Equity market indicators: A primer - World...

Financial Sector Operations and Policy Financial Sector Development IndicatorsComprehensive assessment through enhanced information capacity

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Going beyond size and introducing dimensions of access, efficiency and stability

New efficiency indicators and their relation to capital market development

Financial Sector Indicators Note: 3Part of a series illustrating how the Financial Sector Development Indicators (FSDI) project enhances the assessment of financialsectors by expanding the measurement dimensions beyond size to cover access, efficiency and stability. Data on these dimensions,as well as other information relevant for financial sector assessment, is intended to become available online during Spring 2006.

Equity market indicators: A primer

Equity markets are multi-dimensional andmeasures to assess their development have togo beyond sizemeasured usually by the ratioof market capitalization to GDP. For a morecomprehensive overall assessment, the devel-opment of capital markets may bebenchmarked along the four dimensions of theFinancial Sector Development Indicators(FSDI): size (conventionally analyzed), access,efficiency and stability. For each of thesedimensions, several indicators have beendeveloped (in FSDI) to generate a compositemeasure, as well as facilitate benchmarking.

At an aggregate level, developed, or high-income countries (e.g. USA) perform betterthan developing countries in all four dimensionsof their financial sector (chart, below). However,there are notable differences between the twosets of countries in terms of various dimen-sions. Some developing country equity marketsare particularly less efficient, such as Pakistan,while in others differences in stability are morepronounced, such as in the Czech Rep. A morefocused identification of weaknesses andstrengths in equity markets, over and above ageneral assessment through FSDI can helpidentify priority areas for policy making informulating financial reforms.

Introduced below are select new indicators thatrepresent dimensions over and above the sizeof an equity market (other similar indicators are

Indicators for equity marketsT raditio nal N ew

Size A ccessM arket capitalization to GDP M arket capitalization o f top 10 firmsTurnover ratio Trading volume of top 10 firmsStock traded to GDP Herfindahls index o f concentration

Closely held shares in top 10 firms

Ef f iciencySynchronicity / Comovement of stocksDetectable private information tradingLiquidity / Transaction costs

StabilityVolatilitySkewness of market returnsVulnerability to earnings manipulationPrice earnings ratioDuration

Efficiency

Stability

Size

Access

Equity market per the financial sector dimensions

Developed

Developing

Note:Axes represent standardized scores for each dimension ofthe capital market.



being developed for bond markets). The focus isparticularly on the efficiency dimension, due tothe novelty of the information, as well as itsrelative lack of familiarity to many users. Thesize and access dimension are discussed onlybriefly, as a detailed discussion is presented in aseparate note (Financial Sector Indicators Note:4).

SizeFSDI enhances the capacity for measuring eventhe commonly assessed size dimension,beyond the widely utilized ratio of Market Capi-talization to GDP, which reflects the value ofexisting stock of equity claims. This is achievedby a couple of other flow variables, the ratio ofValue Traded to GDP and the Turnover ratio.Both these variables measure the capacity of astock market in relation to trading activities,diversification, and liquidity provision function.The graph below shows the turnover ratio in theregions. The highest turnover is in the NorthAmerica and East Asia and the lowest turnoveris in the Africa region.

Creating composite indicatorsThe composite indicator for each of the various fourdimension of capital markets is comprised of sub-indicators. These sub-indicators are standardized bysubtracting the median of the distribution and scaled bythe standard deviation of the distribution. Thesestandardized scores are then averaged to create thecomposite indicator for each dimension.

AccessThe access indicators in FSDI refer primarily tomeasures of concentration, as data for it arereliably available for a wide cross-section ofcountries. The composite indicator of access isbased on the following three variables:

Concentration of market capitalization. This isthe share of the top 10 largest firms in the totalmarket capitalization of a stock market. A goodcapital market should give access not only tothe largest firms, but also to smaller ones.

Herfindahl index. This takes into account thestatistical distribution of the market value of

0

2

4

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10

12

4 7 10 13

Access and sizeComposite Access Indicator

Composite Size Indicator

USA

UK

Russia

SloveniaBrazil

0 20 40 60 80 100

Turnover ratio by region, 2004

South Asia

North America

East Asia

Europe & . C.Asia

Mid East & N. Africa

Latin America

Sub-Sah. Africa



stocks outside the top 10 firms. This measureis quite meaningful, but less naturally interpret-able than the previous one.

Percentage of closely-held shares. As mea-sured by the percent of shares in the hands ofcontrolling majority. This indicator has two foldimplications on access from the perspective ofoutside investors. First when shares areconcentrated in the hands of the insiders,relatively few shares will be available to outsideinvestors. Also concentrated ownership cre-ates barriers for outside investors to monitorfirms operations.

The composite access indicator suggests thatlarger stock markets in general give access to abroader and more diverse set of firms, as exem-plified by the case of the United States, but evensome smaller markets, such as Slovenia, arealso well able to list smaller firms as shown inthe graph (chart right, previous page).

EfficiencyA capital markets efficiency can bebenchmarked against other markets by con-structing a composite efficiency indicator basedon the average of three indicators listed below.

These indicators are constructed by compilingand statistically processing firm level data froma variety of market sources:

Price synchronicity. This indicator capturesthe information content of daily stock prices,as a market operates efficiently only whenprices are informative about performance ofindividual firms.

Private information trading. Based on theexamination of daily price-volume patterns,this variable helps indicate the prevalence oftrading in a stock market based on private orprivileged information.

Real transaction cost. This is based on dailyreturn data of the listed stocks. The estimateof this information is important for determin-ing the barriers to efficiency in an equity stockmarket.

Composite Efficiency IndicatorBased on the composite indicator of overallefficiency, it is revealed that some countries,such as Pakistan, have large but inefficientequity markets, while many small equity mar-kets, such as Austria, are able to display highefficiency (chart, below). The table belowpresents select country rankings on the com-

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4 6 8 10 12

Efficiency and sizeComposite Efficiency Indicator


Pakistan

AustriaBrazil 35China 51France 15Germany 11India 46Japan 29Korea 16Russia 32USA 6

Select rankings for market efficiency

Note: Higher ranking indicates lower efficiency.



posite efficiency indicator. We next discuss thethree indicators.

R2 - Measure of SynchronicityThis indicator captures the co-movement ofindividual stock returns in an equity market. Highlevels of co-movement (or synchronicity) indi-cate that returns on individual stocks do notprovide much firm-specific information. In anefficient equity market, stock prices shouldreflect primarily information about the fundamen-tals of corporations. The highest co-movementis among developing countries like China andIndia (chart below, left).

In scenarios where rights of minority sharehold-ers are weak, the controlling owners or theentrenched management are usually not pres-sured to share their private information about thecorporation with outsiders. High synchronicitycan sometimes be the outcome of corporationsnot reporting timely and reliable informationabout their real performance. Thus, little usefulinformation is available to the public, and specificcorporate information is not reflected in stockprices in an efficient way. Under such circum-stances, outside small investors usually tradebased on rumors and sentiments, and stock

prices of individual firms become influencedpredominantly by the general market sentiment.

Private Information TradingThis measure captures the percentage of firmswith trading patterns that arise from tradingconducted through privately obtained informa-tion. Investors with privileged information cancarry out trades before investors lacking suchinformation, thus giving rise to a correlation instock returns over several successive days(autocorrelation). Such trading with privateinformation is presumably more prevalent whencorporations are opaque in their informationdissemination and corporate governance is

5 10 15 20 25 30 35

Japan

UK

Israel

Pakistan

Portugal

Bulgaria

Trading on private Information, 2004 (higher is worse)

An example of private information tradingWhen an investor privately receives a piece of goodnews about a firm, he will buy the stock before the newsbecome public the day after. The purchase createsabnormal trading volumes and pushes up the price. Onthe next day, when the news is available to the public, thestock price drifts up further towards the newly estab-lished price of the corporation, with good news incorpo-rated. Thus, abnormal trading volumes are observed onthe first day and autocorrelation of stock prices betweenthe first and the second day.

5 10 15 20 25 30 35 40 45

Germany

France

UK

Canada

USA

Thailand

Argentina

Greece

India

China

Developed

Developing

Synchronicity in stock prices, 2004 (higher is worse)



weak. In contrast, transfer of information to thegeneral public is usually prompt and accuratewhen corporations make timely and reliabledisclosures, leaving little chance of privilegedinformation for few insiders. Data on Bulgaria,Portugal and Pakistan suggest that 25%-35%of the firms listed on their stock exchanges lendthemselves to price-volume patterns that maydepict trading based on private information. Incomparison, in Israel, United Kingdom andJapan less than 10% of the listed firms exhibitsuch a pattern (right chart, previous page).

Transaction Costs/LiquidityFor the purposes of this indicator, transactioncosts are broadly definedimplicitly taking intoaccount the potential impact on stock pricesdue to large trades, information asymmetry anddirect costs such as fees etc. Informationcontained in daily stock price movements isexploited to implicitly derive transaction costassociated with trading a particular security. Acomparison of trading days when market pricesdo not move (zero return or stale trading days)is made against days when prices do move(active trading days).

Stale trading days generally result when trans-action costs of trading exceeds the gainsavailable to an informed trader. Trades will onlyoccur when investor gains exceed the transac-tion cost in a particular security. A security withhigh transaction costs will have less frequentprice movements, i.e., more zero returns thana security with low transaction costs. An illiquidcapital market with high transaction cost will beineffective in monitoring the performance ofindividual firms, because new informationcannot be incorporated into stock prices effi-ciently and promptly. The causes of illiquiditycan be transaction costs, but equally as wellinformation asymmetries that make outsiders

reluctant to trade with insiders.

Low Cost High CostCzech Republic Sri Lanka

China CyprusUSA Slovakia

Mexico PhilippinesItaly Venezuela

Ranking of Countries by Transaction Costs

StabilityThe composite indicator measuring stability isbased on indicators that go beyond traditionalmeasure of market stability, such as volatility instock price or returns. The stability measuresare based on total market returns and attempt tocapture systematic risk. The composite indicatorfor market stability highlights interesting results,such as less stable markets are usually smaller(e.g . Venezuela), however, this correlation is farfrom perfect, for example Korea has a large but

Opaque stocks and higher skewnessThere is evidence that high opacity of a corporation, asmeasured by high synchronicity of its stock returns withthe market, is usually associated with less stability. Thereason is that, the management has a greater incentiveto hide bad news than to hide good news. Good news isalways released to the public promptly after it arrives,and the public adjusts the stock price accordingly, whichcreates more gradual upward price adjustments. Badnews, however, is usually accumulated and covered upby the management, particularly when corporate gover-nance is weak. Bad news eventually comes out thoughwhen the management finds it impossible to hide it for-ever. As a result, bad news is usually released in a batchand creates abrupt and large negative impact on the stockprice. Furthermore, the public inevitably feels that the cor-poration is still hiding something, and overreacts to thebad news. As a result, the firms stock returns becomeskewed to the negative side, i.e., the stock may deliverlarge negative returns concentrated over several days.



less stable market (top chart, where lowerscores are less stable).

The new measures of stability, mentioned below,are incorporated in the composite indicator,particularly take into account negative returns. Measure of skewness. A market with a more

negatively skewed distribution of stock returnsis likely to deliver large negative returns, andmay be prone to less stability. Distributionskewness is an ex-post and market-wideindicator based on a previous history of largenegative returns.

1

40

1 40

Accounting practices and stock markets, 2003 Stock market synchronicity, annual ranking [1=best]

Earnings management, annual ranking [1=best]

Sample: 40 countries

Vulnerability to earnings manipulation. Thisindicator is derived from certain characteris-tics of information reported in the balancesheet and income statements of companies,which can be indicative of manipulation ofearnings. It highlights the percentage of firmslisted on a stock exchange that are suscep-tible to such earnings manipulation. Firmsscoring higher in this indicator are expected tobe more likely to experience reinstatement ofincomes in the future, and may thus end updelivering large negative returns. Unlike theskewness measure, this is an ex-ante andfirm-specific measure of stability.

Using the indicator for earnings manipulation,interesting comparisons and benchmarking canbe conducted. In Zimbabwe, almost all firmsmay experience high manipulation of theiraccounting statements, while in Turkey, thenumber is nearly 40 percent. This stands insharp comparison to high-income markets suchas in France, United States and Belgium, whereless than 10% of firms have issues concerningearnings manipulation, and their markets areless vulnerable to instability (chart below, left).

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Stability and sizeComposite stability indicator


Venezuela

Switzerland

USA

Argentina

Korea

0 20 40 60 80 100

BELGIUM

USA

FRANCE

HONG KONG

SINGAPORE

TURKEY

ZIMBABWE

Earnings manipulation probability, 2004 (higher is worse)



Availability of information through the FSDI Web siteData on traditional, as well as new indicators forassessment of capital markets will become availablethrough the FSDI interactive Web site, currently underconstruction. Such indicators, along with various othervariables, would form part of an overall framework forassessing financial sectors that would be availableonline. Provision of regional and country details in theWeb site will offer users the flexibility of customizinginformation to their unique requirements.

The other two indicators are based on the factthat market prices contain expectations of futurecash flows and growth instead of current funda-mentals only, and therefore stock prices may bemore volatile and negatively skewed in thefuture. The indicators available for measuringthis behavior are: Price earnings (P/E) ratio. A high P/E ratio

means that stock prices contain expectationabout earnings growth.

Duration. This indicator is a refined version ofP/E ratio, which takes into account factorssuch as long term growth, interest rates, etc.

Benefits of enhanced informationThe size, access, efficiency and stability indica-tors introduced provide a comprehensive,multidimensional framework that is also possibleto implement in order to assess the develop-ment of equity markets. Such a framework canbenchmark stock markets across countries,regions, and identify the relative strengths andweaknesses across various dimensions. Analy-ses through comprehensive information can notonly assist in policy formulation, but also providea mechanism to evaluate the impact of thereforms. In addition, benchmarking tools canprovide incentives for reforms and facilitatecollection of reliable data that can help increasetransparency in financial systems.

Select ReferencesBae, K. H, C. Lin and J. Wei, 2005, Corporate Gover-nance and Conditional Skewness in the Worlds StockMarkets.Journal of Business forthcoming.Jin, Li and Myers, Stewart C., 2005 R-Squared Aroundthe World: New Theory and New Tests, Journal ofFinancial Economics forthcomingMorck, R B Yeung and W. Yu., 2000., The InformationContent of Stock Markets: Why Do Emerging MarketsHave Synchronous Stock Price Movements? Journal ofFinancial Economics 58(1) 215-260.Lesmond, D., C.Trzcinka and J. Ogden.,1999.,A NewEstimate of Transaction Costs, Review of FinancialStudies, Volume 12, Number 5, Winter 1999, 1113-1142.Lesmond, D.,,2005.,Liquidity of Emerging Markets,Journal of Financial Economics forthcoming.Llorente G., R Michaely, G Saar, J Wang, 2002, DynamicVolume-Return Relation of Individual Stocks, Review ofFinancial Studies, Vol 15, No.4, 1005-1047

Equity marketsSizeAccessEfficiencyStabilityBenefits of enhanced informationSelect References

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