The importance of signalling effect in Capital Market

Why suspending the "Watch List" action in the stock exchange does not bode well for the capital market.

Bursa Malaysia will temporarily suspend Practice Note 17 (PN17) or Guidance Note 3 (GN3) classification on companies whose financial positions slip into the status. The period for the relaxation for the affected issuers is from April 17 to June 30, 2020. Hence, any listed companies whose financial situation has deteriorated will not be classified as PN17 or GN3 until July next year.

Similar action has been taken by the Singapore Stock Exchange (SGX) last month where Singapore Exchange Regulation (SGX RegCo) has announced that it would not put firms on the financial watch-list this year, as the Covid-19 pandemic roiled business and economic conditions.

On 12 May 2020, the Singapore Stock exchange also announced to remove its minimum trading price rule for Mainboard-listed companies on 1 June 2020. Since 2016, companies on the mainboard must have a six-month volume-weighted average share price of at least S$0.20 and an average daily market value of at least S$40 million.

After these announcements, retail investors have been cheering and started to speculate on companies that are in a bad financial situation, knowing that these easily manipulated stocks will not be categorized under the exchange Watch List for the time being.

However, we think this is a very bad move for promoting a healthy market. Let us use the job market as an example so that you could understand easier. In the job market, potential employees seek to sell their services to employers for some wage. Generally, employers are willing to pay higher wages to employ better workers. While the individual may know his or her own level of ability, the hiring firm is usually not able to observe such an intangible traitthus there is an asymmetry of information between the two parties.

Education credentials can be used as a signal to the firm, indicating a certain level of ability that the individual may possess; thereby narrowing the informational gap. This is beneficial to both parties. If there are no such tools to provide a signal to the firm, the hiring firm will have to resort to employing workers with working experience, making fresh graduates out of the employment market.

Similarly, a lot of investors will avoid investing or trading in companies that had been watched by the exchange. With the absence of such a list, investors are no longer able to identify the lemons. This will create an information gap and make investors having a hard time avoiding bad stocks. In order to avoid this risk, investors will only invest in big names such as Maybank or OCBC as they perceived these counters will never fail, making a more concentrated market where the top 1% of companies get all the limelight and the remaining companies remain highly undervalued.

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