Read an Excerpt
Chapter 2: THE NASDAQ EXPLOSION
THIRTY-SIX KEY STOCKS
When the S&P 500 Index added Yahoo to its index in 1999, it surprised many people. It was unusual to see a super-high P/E Internet stock, which is appropriately listed on the Nasdaq-100 Index, also listed on the more staid S&P 500. This raises the question of which other Internet/tech/growth stocks are also listed in the other benchmarks, such as the Russell 1000, the Russell 100 Growth, as well as the S&P 500.
This question takes on importance when you consider that the performances of many of the larger money managers are based on these indexes. If there are stocks that have to be bought and held by managers to replicate certain indexes, when the stocks are bought, the managers could bump into each other in their hurry to buy those stocks.
This can run into major money. When giant funds, including index funds, come into the market to benchmark a stock (own the same proportional amount in the index fund as is held in the index: say the index has a 17 percent weight of Microsoft, then a $20 billion fund will have to buy a 17 percent weighting of MSFT$340 million worth), that stock can be driven upward. This is not a rare occurrence. There are many $20 billion funds out there, as well as active managers, who want to own the stocks that the indexes, against which they are compared, own.
Also, transaction costs are a big factor for money managers. Transaction costs are not just commissions; transaction costs can also be impact, which means how much it costs in terms of market price because the institution moved stocks higher when it had to rush in to buy. Big funds would have to tiptoe into these stocks slowly so as not to move them; maybe take a week to a month to get their position built. Tiptoeing in when a stock is added to an index is hard to do; the funds have got to own the shares. And this is where the volatility starts, with managers bidding against each other and themselves.
Douglas Coté at Aeltus Investment Management studied 36 stocks that were heavily weighted in the different indexes. The equal-weight average return for these stocks over most of 1999 was an impressive 172 percent. The problem gets clearer: funds do not have a chance to tiptoe into a stock when those stocks are appreciating 172 percent in a year.
The factor that could be overlooked by the big money managers is how heavy buying of their index stocks increases their transaction costs. Individual investors, those who buy 500, 1000, 5000 shares, do not have an impact on the price of these stocks; but a buyer, say, of a million shares will, essentially, start bidding against herself. Some of these stocks do not have a large daily trading volume; a million shares to buy could drive many of the "have to own right now for index representation" Nasdaq stocks higher.
Also stampedes can cut both ways: if everybody heads for the exits at the same time, a scenario I’m not suggesting is developing, but could, sellers could be stumbling over themselves and each other in order to get out, driving the prices of these stocks lower.
Can The Stocks Get Bought Up?
A concern would be whether all the big money managers could complete their stock positions with the stocks needed to match the indexes or the stocks required for enhanced index needs. And with that happening, would the stocks that need to be bought for the indexes drift lower or even
Before pondering that question further, it should be understood that an enhanced index fund or portfolio is one in which there are stocks held that mirror the stocks in an index; additionally, the fund or portfolio will purchase stocks or synthetically increase holdings of stocks to improve the performance over that of the benchmark index, without materially increasing risk. For example, an enhanced fund might buy calls on an up-moving stock; if the stock continues to go up, the fund calls the stock at a lower price, and perhaps outperforms its index benchmark. There is a change in the risk profile of the fund using this strategy: the amount that the fund paid for the call premium will lessen the fund’s performance if the stock it bought options on does not go higher.
As for the previous question of whether stocks in the index could be bought up to a point that demand would be filled, with the stocks going down after demand is filled, it is a set of circumstances that seems to be an oversimplification and probably unlikely to happen. The need for all of the indexes simply is not large enough to keep stocks propped up. Ultimately, the stocks will sell on their own merit, according to earnings and other factors.
As long as stocks are expected to outperform bonds and money market funds, new money might continue coming into the stock market. Index funds have to replicate an index with their newly injected cash, and to this end will go out and buy more stocks. Some nonindex funds have experienced $1 million a day coming into their funds. Some of this cash will be invested in stocks in proportion to the indexes. And as for the enhanced-index funds, the more stocks they buy that are in their benchmark, the easier their job to match the benchmark.
Active managers as well as individual investors do have to be careful, though: these stocks can go down fast. You have to make sure that the growth outlook for the companies is still there.
For instance, in early 2000, Dell Computer Corporation (DELL) recently announced that it would not make its sales and earnings projections; the stock was immediately punished, going down over 20 percent.
Conversely, growth in earnings is rewarded. Intel Corporation (INTC), a company well represented in the list of 36 stocks, announced new products and joint ventures; the stock went up 17 percent.
A NEW ECONOMY?
Is there a new economy? One that is and will experience unbridled growth for as long as the mind can imagine? Do we throw out the old economic models and say that trees (economically speaking) will now indeed grow to the sky?
There is a new economy that is expanding. But in a certain sense none of this is new. All this growth in the technology sector is a continuum started years ago that is just now being recognized and reflected in technology stock prices.
The coming of the present technology-driven economy was pretty much predicted in 1965, in a theory known as Moore’s Law. In that year, Gordon Moore, then employed at Fairchild Semiconductors, wrote an article for Electronics magazine. Moore expounded his theory that microchip technology change would remain dynamic indefinitely; changes would create a doubling in microchip computational power every year or so. Later, this time was lengthened to about 18 months. Gordon Moore later founded the Nasdaq listed company, Intel, Inc.
Today it is generally accepted that Moore’s theory is accurate. This continuing increase of microchip power is one of the reasons for the drop in the price of PCs. The consumer today can buy a more powerful computer at a lower cost than ever; and this trend continues.
Microchip computational power increasing, however, is not the only reason for low computer costs. There have been technological advances, the popularity of the Internet has spurred consumer demand for computers, and there are marketing considerations and other factors. Computer prices have dropped below the $1000 level on the low end; and the under-$1000 computers are far superior to the high-end computers of years ago. Also the high-end computer of today is much superior to the best of years ago. All this is a result of the workings of Moore’s Law.
Today’s technology-led economy has been developing for quite a while. It is hard to imagine that the influence of technology in the U.S. and world economy will peter out: the popularity of the Internet; needed improvements in software to satisfy the demands of new PC usages; the penetration of technology in underdeveloped countries (China, as an example); and many other factors should keep the technology sector changing and growing.
Computers should continue to get cheaper and better. Realistically, computers will sell for over $400it costs about that to make them today. The new frontiers seem to be in the software sector; software, especially, that is linked to the Internet, should continue to become cheaper and better.
Evolving Uses For The Internet
It is misleading to brand the present an Internet economy. This is a broader, more technology-driven economy. This economy has developed an infrastructure the capability of which did not exist even a few years back, an infrastructure that connects many millions of customers and suppliers worldwide.
To understand how this infrastructure can impact the future, consider business-to-business (B2B) Internet commerce. A company such as General Motors or Ford, instead of having people get on the phone to order goods and services, can now go on the Internet to connect to suppliers, and lower its overall costs.
The savings can be dramatic. A part that costs General Motors $200 to order, for example, can be purchased for only a few dollars. The few dollars is the cost of the part after negotiating. The $200 would include the time and expense to hire a person for the position of contract negotiator; also there are office expenses, wages, commissions, employment taxes, benefits, the cost of phone calls, and other items when a person is hired to do the job.
As a consequence, General Motors and Ford are building Internet sites that are linked to suppliers; this allows Ford, for instance, to go out into the marketplace and, because of its Internet connectivity, offer to service smaller companies. Ford will act as a middleperson for the smaller companies’ supply needs and charge the smaller companies to get them the best deals.
This supplier/customer development is a direct outgrowth of Moore’s Law; the productivity of technologically driven interfacing is increasing exponentially but the price of using that technology is decreasing.
An example of how the Internet has changed daily life can be found in how traders use their brokerage accounts. Many of us use the Internet for our personal finances by using an online broker.
You can use an online broker’s system, make a trade, and instantaneously receive a report. The broker will furnish full statements. When you sell (or buy to cover a short position) the statement will include the trade details and also your cost basis so that tax records will be complete. An online broker charges about $14 to $25 a trade, less than it costs to trade through a full-service broker who probably does not offer these reporting details.
The service is so complete and the cost so low that even if there is a broker downstairs from your office, if your broker doesn’t have online trading you will probably leave that broker. The day of going downstairs, even if your broker is in your building, and "visiting" with your broker is pretty well gone. Because people are so busy, it takes too much time, so you click and the trade is done. It is hard to quantify how much this saves in terms of money.
Because of the Internet, all brokers have become much the same: brokerage trades now are a commodity, a transaction to be done quickly and well. And online brokers do an excellent job at a far less cost than customers previously paid.
So the Internet makes people that much more productive with their time; this is the way that technology is affecting companies like Ford and General Motors similarly.
All sorts of companies are using the Internet for very big capital transactions. For instance, on the Web is a company dealing in railcars. Basically a middleperson, the company offers railcars for lease or the company will lease railcars from suppliers. Now, railcars are seriously large items, and they are being traded on the Internet.
Even in large items the supplier or user can get a better response on the Internet than dealing in the old way. The old way would take a lot of time and expense to determine what buyers and sellers are looking for at any given time. It’s hard or impossible to find a wider audience than the Internet for supplier and user to interface globally, and shopping on the Internet has very low cost.
The New Highway System
The U.S. economy, the most accessible market in the world, is very much involved in the world economy via the Internet; this makes trade opportunities boundless.
One of the reasons that Internet trade has grown explosively is that the start-up costs for a company to link up with the Internet are low, which is a result of technological advances. Internet users are just starting to see how these advances are affecting everyday life. And this technological revolution can be measured in real dollars. Just as you can now trade through an online broker cheaper and better than before, so can companies like General Motors and Ford and the railcar trader use this technology.
When planning a business strategy, the technology component is showing up in about every company’s plans. The reality is that businesses in our present economy have to leverage through technology. In the prior scenario, for example, General Motors let go of hundreds of sourcing agents and replaced them with a Web site and a few technicians. In fact, the whole exercise was so successful that in February 2000 General Motors, Ford, and Chrysler announced plans to set up the world’s largest online marketplace for use by the auto industry. The site would auction off parts, at which the companies would buy the $300 billion of goods they purchase each year.
Demand is worldwide, with all sectors of the globe participating. Gartner Group, a well-known consulting firm, estimates that Europe’s B2B Internet trade will soar over the next several years. According to Gartner, the B2B European e-commerce was about $31.8 billion in 1999; it expects this to grow to over $2.3 trillion by 2004. To accomplish this, Europe’s growth rate in this area would outstrip even the United States. Some of the biggest European companies are getting involved in B2B, including BMW, British Telecom, KLM, and Swissair.
The Internet could be thought of as today’s highway system. When a new system comes along, people try to use it to expand commerce. Years ago, the railroad was built, and that system had an explosive impact on that era’s economy. Today, the Internet is facilitating the development of a new world of e-commerce.
If a business does not use that technology, the business cannot lower its cost on a regular basis, but its competition will. A business not using the Internet will have to do more work at higher costs. That will be a problem, especially because technology will continue to grow. The competition will be improving its operation while saving costs; the business not using the Internet will fall further behind.
BACKGROUND FOR THE NASDAQ EXPLOSION
The brokerage industry went from fixed commissions to negotiated commissions on May 1, 1975. It was thought then by Wall Street that this move would destroy the market. The commissions would be negotiated down, it was feared, making it difficult for brokers to make a living. This fear went unfounded. The market exploded in volume, going from about 20 million shares a day to its present 1 billion shares a day on the NYSE. From an insignificant amount, Nasdaq grew to about 1.5 billion shares a day.
Competitive commissions made a difference for Nasdaq. Nasdaq could now compete with the then dominant market, the NYSE. Also the Nasdaq trading structure, having competitive dealers negotiating with each other regarding prices, lends itself to a negotiated commission world. The Nasdaq system is a sort of "computer-matching orders" system. If it didn’t exist today, it would probably have to have been created.
The next event to impact Nasdaq was in 1984. In that year the SEC granted Nasdaq exemption from the "blue-sky laws." Blue-sky laws are regulations passed by various states to protect investors. These laws require sellers of securities to register said securities, disclosing financial details so that buyers can be fully informed. Before 1984, only the ASE and the NYSE were exempt from these laws. Not being exempt was a problem for Nasdaq. Nasdaq had to go through a whole extra procedure to offer shares for sale on an IPO or secondary offering; this extra procedure took time and necessitated additional costs.
Partly as a result of rule changes, Nasdaq has grown, and in 1994 passed the NYSE in annual share volume. In 1999, Nasdaq passed the NYSE in dollar volume. In fact, Nasdaq accounted for 54 percent of the dollar volume and 56 percent of the share volume of the domestic equity trades in the United States.
As another sign of growth, 2 years ago Nasdaq listed companies that comprised about 18 percent of the market cap of the U.S. economy; today that number is 30 percent.
Explosive Growth In The Size Of The Nasdaq
The stocks on Nasdaq which receive much attention from both traders and investors are the new-economy tech stocks, issues such as technology, biotechnology, semiconductors, computer software, the Internet, and those involved in e-commerce, telecommunications, and some health-care stocks. Many of these companies are on Nasdaq because the companies had their IPOs on Nasdaq and, rather than taking the traditional route of going on to the NYSE when they got large, they stayed in the Nasdaq system.
This factor has allowed Nasdaq to develop into a legitimate national stock market. From a competitive standpoint, Nasdaq must have features to compel companies to stay with it rather than leave for another exchange. Nasdaq must continue to attract as many IPOs as possible. The advent of the Internet has dramatically helped Nasdaq.
The architecture of the Nasdaq trading system is identical to the architecture of the World Wide Web. In a technical waythe manner in which traders are hooked together by computers, forming a Web of competing traders and market makersNasdaq resembles the Web. Or, put another way, Nasdaq could be considered the largest intranet in the world. Nasdaq is very innovative and just beginning to put its electronic trading skin around the corners of the world.
Nonstop World Trading
Nasdaq is spreading over the globe. Nasdaq started Nasdaq Japan, which is a sort of clone of the U.S. Nasdaq system and Nasdaq Europe. It formed an alliance with Hong Kong that includes dual listings (listing stocks on more than one major exchangeas an example, a company could be listed on the Hang Seng, the major Hong Kong market, and also the Hong Kong Nasdaq market). Nasdaq is speaking with officials from other countries, such as Australia, regarding setting up a Nasdaq market.
These developments are leading to 24-hour-a-day trading in Nasdaq markets around the world and trading in the regular trading hours in each country. This arrangement will allow Nasdaq to essentially pass the "book." A book is a record kept by a specialist of buy and sell orders; specialists once kept a notebook for these purposes. The specialist is not a part of the Nasdaq system, and the notebook has mostly become electronic and open, but the expression lingers on.
An example of what Nasdaq envisions follows: One day there could be trading in Japan; as Japan’s morning turns into late afternoon and the trading day expires, trading would start on the Nasdaq market in the morning in Europe; and as in Europe the morning turns into afternoon, trading would start on Nasdaq in the United States.
This development will allow the Nasdaq market to not be open 24-hours a day in any one country. The Nasdaq market will be trading in a country during that country’s regular market hours. An investor or trader could trade in those Nasdaq markets around the world. For some markets a trader would have to get up very early or stay up very late at night to trade, however.
Money Flows Into The Tech Sector
The large tech and Internet stocks have grown in sales and earnings and market price. Some investment professionals such as banks, mutual funds, and money managers have shunned the group, saying that the group is too speculative. The professionals not invested in the group over the last few years have not had nearly the returns that they could have. The tech and Internet and other new economy stocks have proved to be stellar market performers, leaving most other industry sectors behind. For the first several years of this bull market, the institutions could get away with staying in value stocks. But as the tech stocks continued strong, the institutions have been increasingly under pressure for higher performance.
As a result, many investors and traders and investment professionals took money out of value market sectors, nicknamed the "bricks-and-mortar" sectors, and put funds into the stocks of the new economy. The beneficiary of this shift was mostly the larger tech, Nasdaq-type stocks. That money shift pushed the prices of tech stocks even higher.
At the other end of the market, the small-cap and mid-cap stocks were ignored; later these stocks picked up volume and appreciated. The attractive valuations of the smaller companies in comparison to the larger companies have attracted institutional and retail investors and traders. This development is reflected in the performance of the different markets: the Nasdaq indexes have risen sharply over the last few years, even though these indexes have suffered setbacks from time to time.
Another indicator of tech-stock influence is that the DJIA added two Nasdaq stocks; this is the first time a Nasdaq stock was added to this benchmark. There is speculation that because these two companies, Microsoft and Intel, were added to the DJIA, they may list on the NYSE. That however doesn’t seem likely. But one trend will probably continue: more companies from Nasdaq will be added to the DJIA.
The Importance Of E-Commerce
The bricks-and-mortar companies are beginning to see that e-commerce is important. The major companies have begun spinning off dot-com companies. Many of these dot-com companies track subsidiaries of the major companies. As these dot-com companies are spun off, many are listed on Nasdaq, even if the parent is listed on the NYSE.
For instance, Barnes&Noble.com was recently listed on Nasdaq, as well as American Greetings.com. Both of these companies are spin-offs from parent companies that are listed on the NYSE. There will probably be more dot-com companies, adding to Nasdaq’s explosive growth.
THE NYSE ADVANCE/DECLINE LINE
The risk of the Nasdaq market has caused dislocations in some of the old market measurement tools. One of those tools is the NYSE Advance/Decline line. The NYSE Advance/Decline line (A/D line) is a measurement that shows the number of stocks advancing and number declining. All the stocks listed on the NYSE are used in the calculation. There is no market capitalization or other factor: the statistics merely show the number of stocks going up, and those going down. If more stocks advance than decline, the A/D line is considered bullish; more declining stocks than advancing signify a bearish trend. This is one of the oldest and most closely watched of the market indicators, going back about 100 years. Often the A/D line is calculated on a 30-day average or 45-day average, as a means to measure the undistorted market direction. Many traders buy and sell according to the direction of the market as predicted by this indicator.
There are times when the indicator hasn’t worked very well. The Nasdaq market would be climbing, yet the A/D line shows overall NYSE market deterioration. Market savants have offered up reasons why.
They note the fact that 25 percent of the issues on the NYSE are preferred stocks, not common stocks. Preferred stocks tend to act more like bonds than stocks, reacting more to interest rates than any other factor. Therefore, if interest rates change dramatically during the day, the preferreds will react, skewing the A/D line. For example, the bond market can go down and the stock market up, so followers of the A/D will not receive a pure equity read.
Another problem with the A/D line is that the NYSE doesn’t have the wide market capitalization superiority to Nasdaq than it previously had. Therefore, the A/D line does not conclusively represent the U.S. stock markets.
THE NYSE RULE 500 AND ITS IMPLICATIONS
Another change this is affecting the NYSE and Nasdaq relationship is the loosening of the NYSE Rule 500. The NYSE had Rule 500 since the 1930s, and it was recently modified. Until this modification, the rule specified that a company listed on the exchange had to go through certain procedures to voluntarily delist from the NYSE. The delisting company was required to conduct a vote of the shareholders; two-thirds of the voting shareholders would have to vote to delist; if 10 percent of the voting shareholders objected, the company could not delist.
Many large companies, such as Coca-Cola or IBM, that had listed before Nasdaq came into prominence, had no choice but to list on the NYSE; there was no other major market on which to list. Then after Nasdaq became a true national market, the listed companies were faced with a delisting process if they wanted to leave the NYSE.
Conversely, there are no requirements to leave Nasdaq. A Nasdaq company can send the exchange a letter stating that it was leaving, and it goes. Nasdaq has a history of being an inclusive market, including any company that meets its requirements. Nasdaq believes that it is a service organization, providing a place for companies to have their stock traded; if a company doesn’t want that service, that company is free to move.
The NYSE procedures resemble more of an exclusive club. To trade on the floor of the NYSE, one has to purchase a "seat." Not with Nasdaq. If a member meets its requirements, she can sign up, pay a fee, and become a dealer. This lack of exclusivity of the Nasdaq, a sort of democratization of the market, lends itself very well to today’s Internet milieu.
The NYSE has loosened Rule 500. The exchange has done away with the shareholder’s vote. The rule today compels a company that wishes to delist to conduct a vote of that company’s audit committee. Once the audit committee votes for delisting, then the board must vote. If the board approves delisting, the company must write the top 35 shareholders and disclose its intention to delist. The 35 shareholders are given at least 20 business days to approve the delisting.
This loosening allows the NYSE to be more directly competitive with Nasdaq to list quality companies, because it is now easier for those companies to delist later if they wish.
THE LOWER-COST NASDAQ
In the bricks-and-mortar world, the more customers that are added, the more infrastructure that must be added, at least initially, which is an additional cost. This translates into initial decreasing returns to scale.
In the e-world it is the other way around in that there are increasing returns to scale: the more people there are in the network, the more people who are involved, the bigger the system gets; and there are just incremental costs to add customers. Nasdaq has an e-commerce cost model. For
Nasdaq to admit another stock for trading, it simply places its name on the screen.
On the NYSE, however, to add stocks for trading, the NYSE may have to add equipment on the exchange floor; even though orders are electronically sent to the floor, the orders are still manually executed. Also if the NYSE adds a number of stocks, a new trading location might be necessary.
There is a cost differential between the two exchanges. A large company will generally pay more to list on the NYSE than on Nasdaq.
The Word Games
Over a period of time, words have developed that favor the NYSE trading system. The use of semantics emphasizes the exclusivity of the NYSE. Not that stocks can’t and don’t go down, no matter how exclusive the exchange that the stocks are traded on.
One such example: the NYSE uses the term "specialist," which is the one person who trades a designated stock. The term is an invention of the NYSE; in legal filings this person is labeled "designated dealer." In comparison, Nasdaq is a multiple dealer market; the term dealer seems inferior to specialist. Dealer conjures up visions of used-car dealers or a dealer in a casinonot that these are not honorable professions, just that specialist sound more, well, special, similar to having a doctor’s specialty.
Another term that seems prejudicial is "over the counter," and how this term compares to "listed." Over the counter sounds akin to under the countera bit suspect. But these terms are rather old, and as we go into the Internet age, we will see the vocabulary change. The verbal comparisons between the two exchanges should become less meaningful as the terms die out over time.