Will advice regulation create less efficient markets?

Companies issue stock or sell bonds for the first time by IPO. This capital raising takes place in the primary market where investors buy these stocks from the issuing company or from a bank that underwrote the stock issue. This capital forms part of the company’s equity capital.

Business or government may raise capital outside of share capital by issuing a bond with a coupon or interest rate which forms part of the investors investment return. This debt is repayable at some future time. All primary bonds and stocks purchases are made directly with the issuer of those bonds and stocks in the primary market.

Stocks and bonds are subsequently traded between investors on the ASX or other exchange, this is the secondary market. The secondary market promotes safety and security in transactions to encourage good investor behaviour. Although these interactions do not affect the initial equity or debt capital raised, they do provide economic efficiencies by directing financial resources to the benefit of the economy and the people in it. Secondary markets have reduced transaction costs, increased trading opportunities and have promoted better information for investors. Stocks, bonds, managed funds and ETFs are traded through the secondary market.

The important differences

The primary and secondary markets differ in terms of:
- Price – In the primary market, price is set by the issuer whereas in the secondary market price is determined by market forces based on supply and demand. Price fluctuates and therefore volatility and risk are inherent in these secondary markets but the price adjusts quickly to reflect this.
- Access – The primary market is the domain of the institutional investor and is difficult for the average investor to access. The average investor will trade in the secondary market via online platforms, a broker or adviser.
- Transactability – A security is only sold once in the primary market from the issuer (government or corporation) to the purchaser, usually an institutional investor. The secondary market will trade the same security many times over.
- Financing – The primary market raises equity capital and debt capital for corporations and governments for expansion. The secondary market does not create the capital but trades the shares and bonds that were issued to create it.
- A good secondary market is crucial to the primary market as secondary markets create the liquidity needed by institutional investors who convert their bonds and stocks back into cash whenever they want to.
- The secondary market also provides valuable information about the value of a company’s securities by considering concepts such as price to earnings ratios (P/E) and price to book ratios (P/B).
- Secondary markets offer a good indicator of the economic conditions prevailing in a country, for example, when a rise or fall in the stock market stems from that economy being in a recession or in a growth phase.
- The secondary markets allow investors to put their savings capital to work in anticipation of good investment returns.

Governments regulate the secondary market to keep invested money safe since it is a vital source of capital formation and liquidity for governments, companies, and investors.

Since shareholders are owners of the company, they will hold management accountable to a higher efficiency standard regarding operations which can lead to better corporate governance.

Secondary markets offer complex investment advice through stockbrokers, investment advisers and financial advisers, hence the investor doesn’t need to be an expert themselves to invest and make money in this market.

Well-developed financial markets will allocate capital more efficiently with the input from investment professionals by increasing investment in the growing industries and reduce investment in declining industries. Efficient capital allocation is reduced in undeveloped financial sectors but is also adversely affected by the extent of government ownership and excessive government meddling or over-regulation within an economy. When evaluating government intervention and its effectiveness in financial planning we have seen the following issues consistently occurring to the detriment of the public:

- Value judgements – intervention is being demanded by ‘particular industries’ to satisfy vested interests.
- Law of unintended consequences – government intervention produces adverse results rather than the positive outcome government predicted.

Government should only be intervening in financial markets where:
1. There has been market failure (unemployment, poverty, monopolies, abuse of drugs, underutilisation of healthy goods and services);
2. There needs to be a more equitable distribution of income and wealth (social security and taxation); and
3. Performance of the economy can be improved (subsidies, government funded public goods and services for collective consumption).

Destroying a financial planning industry through over regulation, over compliance, unnecessary barriers to entry or barriers to continue providing advice will stunt the effectiveness of the secondary market. In turn, this will remove the efficient allocation of financial resources and restrict the liquidity needed to make the primary market as effective and efficient as it needs to be. Institutional investors will lose confidence in the primary market if the secondary market is negatively impacted to this extent.

Before the global financial crisis, markets used to discount the future market action of any financial asset being priced. Higher profits would typically mean a higher future share price. With higher inflation expectations came lower bond prices.

In some respects, the financial markets are no longer discounting market action. The markets are discounting government intervention based on how well that government intervention is working. After the GFC, any bad news had the effect of causing the stock market to rally since it always carried the prospect of additional government stimulus for the economy.

Predicting the stock market performance is not as much about profits, unemployment, price/earnings ratios or gross domestic product but about the effectiveness of government policy when meddling with the economy. Central bankers and governments around the world are impacting the financial markets eventually going too far and causing inflation in their relentless pursuit of wealth creation and stability. A future scenario of higher inflation should push up wages and assist people in getting out of debt as they will be able to pay off their mortgage debt with a depreciated dollar. Maybe this will stave off thoughts of deflation?

But the likelihood of a stock market correction becomes more likely when interest rates and bond rates are so low that conservative investors are turning to the stock market for their investment returns. This action typically overheats the stock market (pushing share prices up) as too much money chases the limited number of shares on offer. When the market corrects, and it will, inexperienced or conservative investors will panic and revert back to cash to prevent losing capital.

At this time access to financial advisers well skilled in behavioural finance and with experience in the market will be crucial. It doesn’t make sense to legislate the industry out of existence.

Gavin Bramley, managing director, Unique Wealth