Marking the Markets

Although largely homogeneous, different markets play by different rules. Apart from the obvious differences between markets in the developed economies and those in the emerging economies, each market has its own dominant set of investors, with a unique level of risk aversion.

Other features of a market to consider before investing in it are:

  • Market maturity
  • Listing process
  • Liquidity
  • Predominant industries and the quality of the names
  • Composition of investors/traders/speculators
  • Process of trading, transparency and spread
  • Research and coverage
  • Safety mechanisms

We as investors are not in charge of the markets, nor do we have any influence on them. But it is wise to know the subtleties between investing in different markets, be it Wall St or Dalal St, LSE, Bovespa or GreTai.

Some markets are populated with local investors who have additional information about the companies, putting foreign investors at a disadvantage, while others are commodity heavy that require special knowledge.

512px-Aertsen,_Pieter_-_Market_Scene
Aertsen, Pieter; Market Scene.

In addition, some markets are prone to market manipulation which can discourage long term investors, the foundation of any successful markets. If only short-term traders and speculators are left in that market, then we will see high volatility, increasing friction and more opportunities for fraud to happen. Often even well-intentioned government intervention can make matters worse. Multi-day limit up or down suspensions or prolonged short sale bans help nobody and only increase risk.

Ultimately, the market should be a place for price discovery and value seeking, not a gambling house. As for an example of a market turned gambling house?

From James Mackintosh, FT,

China’s market is broken. Not the way the New York Stock Exchange broke for four hours on Wednesday, and not merely because China’s government is doing everything short of sending in tanks to make shares go up. It is broken because the indices everyone uses to measure the market are entirely disconnected from what’s actually happening.

Consider the ChiNext Composite, an index of 484 supposedly fast-growing companies on Shenzhen’s ChiNext market. The index rose 2.9 per cent on Thursday, a welcome relief after a 43 per cent fall in less than a month.

But as a measure it makes China’s official statisticians look like paragons of virtue. There are 192 stocks on ChiNext still trading, and every single one is up on Thursday by the daily limit of 10 per cent. The index is measuring something which doesn’t exist any more — an imaginary market where virtually all the shares are available to trade.

Perhaps some would disagree, but an example of a speculative market would be the London’s Alternative Investment Market, or AIM. Celebrating its twentieth year, this is what is said of the market,

Over the past two decades, close to 3,000 companies have listed on Aim, but 72 per cent of them have never produced a return for investors, according to professors Elroy Dimson and Paul Marsh of the London Business School. Worse still, nearly one in three Aim companies have resulted in shareholders losing 95 per cent or more of their initial investment.

“Over the past 20 years, £100 [invested in Aim] would have become £83, even with dividends reinvested,” said Prof Marsh. “But if you had put £100 into non-Aim smaller UK companies, you would have quintupled your money.”

Aim’s higher level of IPO companies, growth companies and tendency toward investment fads — be it overseas property or resources stocks — has contributed to the poor performance of the index.

For this reason, Prof Marsh argues that private investors are the “least qualified” to navigate Aim’s often choppy waters, despite the array of tax incentives now available to them.

(Disclosure: I’m actively invested in some AIM-listed companies)

The main asset of modern markets is the trust of the participants. For trust to build, the market participants must be able to believe that

  1. with enough effort, the truth can be discovered through the information obtained, and
  2. that once it is obtained, that information can impact prices through buying and (short-) selling.

It is when the information is available and the truth is known, but the avenues for action are closed off, that the market ceases to be a market, but rather, a capital trap. Once a market is viewed as a potential trap, the confidence in the market will be gone, or as the saying goes, “once bitten, twice shy”.

Having said that, no markets are immune from corrections, shock waves, fraud or other unforeseen catastrophe. The distinguishing feature of a ‘good’ market however, is the preparedness of the market regulators in the face of such events and the maturity in the reaction of the market participants.

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