Brent Sheather: Sharemarkets - fair or rigged?

Financial markets have more than their fair share of anomalies - high dividend stocks produce the best growth, risky derivatives masquerade as low-risk-bond funds and shares go up on bad news, down on good news. Similarly some stockbrokers stress the strength of their research departments on the basis of their analysts being close to a particular stock or sector. In New Zealand, as is the case overseas, many companies have a house broker whom they tend to give their underwriting and other business to and this often accompanies a generally more cosy relationship with that firm.

At the same time, however, overseas investors tend to avoid a stockmarket where insider trading is particularly prevalent. There is certainly a fine line between an efficient market and a crooked market, in fact one's perspective often depends on whether you are in the loop or not.

But in spite of the penalties for bad behaviour, are sharemarkets rigged or fair?

We don't have much evidence either way locally although back in the 80s anecdotal evidence suggests that things got pretty bad.

Liam Mason, general counsel of the Securities Commission, says that New Zealand has had insider trading laws since 1988, but until late 2002 enforcement action could only be taken by shareholders, or by the companies themselves.

There had been no successful court actions under this law, although there were a few actions that were settled with a payment to shareholders.

In 2002 the Securities Commission got the right to take court action on behalf of a company but there have only been two cases since 2002 - one against several Provenco directors and one, which continues, against some directors of Tranz Rail.

In the UK the main regulatory body, the FSA, has just published a paper entitled "Measuring Market Cleanliness". The paper looks at the extent to which share prices of companies listed on the London Stock Exchange have moved up or down, above and beyond the market average, ahead of important announcements like takeover bids and profit results. There is an old market saying: buy the rumour, sell the fact. This good advice implies that insider trading is so widespread that it boosts share prices unduly prior to a good announcement and that prices fall back once everyone else knows what is going on and the insider buying subsides. The UK stockmarket is among the world's largest, most liquid and most highly regulated.

Furthermore the FSA has a statutory objective to maintain confidence in the financial system and believes that an efficient, orderly and fair market is one of its highest priorities.

Despite these reassuring noises the FSA's own research suggests that even in London insider trading is alive and well. An astounding 29 per cent of takeover announcements and 22 per cent of profit results were preceded by price movements which suggested that some informed trading had taken place.

What these statistics mean is that a good many investors in UK public listed companies have had part of their savings stolen by people and institutions acting on inside information buying shares cheaply ahead of takeover announcements and selling out prior to bad news. Bad news indeed unless, of course, you are an insider.

Some insider trading obviously occurs on the New Zealand sharemarket. Prices inexplicably rise before positive news then proceed to fall following the announcement leading some commentators to label the market illogical. Not illogical, just a bit too clever. It is, of course, difficult to tell whether the buying or selling activity arises from good analysis or as a result of a strong hint from the chairman.

Stockbroking analysts are forever visiting companies - it's not just the prospect of a free lunch that gets them out of the office. The hope is that they will be given some bit of news which will permit the firm's leading clients to make a quick dollar.

Using NZ Stock Exchange data we looked at 15 takeover bids over the last two years to see whether the price of the target rose by more than the market average over the month preceding the takeover announcement. Of these 15, four looked interesting in that their share prices increased dramatically in the month before the takeover announcement and at a time when the stockmarket as a whole was reasonably stable.

Of course an abnormal movement does not necessarily mean anything dodgy was going on. The company concerned could have simply been performing well or the company launching the bid could have been putting together an initial shareholding.

Anecdotal evidence suggests that the average Mum and Dad are going to get at least as fair a deal on the NZX as in an alternative market like real estate, for example. We have all heard of real estate agents snapping up the bargains for themselves and almost no one knows which bids are genuine at auctions.

The best option for investors worried about market abuse is to stick to the biggest, most liquid stocks which tend to have more rigorous procedures for information handling and directors who have too much to lose from breaking the rules. Better still to buy an index fund, put your trust in the market as a whole and let the insiders rip off someone else.

* Brent Sheather is a Whakatane-based investment adviser.