Back In The Good Old Days
Yes, this is another of those “back in the good old days, when men were men” kind of stories from the old guy in the back. We have to report these to you just because it helps give some perspective on what is going on today and how that differs from how things used to be.
We have often noted that daily volume on the New York Stock Exchange used to be about 10 million shares back in the late 70s. Today, daily volume on the exchange is more akin to 2 billion (yes, with a ‘b’) shares a day. But, back in the Pleistocene we used to trade only about 0.1% of the outstanding shares in a day. Modern volume is more like 0.5% of outstanding shares each and every day. But, sometimes we are reminded of just how this relates to the world around us. It used to take about four years to trade enough shares to equate to trading every share of outstanding stock. Today, we do that in less than a year. (NASDAQ volume has erupted even more dramatically, but we didn’t monitor NASDAQ volume in the old days, just the NYSE.)
Where are all the long-term investors? In the old days, it could take time to build a position in a stock. You kept your trades at a modest share of daily volume in the company both so you wouldn’t call attention to your purchases, but also so you wouldn’t impact the price. Today, you call up your broker and they can create shares for you by writing options or shorting shares to you that don’t even exist (naked shorts). “You want it, you got it” is the motto. It is not at all uncommon for a company to trade more shares than they have in a single day. Obviously, there is some naked trading going on (selling shares that don’t belong to you and are not in your possession.)
So, it comes as little surprise that some of the country’s leading companies trade several percent of their outstanding stock every day. We think that were we CEO of one of these companies, we’d try everything in our power to reduce trading in our shares, keeping them out of the hands of speculators, hedge funds and brokerage house traders.
One of the complaints about the health of this bull market is that the volume isn’t what it ‘should’ be. For the last 30 years that we can attest to, volume has been going up cyclically. Each and every cycle has seen more volume than the one before. This is not a trend we view as necessarily bullish or healthy, speculative yes, but not necessarily bullish. Less speculation in this cycle would be a major trend breaker.
Individual companies grow their share base in several ways. Stock splits and stock dividends are an obvious source of shares. Giving stock options to employees, managers, directors and others is another way to create more shares. Secondary offerings are a third way to increase the share count, while also gathering more capital. Each of these contributes to the stock of shares that can be traded. Probably the biggest source of new shares to trade is companies going public. Again, back in the Jurassic, there were only a little more than 1,000 companies listed on the New York Stock Exchange and maybe another 3,000 trading over-the-counter as we used to call it. Today, the NYSE is home to some 3,500 companies, the NASDAQ has another 3,000 in the national market system and there are still over 4,000 over the counter or pink sheet items, over 10,000 companies versus 4,000.
On the other side of the ledger, public companies going private and stock buy-backs are reducing the overall float in shares. Obviously, this side of the equation has been falling down on the job.
Another important element in the frantic trading that goes on is the cost. Even we weren’t around to witness the May Day change in commission charges. It was May 1, 1974 that all commissions were deemed to be negotiable, no more fixed commission charges. Pre-May Day, it could cost several dollars to trade a single share of a high ticket stock. Say $3 to buy one share of IBM, trading at $280 a share. But, since most major companies actually try to keep their share prices between $20 and $60, typical brokerage commissions used to be between $0.30 and $0.80 a share. After May Day, commissions were negotiated down so that bigger trades paid less per-share than smaller trades. An institutional trader could get a discount of say 60% or 80%-off the pre-May Day rates on a trade of a couple thousand shares, or maybe 40%-off a trade of a few hundred shares.
Then, along came discount brokers, Charles Schwab and his ilk, that charged fixed commission rates of a few cents a share. The cost of trading had come way down, but so too had the cost of processing the trades. The direct order trading system (or DOT) on the NYSE meant that any trade in the system would go the next time the specialist traded that stock and at the same price. So, Schwab would load up the DOT with small trades that got the same price negotiated by some pension fund, slick. It took institutions about a millisecond to demand similar treatment from institutionally oriented brokers. This is also about the time a lot of brokerage firms started disappearing.
Today, hedge funds trade essentially for free. The algorithmic trading operations (better known as index arbitrageurs) trade essentially for free. Billions of shares whipping around Wall Street (estimated to be between half and two-thirds of the daily volume) in the blink of an eye and no one is making any money off the trade. Well, that’s not exactly true. There is still the spread. The spread is the difference between the bid price (the one some broker will pay you if you decide to sell your shares) and the asked price (the price to buy shares from the same broker). This bid/asked spread can be anywhere from a penny or two on very liquid stocks to a couple of bucks on seldom traded items. The broker still can make money buying from one customer at the bid and selling to another at the asked. Even hedge funds swallow the bid/asked spread, but they are very aware of it and try to keep that to a minimum.
One solution that the SEC and Fed ought to look at to fix what ails Wall Street and make it a fairer game for small investors is to reinstitute commission schedules. For small investors there has never been a time (except right after opening an E-Trade account) to get free trades on stocks. So long as the commission was small enough to not materially impact small traders, then hitting the hedgies and arbs shouldn’t bother anyone in the regulatory arena. But, the little guy doesn’t have a lobbyist arguing about price discovery of market efficiency. Maybe part of that fixed commission could go to hire a guy like that?
Crisis of the Week
Like last week’s crisis, this week we are looking at a trend that we think is just awful and could become a crisis one of these days. Today’s topic is what we deem the ‘Spitzerisation of Regulation’ (how about that for inventing new terms?). Eliot Spitzer was the Attorney General of the State of New York back in the latter 90’s and early 00’s. He went on to the governorship and thence to disgrace but that has nothing to do with what we are talking about here. While AG, Spitzer won a series of headline-grabbing settlements from Wall Street, insurance companies, money management firms and others by essentially starting well-publicized civil or criminal investigations and then opening settlement talks.
We see the same thing happening today in a couple of areas. First, the Goldman Sachs ‘Abacus’ suit and related mortgage-backed securities investigations on Wall Street. The Justice Department has opened many investigations recently into politically-charged areas. We are waiting to see if any of these investigations actually yield any indictments or convictions or for that matter any misbehavior. There is some doubt that Wall Street actually did anything illegal in sponsoring mortgage-backed securities, even if later many of those securities went bust and investors lost money. There may be a good case for unethical behavior, but unethical isn’t the same as illegal. Our guess is that no one will take these investigations all the way to trial. Most of the firms involved here will not acknowledge any guilt, but pay a big fine regardless. This is just what Spitzer used to do and now it seems to be Federal policy to use the Justice Department to bully people.
The newest version of this is the announcement of a criminal probe into the British Petroleum Deepwater Horizon oil spill. For criminal charges to follow, some criminal act would have to have been perpetrated by British Petroleum either before, during or after the disaster on the drilling platform. Since British Petroleum is the largest victim of this disaster, we find it hard to believe that they were intentionally negligent or acted in a criminal manner to cause this disaster. Can you imagine the board meeting where the directors all sat around and agreed to spend tens of millions of dollars on a well just to spew crude oil out into the gulf? The company has accepted responsibility for the spill and for damages to property caused by the spill. We’d guess they are doing all they can to limit the damage to themselves and to others.
Since we are not lawyers, only CFAs, we can not opine on the justification for any investigation or for any potential damages to British Petroleum from these charges. All we can do is look at this and the trend and make an assessment that the Justice Department seems to be Spitzerizing people at a pretty good clip these days.
The Employment report was awful. While Wall Street was expecting some 540,000 new jobs in May, they only got 431,000 new jobs. The basis for all these expectations was hiring for the census, which added 411,000 temporary workers to get through the house to house follow-up to the snail-mail census. So, while we were expecting over 100,000 private sector jobs, we only got 20,000, ouch! At the same time, the data for March and April were revised downward, so we didn’t get as many jobs created in that time frame as we thought. However, the unemployment rate dropped from 9.9% to 9.7%, temporary census workers are employed for now.
There was a rise in hours worked and in hourly pay, hiring in manufacturing and transportation. But, state and local governments lost jobs as did construction, finance, retail and real estate.
All in all this was a lousy report, no wonder the market sold off on Friday. We are reminded of the complaints by the media that the Bush economic team used to fudge the numbers on the economy to make things look better. If that were true, wouldn’t it be in the current administration’s best interest to make these numbers look worse? There is a ‘jobs bill’ in the Congress (the opposite of progress) as we speak. A solid employment report would reduce if not eliminate the need for yet another worthless jobs program. Not accusing anyone of anything, but it sure seems awfully convenient that we have an unexpectedly weak jobs number just as we’re debating spending even more gobs of money to generate jobs in the economy.
Besides (and this is an old rant so if you want to skip ahead, that’s alright) when the statisticians go home at night, they see the same news programs as the rest of us. They tend to read the same newspapers and hear the same radio reports. They ‘know’ what they are supposed to find in the numbers and so not surprisingly, that is often what they tend to find. This initial report will get revised twice before it goes into the history books (and even then there are benchmark revisions that rewrite history from time to time) and those revisions may tell a different story. Last year in November, we started off with an employment report that showed a decline of 11,000 jobs but upon revision the number became a gain of 11,000 jobs. So these guys sometimes can’t even get the direction right, let along the magnitude.
The ISM manufacturing index showed continued strong data with a report of 59.7% versus the 60.4% from April. The pace at 59% is still very good for the future of manufacturers in the US. As we have explained before, in this diffusion index any value above 50% represents expansion in manufacturing. 59% is well above 50%. The reports from manufacturers weren’t quite as lopsided as the month before, but very positive. Of the sub-indexes, employment was at 59.8% showing strong hiring in manufacturing; new orders were at 65.7% arguing that future data will continue to be good; prices paid was down to 77.5% but still very high and possibly inflationary.
The ISM services index (technically non-manufacturing) continued to show strong results. For the third month in a row the index was at 55.4%, comfortably above the 50% level indicating expansion in service industries. Most service industries recorded expansion with 16 of the 18 service industries having indexes above 50%.
Car sales edged higher in May from April, but the pace at 11.6 million units is still a far cry from the nearly 16 million cars we were buying just a couple of years ago. We may not get fully back to the higher rates for several more years, but progress from today’s modest level of sales is almost a guarantee. Remember that the US junks about 14 million cars each year, so simply replacing those will require a higher sales pace.
Productivity for the first quarter was revised lower by the Commerce Department. The original report was for 3.6% productivity and the new, improved number is 2.8%. Evidently the original estimate of hours worked in the economy was too low, so roughly the same amount of stuff produced by more people left lower productivity as the plug figure.
Really, it wasn’t half as bad as you might guess at first glance. The big rally on Wednesday, which if you recall was almost as big as the drop on Friday, gave us a better spot from which to start the decline. Also, recall that we did that in four days as last Monday was a holiday here in the US and also in Britain, but nowhere else.
The declines of roughly 2% in large cap for the week weren’t all that bad compared to the shift in sentiment that you feel when talking to folks or listening to folks talk about it. It seems that we are far more concerned about closing below 10,000 on the Dow this time than the last time two weeks ago. This is classic bottoming behavior as we get geometrically more cautious on arithmetically lower lows. This awakes the contrarian in us. Also, the generally high level of anxiety makes us think that we are close to the low. It might take some time to get this bottom built, but we are at least building.
Foreign stocks were pummeled much worse than US stocks. Well, really European stocks were pummeled much worse than US stocks. Japan actually had a gain last week (which has since been wiped-out, but let’s not quibble right now.) The major European bourses were down pretty much across the board. All because (or mostly because) Hungary has joined the PIIGS, making them the PHIIGS now. The Hungarians aren’t covered by the Euro, so they aren’t in anywhere near the tough spot that Greece is, but were it not for Greece, their route out of this mess would be a lot easier. They can debase the florint, they can flood Hungary with money, they can do more stuff, but it is still Hungary. They need to export to the rest of Europe and that isn’t going to be easy. They still need to raise revenues and cut spending and that isn’t going to be easy, either.
Emerging markets couldn’t quite shrug-off the declines, but they were hurt a lot less. The major Asian emerging markets did reasonably well, except China. Latin America was down but not badly.
Bond markets did well as the fit hit the shan, so to speak. US Treasuries gained in price and saw their yields drop as many investors sought out the temporary safe haven. This bled over into many other high grade parts of the market with gains in high grade corporates, mortgages and munis. High yield bonds suffered along with the stock market.
We saw the same safe haven trade in German bunds and British Gilts. Swiss interest rates also dropped. Japan saw its rates rise with the modest political drama there as the Prime Minister had to step down, but was replaced without having to resort to a general election.
Real estate securities were generally lower last week. REITs followed financial shares lower at a leveraged pace. The REIT index fell almost 6%. Foreign REITs also dropped, just not as fast.
Commodities were generally lower with crude oil falling (though coming off its lows by week-end), precious metals were down somewhat with many industrial metals dropping.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.