Investors looking for the bottom of the bear market can ponder economic reports. They can watch trends in stock prices and other technical market patterns. They can observe tea leaves.
Another place to look is inside the stock market itself.
“Larger firms are making markets in fewer and fewer stocks,” said Michael Maloney, co-manager of the Chicago-based Skyline Special Equities Fund.
Amid the essentially flat-line performance of major stock indexes in the last 12 months, the willingness of Wall Street firms to perform their role as buyers and sellers of securities has dried up.
“People forget that it takes two sides to make a trade,” said Eugene Noser, president of Abel/Noser Corp. in New York, which provides trading services and trading cost analysis to institutional investors.
As trading languishes, brokerages and stock-dealer firms are churning their own accounts, just to create transaction volume and the illusion of activity.
The New York Stock Exchange disclosed Thursday it was investigating the trading practices of NYSE specialist firms, which make markets in NYSE-listed stocks.
The Wall Street Journal on Thursday reported allegations that specialist firms are “front-running” their customers–buying and selling shares ahead of client orders. The allegations couldn’t come at a worse time for Wall Street, which is trying to restore investor confidence after a series of historic scandals at corporations that issue stock.
Economic pressures on the firms that make up the stock market are evident in NYSE statistics. The number of companies listed on the NYSE has remained stable over the last year, at about 2,800. The number of common and preferred shares listed has increased slightly, to 351 billion from 343 billion 12 months ago.
But signs of life on the NYSE trading floor have dimmed.
– Average daily share volume of trading is down from last year’s pace. If the pattern holds, it would be the first year-over-year decline since 1973-74.
– The average size of a trade sold on the NYSE has dropped to 525 shares in the first three months of 2003 from 666 last year.
– The percentage of NYSE volume attributed to so-called program trading–computer-driven strategies typically designed to capture quick trading profits–has jumped to 40 percent from 30 percent last year.
Noser estimates that hedge funds, which also pursue short-term strategies, represent an additional 25 percent of NYSE trading, up from 10 percent last year.
Such trading attempts to skim quick profits from daily market volatility, not to invest for the long term.
Last week, LeBranche & Co., the biggest specialist operation on the NYSE, said first-quarter profits dropped 80 percent from the year-ago first quarter.
Trading conditions
Chief Executive Officer Michael LaBranche said in a conference call announcing the results that “a substantial decline in favorable trading conditions” began last December.
On typical days, a rush to buy or sell in the first hour of trading was followed by “inert” markets for the rest of the day, LaBranche said. Wall Street now faces the seasonally slow late spring and summer months, he added.
The ability of a stock to trade easily and cheaply does not directly affect the value of the company it represents. Company fundamentals, such as sales, profits, cash generation and the market share of the business, help determine a stock’s liquidity, not the other way around.
But with many investors sour on stocks generally and war news dominating investor attention, the internal dynamics of the market play a greater role in investment results.
Investors in a company with subpar share turnover are less likely to be rewarded for taking the risk inherent in the stock.
Constrained trading threatens many top-rated stock mutual funds that in recent years enjoyed a flood of cash from eager investors.
In many cases, managers simply used the cash to buy more shares of the same companies that had performed well for them in the past. As a result, many funds now own too much of their best companies. The fund’s diversification suffers, trading costs rise, and the riskiness of the fund increases.
Check your fund’s reports. If it owns 4 or 5 percent or more of individual companies, especially small companies, the fund manager will face a liquidity problem if the fortunes of the companies deteriorate.
“There is a limit to the amount of assets you can manage,” said Maloney. The Skyline Special Equities Fund has $1.2 billion and probably would close if it reached $2 billion, he said.
The alternatives to owning a greater proportion of companies are owning more companies and owning bigger companies. Neither of these steps may meet the investment objectives of the fund, Maloney said.
Another symptom of tight markets is the lack of “currency” in the form of stock of large companies available to acquire small companies, said Michael Crowe, a manager of micro-cap stocks for Chicago-based Mesirow Financial.
Many investors in small companies are rewarded when a bigger company acquires a smaller company in an exchange of stock.
“That currency heightened market liquidity,” Crowe said. Without it, “some of these companies are so frustrated with the low valuations, you will see more companies going private.”
Without adequate interest from market dealers and specialists, many companies are virtually private anyway, said Noser.
“By the time you got to the bottom in 1974, there were thousands of companies that had gone public but had no marketmakers,” he said.
Currently, he said, just 850 of the 8,000 stocks traded account for 90 percent of the dollars that change hands daily.
For professional investors, tight markets require more time to establish the position they desire in a stock.
“If you demand urgency, then somebody is going to have to be rewarded for taking the risks associated with taking a position in the stock and finding the other side,” said Robert Russel, chief executive of New York-based Investment Technology Group, which provides trading services and analysts for institutional investors.
Gap widens
The risks to a dealer of holding a less liquid stock explain why the gap between dealer bids to buy and dealer bids to sell a given stock widens in times of market stress.
“The cost of going to the market and asking for liquidity is going up all the time,” Russel said. “If you were a portfolio manager and you said, `I think I’ll sell these shares at $25 right now,’ and by the time you got the trade off the price was $23.50, it might turn out that was a really good job.
“But in terms of your analysis, you weren’t factoring in that type of slippage. In today’s market, that kind of slippage happens more and more frequently.”
Ironically, the recent narrow trading range for most stocks prevents a company’s price from running away from the investor’s target price.
The solution to tight markets and higher transaction costs in trading stocks is more optimism about stocks.
“We want to own stocks at the best prices, but we want to own stocks,” said Maloney.
Meanwhile, trading costs play a major part in bottom-line returns to investors.
