OKay, one last last post
for those who previously missed this.
Stock Basics 101
Topic: Volatility
Quoted from "Forbes" 7/29/98
Of course, one would expect Nasdaq volatility to be higher than the Big Board's. But the trend is interesting. Since mid-1995 volatility on Nasdaq has risen markedly, even as volatility in the NYSE and Amex composites has declined. The linked chart traces average volatility, from daily close to daily close, for three composites, the NYSE, the Amex and the Nasdaq, since 1990.
Some investors have already gotten a taste of what happens on the downside in formerly high-flying Nasdaq stocks. On June 21 shareholders of Manhattan Bagel watched in shock as their stock lost 35% of its value on news that the company had made accounting errors. That day the tiny stock traded over 100 times its typical volume. And Presstek, a stock that went from 50 to almost 200 in less than a year, took a nosedive in early June, falling to as low as 43. Just before the fall there were only four marketmakers in the stock, down from around a dozen or so in previous months. The dealers who opted out looked smart after the fall. But that didn't help investors looking for ways to get out of their stock.
What do you expect? the Nasdaq people respond. These are often startup companies. They are inherently dicey. You can't get outsize gains without taking outsize risks. Furthermore, investors are crazy for high-tech and Internet stocks, many of which trade on Nasdaq. True enough, but that doesn't fully explain the rise in volatility or the tremendous increase in trading. The American Stock Exchange, also home to smaller companies, experiences much less volatility. Any full explanation of what is happening must take into account the mania for so-called momentum investing by both professional--including those who use the Small Order Execution System, known as SOES--and amateur traders. Forget the hype: Momentum investing means selling a stock that is going down and buying a stock that is going up. A better name would be bandwagon investing. Much in the nature of Nasdaq makes it hospitable to bandwagon investing. Unlike the exchanges, where brokers simply match buyers and sellers, the Nasdaq market is one in which marketmakers act not simply as brokers but as middlemen, buying shares from sellers and selling them to others.
Watch what happens to a stock's trading patterns when it moves from a dealer market--Nasdaq--to an auction market, in this case the NYSE. Of the 68 companies that made this move from January 1995 to May 1996, 93% saw a decline in intraday volatility in their stocks--from 3.4% on Nasdaq to 2.2% on the NYSE.
Any way you slice it, life is more volatile on Nasdaq. When a company stops trading in an auction market--in this case the Amex--and begins trading on Nasdaq, it becomes more volatile. (Companies are prohibited from leaving the NYSE unless their stockholders vote to do so, so this comparison can't be made.) Between January 1995 and May 1996, 19 companies moved their stocks from the Amex to Nasdaq; 95% experienced a wider intraday price range over-the-counter.
Who pays for this volatility? The investor. A good part of the volatility is explainable by the wide dealer spreads. Let's say you want to sell 500 shares of Big Board-listed Micron Technology at 23 1/8 a share. The current market is 23 1/8 bid, 23 1/4 asked. If you put your order in with a 23 1/4 limit and are patient, the specialist in Micron will very likely find a customer who is willing to pay 23 1/4 for your shares. In any case, the specialist could not sell shares ahead of you at that price. But if Micron were traded over-the-counter, your limit order would very likely not get executed unless the market started to move up. As long as the market is 23 1/8 bid, 23 1/4 asked, over-the-counter, your order would generate a "nothing done," and marketmakers could trade ahead of you.
How do we know this? By comparing how many investor orders are matched or "crossed" on average on NYSE and Amex stocks with the "crosses" that take place on Nasdaq. The numbers are revealing. On the NYSE and Amex, investor orders are matched in 91.4% and 89% of trades, respectively. Nasdaq's spokesman says the number of investor crosses in its market is 1.7%.
Thus, in 98.3% of Nasdaq trades, a marketmaker inserts himself between buyer and seller. He isn't there for his health; he's there to bite off 1/8 of a point or more. Those fractions can mount up when you are moving nearly 2 billion shares a week. According to Abel/Noser, average Nasdaq spreads are roughly double those on the NYSE--38 cents versus 19. This was confirmed by a March 1996 draft study on trading costs and exchange listing by Paul Schultz, a professor at Ohio State University, and Mir Zaman, a professor at the University of Northern Iowa. The academics found that on small trades, effective spreads usually increase by more than 100% when a stock moves from a listed market to Nasdaq.
Who are the marketmakers? They include big retail investor firms like Merrill Lynch, Smith Barney and Charles Schwab's Mayer & Schweitzer, giant trading houses like Goldman, Sachs and Salomon Brothers, so-called wholesale firms like Herzog, Troster Singer and Sherwood Securities and hundreds of smaller firms like Ryan, Beck & Co. and Key West. In fact, much of the volume that looks so impressive on Nasdaq is not investor meeting investor but marketmaker meeting investor or marketmaker meeting marketmaker. Actually moving a share from one investor to another may involve not a single trade but several: seller to marketmaker; marketmaker to buyer. John Gould and Allan Kleidon in the Stanford Journal of Law, Business & Finance in 1994 analyzed this method of counting volume and concluded that roughly 41% of Nasdaq volume is investor-generated. The rest--59%--is marketmakers trading among themselves, known as "the churn."
Double- and triple-counting volume achieves a couple of things. It creates the illusion of liquidity in a stock. It also explains why a single day's trading in a Nasdaq stock may represent a major part of its float. Not a big turnover in ownership but simply trading the same shares several times in the day may have accounted for the bulk of the action.
Mark Le Doux is chief executive of Natural Alternatives, a vitamin and nutritional supplement company whose stock formerly traded on Nasdaq. "I was curious why 100,000 shares traded one day and the stock was up 1/4, but the next day only 10,000 shares traded and it was down 1/4," says he. "So we went back through clearing records and tried to identify where the shares were going. We couldn't identify who bought and at what price." It's only slightly far-fetched to compare this with the old-time bucket shop, where only phantom stock changed hands. Le Doux found that on a day when 100,000 shares were reportedly traded in his stock only 20,000 shares actually were investor to investor.
"There were too many unanswered questions," Le Doux says. "I said why don't we go somewhere where it's all done in the light of day?" His stock now trades on the Amex.
Under the cover of this dealer-to-dealer trading, all kinds of games are played. For example, insiders can unload restricted stocks under conditions set up by the sec. Rules say that, per quarter, insiders cannot sell more than 1% of the shares outstanding or more than the average weekly reported volume in the stock for the previous four weeks. The more volume in the stock, the more stock you can sell. If volume were counted as it is on other exchanges, executives of Nasdaq companies could sell less than half the insider stock they can sell today. This is a powerful incentive for stocks to remain on Nasdaq long after they have achieved sufficient seasoning to move to the Big Board.
Dealer-to-dealer trading also provides splendid opportunities for creating attention-getting volume that will show up on computers and attract momentum investors. Nasdaq admits to as much in marketing materials it uses to recruit companies. Nasdaq's "increased demand creates a higher price" for your stock, according to the sales pitch. The Nasdaq sales kit goes on to say that Nasdaq marketmakers "actively find buyers and sellers to increase demand" for your stock. They also "make potential investors more aware of your stock through research." Why? With their fat spreads and their ability to get in between buyer and seller, Nasdaq marketmakers can profit greatly by moving every share they can. Nasdaq boasts that "over the past 20 years the Nasdaq index has outperformed the NYSE, S&P and Dow Jones." True, but this performance measure does not take into account the higher costs of trading on Nasdaq. Those costs can diminish returns pretty darn fast.
|
