US Capital Markets: Dominance Erode as Investors Shift Overseas

In the world capital markets, the US appears to be losing its leadership

Reports the New York Times (bold highlights mine)

Reva Medical did what a small but increasing number of young American companies are doing — it looked abroad for money, in Reva’s case the Australian stock exchange.

After an eight-month road show, meeting investors and pitching the prospects of a biodegradable stent, the 12-year-old company sold 25 percent of its stock for $85 million in an initial public offering in December.

“There are so many companies that require capital like our company, and they don’t have access to the capital markets in the United States,” said Robert Stockman, Reva’s chief executive. “People are looking at any option to stay alive, which is what we did.”

Reva’s example shows that nearly three years since the financial crisis began, markets in the United States are barely open to many companies, leading them to turn to investors abroad. Denied a chance to list their stock and go public here, they are finding ready buyers of their shares on foreign markets.

Nearly one in 10 American companies that went public last year did so outside the United States. Besides Australia, they turned to stock markets in Britain, Taiwan, South Korea and Canada, according to data from the consulting firm Grant Thornton and Dealogic.

The 10 companies that went public abroad in 2010 — and 75 from 2000 to 2009 — compares with only two United States companies choosing foreign exchanges from 1991 to 1999.

The trend reflects a decidedly global outlook toward stocks, just as the number of public companies in the United States is shrinking.

From a peak of more than 8,800 American companies at the end of 1997, that number fell to about 5,100 by the end of 2009, a 40 percent decline, according to the World Federation of Exchanges.

The drop comes as some companies have merged, or gone out of business, or been taken private by private equity firms. Other young businesses have chosen to sell themselves to bigger companies rather than go public.

Here’s why...

Again from the New York Times, (bold emphasis mine)

A variety of factors explain each company’s decision to list on a foreign exchange, like the increased regulatory costs of going public in the United States. Underwriting, legal and other costs are typically lower in foreign markets, companies say.

The Alternative Investment Market, or AIM, a part of the London Stock Exchange intended for small company listings, is a popular destination for some American companies. The cost of an initial public offering there is about 10 to 12 percent of total capital raised, compared with 13 to 15 percent on Nasdaq, according to Mark McGowan of AIM Advisers, which helps American companies list on AIM.

In addition, the extra annual cost of maintaining a public listing, including complying with Sarbanes-Oxley rules, can be typically much higher in the United States: $2 million to $3 million each year depending on the size of a company compared with a cost as low as $320,000 on AIM or $100,000 to $300,000 in a market like Taiwan, according to advisers.

There are concerns that some foreign exchanges attract companies because their oversight may be less stringent. But companies insist standards are high.

A more important factor than cost, said Sanjay Subhedar, managing director of Storm Ventures, a California venture capital firm, is that investors in the United States who traditionally participate in I.P.O.’s and the banks that underwrite the offerings are no longer interested in share sales by small companies.

Institutional investors like mutual funds want the liquidity of larger offerings with abundant buyers and sellers, he said; bank underwriters want to focus on the more lucrative fees that bigger deals generate.

So fundamentally the article cites compliance cost, cost of listing and maintenance and liquidity as direct costs for the erosion of the dominance of the US.

True, direct compliance costs have been a major hurdle.

Many see that the cost-benefit trade off of the Sarbanes Oxley act (SOX) has been weighted towards costs. In short, the law has been economically unviable and has prompted for unforeseen consequences.

Companies have been spending billions of dollars a year to comply with the SOX with little benefit in return.

Richard Karlgaard of Forbes magazine exhorts for the repeal of SOX

Dump Sarbanes-Oxley. Enacted in 2002 to prevent the next Enron scandal, Sarbox has thrown sand into the gears of entrepreneurship. It has severely slowed the U.S. market for IPOs, since companies earning less than $200 million in revenue can't afford the legal and accounting costs of being a public company today. Deprived of capital, young companies not named Facebook or Twitter prematurely stagnate or sell out. Investors are deprived of opportunity, and the nation is deprived of independent companies that surpass the $1-billion-in-revenue mark.

But there are other indirect factors that also contributes to such dynamic

There is the expanding risk of changing the rules of the game midway or “regime uncertainty” as government intrusions adds onus to the business climate by the contorting expectations and upsetting the balance of risk-reward tradeoffs. This penalizes existing firms and provides disincentives for prospective ventures.

Part of which have been policies that push for boom bust cycles which engenders widespread malinvestments or misdirection of resource allocation.

Another is the effects of policies to devalue. Eroding value of the US dollar may have prompted US companies to go overseas and tap (or arbitrage on) savings denominated in foreign currencies.

There is also the crowding out effect where companies spend money on lobbying to protect their political interests than for expansion.

The Business Insider gives an example of how tech companies have been spending to placate the political deities of Washington.

All these interventions add up to the intensive diversion of productive resources, raise the cost of doing business and consequently reduce the public’s appetite to invest, thereby adding to pressure on jobs creation.

It doesn’t stop here. Taxes have also been a significant part of these growing costs.

Tax Laws have been mounting as government intervention increases.

Chart from Taxes for expats

Also US government’s social spending will likely mean higher taxes.

From Heritage Foundation

And this has already been hurting small businesses which makes up the biggest share of jobs creation.

From Small Business Trends

Total compliance cost for the US economy on current regulations has been estimated at $380 billion per year

So much money has been lost to politics.

As supply-side economist Art Laffer writes at the Wall Street Journal in June of last year

On or about Jan. 1, 2011, federal, state and local tax rates are scheduled to rise quite sharply. President George W. Bush's tax cuts expire on that date, meaning that the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% from zero. Lots and lots of other changes will also occur as a result of the sunset provision in the Bush tax cuts.

Tax rates have been and will be raised on income earned from off-shore investments. Payroll taxes are already scheduled to rise in 2013 and the Alternative Minimum Tax (AMT) will be digging deeper and deeper into middle-income taxpayers. And there's always the celebrated tax increase on Cadillac health care plans. State and local tax rates are also going up in 2011 as they did in 2010. Tax rate increases next year are everywhere.

So with the prospects of tax increases, capital investments are likely to be constrained (manifested by declining number of public companies) or will shift outside (raising capital overseas).

Bottom line: The eroding dominance of the US capital markets signifies a symptom of an underlying disease- government interventionism (mostly via inflationism)

Sand Castles From US Regulatory Reforms

“Any fool can make a rule. And any fool will mind it.” - Henry David Thoreau

Among the popular misconceptions about resolving today’s social and institutional problems is the issue of regulation.

For many (particularly for the left), the recent Financial Crisis had been a product of “free markets” or “market fundamentalism”. This notion is totally absurd.(there can be no pure free market in a world of central banking)

For instance many hold that the repeal of the Glass Steagall Act via the Gramm-Leach Bliley as responsible for today’s crisis.

Economist and Professor Luigi Zingales argues otherwise[1], ``In 1984, the top five U.S. banks controlled only 9% of the total deposits in the banking sector. By 2001, this percentage had increased to 21%, and by the end of 2008, close to 40%. The apex of this process was the 1999 passage of the Gramm-Leach-Bliley Act, which repealed the restrictions imposed by Glass-Steagall. Gramm-Leach-Bliley has been wrongly accused of playing a major role in the current financial crisis; in fact, it had little to nothing to do with it. The major institutions that failed or were bailed out in the last two years were pure investment banks — such as Lehman Brothers, Bear Stearns, and Merrill Lynch — that did not take advantage of the repeal of Glass-Steagall; or they were pure commercial banks, like Wachovia and Washington Mutual. The only exception is Citigroup, which had merged its commercial and investment operations even before the Gramm-Leach-Bliley Act, thanks to a special exemption.” (bold emphasis)

On the other hand, the Community Reinvestment Act (CRA), whose regulations forced financial institutions to accept risky borrowers have also been held responsible.

According to Peter J. Wallison of the American Enterprise Institute[2], ``In 1995, the regulators created new rules that sought to establish objective criteria for determining whether a bank was meeting CRA standards. Examiners no longer had the discretion they once had. For banks, simply proving that they were looking for qualified buyers wasn’t enough. Banks now had to show that they had actually made a requisite number of loans to low- and moderate-income (LMI) borrowers. The new regulations also required the use of “innovative or flexible” lending practices to address credit needs of LMI borrowers and neighborhoods. Thus, a law that was originally intended to encourage banks to use safe and sound practices in lending now required them to be “innovative” and “flexible.” In other words, it called for the relaxation of lending standards, and it was the bank regulators who were expected to enforce these relaxed standards.”

Meanwhile, the Cleveland Fed downplays the role of the CRA in this crisis[3].

There has been “no consensus” as to which of the two laws had truly an adverse impact on the markets. Since there has been no perfect correlation, the ensuing tit-for-tat in the media had been reduced into a debate based on ideological slant.

In addition, we also said that the impact of laws tend to be divergent and ‘time sensitive’, where some laws could have positive interim term effects but with negative long term impact, and vice versa.

As caveat, while correlations may not appear to be outright linear, as the debate above holds; it would be misguided to attribute the lack of correlation to a single variable or to one law considering that there are many other laws or variables that also combine and or compete to expand or diminish the effects of a particular law.

Here the underlying general principles or theory will be more dependable than simply relying on statistics or math. Murray Rothard notes of the observation of John Say in distinguishing these[4],

``Interestingly enough, Say at that early date saw the rise of the statistical and mathematical methods, and rebutted them from what can be described as a praxeological point of view. The difference between political economy and statistics is precisely the difference between political economy (or economic theory) and history. The former is based with certainty on universally observed and acknowledged general principles; therefore, “a perfect knowledge of the principles of political economy may be obtained, inasmuch as all the general facts which compose this science may be discovered.” Upon these “undeniable general facts,” “rigorous deductions” are built, and to that extent political economy “rests upon an immovable foundation.” Statistics, on the other hand, only records the ever changing pattern of particular facts, statistics “like history, being a recital of facts, more or less uncertain and necessarily incomplete.” (underscore mine)

In short, trying to pinpoint the effects of one law based on oversimplified statistics to the political economy can be tricky. And this is where the left has used statistics or math to obfuscate evidences.

More of John Say from Murray Rothbard, ``The study of statistics may gratify curiosity, but it can never be productive of advantage when it does not indicate the origin and consequences of the facts it has collected; and by indicating their origin and consequences, it at once becomes the science of political economy.” (underscore mine)

Regulatory Arbitrage And Fighting The Last War

And as we earlier pointed out to the contrary, where laws are lengthy, ambiguous, partisan and subject to political discretion, they tend to be distortive and create imbalances in the system. And the impact of some of these laws indubitably accentuated the crisis.

Nevertheless there had been some policies or regulations that had relatively more material impact among the others (see figure 3).

Figure 3: Bank of International Settlements: Ingredients of the Crisis

The apodictic evidence from last crisis had been the surfacing of the “shadow banking system” (see right window).

As pointed out earlier above, one of the unintended consequences of bad laws or overregulation is to have regulatory arbitrages, where markets look for regulatory loopholes from which it exploits. These are parallel to the emergence or existence of black markets over economies that operate heavily under price controls[5].

So even the multilateral government agency as the UN via its subsidiary the UNCTAD had to admit this[6], ``Recent United States banking regulations, for example, were designed to control risk through the measured capital ratio used by commercial banks, the report says. This attempt backfired because bank managers circumvented the rules either by hiding risk or by moving some leverage outside the banks. This shift in leverage created a "shadow banking system" which replicated the maturity transformation role of banks while escaping normal bank regulation. At its peak, the US shadow banking system held assets of approximately $16 trillion, about $4 trillion more than regulated deposit-taking banks. While the regulation focused on banks, it was the collapse of the shadow banking system which kick-started the crisis.”

The lesson of which clearly is that politics, no matter how heavy handed, can hardly control the fundamental laws of economics.

Another problem with regulation is that it fights the last war.

For instance during the last bubble, the issue of prominence had been the accounting fraud from Enron, Tyco International, Worldcom, Adelphia and others that gave rise to the Sarbanes-Oxley Act[7].

Obviously, from a hindsight bias the regulation failed to make any headway to stop the recent crisis. Again that’s because markets are dynamic and seizes the next loopholes as opportunity to expand.

Nonetheless some has argued that the Sarbox law itself has been a drag to the recovery of the US. An example is this commentary from Wall Street Journal’s James Freeman[8],

``Is Sarbox to blame? Many financial pundits say no, but the SEC survey results point in the other direction. When public companies are asked whether Section 404 has motivated them to consider going private, a full 70% of smaller firms say yes, and 44% of all public companies also say yes.

``Has Sarbox driven businesses out of the country? Among foreign companies, a majority in the survey say that Section 404 has motivated them to consider de-listing from U.S. exchanges, and a staggering 77% of smaller foreign firms say that the law has motivated them to consider abandoning their American listings.”

In short, another unintended consequence of having more regulation is to raise the cost of compliance.

In a globalized market, investors can arbitrage away regulatory burden or the cost of compliance by simply transferring to where there is less onus or costs.

Figure 4 IMF: Sovereign Debt to GDP in the G-7

Yet fighting the last war means attacking past problems which may not be the source of the next crisis.

Another factor that is seemingly ignored is that the leverage, which is now a “prominent” factor, acknowledged by the mainstream seems to be building not in the previous sectors, which suffered from a bust, but instead in government debt.

As in the earlier chart (figure 3 left window) from the speech of Hervé Hannoun[9] Deputy General Manager of the BIS, low interest rates which has allowed for the chasing of yields, low volatility and high risk appetite, were outstanding features of the last crisis. However, practically the same ingredients in the past we are seeing today.

And governments are in a tight fix because, as we have been saying[10], “ governments will opt to sustain low interest rates (even if it means manipulating them-e.g. quantitative easing) as a policy because ``governments through central banks always find low interest rates as an attractive way to finance their spending through borrowing instead of taxation, thereby favor (or would be biased for) extended period of low interest rates”

So governments are operating in a policy paradox.

They pretend to know the main sources of the crisis yet are addicted to it for political reasons. An addict can hardly refuse what’s keeping them going. It’s simply path dependency from what we call as policy “triumphalism”. According to the G-20, ``The global recovery has progressed better than previously anticipated largely due to the G20’s unprecedented and concerted policy effort.”[11]

Again we are being validated.

Agency Problem And Socializing Losses While Privatizing Profits

There is another problematic aspect in regulation; it’s called the agency problem or the principal agent problem.

It’s a problem which emanates from different incentives or goals by those operating within the industry.

For instance during the last crisis, risk monitoring was fundamentally outsourced by risk buyers to the ratings agencies (yes in spite of the army of professionals). On the other hand, originators of risk securities or risk sellers tied fees due the credit ratings agencies on the credit ratings they issued which were then sold to “sophisticated” financial institutions.

Said differently, the job of credit appraisals were delegated to the ratings agencies which incidentally derived its income from the issuers of securities, and not from the buyers. Whereas buyers of securities fully delegated the role of due diligence to the ratings agencies.

So credit risks had been ignored in the assumption that someone else would do it for them. As Charles Calomiris Columbia University recently said in an interview[12], “Agency problem...Ratings agencies were a coordination device for plausible deniability."

Figure 5: The Economist: Reforming Banking

Perhaps the ultimate source of ‘plausible deniability’ comes with attendant with the current structure of the banking system-it’s basically called the fractional reserve based banking platform (see figure 5).

Bank equity as % of assets is now nearly at the lowest level since the introduction of central banking and deposit insurance.

In a BIS paper from Andrew Haldane of the Bank of England[13] writes, ``Over the course of the past 800 years, the terms of trade between the state and the banks have first swung decisively one way and then the other. For the majority of this period, the state was reliant on the deep pockets of the banks to finance periodic fiscal crises. But for at least the past century the pendulum has swung back, with the state often needing to dig deep to keep crisis-prone banks afloat. Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing.”

This means that the banking system’s ability to take more risks comes under the broadening premise of “privatizing profits and socializing losses” as the guiding policy.

This means that aside from central banking, deposit insurance is another means to “privatizing profits and socializing losses” which allows the banking system to absorb more risks, while on the hand tolerates the expansion of regulatory powers by the central bank.

As Murray N. Rothbard wrote[14], `Under a fiat money standard, governments (or their central banks) may obligate themselves to bail out, with increased issues of standard money, any bank or any major bank in distress. In the late nineteenth century, the principle became accepted that the central bank must act as the “lender of last resort,” which will lend money freely to banks threatened with failure.

``Another recent American device to abolish the confidence limitation on bank credit is “deposit insurance,” whereby the government guarantees to furnish paper money to redeem the banks’ demand liabilities. These and similar devices remove the market brakes on rampant credit expansion.”

So moral hazard and the agency problem seem to be significant factors that had been transforming the developed world banking system.

Of course there are other potential sources of regulatory problems, such as economics and behavioural aspects of enforcement, conflicting laws, a multitude of arcane laws which the public can’t comprehend, Arnold Kling’s legamoron (laws that could not stand up under widespread enforcement) and others, but due to time constraints we will be limited to the above.

At the end of the day, those building up the expectations for more regulations as elixir to the current problem would likely fail them. Why? Because there will be a new crisis down the road and hardly any of the current reforms will stop it.

Until they deal with roots of the problem, bubbles like the game called whack-a-mole will keep reappearing. Yet history says that all paper money is bound to go back to its intrinsic value-zero.

---

[1] Zingales, Luigi Capitalism After the Crisis, National Affairs

[2] Wallison, Peter J. The True Origins of This Financial Crisis, American Spectator

[3] Nelson, Lisa Little Evidence that CRA Caused the Financial Crisis, Cleveland Fed

[4] Rothbard, Murray N. Praxeology as the Method of the Social Sciences

[5] An example of this is North Korea, which recently massively devalued her currency to fight the black markets. But unlike before where policies where met with passive resistance, riots broke out from which tempered Kim’s political approach. See Will North Korea's Version Of The 'Berlin Wall' Fall In 2010?

[6] UNCTAD, Shadow banking system that escaped regulation, faith in ´wisdom´ of markets led to meltdown, study says

[7] Wikipedia.org, Sarbanes-Oxley

[8] Freeman, James The Supreme Case Against Sarbanes-Oxley, Wall Street Journal

[9] Hannoun, Hervé Financial deepening without financial excesses, Bank of International Settlements, 43rd SEACEN Governors’ Conference, Jakarta

[10] See How Myths As Market Guide Can Lead To Catastrophe

[11] Wall Street Journal Blog, Text Of G-20 Finance Ministers, Central Bankers’ Statement

[12] Calomiris Charles, Econolog David Henderson: Calomiris on the Financial Crisis

[13] Haldane, Andrew Banking on the state Bank Of International Settlements

[14] Rothbard, Murray N., The Economics of Violent Intervention, Man, Economy and State

The Lost Decade: US Edition Part 2

As we earlier pointed in The Lost Decade: US Edition, stock market returns had been dismal, a decade since the new millennium.

Well, America's blemished decade hasn't just been confined to the performance of its stock markets, but likewise reflected on major economic indicators as magnificently shown in the chart below from the Washington Post.
According to the Washington Post, (bold emphasis mine)

``The U.S. economy has expanded at a healthy clip for most of the last 70 years, but by a wide range of measures, it stagnated in the first decade of the new millennium. Job growth was essentially zero, as modest job creation from 2003 to 2007 wasn't enough to make up for two recessions in the decade. Rises in the nation's economic output, as measured by gross domestic product, was weak. And household net worth, when adjusted for inflation, fell as stock prices stagnated, home prices declined in the second half of the decade and consumer debt skyrocketed."

The obvious lesson is that policies that promote short term prosperity through inflating asset bubbles negates the ephemeral yet unsustainable policy driven gains.

As Ludwig von Mises presciently warned in his magnum opus, ``The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment."

In short, bubble blowing policies simply don't work.

To add, the impact of the fast ballooning Federal regulations as seen in the Federal Register journal [as earlier discussed in Has Lack Of Regulation Caused This Crisis? Evidence Says No] should likewise be considered in the decomposition of the prevailing conditions of the US economy.

As previously quoted,``According to the Washington, DC-based Competitive Enterprise Institute’s 2009 edition of “Ten Thousand Commandments” by Clyde Crews, the cost of abiding federal regulations is estimated at $1.172 trillion in 2008 – 8% of the year’s GDP. This “regulation without representation,” says Crews, enables the funding of new federal initiatives through the compliance costs of expanded regulations, rather than hiking taxes or expanding the deficit."

In other words, numerous opportunity costs from the costs of compliance, costs of an expanded bureaucracy and the attendant corruption, the cost of the crowding out of private investments, the misdirection and wastage from inefficient use of resources and other forms 'unseen' distortions from the said regulations should also be reckoned with in appraising the economy.

To argue that America's decade have been emblematic of the frailties free markets is to engage in Ipse Dixitism or plain falsehood.

That's because it's easy to use the strawman to blame others, yet the worst is to admit one's mistakes. And passing the buck won't solve anything but agitate for more restriction of individual liberties and possibly provoke unnecessary conflicts.

Has Lack Of Regulation Caused This Crisis? Evidence Says No

We find it odd when experts argue of the lack of regulation as the cause of this crisis.

Evidence simply don't support such claims...

Chart From Casey Research

According to Casey Research, ``The Federal Register is a daily publication of all the proposed and final rules and regulations of the U.S. government. The size of the register is often used to gauge the scope of regulation, and it’s been on steroids for decades.

``According to the Washington, DC-based Competitive Enterprise Institute’s 2009 edition of “Ten Thousand Commandments” by Clyde Crews, the cost of abiding federal regulations is estimated at $1.172 trillion in 2008 – 8% of the year’s GDP. This “regulation without representation,” says Crews, enables the funding of new federal initiatives through the compliance costs of expanded regulations, rather than hiking taxes or expanding the deficit."

Imagine, compliance costs at an estimated 8% of the GDP and growing!!! This represents as tremendous burden, since it reduces the productive capacity of the US economy. Money that would have gone into capital investments have been lost due to sheer compliance on the massive regulatory structure.

To add, the Federal Tax Code (see below) which is also incorporated in the Federal Register has also seen a ballooning of pages-67,506.

chart from Don't Mess with Taxes

The tax code had only 400 pages in its inception in 1913!

More from George Reisman [The Myth That Laissez Faire Is Responsible For Our Crisis] (bold highlights mine)

1. Government spending in the United States currently equals more than forty percent of national income, i.e., the sum of all wages and salaries and profits and interest earned in the country. This is without counting any of the massive off-budget spending such as that on account of the government enterprises Fannie Mae and Freddie Mac. Nor does it count any of the recent spending on assorted "bailouts." What this means is that substantially more than forty dollars of every one hundred dollars of output are appropriated by the government against the will of the individual citizens who produce that output. The money and the goods involved are turned over to the government only because the individual citizens wish to stay out of jail. Their freedom to dispose of their own incomes and output is thus violated on a colossal scale. In contrast, under laissez-faire capitalism, government spending would be on such a modest scale that a mere revenue tariff might be sufficient to support it. The corporate and individual income taxes, inheritance and capital gains taxes, and social security and Medicare taxes would not exist.

2. There are presently fifteen federal cabinet departments, nine of which exist for the very purpose of respectively interfering with housing, transportation, healthcare, education, energy, mining, agriculture, labor, and commerce, and virtually all of which nowadays routinely ride roughshod over one or more important aspects of the economic freedom of the individual. Under laissez-faire capitalism, eleven of the fifteen cabinet departments would cease to exist and only the departments of justice, defense, state, and treasury would remain. Within those departments, moreover, further reductions would be made, such as the abolition of the IRS in the Treasury Department and the Antitrust Division in the Department of Justice.

3. The economic interference of today's cabinet departments is reinforced and amplified by more than one hundred federal agencies and commissions, the most well known of which include, besides the IRS, the FRB and FDIC, the FBI and CIA, the EPA, FDA, SEC, CFTC, NLRB, FTC, FCC, FERC, FEMA, FAA, CAA, INS, OHSA, CPSC, NHTSA, EEOC, BATF, DEA, NIH, and NASA. Under laissez-faire capitalism, all such agencies and commissions would be done away with, with the exception of the FBI, which would be reduced to the legitimate functions of counterespionage and combating crimes against person or property that take place across state lines.

4. To complete this catalog of government interference and its trampling of any vestige of laissez faire, as of the end of 2007, the last full year for which data are available, the Federal Register contained fully seventy-three thousand pages of detailed government regulations. This is an increase of more than ten thousand pages since 1978, the very years during which our system, according to one of The New York Times articles quoted above, has been "tilted in favor of business deregulation and against new rules." Under laissez-faire capitalism, there would be no Federal Register. The activities of the remaining government departments and their subdivisions would be controlled exclusively by duly enacted legislation, not the rule-making of unelected government officials.

5. And, of course, to all of this must be added the further massive apparatus of laws, departments, agencies, and regulations at the state and local level. Under laissez-faire capitalism, these too for the most part would be completely abolished and what remained would reflect the same kind of radical reductions in the size and scope of government activity as those carried out on the federal level.

It's incredible to discover how the gullible public falls for such deceptions.

PSE: The Handicaps Of A One Directional Reward Based Platform

``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.

Figure 1: ADB Bond Monitor 1^st Quarter 2009: Year on Year Performance

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.