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 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. "Sell it 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.
Issue Date July 29, 1996 | Copyright Forbes Inc. 1996 ©
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