Stock market speculation, manipulation and regulation: What is your stand point?

23 March 2015 06:16 am - 1 - {{hitsCtrl.values.hits}}

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The debate on speculation, manipulation and regulation/enforcement in equity markets is on-going. Hence, it is timely to pave the way to a discussion on the aforementioned.

Speculation forecast psychology of market
John Maynard Keynes with the release of his landmark ‘The General Theory of Employment, Interest and Money’, distinguished between two ways of investing in the market- enterprise and speculation. Enterprise refers to investing based on fundamental analysis while speculation is defined by him as the activity of forecasting the psychology of the market.
Differently stated speculation could be explained as the practice of engaging in risky financial transactions in an attempt to profit from fluctuations in the market value of a stock (price movements), rather than attempting to profit from the underlying financial attributes of a stock (commonly known as fundamental analysis).

Investing vs speculation

There is a vast difference between investing and speculation. Investors base their decisions on fundamental analysis and incorporate in-depth analysis on the stock. They focus on long-term returns and it usually entails low levels of risk. The local equity market has performed remarkably well in the long run and has been a suitable destination for long-term investing. The market has grown by 26 percent, 31 percent and 41 percent (on average) during the last 30, 14 and six years, respectively.
On the contrary, speculators invest based on price movements (fluctuation in prices) and focus on short-term returns. The nature of speculation results in high levels of risk. It is usually recommended for seasoned investors. A fine blend of investors as well as healthy speculators is vital for a robust market.

Speculation is universal
If we accept the theory that stock prices follow a random walk (in short, random walk says that stocks take a random and unpredictable path) speculation becomes an inherent factor in financial markets. Analyst believe that what really matters in an exchange market is the state of confidence or what is better known today as investor sentiment, which is the result of the “mass psychology of a large number of individuals.” Accordingly, one could not talk of an equity market without referring to speculation.
Speculation is seen across global capital (stock) markets and investors may speculate based on factors they feel would impact the price of a stock. This could be understood by the following example.
*The Chinese government informed the public on its commitment to boost growth. Investors speculated on the probable impact it would hold on the market and purchased shares. By March 18, 2015, shares recorded an all-time high since May 2008.

Economic benefit of healthy speculation
The common thinking is that prices should be driven by fundamentals alone. We believe that anyone who is buying a stock should have done the research, studied the company and should be an informed investor. Relevant authorities promote it due to the low-risk factor. Yet, how practical is this for all investors? If buyers were only made up of such informed investors, we would have a costly market. It would take too much time, resources, capital and effort to be a buyer, leaving a few players in the market. In such circumstance, the seller, who needs to liquidate his holdings as he needs cash, will not find a buyer and even if he did, the prices and volumes might not match as the choice is less.
This brings us to the importance of active trading that is fuelled by speculators. Differently stated speculators promote liquidity in the market. Attractiveness of an equity market greatly depends on the levels of liquidity and is also a vital factor in the growth story of the Sri Lankan stock market. Increase in liquidity could also increase market turnover.
As the regulator, the Securities and Exchange Commission of Sri Lanka (SEC) identifies the importance of liquidity in the market and allows healthy speculation in the market.
Yet, the SEC has stressed on the risk involved in speculation and advised investors to adopt speculation after a comprehensive understanding on market dynamics. It only urges investors to be well informed of the risk factor and take required measures to minimize it when speculating. The intensity of the risk factor in speculation especially in a downturn market should be looked into.
This could be understood by the popular Mark Twain Effect. As his popular quotation states OCTOBER: This is one of the peculiarly dangerous months to speculate in stocks in. The other are July, January, September, April, November, May, March, June, December, August and February. This quotation is an indication that speculation is always risky.
However, if investors don’t engage in healthy speculation it could lead to market bubbles that could cause price distortions and hamper efficient markets.

Speculation vs gambling
At this juncture, it is important to draw a distinction between healthy speculation and unhealthy speculation that is referred to as gambling. The distinction lies in quality and the risk involvement. While gambling is based on ignorance and wild guesses speculation involves educated decision-making. It implies an almost scientific prediction based on probability and risk assessment.
Gambling with stocks exposes your portfolio towards much more risk than healthy speculation. Gambling could even hamper performance of the market and would be impossible to expect sustainable levels of liquidity through gambling.
The local investor community fails to understand the fine difference between the two. This mentality was widely visible during the post-war boom in the market. History stands as evidence for the ill effects of investors focusing more towards gambling than speculation in the market. They accepted unwanted risk with open arms. The situation intensified as they gambled/speculated on credit. It is due to such situations that the SEC has advised the investors to refrain from gambling with stocks.

Manipulation is illegal
On the contrary, manipulation is a different story altogether. Manipulation is intentional conduct designed to deceive investors by controlling or artificially affecting the market for a security. Manipulation can involve a number of techniques to affect the supply or demand for a stock. They include spreading false or misleading information about a company, improperly limiting the number of publicly-available shares, etc., to create a false or deceptive picture of the demand for a security.
The Securities and Exchange Commission of Sri Lanka Rules, 2001 (Rule 12 & 13) defines market manipulation as follows:
Rule 12: No person shall create, cause to be created or do anything that is calculated to create a false or misleading appearance or impression of active trading or a false or misleading appearance or impression with respect to the market for or the price of any securities listed in a licensed stock exchange.
Rule 13 (specifically for wash sales): No person shall by means of purchase or sale of securities that do not involve a change in the beneficial ownership of those securities or by any fictitious transactions or by any other means, create a false market in any security listed in a licensed stock exchange.
The SEC has at all times forbidden such malpractices. According to Section 51 (2) of the SEC Act No.36 of 1987, any person found guilty of market manipulation shall be liable on conviction after summary trial by a magistrate to imprisonment of either description for a period not exceeding five years or to a fine not less than Rs.50,000 and not exceeding Rs.10 million or to both such imprisonment and fine.
Intentional conduct designed to deceive investors by controlling or artificially affecting the market for a security can distort markets. It hampers the efficient price discovery mechanism and above all allows one segment of investors to earn profits at the cost of other investors.
One could not forget the attempts made by certain investors to manipulate penny stocks during the market boom a few years ago. The nature of manipulation is such that stocks are usually taken far above its intrinsic value and later dumped into the market. This emphasizes the dire need of the regulator stepping in.
In such a context, it is the role of the regulator to promote a conducive environment by creating a level-playing field for all segments of investors (may it be the veterans, knowledgeable or even the less knowledgeable) to actively participate in the efficient mechanism of price discovery and thereby maximizing profits. This might require constructive regulation and enforcement but not over regulation.

Manipulation vs speculation
The above stated could be reiterated by inferring into the difference between the two.
In order to establish the offence of manipulation one or more persons must deliberately effect a series of actions/transactions in a security (pump and dump/wash sales/matched orders, etc.) and these actions/transactions must either create actual trading in such security or cause a rise or decline in the price of such security.
Even in speculation the prices could rise/fall, yet the root causes are different than in manipulation. In manipulation price is determined by demand/supply forces that are artificially and deliberately created to mislead the market while such intension is not visible in speculation.
Stock markets identify the importance of healthy speculation in achieving economic benefits while prohibit manipulation as it is a deliberate attempt to interfere with free and fair markets that lead to market failure.

Multi-dimensional role of regulation/enforcement
Are you aware of the multidimensional role of regulation/enforcement? It could increase efficiency/transparency and also promote market infrastructure, etc., that is required for a growth of a market. Investors should grasp to essence of need-based regulation and enforcement.
It is timely for market stakeholders to deviate from the traditional and out dated notion of regulation/enforcement. Regulation and enforcement will be incorporated only when required for the benefit of the market and to protect the interest of the investors. One could even say that a regulator acts as a facilitator.

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Comments - 1

somosoygar@yahoo.com Tuesday, 24 March 2015 09:16 AM

all these lectures looks like pouring water on a ducks back.

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Stock market speculation, manipulation and regulation: What is your stand point?

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