Free and fair stock markets promote innovation, capital formation and productive motivation.
Clear proof is that the Nasdaq Stock Market is home to more than 4,500 stocks while only 338 trade on the not-so-open German Neuer Markt. Or look at what happened to the Japanese equity markets, now trading at a 17-year low, once everyone figured out, sometime around 1990, that they were rigged.
But parts of the American market too, unfortunately and unknown to many, are rigged.
Nasdaq is 62% off its all-time high, having closed below 2,000 yesterday for the first time in 27 months.
IPO mania and momentum funds created rampant speculation and the psychology of riskless stocks. Now, in exact reverse, there is rampant fear and stocks are considered too risky. The problems are rules that discourage disclosure, prevent liquidity and rig the IPO market. Before the next bull market starts, it’s time we fix the problems with Wall Street that ruined the last one.
(Hint: It has nothing to do with the decimal trading Nasdaq started yesterday.)
Here are six steps to start healing Wall Street:
Fix Reg “ND.”
The Securities Acts of 1929 and 1933 established most of the disclosure rules that Wall Street abides by today. They’re the best in the world, bar none. But late last year came a new rule misnamed Regulation FD, which stands for “fair disclosure.” Companies are required to disclose any “material” information to everyone simultaneously. That’s impossible. So instead, afraid to say anything, they just clam up.
I just got off the phone with the CFO of a small technology company, asking how business was tracking. He told me he gave guidance in January on their quarterly conference call and I should wait for their next one. “Reg FD, man.” In reality, it should be called Reg ND, for “no disclosure.” Without disclosure, long-run conviction evaporates and trading focuses on short-term trends, a situation that’s inherently unstable.
Sue Bill Lerach
In 1998, virtually every Wall Street firm settled, to the tune of $1 billion, a class-action suit led by tort king Bill Lerach accusing them of collusion on Nasdaq spreads in violation of antitrust laws. Spreads are the difference between the bid and the ask price on a stock. Merrill Lynch, for example, would put up its own capital and buy a stock from you at 24 and then try to sell it at 24 1/8. Those 12.5 cents are the payment for Merrill providing liquidity. Sometimes spreads were 25 cents, sometimes higher.
But collusion? The unintended consequence of Mr. Lerach’s suit has been the almost complete loss of liquidity. Without wide enough spreads, there is no incentive to put up a firm’s capital to provide customers liquidity and keep prices stable. There are times that I would gladly pay a 25-cent, even 50-cent spread, to buy or sell a stock if I could get it in size without affecting the price. Should that be illegal?
But now, if someone is trying to buy 10,000 shares, the Nasdaq trader will just bid the stock up in $2 to $5 increments until sellers show up, which explains why Amazon hit $112 a share. And, no surprise to those bleeding to death in the market, what works on the way up also works on the way down. So I propose suing Mr. Lerach for $2 trillion (about what has disappeared in the past year) for the damages of no liquidity to portfolios.
Loosen lockups
In the past two years, shares of newly minted initial public offerings did nothing but go straight up. Ever wonder why? The transition from the private world to the public is tricky and needs to be handled with care. Wall Street charges 7% for the act of “underwriting” an IPO. This fee is too high and the IPO allocation process is a mess, but much of it stems from the underwriter-imposed lockups.
When a company goes public, it only sells 15% to 20% of its shares. The rest are typically locked up for 180 days as part of a deal with the underwriter. The concept is the IPO shares are to be placed in the hands of friendly institutions that will hold them for the long term. The lockup helps the traders track where all the shares are and nudge them to these happy homes. So much for concepts. The reality is that the lockup helps create a buying frenzy on the first day, since demand outstrips supply for the next six months.
Gaming IPOs is a full-time pursuit. Traders make a fortune. Not because they have wide spreads. They paid $1 billion for that no-no. Instead, it seems, they happily buy the shares for their own account and then place them with institutions at much higher prices. Then 180 days later, a waterfall of shares douses the enthusiasm, and many new companies see their shares down sharply, just as insiders are ready to sell.
A staged unlock of 5% of the shares every week would limit the upside, but still allow good placement and hasten efficient market trading after the IPO, and dampen wild swings.
Make analysts analyze
In the past five years, the job of a research analyst on Wall Street has changed from research to entertainment. Pick an industry, get rah-rah about it, meet all the private companies, take them public, put a buy rating on them, pass go, collect bonus. Objective analysis is gone. Instead, high rankings in Institutional Investor magazine help win IPO assignments. A 100-to-1 ratio on buy to sell ratings? Everyone knows it’s a joke; there are very few institutions that listen to analysts anymore.
This is all easily fixed. Make analysts own the stocks they follow. Directly or indirectly, make the majority of analyst compensation tied to stock performance. If you have a buy rating and the stock goes up, congratulations. If you think a stock is going to go down, put a sell on it and get paid when it goes down. Objectivity and deep, thoughtful research returns in a flash.
Open up exchanges to full competition
Centralized markets are dead. It turns out the only good thing that came out of the Lerach spread collusion suit was a little-noticed rule from the SEC in 1996 forcing Nasdaq member firms to display quotes and limit orders. This helped the proliferation of electronic communications networks, or ECNs, basically electronic matching services that do away with the middleman. Five years later, ECNs represent 30% of Nasdaq volume. Nasdaq, of course, hates them.
But what about the New York Stock Exchange, where no commissions are paid to the specialists, just spreads, in exchange for their vow to help maintain stable prices? An ECN is perfect as it adds to liquidity. But that would lower spreads, so club rules dating back to soap box days keep the exchange closed to ECNs. The opening bell and old, bald guys running around creating confetti make for great TV, but are as dated as disco. The SEC should apply the Nasdaq rule to the New York Stock Exchange too.
Tame capital-gains taxes
I never understood why you have to pay a tax for selling a stock that went up, just so someone else could hold it and pay a tax when he sells it. If it was meant to discourage trading and encourage long-term investing, it has failed. Mutual fund holders who never sell their fund are nonetheless required to pay taxes on capital gains distributed to them in December. Why not just accumulate them until you sell the fund?
Even capital-gains taxes on ordinary stock trades distort the market, perhaps causing selling of losers in December to generate losses to counter gains, and the supposed “January effect” of small companies’ stocks going up when the selling stops. I actually found the January effect to be that small stocks go down as growth fund managers are fired on Dec. 31 and the new guys come in and clean out all the old garbage.
There are plenty of other problems that need to be addressed — paying for order flow, shorting stocks, the short short rule, offshore tax rules, Rule 144, Erisa and QPAM rules. But I have to figure out what they are first.
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