Principal Agent Problem: Hong Kong-China Edition, Roots of Why The Mainstream MUST Remain Bullish

Despite growing risk conditions, this is an example why the mainstream has to remain bullish.

From Bloomberg’s Every Stock Was a Buy to This Analyst Team, Then Shares Tanked (May 30)

Companies probably love getting attention from analysts at Emperor Securities Ltd. in Hong Kong. Investors who followed their advice for the past year, not so much.

The unit of Emperor Capital Group Ltd. issued buy recommendations on every one of the 173 companies it reported covering from April 2015 through May 16. Its target prices, which the company says forecast trading levels within weeks, predicted gains of 25 percent on average. They are frequently the most bullish among analysts who cover the same stocks and list their calls with Bloomberg, including those based on the standard 12-month horizon.

The picks ended up being so wrong during the past year’s rout of Chinese and Hong Kong stocks that shorting every one would have resulted in gains of about 6 percent after just four weeks and almost 13 percent if all were held through last week.

Emperor’s record highlights the perils of equity trading for new retail investorsflooding markets in China and Hong Kong. Individuals piled into stocks as the Shanghai Composite Index recorded one of its best rallies ever and policy makers relaxed restrictions on mainland and Hong Kong citizens trading in each other’s markets. Emperor, which caters to such traders, said its revenue increased 64 percent in the year ending March 31 thanks in part to big increases in brokerage fees and margin-lending interest payments.

The firm was hardly alone in making bad calls during the turmoil. Forecasts by firms covering mainland Chinese equities were off by bigger margins on average than those of analysts researching stocks in the rest of the world’s 20 largest markets. Analysts covering Hong Kong-listed companies, Emperor’s focus, were second worst, with their average year-ago targets overshooting the benchmark Hang Seng Index’s current level by 44 percent.

“It’s our style to have a buy with a target price and a stop-loss price and not have hold or sell” recommendations, said Stanley Chan, director of Emperor Securities Research, by phone. The “small, local brokerage” offers trading ideas based on “market sentiment” and “news, events or momentum,” he said, not valuations, earnings potential and other fundamentals. “We pick stocks with a one-to-two-week horizon,” Chan said.

An investor buying each of the 173 stocks on the day of Emperor’s recommendation would have lost 0.9 percent after a week on average, 2.9 percent after two weeks, 4.2 percent after three weeks and 6.1 percent after four weeks, by which time 119 of the stocks had fallen, data compiled by Bloomberg show.

You see, the incentives for brokers, banks and fund managers are commissions and fees generated from transactions. On the other hand, the incentives for the public have generally been to make profits from trades. 

By virtue of asymmetric information (where sellers know more of the market than the buyers), when the mainstream peddles a ruddy outlook in order just to sell financial products, they take advantage of the public’s gullibility by purposely disregarding the risk from their proposed trades. They make it appear that that their trade recommendations are a one way road.

And this goes beyond scheming. Most have been ingrained to steadfastly believe that nothing can go wrong. That’s because when puritanical bullishness morphs into a creed**, this further incents the mainstream’s one sided recommendations.

In short, everything is a buy. The mainstream MUST remain bullish because this feathers their nests. So they won’t ever bite the hand that feeds them by telling of the public of the risks from the environment. They would censor or deflect or dismiss anything or any information that will go against their interests or beliefs.

This is called the principal agent problem or conflict of interest operating behind the interactions between financial agents and their clients. But this is not limited to finance as this is also seen in the world of politics.

So when the market goes awry, clients are left hung out to dry.

For as long as the market remains up, such conflict of interest won’t seem apparent.

But as Hong Kong and China’s experience has shown, when the market has been sharply down that’s when the public gets to know who’s been swimming naked

**In behavioral finance this is called the endowment effect or "people ascribe more value to things merely because they own them". For instance if one is invested into an industry, the endowment effect means that because one has already been exposed in it, one cannot go against this position because doing so only means an admission of a wrong decision. So during market cycle tops (manias) or economic cycle peaks, denials transforms into a religious like conviction.

At the day’s end: Bulls Make Money, Bears Make Money, Pigs Get Slaughtered