Is noise trading culture hampering the upcoming developments in stock market?

Fri, Jul 20, 2018 9:40 AM on Exclusive, Latest, Recommended, Stock Market,
Is noise t...

On 5th July, 2018, the rumours on margin lending spread like a wildfire that the declining NEPSE bourse took an upward turn with an increase of 36 points. On the other hand, the monetary policy that was supposed to bring positivity in the market lead to a decline of 13.66 points, on 12th July, 2018. Do we believe more on rumours than the policies?

Here comes the role of noise trader.

The noise traders are the traders in trading floor who do not indulge in fundamental analysis instead trade according to the movement of market. A fundamental analyst values companies' principles whereas a noise trader values noise in the market.

Keeping this into consideration, the Efficient Market Hypothesis presumes no noise trader can make profit as prices are reflected in the market. On the other hand, behavioural finance believes that number of noise trader exceeds the rational or quasi rational investors in the capital market leading the market to move as per the noise traders. Here, noise traders are better off in the market.

Now, let us consider two recent incidents from Nepalese stock market. The rumours of the margin lending and the expectation of investors after monetary policy.

The market rising on the basis of rumours of margin lending shows that traders in the market are motivated by rumours. On the other hand, the market being underestimated after monetary policy depicts that Nepalese stock market prefers rumours over policies.

A rational or quasi rational investor would make an investment decision analysing the after effect of monetary policy. If the monetary policy is to be analysed, the investors in the market are not hampered. For instance, although the decline in margin loan from 40% to 25% of the core capital might have shown a negative perspective yet the banks to get broker license provides a positive outlook towards the market. Similarly, the 25% of core capital as margin loan should not hamper the investors in individual level. Besides, the margin call that has been increased to 20% should have added positivity in the capital market. Although the monetary policy was formed in a balanced position, the investors did not take it positively leading to further decline in NEPSE.

In general, the noise traders trade in three different ways:

  • On the basis of news
  • On the basis of emotions
  • On the basis of investor's mimicry

The noise traders usually trade in risk. Meaning: there is no guarantee that their emotions, rumour or mimicking other investors will put them in a better position. For instance, the rise in market that is a result of rumour does not last for a long period. The traders can advantage by arbitrage at such events. However, provided that, Nepalese stock market does not have a facility of intra day trading so, not all noise traders can arbitrage.

When noise traders exceed the number of long term investors, the disadvantageous parties are usually the long term investors. The noise traders often influence the volatility of scrips and the fluctuation in stock price. The long term investors are hampered as the real value of  their investment is not reflected. The often fluctuating share price results in unstable investment value of long term investors.

There are several drawbacks of noise trading culture for a stock market in the economy like that of Nepal's. Some of these are:

  • Nepalese Secondary market is in a primitive stage. The market is looking forward for major changes such as full fledged online trading, brokers operating under banking institutes and a stricter regulation to prevent insider trading. In such contexts, if the capital market keeps on being affected by the noise traders, even these new developments will not be effective for the stock market.
  • The stock market of the country focuses only in the major urban cities. 90% of investors can be assumed to be the residents of Kathmandu. However, new regulation encourages brokers to open branches outside of Kathmandu valley. It is of no doubt that new retail investors would be interested in a stock market that is at least semi rational. However, the constant influence of noise traders discourages these rural investors to enter the market.
  • Thirdly, if the noise traders will be able to influence the market, the stock market will keep on being manipulative and price rigging. The actual valuation of the company's stock will not be reflected. This means the investors will not be able to understand the value of a firm. Until and unless the actual value of firm is identified, an investor will never understand the worth of his/her investment.
  • Similarly, the noise traders often mimicry the big traders in the market. Provided this, the big players will be able to manipulate the market as per their desire. In this context, the victim will be the retail investors with very less knowledge of the market.
  • The supply of shares in the stock market has increased immensely due to NRB's direction to increase the paid up capital. The issue of right and bonus shares have floated a lot of shares in the market. Further, the demand of shares has suffered due to the macro economic factors of the country. With this mismatch of the supply and demand of shares in the stock market, noise trading culture is likely to effect the demand more.

These evidences show that noise traders are nowhere beneficial to Nepalese stock market. In fact, the noise trading culture can hinder the upcoming developments in stock market. Although we cannot blame the noise traders entirely as it is solely the outcome of emotions, rumours of investors and each trader has his/her own right for the style of investment/trade. Studies even show there should be presence of some degree of noise traders in any capital market. But considering that Nepalese market is still in its infancy and a lot of prospective investors are yet to enter the market, isn't there a need to eradicate the noise trading culture in Nepalese secondary market?