Rock And Roll Stock Markets

Why emerging markets are volatile

As the past 15 years demonstrate, investing in stocks of developing countries is not for the faint of heart. You can make a ton of money--doubling your investment within the space of a year--and you also can lose your shirt.

Most experts attribute the stock market volatility in emerging nations to their underlying economic and political instability and their vulnerability to external economic shocks and the whims of foreign investors. But a forthcoming study in the Journal of Financial Economics by economists Randall Morck, Bernard Yeung, and Wayne Yu addresses an issue that may also help explain this pattern: the inefficiency of emerging markets.

In an efficient market, stock prices instantly reflect not only broad developments, such as the business cycle and shifts in macroeconomic policy but also company-specific information about sales, costs, profit margins, new products, and other factors. Thus, while stocks will tend to move together to some extent, they should show a more pronounced tendency to move in a random fashion in line with the changing fortunes of individual companies.

In their study analyzing stock movements in 40 advanced and developing nations, however, the three researchers found that stocks in developing countries have a far stronger tendency to rise and fall together. Over an average week in 1995, for example, more than 75% of Chinese, Malaysian, and Polish stocks moved in the same direction, compared with fewer than 62% of U.S., French, and German stocks (chart).

Of course, this pattern doesn't necessarily point to stock market inefficiencies. It could reflect structural factors peculiar to developing nations, such as their tendencies to be geographically small, to have relatively few stocks, to be less economically diverse, and to suffer greater economic instability than wealthier nations.

But the researchers' statistical analysis indicates that none of the above variables, either alone or combined, account for very much of the tendency of such stocks to move together. What does appear to fully explain the pattern is the low ranking of emerging nations on a "property rights" index--reflecting measures of official corruption and the risk of a government expropriating private property or repudiating contracts.

The authors conclude that emerging markets are inefficient because investors have little incentive or ability to ferret out company-specific information. In such environments, where company fortunes and shareholder returns are highly dependent on political factors, they argue, stock prices tend to be driven by "noise" rather than economic fundamentals. Thus, stocks tend to rise and fall together as investor moods shift with changes in macroeconomic conditions and the prevailing political winds.

For investors and for emerging economies themselves, of course, such market inefficiency is bad news---increasing investment risks and impeding the ability of the market to allocate capital to its most productive use. But for foreign companies interested in direct investments in emerging economies, it can spell some golden opportunities.

"Those able to use their economic power and the backing of their own governments to cut deals ensuring that their property rights will be respected can often pick up underpriced assets at bargain prices," Yeung says.

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