Beware regulators who start to offer investment advice

PUBLISHED : Monday, 06 August, 2012, 12:00am
UPDATED : Wednesday, 15 August, 2012, 11:04pm
 

In most markets, the dividing line between investment advisers and regulators is clear.

Advisers tell you what they think you should buy or sell. In return, they earn a fee, or more likely a commission, for their advice.

In contrast, it's the regulators' job to police the advisers and keep them on the straight and narrow.

In an attempt to protect investors' interests, the regulators ensure basic standards of professionalism. They make advisers pass an exam before giving them a licence to practise. And they force advisers to qualify their recommendations with dire risk warnings.

At least as important, regulators should enforce their rules. Anyone offering advice without the proper licence, or without making the required risk statements, should face stiff fines. And anyone found guilty of manipulating the market should end up in jail.

Given this clear demarcation of roles, you don't expect the regulator to begin offering investment advice in his own right. And you certainly don't expect the regulator to try to steer the market up and down.

On the mainland, however, things work differently.

Concerned about declining share prices, the new head of the China Securities Regulatory Commission, Guo Shuqing, declared six months ago that Chinese stocks offered 'rare investment value'. Buyers, he said, could expect to earn handsome returns of 8 per cent a year.

Guo should have stuck to regulation. Since he advised investors to buy, the Shanghai Composite Index has slumped another 10 per cent, bringing the total decline in the benchmark A-share index over the past 12 months to a painful 20 per cent.

But rather than learn his lesson, Guo decided to try more direct action. In what has been widely interpreted as a blatant attempt to manipulate the A-share market, the CSRC cut transaction fees last week for the third time since April and told companies whose shares are trading below the book value of their assets that they should buy back stock.

Some brokers thought the CSRC's measures excellent news, promptly predicting a market rally. And on Friday, the Shanghai index did indeed edge up by 1 per cent.

But in the longer term, it is doubtful whether last week's attempt will be any more effective than Guo's earlier advice to investors to buy.

At first glance, it looks as if Guo had a point when he said A shares were good value. As the first chart shows, at a price-earnings ratio of just 11.5 last week, the Shanghai index looked even cheaper than in the depths of the market slump following the implosion of Lehman Brothers in the autumn of 2008.

And as the second chart shows, valued in terms of the ratio of its price to the book value of its assets, the index was cheaper last week than at any time since mid-2005, when share class reform revitalised the market.

But if the market is cheap, it's for a reason. Mainland economic growth is slowing, and that's hitting corporate profits. As a result, more companies are giving negative than positive earnings guidance.

On top of that, thanks to share-class reform and a spate of new issues, the capitalisation of tradable stock has climbed at roughly twice the rate as household demand deposits. That's imposed a heavy weight of supply on the market relative to demand.

And there's more to come. Analysts at HSBC point out that more than 100 companies have received CSRC approval to launch initial public offerings, but have yet to come to the market: a massive overhang of future supply.

As a result, potential investors should be sceptical. In the past, the CSRC has consistently acted on behalf of state firms trying to raise capital, rather than the investors who buy their shares. So it would hardly be surprising if investors now concluded that the CSRC's new-found enthusiasm for dispensing investment advice and boosting stock prices was just a cynical attempt to reduce capital costs for companies launching new issues.

If Guo really wants to persuade investors he is trying to protect their interests, in future he'll just have to resist the temptation to cross that line between regulator and adviser.

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