Monday, July 16, 2012

Controlling Stock Market Volatility: Positives And Negatives Of Regulatory Intervention

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Volatility in the capital markets is an interesting phenomenon that creates arbitrage and other fast-trade opportunities, while it also has a destructive potential potential to create anticipatory cost-push inflation and to "thin" the market out [a situation where many marginal shareholders who give the market its normal volume and breadth drop out for fear of calamitous losses]. Volatility attracts large stakes gamblers, and forces the more conservative participants to leave the game and hoard their limited savings and smaller incomes for sustenance.

Volatility further stratifies the constituent players in the  capital markets in terms of wealth and income class - while the large institutional and private players continue to toss the dice, the shrinking middle class and growing working poor populations continue to exit and seek more conservative and controllable (albeit lower yield potential) investments, with their highly-limited investable income.

Program (i.e., algorithmically-based, rapidly reactive) trading and the entry of more of the formerly thrift-oriented financial institutions into the casino make volatility a major market force -- it is, in fact, a market variable in its own for which there are numerous instruments and exchanges.

I am not personally in favor of the government trying to parametrically constrain market volatility unilaterally. Regulators have already done as much damage to the capital markets as regulations violators. Putting a tight collar on the beast of volatility may seem to be economically stabilizing, but it must be a very flexible collar to allow for a variety of possible market conditions.

The collar cannot put a complete stranglehold on the vagaries of the stock and capital markets in response to news regarding the economy at large, an industry sector, a new regulation, or a company's earnings announcement -- that would interfere with the already-hogtied notion of the efficient markets hypothesis.

Controls, if any, should be imposed in order to merely decelerate market activity in either direction to avoid catastrophic swings which lead to financial crises; perhaps to slow down the rate of change in total market valuation  such that it provides the participants with an opportunity to view investments on a longer-term, less reactive basis in order to avoid the types of rapid entries, exits and speculation which have fed the crises which have eroded the markets' credibility as a fair forum for the exchange of different types of financial instruments, currencies and commodities.

There are certain regulations which decelerate the public's mob mentality to run on the banks to be able to cash out -- so should it be with capital markets controls... if imposed at all, they should be imposed carefully in order to permit investors time for reason to outweigh knee-jerk reaction. These types of regulations should be more of a parachute than an anchor.

It remains to be seen 1) how far the regulatory authorities will go in terms of the severity of imposed limit rules, and 2) how effective implementation and compliance will actually be.

The article excerpt which follows appears courtesy of an archived SmartBrief Newsletter. After you have taken an opportunity to read it, please come back to this page for a view of some of the potential implications of this initiative:   

SEC approves "limit-up/limit-down" initiative
The Securities and Exchange Commission approved a couple of measures intended to curtail market volatility. The SEC said its "limit-up/limit-down" initiative, which prevents trades from taking place outside a specified price band, will replace single-stock circuit breakers. The agency also supported changes to broaden circuit breakers that were introduced after the 1987 market crash. Reuters (6/1), Bloomberg Businessweek (6/2), Financial Times (tiered subscription model) (6/1), The Wall Street Journal/MarketBeat blog (6/1)

Some Possible Implications And Actionable Items:

1)  The re-entry of some smaller lot investors into the marketplace, based upon an increased feeling of regulatory oversight and greater stability -- especially in the current low interest rate environment;

2)  Slightly increased (tentative at first, but possibly building) foreign investment in US publicly-traded companies, as well as in companies traded on international exchanges.

3)  A possible increase in the accessibility of capital for secondary offerings of medium to large-sized companies, with a "trickle-down" to SMEs. I would expect this change to take the better part of a year following regulatory enactment to commence significantly;

4)  The proposed regulations, in conjunction with the JOBS Act, should make it the public capital markets (as well as private equity investors) open to financing smaller ventures having the promise of employment creation. It might also cause a lagging but positive effect on the openness of some of the world's banks to entertain a greater portfolio allotment to small business loans and business development financing;

5)  Larger money management and investment banking houses will provide a great deal of additional work for their securities attorneys (and legislative lobbyists) to find ways to breach the intent and effect of the regulations - they have a talent when it comes to forming private sector/ public sector alliances and strategies;

6)  Foreign exchange (FOREX) markets may become somewhat less volatile;

7)  Some day-trading business might swim into the "buy and hold" for growth or dividends side of the pool. This, in and of itself would bolster securities price stability and investor willingness to participate;

8)  Greater portfolio percentages will likely gravitate toward preferred stocks (historically dividend-paying), and into direct participatory investments which are private (predominantly partnerships and limited liability companies) and allow the direct flow of cash to the participants, yielding [hopefully] a better-than-capital-markets rate of cash-on-cash return;

9)  Some innovative guaranty and surety companies will (inspired by the intent of the subject legislation, whether or not it proves effective) create insurance-type products or instruments [are you property, casualty, and bonding companies listening? Well?] which have the effect of
either A) providing or ensuring liquidity if you are "caught in the collar," or B) providing their own version of a stop-loss "supplement" to hedge your investment position in the event you are unable to liquidate when regulations prohibit it but you believe that you should be selling off stock. From an entrepreneurial standpoint, this represents a potentially exciting and lucrative opportunity for the daring few;

10)  I believe that the regulations, in practice, will be eroded through various means, i.e., by special exception, by special exclusion, by specific permission, and the like, but that a flight toward consistently dividend-paying stocks, very sleepy but stable common stocks and direct participation programs (some of them invigorated by proposed regulations to be enacted in the first calendar quarter of 2013 regarding Crowd Funding, the business that has most recently put crowdfunding platform KickStarter in the news for a record raise of funds for one of its client companies (Pebble) without a deemed securities offering.

For those of you who are ardent general Disruption Theory students and advocates, the coming year might provide you with an empirical, credible proof of concept if the items listed 7, 8 ,9 and/or 10, immediately above, come to pass.  Perhaps there will be some innovation spawned of this macroeconomic disruption.

I hope so. It takes an irritating grain of sand in the oyster in order to produce a pearl.

Douglas E. Castle for The InfoSphere Business Alerts And Intelligence Blog

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