To All.
Here is what a friend sent me. I hope you'll find
it as interesting and instructive as I have.
re: MM's and their tactics.
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 « on 1,000 shares. That was the low for the day, for in the next 6 « 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
nufacturer 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.
TOYOTA
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 « 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 holders 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 ¬ asked. If you put your order in with a 23 ¬ limit and are patient, the specialist in Micron will very likely find a customer who is willing to pay 23 ¬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 ¬ 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 ¬, but the next day only 10,000 shares traded and it was down ¬," 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 er-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. rading 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 _, signaling to the other dealers in the stock that there's a seller out there. The market in the stock drops to 46 _ bid, 47 _ asked.The marketmaker who dropped his offer buys the stock at 46 _, 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 _. 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 «. 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 ¬ bid, 12 _ 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 « bid, 8 _ 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 « 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 Market Stocks last year, and 63.4% of trading in Nasdaq's top 100 issues. As a comparison, nonblock trades on the NYSE
were 43%.
There's an old Wall Street joke. Dr. Smith buys 100 shares of Ajaxonics at 10. It goes to 15. He buys 100 more. It goes to 20. He adds another 100. Next time he calls, it's at 25. "Why not buy
another 100?" his broker suggests. But Dr. Smith isn't greedy. He decides to take his profits. "Sellit all," he says.
"To whom?" the broker responds. We don't know when this is going to happen. But it will. WHY STAY ON NASDAQ?
WHY DO COMPANIES that could list their shares on the New York Stock Exchange or the American put their shares on Nasdaq? In some cases, the answer is: They are persuaded the stock will do better on Nasdaq.
That's the message of a 20-page Nasdaq sales piece. Companies
should list on Nasdaq, it says, because the multiple marketmaker
system pushes stock prices higher. "Nasdaq marketmakers create
demand (generate bid prices) through their expanded roles,
including: increasing visibility of stocks in which they make markets by generating research, retail sales and institutional transactions.
Increased demand creates a higher price."
Nasdaq delivers cheaper capital for listing companies, says the piece. "The Nasdaq company can raise more capital with secondary offerings, retain more ownership through mergers and
acquisitions [and reap] increased value in stock options."
In short, Nasdaq dealers have the means for coaxing higher prices
from investors. Nasdaq cites a 1994 study by Reena Aggarwal, associate professor of finance at Georgetown University's School of Business. Her research, which Nasdaq helped fund, found that from 1983 to
1991 price-to-earnings ratios and price-to-book values were consistently higher on Nasdaq stocks than on NYSE stocks. Aggarwal did not include Amex stocks in her research, even though they
are closer in characteristics to the emerging companies found on Nasdaq than NYSE stocks are. Nasdaq calls her work "a study," when it is in fact a research draft that remains unpublished even though it was produced in 1994. How does Georgetown feel about having its imprimatur on the
Nasdaq stock market? "Once a paper is made public, it enters the marketplace of ideas," says spokesman Liz Liptak.
Whether or not these higher prices are good for investors, they surely are good for brokers. Earlier this year Amex-listed Del Global Technologies registered to sell 2 million shares in a secondary offering. Leonard Trugman, Del Global's chief executive, was told by Needham & Co. and Tucker Anthony, the firms underwriting the issue, that the company "would have a better opportunity for a successful offering if we moved the shares to Nasdaq." Trugman followed their
advice and moved. -G.M. |
