zimbabwe Stock Market has been suspended since December 17^th (Bloomberg).

Stock Market Is Generally Not A Casino Until…

The overall the goal of this article is to enlighten the public from the mistaken notion that stock markets generally represent as gambling casino.

Given that the stock market has measurable risk-reward variables, involves time continuum dynamics and value added functions (as dividends) it operates like any entrepreneurial undertaking.

Moreover, it has an economic wide and social significance which is largely unappreciated by the uninformed public.

Hence, the speculative ‘casino’ trait is often associated to individual actions or participants who engage in the markets with a short term outlook and without the proper understanding and scrutiny of risk. [Further reading please see Professor Alok Kumar of McCombs School of Business, University of Texas in a recent paper, Who Gambles in the Stock Market?]

Lastly of course government interventions can tilt or distort any markets away far from its price signaling efficiency. This is where the level of the playing field or the distribution share of the odds are skewed to favor one party over the others, mostly the recipients or beneficiaries from these interventions. Where the governments assume the role as the HOUSE and the beneficiaries as the DEALERS, then all other participants operate as PLAYERS, hence your basic description of a gambling casino.

Panics: Die of Exhaustion Or From Policy Overdose?

``Word to the wise - don't accept advice or analysis about this crisis from anyone who failed to anticipate it in the first place! The people warning about Depression now are the same reckless jackasses who told investors that stocks were cheap and “resilient” at the highs.”- John P. Hussman, Ph.D. Four Magic Words: "We Are Providing Capital"

Let me offer a non-sequitur argument: Because we could be destined for doom, we might as well bet on hope.

In other words, with so much of the prevailing gloom in the atmosphere this could, by in itself, possibly signify an end to the panic.

As Morgan Stanley’s Stephen Roach eloquently articulated in the International Herald Tribune (hightlight mine), ``The most important thing about financial panics is that they are all temporary. They either die of exhaustion or are overwhelmed by the heavy artillery of government policies.”

True enough, as we have always pointed out, doom or boom or market extremes have simply been accounted psychological phases of the market cycles.

Nevertheless, Mr. Roach uses the Professor Charles Kindleberger’s “revulsion stage” as a paragon for the possible panic endgame.

Professor Charles Kindleberger in Manias Panics, and Crashes A History of Financial Crisis identifies the phase as [p.15] ``Revulsion and discredit may go so far as to lead to panic (or as the Germans put it, Torschlusspanik, “door-shut-panic”) with people overcrowding to get through the door before it slams shut. The panic feeds on itself, as did speculation, until one or more of the three things happen: (1) prices fall so low that people are tempted to move back into less liquid assets: (2) trade is cut off by setting limits on price declines, shutting down exchanges or otherwise closing trading, or (3) a lender of last resort succeeds in convincing the market that money will be made available in sufficient volume to meet demand for cash.” (highlight mine)

While low prices and lender of last resort could likely be more pragmatic solutions, it is doubtful if the cutting of trades or closing exchanges will succeed in limiting the panic phase. As the recent examples of Indonesia and Russia manifested, temporary suspensions of bourse activities have not deterred the onslaught of a rampaging bear.

It would be more suitable for the markets to discover the price clearing levels required to set a floor than to applying stop gap solutions that only delays the imminent or worsens the scenario. Price controls rarely work especially over the long term and could lead to extreme volatility.

Nonetheless, with the successive coordinated barrage of heavy systemic stimulus by global central banks, possibly attempting to err on the side of a policy overkill, we might as well hope that 1) these efforts could somehow jumpstart parts of the global markets and or economies that have not been tainted by the US credit bubble dynamics or 2) that market levels could be low enough to attract distressed asset buyers which could provide the necessary support to the present levels.

While it likely true that the credit system in the US and parts of Europe have been severely impaired and will unlikely restore the Ponzi dynamics to its previous levels that has driven the massive buildup of such bubble, the most the US can afford is probably to buy enough time for the world economies to recover and pick up on its slack and hope that they can the recovery would be strong enough to lift the US out of the rut.

Divergences of Policy Approaches: Asia’s Market Oriented Response

One thing that has yet kept the world out of pangs of the 1930s global depression is that global economies have remained opened and that actions of policymakers have been constructively collaborative instead of protectionist.

Put differently, the world has been using most of its combined resources to deal with such a systemic problem. While such grand collaborative efforts may lead to the risks of huge inflation in the future, the scale of cooperation should likely diminish the menace of “deflationary meltdown”.

So while the US and Europe have closed ranks and concertedly used governments to assume the multifarious roles of “lenders of last resort”, “market makers of last resort”, “guarantors of last resort” or “investors of last resort” to shield its financial system from a downright collapse, Asia’s approach has been mostly “market-oriented”.

Some of the recent developments:

1) Taiwan removed foreign ownership restrictions or opened its doors to the global marketplace (Businessweek) encouraging overseas companies to list, aside from attracting potential foreign investors (particularly China’s resident investors) to participate in Taiwan’s financial markets.

2) Taiwan slashed estate and gift taxes from 50% to 10% (Taipei Times)

3) The Indian response: From the Economist ``On October 6th the Securities and Exchange Board of India removed its year-old restrictions on participatory notes (offshore derivative instruments that allow unregistered foreign investors to invest in Indian stockmarkets). The next day, external commercial borrowing rules were liberalised to include the mining, exploration and refining sectors in the definition of infrastructure. That raised the cap on overseas borrowing for companies in these sectors from US$50m to US$500m—although there may be little international money to borrow.” (highlight mine)

4) To cushion the effects of a global growth slowdown, China’s leaders are presently deliberating to allow its rural farmers to sell or trade state owned land rights and possibly also extending the tenure of land rights ownership from 30 to 70 years.

According to the New York Times, ``The new policy, which is being discussed this weekend by Communist Party leaders and could be announced within days, would be the biggest economic reform in many years and would mark another significant departure from the system of collective ownership and state control that China built after the 1949 revolution….Chinese leaders are alarmed by the prospect of a deep recession in leading export markets at a time when their own economy, after a long streak of double-digit growth, is slowing. Officials are eager to stoke new consumer activity at home, and one potentially enormous but barely tapped source of demand is the peasant population, which has been largely excluded from the raging growth in cities.”

So what could be the potential impact for such a major reforms to China’s rural population? See figure 4.Figure 4: Matthews Asia: China’s Rural and Urban Incomes

According to Matthews Asia, ``This reform is timely as a growing wealth disparity between China’s rich and poor is becoming a concern. China’s rural economy, despite representing over half of China’s population, has lagged behind urban economic development. The agriculture sector currently accounts for less than 12% of the nation’s GDP compared to 25% two decades ago. The top 10% of wealthy individuals command more than 40% of total private assets in the country. The impact of this reform is likely to benefit both the agricultural sector and rural areas by increasing agricultural investment and rural consumption. Enhanced rural standards of living should also help improve farm productivity and yields, important aspects for China to continue its self-sufficiency in grain production.” (highlight mine)

In other words, we shouldn’t underestimate the reforms undertaken by Asian governments out to achieve productivity advantages by tapping into market oriented policies while their western counterparts are presently burdened with restoring credit flows and in the future paying for the cost of such rescue missions.

Inflation As The Next Crisis?

So while the risks are real that the US banking sector could collapse and ripple to the world as global depression, the lessons from Professor Kindleberger shows that panics either exhaust itself to death or will likely get overwhelmed by an overdose of inflationary policies.

Basically all we have to watch for in the interim are the actions in the credit markets. So far we have seen some marginal signs of improvement, but not material enough to declare an outright recovery, see figure 5

Figure 5: Bloomberg: Overnight Libor (left), and TED spread (right)

Yes, markets almost always tend to overshoot, especially when driven to the extreme ends by psychology spasms, but ultimately credit flows are likely to determine the transitional shifts.

If credit markets do recover, market concerns will likely move from threats of a systemic meltdown brought about by “institutional or silent bank runs” to one of the economic impact emanating from the recent crisis.

Besides, the policymakers are likely to keep up with such aggressive pressures to reinflate the system and possibly engage the present crisis with a zero bound interest rate policy which basically adds more firepower to its various arsenals to combat deflation.

It isn’t that we agree to such today’s policy actions but it is what they have been doing and what they will probably do more under present operating conditions. This means that if they succeed in reinflating the system the next crisis would likely be oil at $200!

Figure 7: iTulip: Inflation Is The Menace

According to Eric Janzen of iTulip ``Since the international gold standard was abrogated by the US in 1971, ushering in the second era of floating exchange rates in 100 years – the last one ended badly as well – no deflation has occurred. Japan's experience with "deflation" would not show up on this graph because in no year since 1990 has deflation in Japan exceeded 2%.

“We continue to expect that the actions of central banks to halt deflation will, as usual, in the long run work too well.”

So hang on tight as the next few weeks will possibly determine if our doomsday emerges (and I thought they said that the scientific experiment of the Large Hardon Collider risks a true to life Armageddon) or if the impact from the inflationary overdrive of the collective powers of global central banks materializes.

Increasing Signs of Pakistan's Depression?

Last July we posted in Does The Violence In Pakistan’s Stock Market Signify Signs of Panic? indications of "panic" from rioting retail investors.

With the Karachi 100 down only about 40% from the peak (compared to others), domestic retail investors appear to have given up hope.

This week's quote reveals much of the rapidly sinking sentiment...

“There are no longer any small investors left in the stock market, they have all been destroyed,” said Kausar Qaimkhani, chairman of the Small Investors Association, leading a group of about 50 shareholders outside the Karachi Stock Exchange. (New York Times).

courtesy of Danske Bank

To consider Karachi's decline has been relatively muted when the country seems faced with a typical Emerging Market "balance sheet crisis" of exploding current account deficits which in times of external turmoil and lack of global liquidity has led to a rapid reduction of foreign currency reserves, sharply rising inflation, swooning currency (down about 30%) , debt downgrade on rising default fears and even fears of national bankruptcy (some have been "cleaning out their bank lockers and dollar accounts" on rumors of the possibility of government freeze on withdrawals). This has been aggravated by a weakening economy and deteriorating political atmosphere.

Pakistan has even approached China to solicit for economic aid. (Who won't? With 1.9 trillion in reserves, China could be the world's counterpart of JP Morgan ,the legendary financier who was credited to have rescued the US economy during the 1907 Panic.).

Nonetheless, all these point towards a near despondency- depression scenario.

Interesting times indeed.

Media Sentiment: The US is in a Depression! Warren Buffett Buys!

The US is in a DEPRESSION! That’s if we are to measure depression in the context of FEAR than the actual economic depression itself!

According to the Economist, ``MANY comparisons may be made between the devastation being wrought on America's financial system today and the Wall Street crash of 1929. One similarity that the world is desperate to avoid is a repeat of the depression of the 1930s. Hopes are pinned on the American bail-out plan that the House of Representatives is set to reconsider on Friday October 3rd. If the fear of depression is anything to go by, the future looks bleak. A survey of newspaper articles over the past two decades shows a sharp spike in mentions of the dreaded D-word, as commentators have started to think the worst. The prognostications may possibly turn out to be true, or perhaps the only thing we have to fear are the fears of journalists themselves.” (underscore mine)

Courtesy of the Economist

Growing fears of “A Mother of All Banking System Run” or its downright collapse emanating from the unresolved gridlocked in the global credit markets have aggravated such an outlook, compounded with the rapidly deteriorating economic environment.

Even Warren Buffett, the world’s most successful stock market investor, acknowledges part of this anxiety and analogizes the present conditions to one of the US Economy lying "flat on the floor” and undergoing a “Cardiac Arrest”.

In a recent CNBC interview with Charles Rose, Mr. Buffett said,

``Paramedics have arrived…and they shouldn't argue about whether to put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way, or they shouldn't start criticizing the patient because he didn't have blood-pressure tests.” In reference to his advancement of the bailout package, which was recently approved by the US Congress.

He relates the impact of the credit crunch as ``sucking the blood out of the economic body of the United States”.

Anyway, the Mr. Buffett in apparent empathy with the US, ``In my adult lifetime, I don't think I've ever seen people as fearful, economically, as they are right now….They are not wrong to be worried.''(highlight mine)

Plainly said, the fear the US faces from the present risks environment seems justified, although Mr. Buffett believes that these presents itself as opportunities from which to profit over the long term, ``The prices make a lot more sense now…You want to be greedy when others are fearful and you want to be fearful when others are greedy.''

A classical Mr. Buffett act.

From our end, we understand this as nothing really new.

Boom and Bust always bring about attitudinal change. Inflation is followed by deflation. Greed turns to Fear, Panic and ultimately to depression. Aggressive risk taking morphs into morbid aversion to risk. Generosity turns into frugality. Profits segue into losses. Debt level falls. Collateral values fall. The negative feedback loop of margin calls from reduced collateral values reinforces downward price spirals on asset values. Company Balance sheet shrinks. Unemployment rises. Conspicuous consumption shifts into consumption based on necessities. People’s time references are lowered. Real currency values rises as people and corporations hoard cash. Government fiscal deficits rise as rescue efforts mount or as contingent liabilities are realized as losses. Zero savings can mean more savings. Current account deficits could become surpluses. So what else is different?

Eventually most of the malinvestments and excess levels of gearing or leverage will be reduced to the point where the economy affords them. All these take time. But the adjustments won't be painless.

It’s what history has repeatedly shown. It’s what all cycles are all about. It’s the nature of human beings, especially when misdirected decisions have been impelled by policy incentives that lead to such behavior.

Besides, is this not the essence of capitalism: Profits and losses? We can't say capitalism is purely a one way street of profits, while loses need be socialized. That's the Keynesian brand of capitalism. And that's what has got us into this in the first place.

As US President Franklin D. Roosevelt in his First Inaugural Address on a Saturday of March 4, 1933 ``So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”

While there is nothing to fear but fear itself, eventually there will be a resolution to the crisis as it always had been. It's not the end of the world as we know it. Although we are hopeful that in learning from history we could avoid taking on the similar paths that would risk actualizing these fears.