``A free market has to and does coordinate current and future production against future unknown demands, supplies, and shocks; and it has to and does find ways to alleviate the negative effects of shocks. People generally accomplish this by planning, forecasting, conservative practices, saving, hedging, insuring, and diversifying. There are countless ways, each tailored to particular circumstances. When a man has a backup trade, he is hedging against being laid off in his main occupation. When a family saves, it is hedging against loss of income. When family members help one another in hard times, they are insuring each other. When a business is conservative in obtaining credit and expanding, it is hedging against possible stringent business conditions. When a person diversifies investments, he is hedging against loss in one part of the portfolio. When a business controls inventories, it is managing the risk of shocks to the business.”- Michael S. Rozeff, Destination Collapse
Over at a recent huddle, a good friend asked me “how does one maintain discipline if it is an extended bear market?” The underlying concern was that the temptation or the urge to “catch the falling knife” or to “scalp (day trades)” had been quite strong given the nearly 2 years of drought in profit opportunities.
I would believe that such sentiment fundamentally embodies the unappreciated circumstance that inhibits the progress of our capital markets.
The principal problem with the Philippine Stock Exchange (PSE) is that the sustainability of the equity market industry is almost entirely dependent on a UNIDIRECTIONAL trend- that’s because people and the industry generally make money only when the Phisix goes up or is in a bullmarket!
True, “short” or the securities borrowing and lending facilities lending have been recently introduced. But apparently unfamiliar to the public or to the authorities or regulators is that any regulatory framework operates on economic dimensions : It’s always about the tradeoffs between costs and benefits.
If brokers don’t implement these, for reasons of perceived cost outweighing perceived benefits, primarily due to the compliance albatross, then effectively the program is rendered inoperative. Even if it seems noteworthy in paper, what good is a new trading platform if it can’t be used at all?
Unforeseen Consequences
Nonetheless a one dimensional reward based market has these unforeseen consequences:
1. Deprives market participants to earn
Obviously since markets operate on secular cyclical trends, then the industry or the public profits only from a bullmarket and suffers from a period of agony of “deprivation” once the bearmarket reign.
In Biblical analogy, the PSE is reduced to FAT and LEAN years with basically nothing in between. This, sadly to say, reflects on the primitive state of our financial markets.
2. Limits Liquidity
Industry participants whine of the lack of liquidity or volume. But this is exactly why hardly volume hardly progresses:
In a bullmarket, the volume of trade improves because the public churn trades profitably. In contrast, in a bearmarket, buyers have essentially been confined to a “catching a falling knife” position, where loses from wrong market “timing” or “expectations” would compel a mostly “long” position, thereby containing incidences of trades which effectively shrivels volume.
And reduced liquidity diminishes the incentives for private companies to get publicly listed, increases the market’s risk profile and exaggerates volatility.
3. Restrains growth potential of the industry
Moreover, major industry participants, particularly, brokers, mutual funds or Unit Investor Trust Funds (UITFs) would be reluctant to invest for expansion under the recognition of operational handicaps of a unidirectional reward based market, hence, the growth rate mediocrity of the Philippine capital markets.
The chart above (which shows the year on year changes) also shows state of the Philippine equity markets in terms of market capitalization calculated in US dollars, which has severely lagged the region.
4. Handicapped Financial Industry Is Transmitted To Suboptimal Economic Growth
Another underappreciated dimension is that a unidirectional reward based market has an economic wide impact.
While for most people, the stock market is seen as a gambling casino or as some form of legal embellishment, for us, the stock market functions as a fundamental pillar to national development. And to reprise its importance, from our A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino:
-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.
-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.
-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.
-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).
-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.
-Allows wider public participation in the ownership of major companies, which expands the concept of private property ownership.
-Allows some individuals to save from taxation (e.g. inheritance taxes)
-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.
Hence in a unidirectional reward based market the following factors have been compromised:
-market pricing efficiency (reduced liquidity amplifies volatility and structurally raises risk premium or the hurdle rate),
-the optimum channeling of savings into investment or capital deployment (which translates to lesser investment opportunities and suboptimal returns),
-access to alternative financing (extrapolates to high cost of financing, which implies low public listings),
-investment opportunities that allows for a wider public participation or the “trickle down effect” (limited income growth opportunities for the public),
-the lowering of transactional costs (reduces the incentives for attracting wholesale or bulk institutional investments and requires higher hurdle rate) and
-hedging and other opportunity costs as seen from any sophisticated and deep markets (increases risk profile or premium, and heightens volatility)
From which all of these translates to lost opportunities for national wealth generation.
5. Emits Wrong Impressions and Reduces Role of Specialization
A unidirectional rewards based market exacerbated by Principal Agent problem reinforces the public’s perspective of the simplistic functionality of stock markets.
Information derived from commission based Sell Side institutions accentuates on the short term orientation of market exposure to most retail investors. And this also applies to some institutional accounts as well.
Where markets are seen as operating in a short term framework, the degree of risk taking appetite would be intensified by cyclical extremities. Again this magnifies volatility, increases perception of risk from the international institutional standpoint and diminishes the requirement or the need for division of labor or the role of specialization for domestic industry participants.
Who would want to invest in mutual funds, or UITFs or broker discretionary accounts, when the impression portrayed is -what the so-called experts can do is available to anyone? Who cares about risk, when mainstream literature almost always expounds on momentum, preened in the fundamental or technical charting garb?
To respond to such objections local sell side institutions would then expound on emphasizing on their capability to trade short term fluctuations-which is nothing more than a hokum operating on the graces of lady luck!
It’s is of no wonder why losses suffered by retail investors during bearmarkets, in many occasion, leads to abhorrence and complete desertion of the markets. This is mainly due to the wrong expectations inculcated from misleading foundations of how markets operate and the lack of alternative instruments to protect market participants from market losses during cyclical transitions.
6. Distorts Incentives
Some discretionary accounts operating under a bearmarket would prefer to withdraw proceeds than leave them with industry fund managers.
In my mind’s eye, the perception is that cash would be better off under the clients’ management since there would be no alternative options to put these at work in the capital markets. Hence, these risks skewing the incentives for managers to long the client’s account, despite the realities of an unfolding bearmarket cycle, than to lose handle.
In other words, because the operational arrangements of the fund industry could be impaired by the lack of instruments to employ idle funds in a market which only profits from one direction, fund managers could be motivated to take on more risks than required. Again, the Principal Agent Problem at work here.
From my standpoint, bearmarkets can be classified into two strains: structural or contagion based/cyclical. Both of which requires different investment approaches.
The latter of which is one that can be longed or endured with, since the national economy has no major fundamental impairment (mostly clustering errors from malinvestments from bubble policies) and could be expected to recover and to profit from a reversal of the cycle in the fullness of time. The 2007-2008 financial crises serves as lucid example of this scenario applied to the Philippine setting.
Nonetheless, the former requires total exodus regardless of the conditions of the portfolio when such a cycle emerges. That’s because bubble afflicted markets or industries can vaporize issues regardless of its previous stature. Think AIG, Bear Stearns, Lehman Brothers, General Motors and Chyrsler.
In short, there are no blue chips in an unwinding bubble afflicted industry! The idea that paper losses are merely paper losses without liquidations consummating the transaction is false.
So the analytical approach of the analyst or fund manager ultimately distinguishes between portfolio salvation and damnation, and matters more than what the public normally expects of them.
7. Cognitive Biases Also Shaped In One Direction
Again since markets are basically psychologically driven, participants are thereby influenced by cognitive biases or the reflexivity theory.
Analysts or experts as well as the general public, here, are predisposed towards a bullish bias simply because the current operating environment rewards participants only when the markets move in a sustained upward trajectory.
And we see the same dynamics applied to politics, market participants audibly cheer upon policies that temporarily boost market prices at the expense of the future simply because the public’s general expectation is predisposed towards the short term expectations.
And it is the same reason why many participants, like my good friend, despite the understanding of key market tenets, have been tempted to defy such guidelines to engage in ‘catching a falling knife’ trades- out of the psychology directed by the reward incentives provided for by the present operational market mechanism.
And such a bias doesn’t elude me entirely.
Conclusion and Recommendations
And so what could be done?
For PSE authorities:
We suggest that the “ease of use” principle founded on a sound legal framework, or the proverbial horse before the cart, as the main thrust to introduce market reforms.
New market platforms depend on the functionality or utility more than mere technical legal vernaculars which risks of high compliance costs or choking regulatory requirements that could render reforms inapplicable.
Remember, all regulations operate on latent economic dimensions. Fundamentally, success of any market platform will depend on the cost-benefit tradeoffs and not on intricate legalese.
Moreover, it would be more convenient and pragmatic to rush market reforms to include expanded local investor access to markets as Exchange Traded Funds, basic derivatives (such as options-put or call) and commodity spot and futures markets (I’d say currency markets as secondary) to enable local investors:
-the ability to hedge on or minimize risks by diversification or by utilizing hedge instruments,
-to increase capital efficiency allocation, and
-to utilize moderate leverage to augment returns
Markets that profits from the upside or the downside or sideways complimented with the ability to minimize risks by hedging or diversification will likely attract a larger and more diversified base of capital and deepen the local financial markets that should translate to value added economic growth.
For market participants:
We can only operate under the platform from which the PSE operates on, this means identifying and positioning based on cyclical or secular trends.
Next, for sophisticated investors is to tap the same aforementioned hedge instruments such as ETFs (an inventory list here), basic derivatives or commodity markets overseas. [For a related article see my previous outlook see Should Filipinos Invest Abroad?]
Finally, choose wisely on your investment analyst for guidance or for managing your funds. Avoid from selecting opinions which merely confirms your biases and from embracing viewpoints that merely deduce present price signals as basis for prospective market action. Market analysis should be objective and dispassionate where risk must always be weighed against prospective gains.
In short, avoid the bias traps.
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