Posted by Shyam Moondra
New York Times reported that small individual investors pulled out staggering $33 billion from the mutual funds in the first seven months of this year and invested that money in bonds that are considered relatively safe. It is estimated that individuals have over $8 trillion parked in bonds, gold, and Treasury securities. This unprecedented abandonment of stocks is motivated by many factors:
• The wounds from 40-50% losses caused by the market crash of 2007-2008 are still fresh. At the slightest sign of market weakness, these risk-phobic investors look for an exit.
• Recent slowdown in the economy has raised doubts in the minds of many investors about the sustainability of the recovery. Some are convinced that we are headed to a double-dip recession, as happened during the depression of the 1930’s.
• In recent years, the stock market has become very volatile; the stocks move up and down without any significant reason. It is a widespread belief that the markets are manipulated by institutional investors through their frantic computerized trading.
The investment banks and hedge funds short sell a stock to push it down (often spread false rumors about the targeted company to aid the process of bringing it down) while also trading in options. Then just before the monthly options are to expire, they start covering their short positions and push the stock up. In the process, they may lose some money in trading stocks but they make proportionately more money in options and thus come out ahead. Sometimes they move a particular stock up or down to make the options they wrote worthless and thus pocket the premium the buyers paid. They repeat this process every month in many targeted high-beta stocks and make money at the expense of small investors. Some of these big players also use what is known as "pump-and-dump" strategy in which they take substantial long position in a company, usually a lesser-known small-cap company, and then publish inflated views or research reports about those companies that help move the stock price up ("pumping"), enabling them to sell their holding (“dumping”) at a profit. Some times these big players also use their research departments to make money in their trades. As an example, research departments of some investment banks were touting that oil was headed to $200 per barrel while at the same time they reportedly held long positions in oil through their energy hedge funds. The investment banks and hedge funds call the above trading practices as "investment strategies" and deny that they are engaged in unlawful manipulation. The fact is that if a market player can make a stock or commodity move in a certain direction at will, then that's manipulation.
More recent form of market manipulation is called "quote stuffing." The SEC is reportedly investigating the practice of day traders in which very large numbers of buy or sell orders are placed and canceled almost immediately. It is also reviewing another practice known as "sub-penny pricing," where orders are priced in increments smaller than a penny, but are far from the price at which the stock is trading. Yet another manipulative practice is to initiate buy or sell orders for 100 shares at a time at successive higher or lower prices at a rapid pace to make it look like a trend is emerging, which, in turn, induces other investors to place their bets. These trading practices are very easy to execute with the advent of high-speed computers. Some of these practices may have played a role in the May 6th "flash crash," a panicked disruption in trading that saw the DJIA drop hundreds of points in minutes.
The stock markets were created to help companies raise capital so that they could build new factories and hire more workers and the stock prices moved up or down based on the company fundamentals. Now the markets move up and down in a yo-yo fashion without much change in the underlying fundamentals. The increased volatility caused by market manipulation has turned the markets into gambling casinos that has made small investors desert the equity markets altogether.
We urgently need new regulations to stop market manipulation by the investment banks and hedge funds. The government has already taken some steps in the financial regulations bill such as close oversight of hedge funds, restrictions on proprietary trading by banks, higher capital ratios required for banks, and a total ban on naked short selling that should help reduce the market volatility. However, to lure small investors back to the equity markets, more needs to be done:
• Ban "quote stuffing," "sub-penny pricing," and other computerized trading schemes designed to manipulate the markets.
• Investment banks and hedge funds must be required to hold stocks they buy for a certain minimum period (e.g., for three business days until the trades have been settled) before they can sell those stocks. This will reduce computerized day-trading and induce investors to invest rather than speculate.
• Impose higher taxes (as high as 50%) on profits realized from short-term trading.
• The investment banks must not be allowed to own research business. Currently, they have arm's length relationship between their trading and research departments but that is not enough.
• Pass tough laws to discourage "pumping-and-dumping" so that big players can't make money at the expense of unsuspecting small investors. Strengthen SEC resources to investigate and enforce the laws vigorously to stop market manipulation. The CEOs of the companies that are found to violate any of the new regulations must be given mandatory jail terms and their companies must be fined heavily to discourage them from manipulating the markets.
• Change the tax laws to stop investment banks and hedge funds from escaping from paying their fair share of income taxes. In a recent quarter, a major investment bank paid only 10% in taxes because it reportedly executed its trades through a complex web of off-shore subsidiaries and hedge funds that made it possible for it to reduce the tax levies. It's time we close all these tax loopholes.
