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ECON394Lecture2 1 OverviewofMarketStructure TheSecuritiesandExchangeCommission SEC wascreatedin1934 StockexchangesareregulatedbytheSEC buttheyareconsideredself regulatoryorganizations SROs withconsiderablelatitude ThemajornationalstockexchangesaretheNewYorkStockExchange NYSE andtheAmericanStockExchange AMEX In1998 theNationalAssociationofSecurityDealers NASD acquiredtheAMEX ItthensoldtheAMEXin2003toaprivateequitygroupforonly 110million TheNASDregulatesanelectronictradingnetworkcalledtheNASDAQ NASDAutomatedQuoteSystem TheNASDwentpublicin2001 tradesunderthesymbolNDAQandisnowcalledtheNasdaqStockMarketIncorporated Afunnynameforanexchangethatisnotastockmarket atleastaccordingtotheSEC ECON394Lecture2 2 TheNewYorkStockExchange StockmarketsliketheNewYorkStockExchangeprovidestrictcriteriaforsharestobetradedontheirexchange Forthisreason theyarestillcalledlistedsecurities NYSEFactsandFigures U S listingrequirements Dailytradingvolume Marketcapitalization 10LargestCompanies ECON394Lecture2 3 TheNYSETradingFloor Virtualtour ECON394Lecture2 4 NYSEParticipants Togainaccesstothefloor youmustbuyaseat Thenumberofseatshasremainedat1 366since1953 Theycurrentlysellforabout 1 5million EachstocklistedontheNYSEisallocatedtoaspecialist amarketmakerwhotradesonlyinspecificstocksatadesignatedlocation Allbuyingandsellingofastockoccursatthatlocation calledatradingpost Buyersandsellers representedbythefloorbrokers meetopenlytofindthebestpriceforasecurity ECON394Lecture2 5 TheNYSEAuctionProcess Specialistsorganizetheauctionprocessonthetradingfloor Theyprovideinformationaboutthecurrentstateofthemarket thepriceatwhichsharescanbebought bid orsold offerorask andthequantityofsharesavailableateachprice calleddepth Thedifferencebetweenthebidandofferiscalledthespread In2001 allU S equitymarketswenttodecimalswithaminimumspreadof 0 01 ECON394Lecture2 6 TheSpecialist Agent Principal Specialistsactasagents executingordersentrustedtothembythepublic Ininstanceswhenthereisatemporaryshortageofbuyersorsellers NYSEspecialistsactasagents buyingorsellingfortheirownaccounts Thespecialisthasanaffirmativeobligationtostabilizemarketsduringseveremarketdownturns likethemarketcrashofOctober19 1987 Thevastmajority 77 ofNYSEvolumeisaresultofpublicordermeetingpublicorder individuals institutionsandmemberfirmsinteractingdirectlywitheachother Non specialistshandle14 andspecialists10 Note Therecanbeaconflictbetweenthespecialistactingasbothprincipalandagent ECON394Lecture2 7 NYSESpecialistFirms ThelargestNYSEspecialistfirmisLaBrancheandCo whichhandlesmorethan500stocks Spear LeedsandKellog acquiredbyGoldmanSachsin2000for 6 5billion andFleetMeehanaresecondandthirdwith493and428stocks Together these3firmstradeabout2 3ofthedailyvolume Youcanfindacompletelistonthehere ECON394Lecture2 8 NYSEOrderBook ECON394Lecture2 9 TypesOfOrders NYSE Thesearefourkindsororders marketorders anordertobuyorsellafixedquantityatthecurrentmarketprice limitorders anordertobuyorsellafixedquantityatadesignatedprice stoporder anordertobuyorsellonceadesignated stop pricehasbeenhit stop limitorders acombinationofalimitandastoporderOntheNYSE stopordersbecomemarketordersonceatradehasbeenexecutedatthestopprice ECON394Lecture2 10 NYSEAutomatedExecutionSystems SuperDOTADotNYSEDirect Largeinstitutionalinvestorscanalsotradeinwhatisknownastheupstairsmarket ECON394Lecture2 11 RegulationNMS 1 Tradethroughrule 2 Accessrule 3 Sub pennyrule Theoverridingprincipalofanationalmarketsystemistoenabletraderstogetthebestpricesindependentoftradingvenue ECON394Lecture2 12 SpecialistInvestigations Background Sincedecimalsandwiththedeclineintradingvolumefollowingthebubble specialistprofitshavedeclined ThestockpriceofpubliclytradedspecialistfirmLaBranche LAB confirmsthis LABandothersbottomedoutinearly2004whenthe5majorspecialistfirmswerefined 240million Calpers amongmanyothers hassuedtheNYSEtorecoverinvestormoney Criminalcasesarepending ECON394Lecture2 13 ExampleOfInterpositioning ThiswasthestateofthelimitorderbookinonJanuary3 2003at11 04AM ThestockisVZandSpearLeadsandKellogg SLKS wasthespecialist Thebookalsoincludedmarketorderstobuy3 300sharesandmarketorderstosell2 100shares Thespecialistcouldhavepairedoffthemarketbuyandsellordersandsatisfiedtheremainingorderfromhisaccountoragainstthelimitordersat41 10and41 12 Instead thespecialistshorted3 300sharesat41 10 400sharesat41 04 200sharesat41 03 bringingthespreadto41 00X41 10 Atthatprice hecovered2 100sharesfromthemarketsellorders earningarisklessprofitonthatportionofthetrade ECON394Lecture2 14 Grasso sCompensation DuringhistenureaschairmanandCEOoftheNYSE RichardGrasso whohadstartedoutasaclerkofthefloor receivednearly 160millionincompensation TheWebbreporthasallthedetails EliotSpitzerhassuedGrassotorecoversomeofhispaypackage Thebottomline thespecialiststocksaredown tradingvolumeisdown electronicexchangesareerodingNYSEmarketshare NYSEseatpricesaredownto 1millionfroma1999peakof 2 5million MutualfundslikeFidelityareactivelyexploringalternativestotheNYSE Grassowasessentiallybeingpaidhushmoneytoprotectthespecialists Myspeculation TheNYSEistheonlyremaininglargefloorbasedtradingsystemintheworld 5yearsfromnow it likeLondon maynolongerexist Nonetheless thepowerofthisinstitutionishugeanditwillfighttoprotectitsmonopoly ECON394Lecture2 15 NYSEGoesPublic IntheSpringof2005 theNYSEmadetwoboldmovesthatarethemostradicalinitshistory NYSEendsitspartnershipstructureandwillgopublic 2 NYSEwillacquireanelectronicexchangecalledArchipelago NYSEcomments Archipelagocomments ECON394Lecture2 16 WinnersandLosers Winners Archipelago theirsharesjump70 onnewsofthemerger NYSEseatholders Mergerestimatesvaluetheirseatsat 3 5millionSomeseatholdersarestilldisgruntled Goldman ex partnerThainnowrunsNYSE ownsSpear Leeds KellogNYSEspecialistfirm oneofthetop3Nasdaqmarketmakers andowns15 ofArchipelago Losers NasdaqandInstinetSpecialistfirmslikeLAB ECON394Lecture2 17 OverviewofNASDAQ TheNationalAssociationofSecuritiesDealersAutomatedQuote NASDAQ pronounced naz daq systemisaninterdealermarketrepresentedbyover600securitiesdealerstradingmorethan15 000differentissues Thesetradersarecalledmarketmakers NasdaqoperateswhatitcallstheNationalMarket NNM forlargercapitalizationstocksandasmallercapmarketcalledtheNasdaqSmallCapmarket Thereisanoverthecounterservicecalledthe OTCBulletinBoard OTCBB OTCBBhasnoformalrelationshipwiththeNasdaq ECON394Lecture2 18 NASDAQOwnership Nasdaqwasowneduntil2001entirelybyitsmemberfirms NasdaqissuedstockthattoitsmembersthathasbeengraduallyacquiredbyanindependentbodycalledtheNasdaqStockMarket Inc whichnowtradesontheNNMunderthesymbolNDAQ TheNASDhasre organizedasaprivate notforprofitregulatorybody IthassofarbeenmorediligentthantheNYSEinoversightofitsmembers Volume FactsandFigures 3 271listings Listingrequirements Nasdaq100bymarketcap ECON394Lecture2 19 NASDAQParticipants Approximately600marketmakersrangingfromlargeinvestmentbankslikeGoldmanSachs GSCO toretailorientedoperationslikeKnightTrimark NITE tosmallfirmslikeGlenRauchSecurities GRSI Therearenowjust3ECNs Nasdaq BRUT INET andARCA ECON394Lecture2 20 NasdaqMergerwithInstinet NasdaqhasrespondedtoECNcompetitionandtheNYSE smoveintoelectronictradingbytryingtograbmarketshare TheyacquiretheBRUTECNin2004 TheyalsoproposedamergerwithInstinetintheSpringof2005 InstinethadmergedwithapopulardaytradingECNcalledIslandin2003 InstinetwillgiveNasdaqtheabilitytotradeNYSEstocks Forthefirsttime thereisadirectcompetitortoNYSE Ontheotherhand ARCAwillgivetheNYSEtheabilitytotradeNasdaqissues ECON394Lecture2 21 TheNasdaqLimitOrderBook Thisisthetotalviewdisplaywhichshowsmultiplelevelsofliquidityfrommarketparticipants Forexample MorganStanley MSCO isonthebidatboth19 98and19 97 TheLevelIquoteis19 98x19 99withdepthsof21and10 thelargestattheinside MostofNasdaqexecutionsystemshavebeenfoldedintoSuperMontage ECON394Lecture2 22 SuperMontage NASDAQSuperMontageisafullyintegratedorderdisplayandexecutionsystemforallNASDAQNationalMarketandSmallCapsecurities SuperMontageisavoluntary open accesssystemthataccommodatesdiversebusinessmodelsandtradingpreferences SuperMontageallowsmarketparticipantstoenterunlimitedquotesandordersatmultiplepricelevels QuotesandordersofallSuperMontageparticipantsareintegratedanddisplayedonmarketparticipants front endsaswellasviadatafeeds Thesystemdisplaysaggregateinterestfivepricelevelsdeeponeachsideofthemarketonadynamicbasisandadditionalpricelevelsonanon dynamicbasis SuperMontageparticipantsareabletoaccesstheaggregatedtradinginterestofallotherparticipants Anonymity OfferedthroughSuperMontage sSIZEfeature InternalizationofordersisavailablebutnotrequiredforquotingmarketparticipantswhentheparticipantisattheNASDAQBestBidandOffer NASDAQBBO Thisallowstheinitialmatchatapricetohappenagainstthefirm sownorders ECON394Lecture2 23 NASDAQNewRegulations RegNMS AdoptedJune9 2005NasdaqlikesthefactthatRegNMSwill CapfeesonECNsPutinapennyminimumincrementTheydon tlikethat c thetradethroughoptoutwillenableECNstotakemarketshare RegSHOpilotimplementedonJanuary3 2005 ThiswilleliminatetheuptickruleonanumberofNasdaqsecurities ECON394Lecture2 24 MicrostructuresAroundTheWorld ECON394Lecture2 25 GlobalStockMarketCapitalization ECON394Lecture2 26 HowDoYouBuyForeignStocks ADRs e g SonyonNYSE Toronto TokyoETFs bycountry region e g iSharesMalaysianFundoriSharesEuropeMutualfunds e g VanguardEmergingMarkets ECON394Lecture2 27 EfficientMarkets Manyeconomistsbelievethatmarketsareefficient Thismeansbroadlythatinformationisincorporatedintostockprices Thisimpliesthatfundamentalanalysis technicalanalysisandotherapproachestothemarketdonotproduceabnormalreturns Wewillpresentsomeevidenceforandagainstmarketefficiency Theevidenceagainstisthebubblesandcrasheswehaveobservedinmarkets Theevidenceforisthepoorperformanceofprofessionmutualfundmanagers Togivethisevidencesomecontext wefirsthavetodiscusssomebasicvaluationmodelsforthemarket ECON394Lecture2 28 ValuationModels Manymodelsassumethatstockpricesareapresentdiscountedvalueofthefuturedividends Ifdividendswereconstant thissimplifiesto Ifdividendsweregrowingataconstantrateg Thesolutionhereis ECON394Lecture2 29 Bubbles ECON394Lecture2 30 PeaksAndCrashes TheDowJonesaveragedidnotreturntoits1929peakuntil1954 Japan sNikkeiindexpeakedat40 000onJanuary1 1990andcurrentlytradesat TheNasdaqCompositepeakedat5 000inMarchof2000andstilltradesalmost3 000pointsbelowthatlevel Nonetheless awelldiversifiedportfolioofcommonstockshasreturnednearly6 inrealtermsoverthelast200years Bondshavereturnedonly2 Thisdifferenceiscalledtheequitypremium ThisargumenthasbeenpromotedbyJeremySiegel authorofStocksfortheLongRun ECON394Lecture2 31 IrrationalExuberance ThecounterargumenttoSiegel sviewhascomefromYaleUniversityprofessorRobertShiller authorofIrrationalExuberance Shillerclaimsthatthemarketisovervaluedcomparedtoitshistoricallevels ECON394Lecture2 32 RealEarnings Anevenstrongerargumentscomesfromcomparingrealearningsandrealstockprices TheShiller Siegeldebateisongoing ECON394Lecture2 33 Under PerformanceofMutualFunds MarkCarhart nowatGoldmanSachs hasshown OnPersistenceinMutualFundPerformance JournalofFinance 1997 thatoverthe34 yearperiodfrom1962to1995 only23 offundsoutperformedtheS P500index ECON394Lecture2 34 Don tChaseMutualFundWinners Carhartmakesasecondpointwhichisevenlesswellunderstood Fundswithhighreturnstendtohavehighreturnsonlyintheyearfollowingtheiroutperformance Thisisjustthemomentumresultwesawinindividualstocks Afterone year theirperformanceisjustaverage FidelityMagellan underPeterLynch andLeggMasonValue underBillMiller havehadlongperiodswheretheyoutperformtheindex Aretheyjustwinnersinabigcoinflippingcompetition RecentreturnsforMagellansuggestthatmaybethecase ECON394Lecture2 35 TheRoleofSecurityAnalysts AccordingtotheSEC theroleofanalysts researchanalystsstudypubliclytradedcompaniesandmakerecommendationsonthesecuritiesofthosecompanies Analystshavebeeninthenewslatelyfornotfulfillingtheirfiduciarydutytoinvestors Ifweunderstandtheirincentives wecanunderstandtheproblemstheyhavefaced Analystsarenotdirectlyrevenueproducersforsecuritiesfirms Theyareacostcenter notaprofitcenter Yetweknowtheyarewellpaid Howdotheyearntheirmoney Byattractingbrokeragebusinesstotheirfirms Throughinvestmentbankingbusiness ECON394Lecture2 36 AnalystsAndInvestmentBanking Researchonreveals 1 Theyrecommendstockstoobtaininvestmentbankingfees AccordingtoMichaelyandWomack RFS 1999 leadunderwriteranalystsissue50 morebuyrecommendations Theirrecommendationsunderperformotheranalystpicksbymorethan25 peryearfor2years AnecdotalevidencefromtheMerrillLynch HenryBlodgettcase 2 Anoverallbiastowardspositiveratings InJune2001 accordingtoFirstCall only2 ofstockshadsellrecommendations despitemorethanayearlongbearmarket 3 Theyaredefactocorporateinsiders JackGrubmanattendedWorldComboardmeetingsandwaspaidconsultingfees ECON394Lecture2 37 Reforms RegFDOnAugust10 2000 theSECapprovedRegulationFairDisclosure RegFD whichbecameeffectiveonOctober23rdofthesameyear AccordingtoEricZitzewitzofStanfordBusinessSchool Thisregulationprohibitstheselectivedisclosureofmaterialinformationtofinancialprofessionalsincludinganalysts companieswithmaterialinformationtodisclosemustnowdosoinapressreleaseorconferencecallthatissimultaneouslyopentoallinvestors SpitzerinvestigationsMay2002settlementwithMerrillLynch GlobalsettlementinDec 2002 1 4billionsettlementwasreachedwithBearStearns 80mn CreditSuisseFirstBoston 200mn DeutscheBank 80mn GoldmanSachs 100mn JPMorganChase 80mn LehmanBrothers 80mn MerrillLynch 200mn MorganStanley 125 SalomonSmithBarney 400mn andUBSWarburg 80mn ECON394Lecture2 38 ConductRemedies 1 Theinsulationofresearchanalystsfrominvestmentbankingpressure Nofeesforbankingbusiness noanalystsonroadshows 2 AcompletebanonthespinningofInitialPublicOfferings IPOs BrokeragefirmswillnotallocatelucrativeIPOsharestocorporateexecutivesanddirectorswhoareinthepositiontogreatlyinfluenceinvestmentbankingdecisions 3 Forafive yearperiod eachofthebrokeragefirmswillberequiredtocontractwithnolessthanthreeindependentresearchfirms 4 Disclosureofanalystrecommendations Eachfirmwillmakepubliclyavailableitsratingsandpricetargetforecasts investmentbanksmaysimplydropresearch WhywasEliotSpitzerdoingthejobofthefederalgovernment ECON394Lecture2 39 MutualFunds ECON394Lecture2 40 SpitzerGoesAftertheMutualFundIndustry Managertradingabuses e g RichardStrong Markettimingtrades particularlyaproblemwithinternationalfunds Latetrading e g EdSternofCanaryPartners Thebottomline BasedonZitzewitz 2002 Takingthesepiecestogether theannuallossfromthe 364incommissionover charges theannuallossof0 28 inreturnfrommarkettimingandthejointeffectcompoundedbytherateofreturntotheS P500 thetypicalmiddle incomeAmericanfamilylostabout 3 740overfiveyears Firmsimplicatedinclude BankofAmerica Citigroup MorganStanley LeggMason BearStearns CharlesSchwa