ContraryInvestor - Market Observations

MARKET OBSERVATIONS

THE EXECUTIONER

MARKET OBSERVATIONS - 2/24

MyDiscountBroker.Bomb?..."The web has democratized investing. It's created a level playing field between the professionals and the common man (of course we mean person) investor. Information is at our fingertips. And the best part of all is that brokerage commissions have permanently decreased the cost of investing for the average investor." Oh, really?

We thought we'd spend a little time today discussing what may be a bit of a misperception in the current environment - that discount commissions have actually lowered the "cost" of trading for today's investors. We have no doubt that in the long run this will be true. As with all things "web", margins and profits are forced to commoditized levels over time. The "web" will ultimately force the cost of brokered transactions of any type to that price level demanded by the lowest cost provider in any particular industry. Advances in technology that lower the cost of providing the brokering action only hasten the process of price destruction. That's price destruction both for the item demanded and the price of the brokering activity itself. Simple economics. (In fact, the only people who don't seem to "get it", are those still long etailing stocks and those believing the B2B sites will be able to maintain suitable margins against massive and continuous, technology induced competition.) We believe that a number of factors have come together in the current environment whereby the actual costs of trading have gone up, despite lowered commission structures.

VOLATILITY

You don't need us to tell you that volatility has increased dramatically over the last few years. In the last seven weeks alone, if memory serves us, we have witnessed something like the 10 greatest intra-day trading moves in NASDAQ history. Stocks respond with ferocity to even the slightest news release, earnings statement, rumor, Central Banker's comments, etc.

From almost an Economics 101 perspective, "elasticity of demand" is playing out as the birth of electronic trading evolves. Declining costs of trading have naturally attracted more trading activity. Simple "prices down, volume up" concept. In this case, the volume up part may be the key. We believe that the vehicle of low cost trading has increased volatility as the sheer number of traders active at any one time has increased significantly. Coincident with the sheer number of traders rising is the phenomenon of instantaneous access to information. The same information. Don't get us wrong. Long run this creates a more price efficient marketplace. But, for many traders new to "the game", emotions run high. They all rush for the entry or exit door at the same time. Hence the extreme price volatility. Clearly the above chart speaks to the fact that volatility has increased markedly over this decade. We attribute this directly to many traders acting upon like information simultaneously at low trading costs on a per share basis.

The absolute characterization of price volatility is that prices experience "gapping" effects more often than not in today's environment. The simplistic example is an IPO. We've heard too many unsophisticated investors wonder why when an IPO is "priced at" $20 and "goes to" $80, they couldn't buy at $30, or $40, or $50. We all know that the answer is that the first trade occurred at $80. It gapped open plain and simple. In like manner, too many stocks these days experience instantaneous price drops of 30-50% at the open after releasing bad earnings, negative comments, etc. prior to the opening bell. Prices often gap to new levels as opposed to ascend or descend in somewhat of an orderly fashion. So what if you are paying $7 for the trade when the stock gaps down 50% and you are filled on a market order? Discount commissions do not cause volatility directly, it's just that cheap commissions have allowed swelling amounts of investors of all sophistication levels to play the game on a simultaneous basis with very little friction .

LIQUIDITY

It's no secret that the advent of cheap electronic trading has closed the spreads on many a NASDAQ issue over the last few years. Moreover, it has really driven many a market maker away from the business of individual NASDAQ stock market making activity in general. Again, from a long run efficiency standpoint, closing these spreads adds to price efficiency to the benefit of all shareholders. But, the price to be paid is that broad liquidity in NASDAQ names has declined markedly. Especially in a market such as this where broad investor focus is funneled into a few handfuls of issues. It's simply a losers game for brokerage firms to risk their own capital to accommodate liquidity for a large number of issues. Let's face it, large brokerage firms will always provide a market for the stocks of their large underwriting clients, but where there is no underwriting axe to grind, why bother? After all, brokers are simply not in business to be benevolent. You know the old saying, "neither buyer nor a seller be, just a broker for a fee."

Clearly the advent of electronic trading has forced the narrowing of spreads for a good number of OTC issues, but for a significant majority, we believe the macro reduction in market making activities has increased the overall costs of trading NASDAQ issues broadly. There is no question in our minds that in this case, electronic trading is primarily responsible for a reduction in liquidity and heightened all-in trading costs. Forget the $7, or whatever the discount commission may be, the lack of liquidity can be measured in dollar differentials. We've argued many times that the explosion in mutual fund assets in this country continues to preclude the large funds from even considering small cap issues. Well, given the liquidity situation in many small NASDAQ issues, more fuel is being added to the big cap - small cap dichotomy fire. After all, for many issues there is simply no way in and no way out these days without causing significant prices moves on either side of the trade.

MOMENTUM INVESTING

Never before in our recollection of the markets has momentum investing been such an all consuming strategy. What better a testimony to the momentum discipline than the day trading sect. In today's market, day trading has become a supposedly legitimate, if not envied, profession. Unquestionably the day trading crowd could not ply their currently hallowed trade without discounted commission based electronic trading. Without this infrastructure it just would not exist. Although the institutions still carry the biggest sticks on the Street, the day trading crowd can move stocks. Sometimes it's institutional trading that will spark the day trading legions to shift in one direction or another. Sometimes it's the day traders who spark the institutional momentum players to join the party. Either way, it is simply not uncommon to see extreme imbalances or buyers or sellers at any point in time. The crowd huddles around one side of the trade. We are convinced that the momentum investing dominance of the moment has been significantly aided and abetted by electronic "retail" trading.

An offshoot of momentum style dominance is that many fundamental and value players have learned to walk away from the bid when the imbalances to the sell side swell. (In like manner, offers dry up instantaneously when a "flock" of buyers lands on the tree.) Without a doubt, this contributes to individual and macro stock price volatility. Is discounted commission electronic trading responsible for momentum myopia? Of course not, but we will admit it becomes a bit of the chicken and the egg scenario after the game has gone on for this long.

With the type of volatility we experience today, it often does not make sense for investors/traders to use GTC orders, stop loss orders, or any other type of standing orders that may be a bit out of the money. The whipsawing in prices can easily cause what in hindsight may become unwanted fills. Whether a product of the current environment or sparked by low commission electronic trading itself, $7 commissions pale in comparison to 10% daily moves in some individual stock prices.

THE ECN's (Electronic Communication Networks)

Although still in their infancy, there is no question that all-in trading costs are being effected in after hours antics. The first and most obvious statement is that we see competing networks these days. Are prices ubiquitous across these disparate entities? Of course not. What may seem reasonable execution on one ECN may prove to be a blatant rip-off compared to a time comparable execution "across town" (or maybe we should say across cyberspace).

Despite what are clear vested interests of the moment, when we step back we envision a future of 24/7 continuous electronic trading in a single format structure. One big market. Not price inefficient decentralized entities competing against each other for investor business. One centralized price setting/settling mechanism under a central clearing house concept. Maybe we are being too naive given the vested economic interests involved, but technology will take us there (even if it's kicking and screaming). SEC Chair Levitt has called for a "central limit-order book" to display all competing buy and sell orders simultaneously, no matter where the orders originate. We'll just have to see if anyone is listening. No matter what, that's where we are headed.

But for now, the ECN's create an environment that we believe has increased trading costs through singularly disparate pricing mechanisms. Simply put, the ECN's can act independently of each other. Again, forget the $7, does the investor get the best execution? You already know the answer is maybe, if they are lucky. Here's the latest ECN headcount: Island, Optimark, Brut, Redibook, Market XT, Primex Trading, Archipelago, Strike, Attain, Nextrade, Posit, Tradebook, Instinet and Tradepoint. Go ahead. Take your pick. As Bill Gates would say, "where do you want to go today?" None of this would be available without a low friction electronic mechanism.

We're not arguing that the advent of discounted electronic trading has "changed the world", rather we are suggesting that this mechanism has changed the texture of the current market relative to what we have seen in the past. As a result, we truly do believe that in many instances low cost electronic commissions are a misperception in terms of providing low trading costs. Trading costs should be considered from an all-in standpoint. The most important of the inputs to that equation is how prices are effected by the very mechanism acting upon them (electronic trading). Our vote is that outside of the super large and liquid big cap names, the current electronic market structure effect on individual stock price and price movement is a bigger issue than is generally perceived. To us, all-in trading costs have gone up in aggregate. We're not arguing for a return to the past. Far from it. We're just saying that these issues are something to keep in mind and be aware of in your own investing activities.

Moral Hazard or Mortal Hazard?...Moral now, mortal later. Is it moral hazard or blind, insatiable greed that is holding up the NASDAQ? (Probably both.) Each week seems to bring a new meaning to the term trading frenzy. It was only Tuesday of this week that we discussed the appearance of "certain someone's" showing up to save the day for the market. Well, we didn't have to wait too long for a replay. Once it looked like the Dow was seriously ready to crack the 10K barrier and the S&P was breaking its own Maginot Line this afternoon, the "certain someone's" showed up for a return engagement at the Levitation Room (where the only cover charge is purchasing futures). Miraculously, the Dow and the S&P came back up through critical levels with the Dow tacking on close to 200 points and the S&P almost 30 in the space of about 45 minutes. Unfortunately, the "certain someone's" left their fingerprints all over the scene of the crime - unchanged breadth throughout the entire ramp job. C'mon guys, next time don't make it soooo obvious, will ya? We still just can't comprehend how Greenspan and Company can watch what is happening with the "heart of the capital creation mechanism in America" and in good conscience keep pretending that everything's just fine. In fact, the only way we can see them allowing it to happen is simply with no conscience at all. Welcome to the new economy (where ethics can basically go to hell).