Is Wall Street's End-of-Quarter Window Dressing a Crime?
Wall Street trading houses will then enter massive "program buys" and provide ample media interviews putting the rosiest of slants on whatever the current news is. This provides a feel-good rally that is typically good for a couple days to a week, anyway. This quarter was no exception. With the Dow down 167 Thursday at 12,455, Wall Street swung into action. At 2:35 p.m. the first program buys hit. An hour and twenty-five minutes later the decline was nearly erased as the Dow closed down just 25. On Friday, the Dow opened at 12,791, on its way to a close at 12,880, a swing of 428 points, or +3.4%, in just 8 total hours of open market. The trading houses, hedge funds, mutual funds, and pension funds all joined in the boost, but they may have begun selling by the afternoon.
And what was the great news that "caused" the rally? According to MarketWatch, investors were cheered by "EU policy makers ...agreeing to relax repayment conditions for Spanish banks and lower the bar to possible aid to Italy." Wait a minute. The EU decided to relax repayment conditions for Spain? That helps the EU's fiscal condition how?!! And they lowered the bar to giving a bailout to Italy -- this is good news how?? But we mustn't forget that the EU has also created yet another new agency, this one called the Troubled Country Relief Program (TCRP) which they (under-)funded with all of $149 billion US. In plain English: they kicked the can down the road yet again.
But it didn't matter. If Wall Street hadn't spun this as good news, they'd have just keyed on something else. More people buy houses in the spring and summer, so that "proves" we're beyond our housing woes, or (temporary) summer hiring is picking up so that "proves" unemployment is declining, or whatever. But all this raises two key questions: (1) Why do they do this? And (2) How do they get away with it? Thereby hangs a tale...
Why Do They Do This?
The short answer is: "Because they can." 40 years ago, mutual funds, pension funds, and Wall Street trading houses comprised less than half of all the trading volume in the stock market. Individual investors take (or took, anyway, and the smart ones still take) the time to digest the news and move rationally, not precipitously. Sure, they could be panicked after an onslaught of bad news or become euphoric after a plethora of good news but this all took time to spread through the collective investor pool that was needed to drive the markets one way or the other.
Today, institutions comprise 76% of all trading volume and climbing. With the destruction of Glass-Steagall, what we once called banks were allowed to bring their formidable capital into the day-trading arena. With the more recent sweetheart deal allowing of what are clearly brokerage firms like Goldman Sachs to register as banks in order to get taxpayer bailouts, even more recklessness was encouraged. The advent of technology that allows instantaneous transmission of news further panics or incites the average investor and facilitates program buying, dark pools, high frequency trading, and profits from scalping hundredths of a penny thousands of times a minute.
Their traders are not paid to select fine companies and grow the assets of the "bank" as the American economy recovers and excels; their bonuses depend on what they do in a single trading day with a goal of closing most or all trades that day. Indeed, Goldman issued a sell short recommendation on the market the week before, could easily have bought cheap when the public acted on their recommendation, and could just as easily now sell high!
It isn't just the usual suspects that participate, however. Your mutual fund, your pension fund and the hedge funds also contribute to the madness. You see, the only time they must publish their holdings are at quarter's end. How dumb would they look if the average investor, who only looks at their quarterly statement and only sees the Top Ten holdings, saw that 8 of the top 10 were down for the quarter? So mutual funds and pension funds quietly dole out the stocks that are down over the previous couple weeks, knocking down the prices of perfectly good companies their in-depth analysis previously told them were the best companies to buy, then join the feeding frenzy in buying the Dow 30 or the highest-capitalization stocks on the S&P 500, or the most-liquid and most-recognizable names on the Nasdaq like Apple, Microsoft and Google.
Yes, it's smarmy, and yes, the effect typically lasts only for a week or so before the primary trend in place reasserts itself, but it works to keep their investors in line. As long as it appears to the fund owner that they've held these winning stocks the entire quarter, their investors can forgive a little underperformance; after all, just look at the great companies they own! It doesn't occur to the investor that those "winners" may have been bought two days ago and may be quietly sold in the next few days in order to buy something else. Which brings us to...
How Do They Get Away With It?
The rational investor might at this point think, "But if they bought these things in a buying stampede, aren't they now stuck with these stocks? What if the market goes against them?" Ah, but the reason it works is investor psychology. We all hate to take losses, but we also hate to miss something big.
So the stampede may start with the bulls at the front (the institutions.) But they depend upon the excitement engendered by the market action itself and the gushing media coverage of it to get the rest of the cows and bulls moving. Remember, they make money trading vast amounts of highly liquid securities scalping pennies where they can. Once the rest of the now-stampeded cows and bulls are clamoring to buy "before they miss the big move" the institutions peel off and let the rest of us proceed toward the cliff.
How do they get away with it? The same way Lucy van Pelt gets away with pulling the football away from Charlie Brown every year. Charlie Brown is a nice kid who wants to believe in the goodness of people. As investors, we can't imagine how anyone could do such a thing. And before you put on your tin-foil hat and think this is some grand conspiracy, let me say clearly that I do not believe it is. Each firm acts individually for its own benefit and the result may look like collusion, but I imagine it is not. It's just so effective a tool that they all use it.
If It Works, Why Don't We Join Them? Why Don't You?
Because it isn't investing. And because you and I don't have 50 traders on staff hunched over their Bloombergs or a super-computer that sells a nanosecond before or after someone else does. And, finally, I think our clients and other sophisticated investors aren't fooled by these end of quarter window-dressing rallies.
Besides, in the words of the great value investor Ben Graham, "In the short term the market is a voting machine, but in the long term it is a weighing machine." The problem is that "short term" and "long term" may have become compressed since his day -- but the sentiment still holds true.
Is this, then, the beginning of a brand new bull market or just more Wall Street window-dressing shenanigans? No one knows, but for my money, I'd rather remain hedged rather than drink the Kool-Aid just yet.
In the US we are looking down the barrel of the 2nd quarter earnings reports. Already, stalwarts like Proctor & Gamble and leading indicator companies like FedEx have warned their earnings will disappoint. It's likely many others will as well.
GDP growth was 3.0% in Q4 2011, then declined to 1.9% in Q1, who knows about Q2?
Earnings might disappoint, but how about something even more important? We must create jobs for Americans who want to work. In Q1, job growth fell from 243,000 in January to 216,000 in March. By May, that number was down to 69,000. Not an attractive trend. It may have reversed in June - or it might only be a one-month reversal.
How about housing? While housing prices finally rose in selected markets, what kind of dent did that make in the overhang of foreclosures, short sells and other inventory? Add in the fact that factory orders, retail sales and consumer confidence are all falling, and the summer outlook doesn't appear to be brightening in the US.
In the Eurozone, every time they encounter a structural problem, they paste over it with a short-term fix, creating new layers of regulation and new names for old (failed) approaches. $149 billion for the new TCRP? They already gave Ireland and Portugal $116 million and Greece and Spain even more. Will $149 billion be their "final answer"?
In the rest of the world, the BRICS and Asian economies are showing both economic and stock market deterioration. How could they not, given that their outsized sales of resources, commodities and finished products went less to their own people than to Europe and the USA?
Yet, with all this on the short-term horizon, I remain an optimist on American ingenuity and hard work. I think it may take the entire summer, but I see a powerful end to 2012. But for the short term? We'll stay safely hedged. If you agree that end of quarter window dressing is a poor reason to rush precipitously into the market, you might want to do the same!
Finally, giving at least my answer to my headline question, is window-dressing a crime? No. There may or may not be collusion among a few of the major players (that would be a crime) but no one has ever proved it. In fact, it is rather more pathetic. Its just individual institutions that all have the same goal: to not look as dumb in a particular quarter as they actually were, and to make a few bucks at the expense of the latecomer bulls and cows if they can.
Disclosure: We remain hedged in this volatile market.
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