*OT* One of my favorites from FORBES 1996. Interesting reading when you have time.
July 29, 1996
Getting into over-the-counter stocks is easy. But when it comes time to sell, who
will buy these hot Nasdaq issues?
One day soon the music's
going to stop
By Gretchen Morgenson
FRIDAY, June 28 was a prosperous if jittery day for the shareholders of
SystemSoft Corp., a software company based in Natick, Mass. Its
over-the-counter stock had closed at 42 the prior day and opened Friday at 42
1/2 on 1,000 shares. That was the low for the day, for in the next 6 1/2 hours,
SystemSoft's five marketmakers took the stock to 47--a 12% increase from its
previous close.
What prompted the move? There was no news on the stock, no earnings
announcement or product development talk. But the market in the stock was
boiling, with reported volume of 617,000 shares that day, 6% of the shares
outstanding and roughly five times its average trading.
The day before, Accom, Inc. had a similar experience. A manufacturer of digital
video systems for broadcast television shows, Accom came public in September
at $9 a share but had fallen to around $2.50 on Nasdaq. By the end of the day on
June 27, Accom was up 53%, to 3 5/8, on almost 45,000 shares. Why the jump?
Again, no apparent reason. With a float of just over 3 million shares, volume in
the stock was typically a rather narrow 34,000 shares. The company's chief
financial officer, Robert Wilson, could only guess that the stock rose because it
had been exceedingly oversold.
Perhaps never before in history have hot little stocks sizzled so loudly and so
frequently. Most of the action is not on the stodgy Big Board or even on the small
stock American Stock Exchange but on Nasdaq--the National Association of
Securities Dealers Automated Quotation system. Lucky investors in for the ride
high-five their pals all the way to the bank. At cocktail parties their boasts can be
heard above the din.
The action has been wild and woolly. The market capitalization of all Nasdaq
stocks at midyear 1996 was a bit under $1.5 trillion, as against $6.6 trillion on
the New York Stock Exchange. Reported volume on the Nasdaq last year was in
excess of 100 billion shares, as against 87 billion on the Big Board. Whereas
trading volume on the Big Board has a little more than doubled since 1990,
Nasdaq's has tripled. Marketmaker firms trading Nasdaq stocks numbered 542 in
May, up almost 30% from five years ago.
With all this money pouring into Nasdaq stocks, their prices have soared. The
average price/earnings ratio of a Nasdaq stock stood at a mind-boggling 44 last
month, up from 35 just six months ago. Compare this with the average ratio on
the NYSE--20--or the American's 21.
Perhaps it is true that small companies are the future, but big companies are the
present. Can the future really be worth 2 1/2 times as much as the present, as
these P/E ratios suggest? The truth is that many of these Nasdaq prices are
artificial, pushed to ridiculous levels by marketmaker manipulation and investor
naivete. One indication of how dangerous this market has become is the volatility
found in its shares. It is roughly double that of Big Board- and Amex-listed
stocks. According to the statistical research firm of Abel/Noser in New York City,
the average volatility today in NYSE and Amex stocks--as measured by intraday
price movements off the stocks' daily lows--is 2.09% and 2.87%, respectively. On
Nasdaq this volatility is more than double the Big Board's--4.9%.
Nasdaq's ride: getting rougher
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.
A flock of highfliers
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.
Is Nasdaq dangerous ground for the individual investor? Not in the 50 or so
large, heavily traded Nasdaq stocks that include Microsoft, Nordstrom,
Northwest Airlines and Intel. Those stocks trade with relatively narrow
spreads. But there are roughly 5,300 Nasdaq issues, and in many of these
manipulation is rife. Former and current marketmakers confirm that dealers
can move their bids and askeds around to their heart's content, on little
volume. These sources agreed to describe to Forbes the dealer techniques
that make these markets so volatile, but on the condition of strict anonymity.
Trading around an order is one way for marketmakers to get stock prices
where they want them. A former marketmaker says the following situation is
typical: Say a marketmaker has an order to buy a stock that's trading at 47
bid, 48 asked. He has no inventory in the shares, but he shorts the stock to
the customer at 48. (Big marketmakers can short stocks on downticks, unlike
on the NYSE and the Amex, where the specialist can short only on an
uptick.) Then the marketmaker drops his offer to 47 3/4, signaling to the other
dealers in the stock that there's a seller out there. The market in the stock
drops to 46 3/4 bid, 47 3/4 asked. The marketmaker who dropped his offer
buys the stock at 46 3/4, covering his short and making $1.25 per share. Is
this cricket, taking advantage of a fellow marketmaker? All's fair in this
particular war. The harm to the public lies in unnecessary volatility.
Even though it is against Nasdaq regulations, marketmakers still trade ahead
of customer orders. A customer puts in a big order. Knowing that this will put
the stock up, the marketmaker buys ahead of the customers. This has the
effect of pushing a stock higher, so that the real buyer has to pay up for his
order.
A lender of a stock holds all the cards. At any time after he has lent
the stock, he can call it back in; the borrower has three days to return
it.
Or a marketmaker can push a stock up on little or no volume at all. One
trader's story involves a Nasdaq-traded health maintenance organization
called WellCare Management Group. On May 23 the trader had an order to
buy 10,000 shares of WellCare, a sizable order in a stock that trades roughly
45,000 shares a day. For individuals who were looking to buy WellCare, the
stock carried a dollar spread, but the inside market in the stock--that is, the
price at which dealers can buy and sell--was 12 5/8 bid, 12 7/8 asked.
One of WellCare's marketmakers was Key West Securities, a year-old firm
out of Fort Worth, Tex. The trader looking to buy did 3,000 shares
electronically at 12 3/4. To get the other 7,000 done, she called Key West
and said that she had stock to buy. It was around noon.
The Key West trader put her on hold and proceeded to take his offer price
from 12 7/8 to 13, then 13 3/8, then 13 1/2. She watched him do this on her
screen--it took less than 30 seconds--but the dealer never returned to the
phone. "I called him again and threatened to file a complaint with Nasdaq, and
he clicked the phone in my ear," she recalls. "My client ended up paying
$13.47 on average for the trade." A Key West principal, Amr Elgindy, said "I
have no idea what you're talking about.' He was unable to say if he had made
a market in WellCare that day. The stock closed the day at 12 1/4 bid, 12
3/4 asked.
Another tale told to Forbes by a stockbroker at one of the largest brokerage
firms illustrates why these markets are so treacherous. "My trading desk is
working against my order all the time," he says. "Let's say a stock is 8 1/2 bid,
8 3/4 asked and I want to buy. My firm doesn't make a market in it, so I go
to our agency desk." The agency desk is where all equity trades in which the
firm is not a principal take place. "The agency desk trader," he continues,
"won't go to a dealer who might be interested in selling me stock at 8 5/8. He
goes to the trader he's friendly with at a firm that pays to see the order flow.
In exchange for the order, he gets theater tickets, seats to the ball game,
invitations to golf outings. Meanwhile, my order never gets done."
Nasdaq is especially dangerous for short-sellers. Talk to people in stock loan
departments on Wall Street, the back-office folks who must locate shares to
cover short positions. If they are frank, they will tell tales of tricks used by
professional investors, marketmakers and even company managements to
juice a stock and massacre short-sellers.
When an investor shorts a stock, he must borrow the shares from his broker.
In large, widely traded stocks, this is usually a cinch. But in stocks with
relatively thin floats, it can be a problem. Why? Because according to stock
loan sources, mutual funds--with their massive stockholdings--are not big
lenders of equities today. Bank trust departments lend securities, mutual funds
generally do not.
There could be several reasons for this. One, it's just not that lucrative. A fund
might earn 12.5 basis points--$1.25 million on a billion-dollar stock
position--lending AT&T stock to a U.S. borrower. Hardly worth the trouble.
Then, too, short-selling is considered un-American in some circles. But there's
a more devious explanation for this reluctance to lend stock for long periods
to short-sellers: rich pickings to be made by squeezing shorts. Call in their
borrowed stock, and you force them to go into the open market to cover--at
whatever price the market demands.
A lender of a stock holds all the cards. At any time after he has lent the stock,
he can call it back in; the borrower has three days to return it. Marketmakers
who carry positions overnight in the stocks they "make" have been known to
pull back their stock and force buy-ins. The occasional mutual fund that lends
shares temporarily does this as well.
The short-seller isn't the only victim here. Squeezing the short drives up prices,
creating volume and upward action that can attract momentum players. But
once the squeeze is over, there's nothing to hold up the price. Moreover,
eliminating short-sellers makes it easier to drive up the price of an already
overvalued stock.
Corporate executives of heavily shorted stocks also play this game. First they
put their considerable insider holdings into their margin accounts, making them
available for lending by the firm's stock loan department. Shortly after these
executives make their stock available for lending, it often happens that they
remove their holdings from the brokerage firm. Or they move the position into
the cash account. Both actions force buy-ins. Result: more volatility, volatility
that has absolutely nothing to do with fundamentals.
Although no one maintains records of how many buy-ins take place on a given
day, traders say they are happening much more frequently today, especially in
the past year or so. One professional who has been buying and shorting
stocks for 25 years had experienced one buy-in during the previous 24 years
of doing business. In the past year, he's been on the receiving end of three.
A small army of "freelance" stock promoters ...promise to produce a big
increase in volume ... by getting some friends to post bullish "information"
about the stock on the Internet.
From where they sit, marketmakers can often see where a buy-in is taking
place and rush in buy orders ahead of the squeezed short, further squeezing
him. Shooting fish in a barrel.
Nasdaq boasts that its listings get widespread brokerage coverage even in
small, thin stocks--stocks that might not be worth the broker's efforts if it
were NYSE-listed. The boast is true, but not entirely for praiseworthy
reasons. A small army of "freelance" stock promoters sell their services to
Nasdaq issuers in exchange for either cash or cheap stock. These folks
promise to produce a big increase in volume or to get the stock to a certain
price. They do it by getting some friends to post bullish "information" about the
stock on the Internet. By sounding knowledgeable about the company, these
freelancers impress the Internet's stock market junkies, who buy into the
story.
Or a Nasdaq company might like to hire the Stockbrokers Society of
America, a Los Angeles area-based outfit that will write "research reports" for
companies in exchange for $19,400 and the cost of mailing them out to the
13,000 or so stockbrokers. The Stockbrokers Society will also set up
meetings with brokers in cities across the nation for $4,000 per, including
invitations, lunch and audiovisuals. Brokers wishing to make money by
pushing the stock can simply mail the "research" to their clients. A former
Forbes editorial staffer writes many of the reports.
Robert Dresser at the Stockbrokers Society says he turns down five to seven
companies a month looking for research reports. But one company that asked
for help from the Stockbrokers Society got more than its money's worth on
two occasions. Biospherics Inc. is an o-t-c company that has spent the past
ten years developing a sugar substitute. Biospherics hired the Stockbrokers
Society to write a report and arrange two meetings with interested
stockbrokers in Florida in April 1995. The stock was trading at a
split-adjusted 2 5/8 when the report was issued and the meetings set up,
down from 4 1/8 the previous year. Two days after the second meeting,
Biospherics' stock was at 3 3/8, up nearly 30%. This April, with Biospherics
around 5 a share, Stockbrokers Society wrote another bullish report. The
stock ran to a split-adjusted 9 1/2 in two days on volume of 684,000 shares,
close to 20% of the float. It has since drifted down to around 7. Meanwhile,
in the last 18 months, insiders have sold 205,000 shares.
With promoters like these and 542 marketmakers whipping up an awesome
churn in Nasdaq stocks, it's no wonder volatility is far outpacing that of listed
stocks.
And it is no surprise that short-sellers have largely walked away from Nasdaq
stocks. Which means, among other things, that when the market finally lets go
on the down side they won't be there covering their positions and giving the
market some support. Neither will many of the marketmakers, who have a
habit of not answering their telephones when the market is dropping hard.
After all, these dealers can abandon their marketmaking activities in a stock at
any time; the only penalty is that they cannot return to that stock for 20
business days. Who, then, will be there to buy? Just ordinary investors. For
they are the folks who are most active in over-the-counter stocks. Nonblock
trades--orders for fewer than 10,000 shares--accounted for 64.5% of all
trading in Nasdaq National Marke |
