The future and the forgotten function of capital markets
As aggregators of disparate information, these are the devices we use to see things coming
Public capital markets are the most successful prediction machines humankind has developed.
The basic model of a stock exchange has been adapted for many other purposes. Sports markets and political markets trade the outcomes of games and elections. The “prices” at which different possibilities trade in highly liquid markets are much better predictors than any poll or pundit’s opinion.
In 2001, the CIA even experimented with creating terror markets in order to develop better predictions of future terror attacks than its analysts. That idea was abandoned when politicians got whiff of it.
This works because agents in a market know, on average, more than any one person. Our bond markets are better predictors of future interest rate decisions than any particular economist, over time. And our share markets, for which read the JSE, are better predictors of future company profitability than any one investor or analyst.Sure, individuals get it right sometimes, but they don’t get it right every time. The market is the place where those who get it right in each instant can hold sway.
Yet this function of capital markets – as aggregators of disparate information in order to predict the future – has been forgotten by some local commentators.
Recent big share price falls of Steinhoff and Resilient, and its related Fortress property group, have led to calls that regulators or the JSE itself should have seen it coming and should have done something about it. This completely misunderstands the function of capital markets – they are the devices we use to see things coming.
What seems to confuse the situation is that, at least in the case of Steinhoff, there was criminal fraud going on. Fraud, obviously, is within the domain of the criminal justice system where it should be investigated and prosecuted.Some investors seem to believe that they should be able to rely on the criminal justice system to pick up fraud before they do. We can hope that might be true, but the history of capital markets suggests it is not. Instead it tends to work the other way round: the criminal justice system gets on to the case only after the capital markets have detected it.
Perhaps the most confused is the call in some quarters that the JSE itself should have detected such issues.
The JSE is the provider of market infrastructure. The price discovery that takes place as buyers and sellers trade through that infrastructure provides critical information about beliefs in the market place.
But just like a sports betting market is not responsible for outcomes of a game, the JSE is not responsible for the performance of companies listed on it.The JSE is responsible for ensuring the integrity of its marketplace. That means making sure that buyers and sellers on it are legitimate and that trades will settle. It also means ensuring that particular kinds of information about the listed entities are conveyed to those buyers and sellers, particularly audited financial information and certain company-issued announcements.
It is also responsible for detecting trades on inside information or market price manipulation. This is difficult because it is impossible to know just what is going on in someone’s mind when they trade.We have, nevertheless, had several successful prosecutions for insider trading. Asset manager 36ONE has claimed that the share price of Resilient was manipulated. The JSE should investigate. If it finds evidence, the Financial Services Board should prosecute. Yet it was 36ONE that made the accusation and the subsequent punishment to the share price shows the market took it seriously.This shows capital markets working, not failing.
We may want the JSE and other regulators to detect and stop fraud before it happens, but the evidence is clear that capital markets are far better detection mechanisms.
Let’s not fool ourselves. Regulators should take swift action when information does come to light. Clear consequences should follow. That will add to the disincentives for companies to engage in manipulation, whether of their financials or the share price, in the first place. But it is investors themselves who undertake the research to develop views on the value of shares.
Perhaps the most vocal complaints about recent share price moves have come from those who manage passive index-tracking funds. These funds free-ride on the price discovery that comes from trading by active investors like 36ONE who undertake their own research. They do no research of their own.
This is perhaps why they think regulators should be the ones protecting them. But capital markets work, and do their predicting magic, because of active decision making. Passive funds can free-ride on those if they want, but it is certainly not their place to complain when they are caught by surprise.