THE CURMUDGEON CHRONICLE - #257

THE CURMUDGEON CHRONICLE ©

AN IRREVERENT VIEW


Time Line: March 6, 2009
Date Line: Flemington New Jersey

Suppose you were asked by an eleven year old to explain the stock market. Since no one can escape hearing about falling prices and doomsday predictions, that question may arise when you see your nephew, niece or grandchild.

You could be flip, and tell the story of the man in a poker game who was warned that the game was rigged and replied, “I know, but it’s the only game in town.” You could read the child to sleep with excerpts from the writings of Alan Greenspan. You could be witty and say it is like a sheep farm where the shepherds are all hungry tigers, or you could tell the truth and say that the stock market is only partially explicable, and in hindsight at that.

Everyone should have known in 1932 that GE and Con Ed would be huge winners; everyone should have known that the dot com bubble was a shell game, and anyone could have foreseen that securitized mortgages were the road to ruin. Everyone knew that deals too good to be true are usually not true.

It is all quite clear in hindsight.

Unfortunately we don’t have the benefit of hindsight when Main Street demands payment for groceries and medicine, (let alone that house, auto, or yacht) before delivery to us. We don’t think about the tigers and the con men: we rely on the police and the law to take care of us. However, like the market, cops enforce the laws after a crime has taken place.

I wrote that short selling should have a very limited function in an orderly market. Short selling is a gambling device that can have predictable results if the bankroll is big enough; its saving grace is that there are risks to the gambler. On the other hand, one of the Tigers that shepherds us and our investments, can feast without risk, and does so regularly and at will.

The “Specialist” on a Securities or Commodities Exchange has the responsibility of maintaining an orderly market in a stock assigned to it. In that function the Specialist knows the demand for, and supply of the stocks in his “book” assigned the Exchange. The Specialist seeing both buy and sell orders, matches them and facilitates trades. To maintain an “orderly market” the Specialist must always offer to buy or sell at least a minimum number of shares of a stock in his book. That undertaking earns a Specialist fees and it profits further from trading for its own account in the stocks in its “book”.

You don’t have to be a genius to figure out how to skin that cat; in the trade it is called “trading ahead” or “front riding”. It is simple; the Specialist buys or sells for its own account to take advantage of the pricing of its own inventory, before matching orders for the public. That is against the law.

The SEC has just settled two such complaints, one dating from 1999 to 2005. The total paid by the Specialists came to about $70 million. In the other case2004 five of those firms paid $250 million to settle charges for similar alleged activities on the NYSE. These were civil complaints; the penalties represent a fraction of the gains made by the firms over the years.

The Specialists continue in business and continue to shear the public like sheep. The amount in any one transaction may not be large enough to be noticed, but in total it can amount to enough to permit eight and nine figure settlements to be paid without a whimper.

I continue to buy and sell securities; like the man said, “I know the game is rigged, but it is the only game in town.”

Howard Stamer