Stock market: Policymakers should not suffer from complacency

Dhaka Stock Exchange (DSE) is the pioneer stock exchange in Bangladesh that was incorporated in 1954 but formal trading started in 1956 at Narayanganj. In 1958 it was shifted to Dhaka at the then Narayanganj Chamber Building at Motijheel and subsequently shifted to the present stock exchange building at Motijheel in 1959.
There are three remarkable events in the history Bangladesh stock markets. First, the function of DSE was suspended for a period of about five years, from 1972 to 1976, due to the then government's socialist policy regime. Between 1975 and 1981, a number of major policy changes were undertaken to encourage participation of private sectors that included, among others, the following:
i)    elimination of ceiling on private investment,
ii)    relaxation of investment sanctioning procedures,
iii)    amendment of the constitution to allow denationalisation,
iv)    reopening of stock exchange, and
v)    introduction of a number of export promotion measures.
Thereafter, gradually more and more liberalisation of economic policy was introduced that encouraged private sector and foreign investment. Thus the economic policy has been changed from a public sector-led economy to a private sector-led economy. With the change of government policy DSE resumed its activities in 1976 with nine companies. In 1993 Chittagong Stock Exchange (CSE) was established. Generally, CSE follows the tones and temperament
of DSE.
The second striking event occurred in 1996. This is one of the bubbles that caused DSE Index jumped from 751 on January 26, 1996 to a record high of 3649 on November 05, 1996. It implies that the market price rose to a level of almost five times within a period of 11 months. This was followed by a catastrophic crash that resulted in the lowest level at 463 on May 03, 1999 of the index, nearly one-eighth of the high level of 3649 on November 5, 1996.
The third striking event is another bubble that Bangladesh stock market witnessed in 2010 followed by its subsequently expected catastrophic crash. DSE general index jumped from 2416 on February 11, 2009 to a record high of 4568 on January 01, 2010 and subsequently a new record high to 8912 on December 05, 2010. It means the market price stood nearly double within less than 12 months and quadruples within less than 23 months. The index incurred a drastic loss of 1200 points within two days to a low level of 6499 in January 2011. However, with some policy announcements to contain the downfall of the market by the regulatory authorities some 500 points regained in January 2011. Thereafter, again downward trend continued. People exposed to this market may find similarities between the two events.
If loans to buy stock were not cheap and the role of earnings and dividends was restricted, the surge in prices is likely to be explained in terms of appearance of bubble. Disequilibrium price is explained by "shortage illusion". Shortages (or surpluses) are seen as continuing indefinitely, and possibly also the price increases (or decreases) are seen as continuing indefinitely. This observed excess demand is likely to help to reinforce a boom. Disequilibrium is not considered at all as a reflection of a barrier to price adjustment. Every upturn or downturn eventually comes to an end.
The mark of a suitable policy is that it succeeds in making these turns smaller and shallower than otherwise would have been. This is where we are lacking.
Currently, the index is hovering around 4500. The market system is more attuned to speculating than to making investments that would generate job opportunities, increase productivity and redeploy surpluses to maximise social returns. Policymakers' response to the problem appears to have failed to address the issue, exacerbated it in some cases and created new ones. All these have made the market situation vulnerable and unattractive.
Our current difficulties are the result of flawed policies. The policymakers should not suffer from complacency. The recent imposition of capital gain tax is an example. Many people will not disagree with it but the question arises in the context of prevailing market condition. However, authorities have realised it eventually.
CONVENTIONAL WISDOM AND ANALYSIS OF BUBBLES: The jargon of finance literature offers numerous expressions to describe a market-determined asset price which can't be explained with reasonable arguments. These are like 'tulip mania', 'bubble', 'panic', 'crash', 'financial crisis' and so on. In general, these words give the impression of frenzied and probably irrational speculative activity. These words relate to some historical events. As a matter of fact, the evidence of the influence of some subjective factors dates back several centuries. For example, the Dutch 'tulip mania' in 1636-37, the collapse of Mississipi Company in France during 1718-20 and the South Sea bubble of England in the 1720s are well-documented cases of speculative price movements.
Palgrave's Dictionary (1926) defines a bubble as "any unsound commercial undertaking accompanied by a high degree of speculation." Stock valuation sometimes appear to be completely disconnected from the forecasted performance of a corporation. In such a situation bubble or speculative bubble is said to exist if price rises in the market seem to be generated more by traders' enthusiasm rather than by economic fundamentals. This bubble is understood ex post when at some point the bubble bursts and price correction takes place quickly as natural consequence. Nobel laureate Robert Shiller (2000) provided some of the most persuasive evidence before correction and argued "irrational exuberance" was a good way to describe psychology of the market. This euphoria pushed them to buy which in turn fuelled by expansion of credit in the form of brokers' loans resulting in dangerously leveraged condition. Galbraith and Kindleberger (1978) believe that almost any event could have triggered irrational investors to sell. The vertical price falls forced margin calls and distress sales prompting further decline in prices that might have continued panicked sales in the following weeks.
Two relatively recent remarkable financial crises occurred in 1929 and 1987 in developed markets. The degree of similarity between these two was striking. Galbraith (1954) described the rise in the stock prices as the result of "the vested interest in euphoria that leads men and women, individuals and institutions to believe that all will be better, that they are meant to be richer and to dismiss as intellectually deficient what is in conflict with that conviction." Rapid growth of brokers' loans in 1929 was restricted by Reserve Board. Loan to brokers by New York member banks on their own account reached a peak at the end of December 1927 and then declined. However, the rapid growth occurred in loans from private investors, corporations and foreign banks in Europe and Japan and quickly substituted for bank loans.
There are mixed opinions about the role of fundamentals for the bubble of 1929. The technological and structural changes in industry yielding higher earnings and dividends that created stock market boom which consequently turned into a bubble. Fisher (1930) stated that "My own impression has been and still is that market went up principally because of sound, justified expectations of earnings, and only partly because of unreasoning and unintelligent mania for buying." Although Galbraith ridiculed Fisher in the aftermath of crash, his views might have relevance to some extent. If there is boom effect in the stock market, boom itself is likely to induce/promote market bubble beyond the boom effect. White (1990) indicated that fundamentals may have initiated the boom, but it may not sustain.
The continued disappointment of unrealised dividends and public statements of some managers could not slow the stock price. One favoured alternative to explain it is easy credit or margin loan. Purchasing stock by margin loan is considered by the economic historians as a great, unwise speculative lure to generate mania.
In recent times we have come across notable stock market crashes in Mexico, Bombay and in some South East Asian countries. But the ramifications of the effects of the crash were more pronounced in Bangladesh. In case of Bangladesh, thousands of new generation investors were allured to invest in stock markets. They did not have an iota of knowledge about shares and companies. On the contrary, the people affected by the crashes in other places knew well the risk consequences of the game.
The stock price-rise in Bangladesh happened without having any support by the fundamentals. It apparently   happened by euphoria caused through price manipulation by certain quarters. The authorities concerned did not react in time with effective measures against such undesirable developments. In fact, crash may be interpreted as a disastrous bubble caused by unchecked investor euphoria and an absence of attention to the relation between stock prices and economic and/or company fundamentals.
After the establishment of Amsterdam Stock Exchange at the beginning of the seventeenth century brokers discovered the possibility of profitable manipulation of stock prices even spreading false rumours. This was also found in other stock markets established thereafter.
During the Napoleonic Wars the prices of bonds and stocks on the London Stock Exchange were sensitive to the progress of the fighting. Manipulators would operate in conjunction with newspapers to spread false information about the war and profit from the resulting changes in prices. However, a number of people were tried for a conspiracy to manipulate prices.
After the great crash of 1929, widespread public concern about fall in prices had been caused by bear raids. The evidence uncovered by US Senate Committee introduced extensive provisions in Securities Exchange Act 1934 to eliminate manipulation. The Act effectively outlawed two types of manipulation, i.e., action-based manipulation and information-based manipulation. The former refers to actions that change the actual or perceived value of assets while the latter refers releasing information or spreading false rumours. The Act has been fairly successful in eradicating these two types of manipulation. Besides, there is a third category, i.e., trade-based manipulation which means that trader attempts to manipulate a stock simply by buying and then selling without observable actions to change the value of the firm or releasing false information.
Finance literature indicates that profitable speculation is possible if there is 'price momentum' so that an increase in price caused by the speculator's trade at one date tends to increase prices in future dates. In this case investors' demand function is considered as exogenous rather than being derived from rational expected utility-maximising behaviour. On the other hand, with asymmetric information it can be shown that profitable price manipulation is possible, even though there is no price momentum but all agents have rational expectations. Here the crucial point is incomplete information.
Many financial economists regard all types of manipulation as undesirable which should be eliminated from the securities markets. However, this was not the position that lay behind the framing of Securities Exchange Act 1934. Because this would prevent the type of "price pegging" sometimes done by underwriting syndicates. Thus, the importance of trade-based manipulation remains an open empirical question.
CONCLUSION: In Bangladesh, the market and the relevant institutions have had to work toward the objectives of raising capital and spreading ownership despite their divergent orientation. Critics may characterise attempts to develop securities markets in developing economies as misguided efforts to introduce Western institutions onto entirely different socio-economic system.
Securities markets in the USA and Western Europe evolved in response to the need for capital generated by the industrial revolution. Securities markets in developing countries, however, have typically sprung less from private economic need than government decisions to pursue political and economic goals. It does not necessarily have the same problem as that of other developed markets or does not warrant the same solution of the identical problems. The stages of development, the difference in culture and institutional arrangement or the availability of resources or the extent and context of the problem among these countries need to be taken into consideration.
Dr. M. Farid Ahmed is a Professor, Department of Finance,
University of Dhaka.