Friday, 4 June 2010

Are Our Markets Really "Efficient"?

The price of an asset (say a share in a company) is meant to reflect a number of things: past performance (earnings), future earnings potential, financial strength of the company, quality of management and the idiosyncrasies of the industry/market within which that company operates.

So, according to the above, my answer to this question is a big “NO”. Prices are governed these days by a few speculators betting billions one way or the other. Not surprising when you consider that of the trillions of dollars traded on the foreign exchange market, 95% or more is speculation. Why should other markets be any different?

So who are the people who manipulate our markets (if “manipulate” is the right word)? Simply put, they’re what we call the “institutional investors”: life insurance companies, pension funds, asset managers, hedge funds, sovereign wealth funds. These organisations have huge amounts of money to dispose of and need somewhere to put it. They’re also judged on their performance, so they’re dead scared of loosing money.

As a result, if anything looks risky, they bail out (assuming they’re “in”). This can create a self-fulfilling prophecy as others see the price of an investment fall and, lemming-like, “follow the herd”. A prime example is Europe at the moment. The Euro is under pressure, and as a result, anything European is being treated cautiously (if not cavalierly). Another is BP – a company capable of earning more than enough to cover the costs of cleaning up the shoreline of America, yet whose shares have plummeted (mind you, the “political fallout” will have a bigger impact than the environmental). Never mind sound underlying fundamentals, Europe is bad, let's sell!

Just to add to the fun, some investors deliberately target the shares or bonds of those who look like they may be in trouble and deliberately “short” (i.e. sell those shares/bonds) in the hope of buying them back later (hedge funds are allowed to do this). Although there are market manipulation rules supposed to prevent this, deliberate intent is difficult to prove.

I spoke to a fund manager at the beginning of 2009 who was watching the value of their portfolio drop despite the fact that the underlying fundamentals of the company shares that made it up were strong. This was the result of panic and our question was; what if governments worldwide ordered a cessation for two weeks of all exchange activity? Of course, such action would be unthinkable and would bring unimaginable chaos as those needing to raise cash from asset sales could not do so, but the point was, if people had time to sit back and think, what would be the result?

Perfectly sound companies are seeing billions wiped off their market capitalisation for no good reason other than the panic of a few individuals out to make a buck for a small group of investors. We have all being willing to castigate the bankers for the current crisis, but what about the fund managers? When will people look at what they do?



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