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We are going to turn our attention to the stock market. Although we normally use the singular when referring to this system, the stock market is actually a collection of markets and exchanges that compete with one another. These systems allow for the efficient trading of stocks and other securities. The stock markets are a part of a larger system that is called the capital markets. Entities such as businesses and governments come to the capital markets when they need to raise money. This money is referred to as capital, hence the term capital markets. These entities may seek to borrow money, typically through bond offerings which we will cover in detail later on. Businesses may also attempt to raise money through stock offerings where partial ownership of the corporation is sold to the public. We will see that these systems are undergoing tremendous change. And the changes are showing no sign of slowing down anytime soon.
The Primary Markets and Initial Public Offerings
The capital markets are broken into two parts, the primary market and the secondary market. The primary market is the market in which new issues of securities are sold to the public for the first time. This is called an Initial Public Offering, commonly referred to as an IPO. It is also referred to as “going public” or “taking the company public.” Most retail investors do not participate in the primary market. There is a very good reason for most prudent, long-term investors to avoid the primary market. Obviously, some IPOs eventually become large, successful companies and their stock values rise considerably. However, one year after the Initial Public Offering, the typical new stock has lost 50% of its value. Benjamin Graham, author of The Intelligent Investor, was not fond of IPOs, to put it mildly. He believed that IPO really stood for, “It’s Probably Overpriced,” “Imaginary Profits Only,” and, “Insiders Profit Opportunity.” If you desire to become a Registered Representative, the legal term for a Stockbroker, you will be required to internalize the entire IPO process before taking the Series 7 licensing exam. Hopefully, as a securities professional, you will heed Mr. Graham’s advice and not subject your clients to the vast majority of Initial Public Offerings.
Why would a corporation issue an Initial Public Offering? Why go public?” As mentioned, the corporation is attempting to raise money to start or expand their business. They may already have issued stock but need to go back to the capital markets to raise more money to help pay for ongoing business expenses. This is very typical here in San Diego, California, where there are many biotechnology startup companies that need tremendous sums of money to fund their drug development.
Another very common reason to issue stock to the public is that it is a way to gain prestige and respect within the investment and industrial communities. Once a business is large enough, it is simply expected that they will become a public corporation and sell stock. In the early 2000’s, the owners of Google were reluctant to take the company public. The boys and girls on Wall Street came a’ callin’ and showed them another more personal and profitable reason for going public. In an IPO, those who started the business usually become instant millionaires and sometimes billionaires. One example is Faceplant, ah, Fleecebook, no, Facebook. After the Facebook IPO, the California taxes for the CEO of Facebook were $1 billion. That’s $1 billion with a “b” for the California taxes alone.
This is why we call starting a business the Ultimate Investment. At the very end of our journey, we will briefly discuss becoming an entrepreneur. It’s definitely not for everyone but the rewards can be enormous. But please do remember for every Facebook, there was MySpace, Ello, Bebo, Friendster, and QuePasa. For every Google, there was Yahoo, AskJeeves, Lycos, Excite, AltaVista, and Dogpile. Capitalism breeds intense competition.
A final important reason for issuing stock and becoming a public corporation is that once a business becomes sufficiently large, it becomes very difficult for the owners to “divvy up the spoils” without going public. If you were one of the people who started GE or Coca-Cola or Walmart, how would you sell your share of the business? In fact, by keeping a business private, the owners run the risk of family dynamics negatively affecting the future success of the enterprise. One such example was In ‘n’ Out Burger. Family dysfunction and tragedy put the entire empire into question. Luckily for In ‘n’ Out Burger fans, the story has a happy ending but other companies are not always so lucky.
Corporations that issue stock to the public are under no obligation to repurchase the shares of the stock. The corporation does not have to repay the money they raised. The shareholders may or may not be able to find someone who will purchase their shares from them, especially if the enterprise fails. However, the corporation is now a public entity. As such, it now has many rights and responsibilities that private companies do not need to worry about. The corporation must file annual reports and quarterly reports with the Securities and Exchange Commission (SEC). The annual reports are called the corporation’s 10K report and the quarterly reports are referred to as the 10Q report. Part of our assignment will be to research a recent annual or quarterly report.
Another obligation of public corporations is that they must have at least one public meeting annually where shareholders can air their grievances. Unfortunately, the annual meeting does not necessarily have to be in a location that is easily accessible to shareholders. One such example was the 2005 annual meeting of Sempra Energy, the parent company of San Diego Gas and Electric. Instead of Southern California where it typically held its annual meetings, Sempra decided to hold its 2005 annual meeting in London. Although Sempra publicly stated that their goal was to, “raise Sempra’s profile with European investors and to expose directors to its European operations,” it was widely believed that they were simply running away from some local disgruntled shareholders.
The Secondary Markets: Exchanges versus Over The Counter Markets
The secondary stock market is the collection of markets and exchanges where securities are sold after they have been issued. The secondary market is much larger than the primary market. When people refer to the “stock market,” they are almost always referring to the secondary market. Secondary markets provide liquidity, an easy method for transferring ownership of securities. They also provide an efficient mechanism for pricing and valuation of securities. For example, if a lender wants to know the value of those 100 shares of Chevron you want to use as collateral for a loan, you can quickly point to the current price that Chevron shares are selling for.
The secondary market is divided into two major systems, the organized securities exchanges and the over-the-counter (OTC) markets. The securities exchanges are centralized institutions in which transactions are made in outstanding securities. The over-the-counter markets are widely scattered telecommunications networks through which transactions are made in outstanding securities and smaller IPOs. The exchanges featured face-to-face “double auction” trading while the over-the-counter markets used a quote-based system, originally communicating via telephone and then moving online. However, this is a woefully outdated comparison. Due to technology advancements, mergers, and acquisitions, the traditional differences between the two have been erased. And the changes are just gettin’ started!
Historically, all trading on the securities exchanges was done on the trading floor. Trading was conducted using a “double auction” system. Instead of the “one seller, multiple buyers” that you would see at an estate or farm auction, for example, there were “multiple sellers and multiple buyers,” all calling out prices and quantities of stocks they were buying or selling on behalf of their clients. But due to both technology & the sheer massive volume of shares traded, things have changed. Almost all of the trading is now conducted electronically. Some large trades still involve human interaction but they now consist of far less than 1% of the total number of trades. Many in the industry have declared the trading floor dead. For those interested in the history of the exchanges and the double auction process, there are numerous videos available online of brokers calling out prices and quantities, simply type “stock exchange videos historical” into YouTube or any search engine.
The New York Stock Exchange, aka NYSE, the Big Board
The largest exchange in the United States is the New York Stock Exchange, commonly referred to as the NYSE and the “Big Board.” For over 200 years, the NYSE has been the dominant exchange in the United States. Traditionally, it was responsible for over 90% of the volume of transactions on all the exchanges. There are approximately 2,400 companies traded on the Big Board worth about $23 trillion as of December 2022. About 1 billion shares trade daily.
Companies traded on the NYSE must meet stringent listing requirements. Traditionally, these companies were the largest and most prestigious. If a company fails to continue to meet the NYSE requirements, the company can be delisted. This happens when a company falls on hard times and the stock price plummets.
Many people believe that the NYSE was the first stock exchange in the United States. Actually, that distinction belongs to the Philadelphia Exchange. However, the NYSE quickly grew to be far larger than its older sibling. It was established as a members-only entity in 1792 named after their favorite meeting place, a buttonwood tree on Wall Street when Wall Street really was next to a wall in lower Manhattan.
Traditionally, change happened slowly at the NYSE. It wasn’t until 1967 that the first woman, Muriel Siebert, was admitted as a member. The first minority member, Joseph L. Searles III, was admitted in 1970. In 1991, the first minority-owned company, BET Holdings, was listed on the exchange. The next year in 1992, the exchange celebrated its 200th birthday. That year, if you had told the folks at the NYSE that the next 20 years would see far more changes than in their first 200 years, they would have thought that you were quite insane. However, you were about to prove them wrong.
By 1992, the face-to-face double auction system had already shown itself to be woefully inadequate to keep pace with sheer volume of trading. If there were any doubts, Black Monday and the Crash of 1987 put them all to rest. The NYSE began moving as quickly as possible to electronic trading. They also began a push to expand through acquisitions. In 2005, the Big Board purchased the Archipelago electronic exchange and the Pacific regional exchange. (We will discuss more about these two systems soon.) In March of 2006, they changed their business structure from a members-only partnership to a publicly traded corporation. You could now buy shares in the New York Stock Exchange! That year, they merged with the Euronext electronic exchange and aggressively started to phase out the face-to-face double auction trading in favor of exclusively trading electronically.
Here is where events start to appear similar to something out of a science fiction or fantasy movie. In 2011, Germany’s stock exchange, the Deutsche Börse AG based in Frankfurt, tried to purchase the New York Stock Exchange. The European regulators blocked the deal. Two years later, on November 13, 2013, the NYSE was acquired for $11 billion by a 13-year-old derivatives trading firm from Atlanta, the Intercontinental Exchange. This was a company that did not exist until the 21st Century!
In the historical videos, from afar, the interactions on the floor of the exchange appear to be pure chaos. People, mostly men, are scurrying about with different colored jackets. Some are standing in one place and wildly gesturing and shouting. If one were to approach a particular group, it would become clear what is happening. The people are making deals with one another. Most of the individual buying and selling are floor brokers. The floor brokers executed orders on behalf of their firm’s customers or occasionally on behalf of their firm’s own account. Some are independent brokers who provide as-needed execution services to other brokers, independent of a particular firm. The floor brokers were very worried that the NYSE’s aggressive moves to all-electronic trading meant the end of their way of life. It was not really the end; it was just a big change – from face-to-face interaction to sitting in front of a computer screen all day. Sound familiar? What other major institution is experiencing the same transition? (Hint: You are enrolled at one such institution. Education!)
Some of the professionals on the floor of the exchange had a special role. The specialists were stock exchange members who specialized in making transactions in one or more stocks. The job of the specialist was to manage the auction process. The specialist bought or sold the stock from their own inventory to provide a continuous, fair, and orderly market. If there were not enough buy orders to maintain an orderly market, the specialist was required to step up and buy. Likewise, if there were not enough sell orders, the specialist was expected to offer his or her shares for sale. The role of the specialists has essentially been squeezed out by technology and the tremendous volume of trading. They are involved in only a tiny amount of trading each day.
The specialists were replaced by “designated market makers” and “supplementary liquidity providers” in 2009. From time to time, the specialists were either praised or maligned. Suffice to say that the specialists were trying to make a profit just like everyone else. While their goal may have seemed altruistic, they made sure that when the market received benefits from their efforts, so did they.
The American Exchange, aka, the Curb, now the NYSE American Exchange
For decades, the American Stock Exchange was the distant challenger to the NYSE. The AMEX, as it was commonly called, never achieved more than 3% of the total volume of shares traded on all exchanges. Another popular name for the American Exchange was the “Curb.” Where did that name come from? The AMEX literally started on the curb outside the NYSE! Their brokers would follow the action of the NYSE by looking inside the window and then trade outside. Happily for them, they were able to move into a permanent location down the street from the NYSE. (It gets cold in New York in the winter!)
By the early 1990’s, the AMEX started concentrating on securities other than stocks over 20 years ago. The Exchange Traded Funds (ETFs) that we discussed in our chapter on mutual funds were first introduced on the AMEX. The changes in the industry did not escape the AMEX. In 1998, the NASDAQ purchased the American Exchange. (We will discuss the NASDAQ very soon.) The AMEX then was kicked to the curb (pun intended) in 2004 by the NASDAQ. Finally, in 2008, the NYSE purchased the American Exchange and moved them down the street into the NYSE's building on Wall Street. The NYSE first changed the name of the AMEX to the NYSE MKT and then mercifully changed the name to NYSE American.
The Regional Exchanges
The regional stock exchanges were modeled after the NYSE and AMEX. They only ever accounted for 4% of all exchange volume. These include the Chicago, Philadelphia, Pacific, Boston, Denver, and Cincinnati exchanges. Each is a single location where the trading took place with the exception of the Pacific Exchange which was located in both San Francisco and Los Angeles. Many of the securities listed on the regional exchanges are also available on the NYSE or NASDAQ. Traditionally, the regional exchanges were often places where undesirable or unethical issues were sold. The regional exchanges have tried to diversify and differentiate themselves from the NYSE and NASDAQ in order to survive. Plus the regional exchanges have not been immune to the rush to consolidate. The NYSE bought the Pacific Exchange and the NASDAQ bought the Philadelphia and Boston Exchanges.
Options and Futures Exchanges
We briefly discussed the two major types of derivatives in our first chapter, options contracts and futures contracts, typically referred to as options and futures. Briefly, options allow traders to sell or to buy an underlying security at a specified price for a given time and futures are contracts that guarantee the delivery of a specified commodity at a specific future date at an agreed-on price. We will discuss these in detail toward the end of the class. The Chicago Board Options Exchange (CBOE) was organized to facilitate options contracts trading and likewise, the Chicago Board of Trade (CBT) was created for futures contracts trading. Options and futures are also traded on most all the major and regional exchanges now as well as the CBOE and CBT.
Over-the-Counter Markets and the Role of Dealers / Market Makers
Over-the-counter markets (OTC) started out as widely scattered telecommunications networks through which transactions of securities were made. In an over-the-counter market, there is no single location as with an exchange. It is a quote-based system as opposed to the face-to-face double auction of the exchanges. Decades ago, the widely scattered telecommunications network took the form of people scattered around the country calling one another on the phone and making deals and transactions.
Two of the groups that make up the OTC are the OTC Bulletin Board and the OTC Pink Sheets. And yes, you guessed correctly, the Pink Sheets got their name from their newspaper that listed the thousands of companies and their most recent prices. The newspaper was printed on pink paper. The Pink Sheets are now called the OTC Markets Group. There are approximately 5,000 companies listed on the Bulletin Board and 10,000 companies listed on the Pink Sheets. Virtually all of these companies are sham corporations that should not be discussed in polite company. Their stocks are typically used in swindles. There are some legitimate issues but they are the exception, not the norm. Our advice is to stay far away from the OTC Bulletin Board and OTC Pink Sheets. In recent years, these two groups have stated publicly that they are trying to clean up their acts. However, the sham corporations remain.
The OTC markets use dealers instead of brokers. Dealers, also called market makers, are traders who “make markets” by offering to buy or sell certain securities at stated prices. Similar to the specialists of the exchanges, the dealers / market makers offer buy and sell quotes from their own inventory of stocks. This is different from brokers who simply serve as go-betweens between buyers and sellers and typically keep no inventory. The dealers / market makers post an ask price and a bid price. The ask price is the retail price; it is the price that we retail investors will pay for the shares we want to buy. The bid price is the wholesale price; it is the price we will receive when we sell the shares back to the dealer / market maker. The dealers / market makers earn money from the bid-ask spread, the difference between the ask price and the bid price.
For those who live close to a border such as the United States / Mexico border or the United States / Canada border, this system should be familiar. Situated along the borders are money exchange houses that keep an inventory of United States dollars and Mexican pesos or United States dollars and Canadian dollars. Here is a presentation that highlights the “casas de cambio” that you find along the United States / Mexico border. There is not just one price advertised. There are two prices. When you want to exchange your dollars to pesos, for example, you will receive one price ‒ the ask price ‒ for your dollars. When you want to change the pesos back into dollars, you will receive a lower price ‒ the bid price ‒ for your pesos. This is exactly how it works on the OTC markets. The dealer’s markups or markdowns are not reported to the customers whereas the broker’s commissions are reported. (Psst. How do you think the Internet brokers make money on only $5 or $7 or now $0 per trade? Stay tuned.)
So how did these OTC markets work before modern telecommunications? An OTC dealer in Minneapolis held shares of a tiny company based in someone’s garage in Iowa or Idaho or one of those places that starts with the letter I. Another OTC dealer in Mobile, Alabama, found a sucker, oops!, we mean, a client who wanted to buy the shares of the garbage, sorry, garage company. After the dealers hung up on each other a few times, the deal was finally made. The client in Mobile was now the proud owner of 10,000 shares of Flim Flam, Inc. worth a total of $70 at $0.007 per share. Of course, if our hero immediately wanted to sell his 10,000 shares back, the dealer in Minneapolis would only give him $0.005 per share for a total of $50. The bid-ask spread in this case is $0.002, a small sum indeed but equivalent to 28% of the ask price. Our hero just lost 28% from buying the shares. Of course, virtually all the transactions are now executed online with no human interaction but the result is the same. Most of the shares are garbage.
Traditionally, the NASDAQ was lumped together with the other two OTC markets. Today, NASDAQ does not want to be associated in any way with the OTC anymore, and deservedly so. It warrants its own section.
The NASDAQ was created by the NASD, the National Association of Securities Dealers. NASDAQ initially stood for the National Association of Securities Dealers Automated Quotation system. The National Association of Securities Dealers was the non-governmental organization that used to be responsible for self-regulation of registered representatives. The NASD was sponsored by the Securities and Exchange Commission (SEC). In 1971, the NASD created the NASDAQ, the first electronic communications network for trading securities. The NASDAQ used to be the arena for small companies to get started. Once the companies became large enough to qualify for listing on the New York Stock Exchange, they would typically move to the NYSE. However, since the 1980’s, many prestigious companies decided to stay on the NASDAQ rather than move to the NYSE. You may have heard of a few of them? Ever hear of Apple or Microsoft or Google or Amazon? One can guess with absolute surety that when this started to happen, there were two words that came out of the mouths of the executives sitting atop the 23rd floor of the NYSE building. The first word was, “Oh,” just in case you were wondering.
Although still smaller than the NYSE, the NASDAQ has made the securities trading industry a two-horse race. The National Association of Dealers gave up their position as the non-governmental organization responsible for self-regulation of registered representatives. (That task is now served by FINRA, the Financial Industry Regulatory Authority.) They also changed their name to NASDAQ. No more NASD, no more National Association of Securities Dealers Automated Quotation system, and certainly no more association with the OTC markets. The NASDAQ is simply the NASDAQ and it provides up-to-date bid and ask prices on approximately 3,300 stocks.
The NASDAQ is now a three-tier system. There is the NASDAQ Global Select Market. These are 1,200 companies that would easily qualify for the NYSE, the “crème de la crème.” There is the NASDAQ Global Market, née NASDAQ National Market, that consists of 1,450 larger companies. The third tier is the NASDAQ Capital Market, née NASDAQ SmallCap Market, that lists 650 smaller companies. In an obvious jab at the NYSE, in their advertising, the NASDAQ began positioning itself as the “Securities Market of the Future” as it became apparent that the traditional face-to-face, double auction model was not adequate to keep up with the massive increase of trading. The value of the companies on the NASDAQ is roughly $17 trillion as of December 2022.
Alternative Trading Platforms: The Third and Fourth Markets
With the advent of telecommunications and computing advances in the 1980’s, two alternative trading platforms began to emerge. The third market was a system that sponsored over-the-counter transactions made in securities listed on the NYSE or one of the other organized exchanges. The third market was reserved for institutional investors such as mutual funds, insurance companies, pension plans, etc. The institutional investors trade in large blocks of securities and hence could realize reduced transaction costs. However, the transactions were still facilitated by a dealer / market maker. One example was the Intermarket, which was subsequently purchased by the NASDAQ and became the NASDAQ Intermarket.
The fourth market was similar to the third market. The difference was that the fourth market eliminated the dealers / market makers and let their customers make transactions directly with one another. At first, the fourth market catered to the same large institutional buyers and sellers of securities as the third market. With the advent of the Internet, they successfully started to court retail customers, creating privately owned electronic communication networks, ECNs, that automatically match buy and sell orders that customers place electronically. This got the attention of the big players. The fourth market securities trading system Archipelago was purchased by the NYSE and became the NYSE Arca. Another fourth market player, BATS, the Better Alternative Trading System, was purchased by the Chicago Board Options Exchange.
As with many of today’s technological innovations, the overarching theme we see in the securities marketplaces is disruption. The relatively inexpensive and immensely powerful technologies available are allowing new companies to enter the industry and challenge the staid, storied titans of the past. No longer does a company need to be centered in New York or one of the other historical centers of finance. For example, BATS was started in a strip mall in Kansas City! As such, the newer companies are able to offer their services for less than the older companies. This has created the “urge to merge” in the industry as we saw with the NYSE and NASDAQ buying up their smaller rivals. And by no means is this just limited to the United States as we saw with NYSE merging with Euronext and Germany’s stock market trying to buy the NYSE.
Finally, just in case you might be under the mistaken impression that these securities trading marketplaces are offering their services free of charge as a philanthropic gift to humanity, know that these systems are all for-profit operations. As well as other fees that are charged the companies that list on the securities trading system, there is a fee for every share that changes hands. It makes you wonder yet again how brokerage firms are offering their customers commission-free trades. (Stay tuned!)
“One Big Malignant Casino?”
You may share the same thought that many people believe and ask, “C’mon, Paiano! Isn’t the stock market all just one big malignant casino?” It is a legitimate question. Simply put, the answer is, “Yes,” and “No.” At first, this response seems confusing and at odds with itself. How could it be both, “yes,” and, “no?” It depends upon how you approach stock investing. The answer is, “Yes,” for many individuals who see the markets as one big crapshoot. For them, the way to riches is to buy and sell, buy and sell, buy and sell. We call them speculators or traders. Speculating is very difficult and you are up against the best in the business. Neophytes become very upset when the market turns against them. There is a reason why we often call speculating or trading, “The Loser’s Game.” (This term was coined by Charles Ellis. Please see the Bibliography for more about “Charley.”)
The answer is also, “No.” Many others look at the stock market and the other capital markets as a way to participate in the growth and prosperity of the global economy. We call them investors. With a prudent, long-term orientation, investors are usually very well rewarded. How will you answer the question? Obviously, we hope that you will choose the latter and choose to be an investor. This gives us yet another opportunity to quote from Mr. Benjamin Graham.
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” − The Intelligent Investor, Benjamin Graham
One might be tempted to counter, “Oh, yeah, but what about Enron? Aren’t corporations all crooks?” Fraud and accounting trickery and gimmicks have always been with us. They are always going to be with us. The bank robber, Willie Sutton, when asked why he robbed banks, reportedly was quoted as answering, “Because that’s where the money is!” (He didn’t actually say it, though. A random reporter just made it up. Mr. Sutton was very grateful, though, as it helped him “build his brand,” as we would say now.) Normally, but not always, those firms are relegated to the nether reaches of the OTC markets. But for every one Enron, there are hundreds – no, thousands! – of companies that continue to do business with integrity and honesty (uh, usually). In 1973, it was Equity Funding. In 1986, it was Ivan Boesky and Michael Milken and Vagabond Inns. In 2002, it was Enron, Global Crossing, Tyco, and WorldCom. In 2008, it was Fannie, Freddie, Lehman, Citi, WaMu, Wachovia, and AIG. And don’t forget Bernie Madoff who made off with $13 billion dollars from his luckless investors. Ten or twenty years from now, during the next big bull market craze, someone else will take their place.
To recap, the securities markets exist to allow investors a safe, cost-effective method to participate in the success of the global economy. And even with all the underhanded shenanigans, they have performed very well. They are changing at breakneck speed and the change is accelerating. Whether or not we ever have one or more oft-mentioned global, 24-hour trading markets remains to be seen. But it is exciting and for some, scary, to watch, especially for those of us in the industry who have a stake in the outcome.