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How to Get Started in Active Trading and Investing
By David S. Nassar
The McGraw-Hill Companies, Inc.Copyright © 2004 The McGraw-Hill Companies, Inc.
All rights reserved.
TRADITIONAL WALL STREET—TRUMPERY, TYRANNY, AND TENDENCY
In a rare time of disintermediation whereby money management is flowing to the individual and public domain, there is no better time to understand the economy and the capital markets. In management theory, the Peter Principal is a phenomenon that describes a level in which incompetence is obtained. In other words, even after successive promotions, little can be achieved beyond one's abilities. I believe traditional brokerage firms and the analysts that work for them have reached and surpassed this level of incompetence. As stated, big money does not mean smart money, and the journey you are about to embark on will prepare you to understand and deal with the market, to make your own decisions, or at a minimum, prepare you to filter the advice of others before blindly investing.
Countless battles take place each day on Wall Street. In this arena powerful people rely on the public's order-flow to navigate a world of greed, fear, regulations, and even corruption. The markets are populated with large institutions down to small investors. To the uneducated, the markets may seem covered in a blanket of fog where movements are mysterious. Therefore, in order to participate in the financial markets, these uneducated participants pay for a guide to lead them through the fog. There is trust placed in this guide and participants believe they are being led toward their best interests. At times the guide leads participants safely through the shrouded world, but other times the guide leads participants in a way that only furthers their own interests. This analogy too often describes the relationship between the amateur market participant and their money manager or broker. The relationship between an investor and their money manager is a tricky one, taking on different tones in different market conditions.
During a strong bull market, almost every stock's price increases. This is great news for the investor, both big and small. In most cases, if a person invests any money at all in the stock market during this time, they will most likely see a profit. A strong bull market is also where true greed rears its ugly head, tempting those in positions of influence to put their own monetary gain before the masses that trust them to honestly guide them through the fog. As with most things in life, what goes up must come down. When markets decline and the bearish side shines through, people begin to lose the money they have invested. It is at this time that the exceptional greed and corruption at high levels is uncovered, breaking the trust between broker and investor. Investors begin to understand the trumpery or nonsense being fed to them. This in turn causes confidence levels to plummet. During this time of low confidence, market participation decreases and Wall Street searches for ways to gain back the trust of the investor. Typically regulators jump on this opportunity to step in and enact rules designed to bolster confidence. These rules allow the investing public to feel that the corruption has been stamped out and won't happen again. This bull and bear cycle has been repeated time and again throughout the history of the stock market. History is our teacher and lessons can be learned that apply today.
This cycle reaches as far back as the economic boom of the 1920s, and much farther if we exclude regulation. After World War I, the U.S. economy began to rebuild. In the 1920s the use of electricity expanded and consumerism rose. With this rise in consumerism the stock market rose as well. In fact, the market was driven upward in a craze. Most participants made money and little thought was given to regulation, and the theory of the day was a laissez-faire approach to just "let things be." The crash happened near the end of October 1929, when the Dow lost over 39 percent from the high it made in September of the same year. By June 1932 the Dow had lost over 90 percent.
Many investors borrowed money to participate in the stock market rally, and as prices fell, banks collected on loans made to investors who now had holdings worth very little. Many banks also invested depositors' money in the stock market, and the combined result was that banks had large, uncollectible loans and worthless stock. As word spread and panic set in, people tried to retrieve their money as banks failed by the hundreds. This is what modern day fund managers call a "run on money," and it represents a repeatable crowd reaction we still see in the market today.
In response to the great crash, the Federal Government set up the Federal Deposit Insurance Corporation (FDIC) to prevent such disasters from happening in the future. If an FDIC-backed bank failed, then the government would reimburse depositors. The FDIC still stands today.
After the crash in the 1920s and the ensuing depression, there was a consensus that in order for the economy to recover, the public's faith in the markets needed to be restored, similar to the sentiments felt after the stock market decline that began in 2000. In 1933 and 1934 Congress passed two Securities Acts that required public companies to tell the truth about their businesses and required people who trade, buy, and sell securities to put the investors' interest first. The SEC was founded in 1934 to enforce these rules. Notice the pattern—the market goes up and irrational buying takes place, then the market comes down and people lose money and consumer confidence drops, then regulation is enacted to renew the confidence of investors. See Figure 1-1 for a chart of the Dow during this period.
Direct parallels can be drawn to the Internet bubble in the late 1990s. During the 1990s the stock market grew at an unprecedented pace, led higher by high- tech companies. After the market crested and fell, people once again lost money. Regulators asked questions and uncovered information that contributed to falling confidence. The SEC quickly enacted regulations to increase confidence, and the cycle of market activity followed by regulatory intervention. The common denominator that spans the dimension of time is human nature. History helps us understand the problems that occur today by understanding the problems of the past. To link the similarities, we must have an understanding of how things really work in the markets. The first piece of understanding comes from the knowledge of how information is filtered through the market participants of Wall Street.
Success on Wall Street is based on information. It is a world of tyranny, where important information is given to a select few. The majority of amateur market participants base their decisions on fundamental information given to them by brokerage firms or the public companies themselves. It is key to understand how this information is handed down and how it can be altered. To use a metaphor, a long line of participants clamor and compete for market information. We see this information as "market food." The food chain describes where various participants exist within the information hierarchy. Once this information is received, we must then ask what nutritional value remains. The digestive system of the market operates on a very fast metabolism. These participants include institutions and high producing commissionable accounts that receive the best market food with their commission dollars. As they act on this information, stock prices often discount in value before the public reaches the same information, only now depleted of its nutritional value. In most cases, the public is at the end of the intestinal system, where the "market food" is—well, you can finish the analogy for yourself! But the digestive process describes what the analysts, brokers, and media do with the market food they receive (research and ratings reports) before it reaches the public, who are the last to receive it. Pretty gross, I agree, but I want you to get the message—by the time the market food reaches you, it is not wise to consume it. This explanation illustrates why Wall Street insiders consider the public to be "dumb money." The first step in changing your place in the system is to understand the system itself, and that begins with investment banking.
The first set of relationships to understand are the ones built by a private company that decides to sell their stock publicly. These private companies are located at the beginning of the food chain, where all the relationships start. Initial Public Offerings (IPOs) can be very profitable for the company going public and the investment bank alike. There are a variety of reasons a company may decide to go public. The company may want to use the proceeds from the sale of stock to enlarge their business, pay off debt, or may want to spread risk from the current owners over a larger area. To do this, the company must find initial buyers for the stock they intend to sell. The initial buyers are found through the underwriter. Underwriters are generally institutions that specialize in taking companies public; as a group they are called investment bankers. Understanding this process is in your best interest and will set the foundation of knowledge you need to understand Wall Street.
The next step is to understand how financial institutions make money and the relationship of the broker, analyst, and investment banker. This is important to understand because you need to know where their interests lie and if they conflict with yours.
WHY A BROKER CAN MAKE YOU BROKE
A broker is an individual, who is licensed to buy and sell securities and has the legal power to act on the behalf of a customer. If someone wanted to buy 1000 shares of stock, they would have to go to a person or firm who has access to the market, and this is a broker. Brokers are in the sales business, and most get paid on a commission basis. Much like a real estate agent, who makes money when a house is bought or sold, each time a stock is bought or sold through a broker, they charge a commission. As long as a transaction is incurred, the broker and the firm they work for gets a commission, regardless of whether their client makes money or loses money. There seems to be an obvious conflict of interest between how a broker gets paid, when that broker is paid to manage an investor's money. Many argue the broker's incentive to do a good job in investment management is to retain and attract customers, and this keeps the interests of the customer and broker aligned. History proves otherwise in many ways, such as churning and poor performance to name a few, because brokers are generally not trained as analysts; they are trained to sell. Even if trained as analysts, their interest and your interest align poorly.
An analyst is a person who researches companies then makes buy-and-sell recommendations based on their findings. They often specialize in a certain industry sector or a group of stocks. Analysts prepare recommendations and reports that are usually disseminated through the firms they work for or to market participants and institutions to help make investment decisions. They have their own vernacular of grading stocks, and their recent performance of reading the future is quite dismal as a group. Some analysts have enjoyed a spectacular track record as have many fund managers, but as we shall soon discover, something has gone awry. To some degree the reasons are new, but to a much larger degree, it has everything to do with an agelong flaw—greed. Figure 1-2 shows the various ratings systems of the different analysts.
Many investors lack the time or interest to put a great deal of time into researching a company, so they heed the advice of the analyst. Thus, the analyst is frequently placed in a position of trust. The lessons to be learned should forever remind all participants that risk can never be properly evaluated without having a hand directly in the analysis.
CORRUPTION IN THE FOOD CHAIN
From 1792 to 1975 brokers charged for their services on the basis of a minimum commission schedule. The commission price was set at a high amount. As a result, most financial firms and institutions made most of their money through commissions. Brokers enticed their clients to make transactions, while analysts were paid from the commissions that the firms made. The analysts were truly motivated to make good recommendations, and when clients made money they were naturally motivated to trade again based on the next recommendation the analyst made. Essentially, the analysts were rewarded for being right and objective. This was a good system, whereby the analyst and the public were reasonably well aligned.
In May of 1975 (known as "May Day"), the SEC eliminated fixed commissions after an unexpected intervention by the U.S. Justice Department [who also interceded in 1996 to lead the "order handling rules" that opened the door for Electronic Communication Networks (ECNs) and direct access trading as we know it today] who questioned the need for fixed commissions. The rationale for the repeal of fixed commissions was to eliminate price collusion among firms. While price collusion occurred, its repeal forced firms to find other ways to quench their greed. As we shall soon see, which is the lesser of two evils?
After these fixed commissions were eliminated, discount brokerages such as Charles Schwab emerged and exploded in popularity, and commission prices fell precipitously. The financial firms and institutions, which made the majority of their profits from commissions, saw revenues fall. This caused an increase in investment banking business, and this resulted in more and more companies going public through the 1980s and 1990s. This helps explain how many companies with no fundamental value exploded into the market during the Internet boom, while contributing to a new feeding frenzy of greed for big brokerage.
During this period analysts saw their value to the commission side of the firm decrease. Meanwhile, an increasing number of analysts began to subtly work with the investment banking side of the firm, which handled IPOs and mergers. Their research became increasingly motivated by supporting the IPO process, instead of being motivated by objective research and accuracy. Being accurate regarding the company outlook meant that the research was worth the high commissions to investors, but the IPO process paid them well regardless of accuracy. Pre-IPO craze, if their research was poor, so was the commission income since investors would stop relying on research. This aligned brokerage and the public as well.
To the outside world, the large financial firms maintained that there was a "Chinese wall" that separated research and banking. A Chinese wall is a set of procedures that restricts access to nonpublic information within the firm reaching the brokers who would undoubtedly pass it on to their customers. The Chinese wall is in place to avoid the illegal use of inside information gained by analysts from their close work with companies getting disseminated to the public through the seemingly unrelated divisions of the broker. On the inside, the wall began to crumble and corruption and greed flourished. The timeless human nature of Wall Street participants emerges again.
CORRUPTION BEHIND THE SCENES
Analysts began to recommend that investors invest their money in public companies that had investment banking relationships with the firm. This had nothing to do with fundamentals or objective analysis, but it did influence investors to buy stocks where both the firm and the company benefited from the higher stock price. By the late 1990s this practice was out of control. Soon analysts were using buy recommendations to get business for the investment banking side, and the analysts received bonuses if they helped secure large investment banking deals. While some companies were rewarded for investing with a certain firm, others were downgraded as a form of punishment for investment banking with the competitors' firms. The Chinese wall truly crashed down as executives of major companies leaked information to analysts. When a company leaked earning numbers to the analysts, analysts, in turn, adjusted the earning prediction so the company would beat the estimate. This in turn influenced stock prices to go higher, and the executives and the investment banks made big money. In the past, analysts had to be accurate in their market calls in order to earn additional commissions for their firms. Now, however, many analysts and the firms they represent found even greater success by supporting the stocks they took public, merged, or offered secondary offerings. In this sense, the repeal of fixed commissions hurt the market by taking away the incentive for firms and analysts to make accurate calls.
Inside information as well as valued IPO allocation and the like was then fed to institutional clients high up in the food chain. These institutional clients have very large accounts and trade often. The analysts and investment bankers, as well as the firms' institutional clients, had access to the valuable information before the rest of the market. The number of downgraded companies decreased as analysts learned that if they downgraded a company, then the executives stopped leaking information and turned to another firm for investment banking business. These relationships are a strong indication that corruption was taking place behind the scenes and the Chinese wall had fallen.
A company that was planning on going public would talk to investment bankers and analysts, who in turn found support for their stock. The company went public and the analyst recommended the stock to investors. This created an underlying demand for the stock or a base of buyers, and as the price rose higher and higher, the major players—including the executives and the investment banks—printed money once again. In return for recommending the company's stock, the executives leaked information to the analysts. This created a circle of profitability where most everyone profited. See Figure 1-3.
Excerpted from How to Get Started in Active Trading and Investing by David S. Nassar. Copyright © 2004 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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