Chapter 5
STOCK MARKETS
From the Buttonwood Tree to the World Wide Web
For the vast majority of investors, stocks are bought and sold in the markets. Your success as an investor, and your comfort with your investments, is at least in part coupled with how well you understand the markets in which your stock trades. To help you achieve a broader perspective, this chapter pulls back from the close-up view of stocks offered in the previous chapter to take in the bigger picture: the markets themselves.
Whereas once you could point to a building and say, “There is the stock market,” technology has changed all that forever. The change, though most obvious in the last few years, has been decades in the making. It no longer makes any sense to think of a market, even the New York Stock Exchange (NYSE), that one-time bastion of open-outcry markets, as being limited to the floor of its exchange building. Not only is the New York Stock Exchange no longer primarily based on “open outcry,” it has in the last decade transformed itself into a publicly traded company (ticker NYX), dispensing with its famous “seats” and merging with Euronext to form a global financial marketplace.
Table 5-1 Major Stock Markets of the World as of December 2008
Historically, there were important differences between
stock exchanges like the NYSE and
over-the-counter (OTC) dealer-based markets like the
National Association of Securities Dealers Automated Quotation (Nasdaq) system. Some of these differences persist, while others have blurred as a market like Nasdaq has itself become an
exchange. Over-the-counter markets operate without a central location where traders can come into physical contact. Instead, all trading is done by computer terminal and/ or telephone. We will focus on these two key markets, highlighting the roles played by economic development, regulatory changes, and innovations in information technology. To further clarify our discussion, we will briefly describe
electronic communications networks (ECNs), electronic markets primarily used by institutional traders, and will conclude by describing how the evolution of markets is accelerating in new and sometimes unpredictable ways. (For an overview of the world’s major stock markets, see
Table 5-1.)
The Big Board
The New York Stock Exchange (often just called the NYSE, pronounced by spelling it out) is the second oldest (the Philadelphia Exchange is the oldest) and the largest (by many measures) stock exchange in the United States. Its origin may be traced to the Buttonwood Agreement of 1792, which established common commissions for securities trading. At the time, only five securities were traded in New York: two bank stocks and three government bonds.
Trading activity picked up following the War of 1812, as insurance stocks were added to the growing list of bank stocks and government bonds being traded. In 1817, the New York Stock and Exchange Board was created, traders moved inside, and trading took place in two sessions of a
call market, one in the morning, another in the afternoon. In a call market, the names of stocks are called out one at a time, with all trading limited to the stock most recently announced. Continuous trading in multiple stocks was still more than 50 years away. In the intervening years, a confluence of economic, technological, and regulatory changes would set the stage for its development:
• The exchange prohibits trading in the street (1836).
• The telegraph is invented (1844).
• Listing standards are tightened (1853).
• The first transatlantic cable is laid (1866).
• Stock ticker brings current market price to investors (1867).
• Member seats become a “property right” and can be bought and sold (1868).
• Listed shares must be registered (1869).
Where Do Ticker Symbols Come From?
In 1867, a man named Edward A. Calahan received a patent for the ticker, a small printing machine for transmitting lists of stock symbols and their prices over telegraph lines. It was also used to transmit commodity prices. Calahan worked as an operator for the American Telegraph Company. His coworkers had developed a set of abbreviations, or ticker symbols, for the names of stocks they had to transmit (using Morse code) over telegraph lines. One-letter abbreviations went to the most important stocks of the day. Some of those one-letter abbreviations have survived to the present day. For example, Sears, Roebuck still has its S, while AT&T retains its T.
Eventually, Calahan’s device was improved upon by Thomas Edison, whose ticker became a fixture and an emblem of the stock market in the first half of the twentieth century.
Continuous trading was introduced in 1871. Under the new system, brokers who specialized in a stock remained at a fixed location, leading to the creation of trading posts and specialists. From an annual trading volume of roughly 50,000 shares in 1829, volume mushroomed to the first million-plus trading day on December 15, 1886.
A Seat on the Exchange
From 1953 until 2006, the NYSE was a membership organization with a total of 1,366 “seats.” Seats could only be purchased or sold by individuals. The owner had trading privileges and access to the floor of the exchange. Typically, these individuals represent brokerage firms or firms that act as specialists in the stock of a particular company. Seats, like taxicab medallions, were frequently leased for use by third parties.
Continuous Trading
Trading on the NYSE is done by double auction, meaning that offers to buy and sell securities proceed side by side. Specialists are responsible for maintaining an orderly market in a particular security. This means that they must try to match buyers and sellers in a way that is fair to both. In addition to matching buyers and sellers, specialists are permitted to buy and sell for their own accounts to help maintain liquidity in the security.
Until very recently, all orders placed through the NYSE in a particular security went through the specialist. In 2007, NYSE introduced a hybrid market that gave market participants the option of routing their orders to an electronic system or using the traditional trading floor with its open outcry. There are two basic types of orders: market orders and limit orders.
• Market orders are instructions to buy or sell stock at the best available price. They are the most common type of orders.
• Limit orders tell your broker to buy or sell stock at the limit price or better. The limit price is a price you set when placing the order. For a given purchase, it is the most you will pay; for a given sale, it is the minimum you will accept. You can also place a limit order to buy along with one to sell. For example, if IJK Corporation is currently trading at $42 per share, you can place a limit order to buy 100 shares of IJK at $40 or better (less) and to sell 100 shares IJK at $45 or better (more).
There are a variety of terms for special types of limit orders: day orders, good-till-canceled (GTC), and stop orders.
• Day orders are limit orders that are valid only the day they are made.
• Good-till-canceled (GTC) are limit orders that continue in force until they are filled or you cancel them.
• Stop orders instruct the broker to buy or sell at the market once a certain price target—the stop price—has been achieved. Stop orders are less restrictive than pure limit orders; the market price may be worse than the stop price when the broker executes the order. Stop orders require only that someone bought or sold at the stop price. Pure limit orders require that you get the stipulated price.
In addition to specialists, other members include floor brokers who work for member firms and execute trades on behalf of clients. Since 1996, floor brokers have been provided with wireless communication devices that allow them to receive trading instructions. Once the floor broker has instructions, that individual must go to the appropriate trading post on the floor of the exchange where he or she is surrounded by other floor brokers and specialists in the stock (or other security) being bought and sold. The broker executes the transaction at the best available price. Information about the trade is processed and delivered to the client’s broker, who communicates it to the client. This can all happen in a matter of seconds, while the customer is on the phone.
Ten years later, on May 26, 1896, the Dow Jones Industrial Average was published for the first time.
The Wall Street Journal began daily publication later in the same year. The starting value of the index was 40.94. The original 12 stocks and the current composition of the list are displayed in
Tables 5-2 and 5-3, respectively.
The Dow Jones Industrial Average: Mother of All Stock Indexes
The Dow Jones Industrial Average (DJIA) is the best-known stock market index. An
index is a list of stocks, bonds, or other securities whose prices are combined in a type of averaging process to come up with a number that represents their collective value. For example, the DJIA is a list of 30 stocks. Not just any 30 stocks, mind you, but 30 of the bluest of the blue chips. See
Table 5-3 for a listing of the components of the DJIA as of April 2009, along with each stock’s ticker symbol and the year it entered the index. Current components of the Dow may be retrieved at
www.djaverages.com.
The simplest type of index gives equal weight to all its components. But not all stocks count equally in the DJIA. It is a price-weighted index. This means that stocks with higher prices are counted more heavily in figuring the value of the index. Other indexes, such as the Standard & Poor’s 500 Index, are weighted in proportion to the free float market capitalization of the stocks in the index.
Table 5-3 Stocks in the Dow Jones Industrial Average (April, 2009)
Source: Dow Jones & Co.
1Aluminum Company of America is the official name. If you have trouble locating a ticker, it might be because the official name of the company is different from its more familiar name. 2Short for E. I. du Pont de Nemours. Do you look under E. I.? du Pont? de Nemours? Just remember DD.
*Name change and/or merger.
†Stock not continuously part of the index. For example, GE, the only original DJIA stock currently in the DJIA, was absent from the list from September 1898 to April of 1899 and from April of 1901 to November of 1907.
The DJIA reached a new historic high on September 3, 1929, after a six-year bull market. Eight weeks later, on Black Tuesday, October 29, 1929, it crashed. Over the next three years, the average would decline 89% from its high. Of course, the great crashes affected not just the NYSE, but markets all over the world.
bull market
Market characterized by a pronounced upswing in price level.
Of Bulls and Bears
Colloquially speaking, a bull market is a prolonged period of increasing prices in stocks or other securities or commodities. A bear market is a prolonged decline in prices. Typically, trading volume increases dramatically during a bull market. Famous bull markets include the U.S. stock market in the 1920s, Japanese stocks in the 1980s, and the Internet Bubble of the 1990s. All of these bull markets were followed by bear markets. Not all bull markets are followed by such severe bear markets. For example, the bull market in U.S. stocks that ended with the crash of 1987 was not followed by a prolonged price decline, but rather by a gradual recovery to precrash prices that developed into an even stronger bull market. This difference may be attributable to the existence of long-term secular market trends. In this view, such trends (generally lasting 15 to 20 years) contain alternating bull and bear markets within them. A secular bull market is a period in which bull markets are more powerful than the bear markets with which they alternate; in contrast, a secular bear market is a period in which the bear markets are more damaging and the bull markets are tepid. The period 1982-2000 has been described as a secular bull market for the S&P 500, while the period 1980-1999 can be viewed as a secular bear market for gold. Note that secular bull and bear markets can co-exist in different securities and commodities and may differ in duration and degree of overlap. A more precise definition of bull and bear markets is required in order to make definitive categorizations.
bear market
A pronounced downturn in a market.
Changing the definition of bull or bear market may result in significantly different beginning and ending dates, as well as changing the number of cycles. For example, some people consider a 20 percent decline from a high to constitute a bear market. By this definition, the most recent complete bull market in the DJIA ended on October 9, 2007 with the Dow over 14,000.
A bear market began that day, reached a (closing) low point of 7,552 on November 20, 2008. A rally of slightly less than 20 percent had the DJIA close over 9,030 on January 2, 2009. For some, this marked the end of the bear and the beginning of a new bull market—because the DJIA made an intraday low of 7,449 in November, 2008. Though the difference to the closing low of 7,552 is small, it is enough to make the rally exceed the 20% threshold this definition requires!
So we can see how tricky it can be to know when you’ve reached a turning point. In the present instance, one could argue that a more sensible definition would require a 25 percent gain to constitute a bull market. After all, it takes a gain of 25 percent to offset a loss of 20 percent This “sensitive dependence upon initial conditions” is definitely worth “bearing” in mind!
A Tale of Three Crashes
Three times in the last 100 years, the stock markets have collapsed dramatically, sending millions of investors into a panic and erasing billions of dollars in equity. The first of these great crashes occurred in 1929, after a six-year bull market in stocks had sent the DJIA soaring from 85.76 on October 27, 1923, to an all-time high of 381.17 on September 3, 1929. Fifty-five days later, over a two-day period beginning on Monday, October 28, and continuing on Black Tuesday, October 29, 1929, the stock market crashed. Tuesday’s closing price was 230.07. Measured from the previous Friday’s closing price of 298.97, the index had declined by more than 20percent Measured from the peak attained only 55 days earlier, the index had lost nearly 40 percent.
Many investors were totally wiped out. Some committed suicide. One of the reasons for the devastation (if not for the crash itself) was the widespread use of margin, a form of leverage. Using margin allows an investor to borrow part of the money needed to buy stock from a broker. In the 1920s, investors were able to buy stocks by paying only a small fraction of the cost up front. They would borrow most of the money from their brokers. For example, in those days you could buy $100,000 worth of stock with 10 percent margin ($10,000), borrowing the remaining 90 percent ($90,000) from your broker.
margin
Cash used to purchase investments with supplemental credit supplied by broker; subject to terms of a margin account agreement.
The catch? Each day the value of your holding is marked to market. Let’s see what this means by using an example. If the price of the stock falls by 5 percent, the value of the stock decreases by $5,000. But you still owe $90,000 (plus one day’s interest). The value of your position, sometimes called your equity, has decreased by 50 percent, from $10,000 to $5,000. The process of figuring out how much equity you have in your account is called marking it to market.
marked to market
Calculate the market value of a position; in a margin account, used to ensure that minimum margin is maintained.
A large percentage decline in your equity triggers a margin call from your broker. This means that the broker is demanding more money (or eligible securities) to bring your position back up to its minimum margin requirement. This is sometimes referred to as remargining. If you do not come up with the money in time, your position may be closed out, meaning that the broker can sell your stock in order to recoup (some of) the money you owe. In the crash of 1929, many investors were not only wiped out, but they still owed significant sums to their brokers.
The magnification of losses through borrowing is the great danger of leverage. The use of borrowed money in investing is one example of leverage. Another kind of leverage that does not involve borrowing is the purchase of options (see Chapter Sixteen). Some investors engage in margin-based leverage when they are bullish on a stock. A small uptick in the stock brings a magnified profit because of the larger amount of stock in the investor’s account. A major reason for the high degree of risk in futures markets is the common use of much higher amounts of leverage than is permissible for stocks.
Leverage is a double-edged sword. It can bring great returns, or it can cost you your shirt. Unless and until you thoroughly understand securities and the markets in which they trade, leverage may be hazardous to your financial health.
One of the many reforms instituted in the years following the crash was the regulation of margin requirements by the Federal Reserve Board. Under Federal Reserve Regulation T, initial margin has ranged between 50-100 percent for eligible stocks, meaning your broker can lend you up to half of the money needed to buy a stock.
Federal Reserve Board
Governing board of the Federal Reserve System, which serves as the central bank of the United States.
In the months following the crash, stocks traded in a fairly narrow range, with the DJIA recouping some of its losses. It looked like the worst might be over and that prosperity was “just around the corner.” In fact, what was just around the corner was the Great Depression. With 20/20 hindsight, the period from the end of 1929 to the spring of 1930 became known as the sucker’s rally.
The second great crash occurred almost 60 years later. It came after a bull market of a little over three years. This bull market began on July 24, 1984, with the DJIA closing at 1,086.57. The market reached its peak of 2,722.42 on August 25, 1987. By a strange coincidence, the crash commenced exactly 55 days after another late-summer all-time high. (See
Table 5-4.)
There, were, however, three major differences:
• The market collapse happened faster in 1987 than in 1929.
• Vigorous action by newly appointed Federal Reserve Board Chairman Alan Greenspan provided desperately needed liquidity on the day following the crash. Some analysts believe that it was the Fed’s intervention that prevented October 20 from becoming an international financial catastrophe.
• Finally, though it took almost two years for the market to reach precrash levels, no economic collapse followed in the wake of the 1987 crash.
Some economists believe that the roughly 60-year period between the two great crashes is no accident. They point to an underlying cycle of prices and economic activity, the so-called Kondratieff Wave. Indeed, looking back 60 years from the 1929 crash brings us face to face with another famous financial panic, the original Black Friday: September 4, 1869, when a business panic was precipitated by a group of financiers trying to corner the gold market.
Table 5-4 The First Two Crashes: Comparative Stats
The third crash began roughly seven years after the bursting of the Internet Bubble. During those seven years, a Housing Bubble unfolded, fueled by extremely easy credit policies in the United States and abroad. By the summer of 2007, these credit policies gave rise to extremely unstable market conditions and an initial round of failures of hedge funds and subprimerelated assets. Though the DJIA made a new peak of 14,163.53 on October 9, 2007, it had only barely broken even since 2000 after adjusting for inflation. Seventeen months later, on March 9, 2009, the DJIA was more than cut in half to a low of 6,469.95
The Incredible Growth of Trading and Capital
The total number of shares traded in a given period of time is called the trading volume. Trading volume on the NYSE has roughly doubled on average every 11 years, going back for more than a century. This pace of change shows no sign of letting up.
Another way of looking at trading activity focuses on the behavior of a single share. How often does the average share change hands? This number, expressed as an annual percentage, is called the
turnover: 100% turnover means that, on average, each stock is held for about one year. You might think that the tremendous increase in trading volume has brought with it an increase in the turnover of individual shares. But you’d be in for a surprise. It is worth noting that the expansion of trading on the exchange has not been from an increase in the number of times individual shares of stock get traded. Turnover can be calculated for individual stocks, funds, even for the market as a whole. Turnover in NYSE shares set an all-time record of 319% in 1901, when trading volume was less than one-tenth of 1% of what it is today. (See
Table 5-5.)
turnover
The rate at which a stock, portfolio, or market is traded; expressed as an annual percentage.
At the end of 2008, the total market capitalization of the NYSE exceeded $9 trillion. By this metric, it is by far the largest exchange in the world (see
Table 5-1). As of December 31, 2008, the combined NYSE Euronext facilitates trading in the stock of the more than 8,000 companies that meet its stringent
listing requirements. The historic landmark building at 11 Wall Street and 18 Broad Street has housed the exchange since 1903.
Market Turnover Through the Years
Annual turnover on the NYSE was over 100 percent many times in the early decades of the twentieth century, before going into a long period of low turnover that began with the Great Depression and continued for nearly 50 years. A new uptrend in turnover began in the early 1980s, reaching 73% in 1987, the year of the second great crash, and climbing back into triple digits in the current decade, with a recent monthly peak of 173% (annualized) in October of 2008.
Sources: NYSE, World Federation of Exchanges
On October 30, 1929, the second day of the infamous crash of 1929 (see “A Tale of Three Crashes”), the NYSE set a new record for trading volume when 16.4 million shares changed hands. In October of 1997, the NYSE had its first day of more than 1 billion shares traded. This more than 60-fold increase in trading activity would be impossible to imagine, much less accomplish, without the tremendous technological advances of the intervening decades. On the day of the crash itself, the ticker ran more than two hours late. On October 10, 2008, the NYSE accommodated record trading volume of more than 2.95 billion shares.
NYSE Listing Requirements (minimum standards for domestic equity-listed companies)
1. Number of holders of 100 shares or more (or of a unit of trading if less than 100 shares)
400
1 or Total stockholders together with average monthly trading volume (for most recent six months)
2,200
1100,000 shares
or
Total stockholders together with average monthly trading volume (for most recent 12 months)
500
11,000,000 shares
2. Number of publicly held shares†
1,100,000 shares†
3. Minimum Market Value of Public Shares
$100 million, or $60 million for IPOs, spin-offs, carve-outs, and affiliated companies
Source: NYSE. For additional details and changes, see
www.nyse.com.
From Ticker Symbols to CUSIPs: How to Get a Quote
Anyone who has ever tried to find the closing price of a stock in their favorite newspaper or online service knows that it can be time-consuming and frustrating. It is seldom enough to know the name of the company whose stock (or other security) has captured your interest. Newspapers and online services don’t always provide the company’s name, or even a recognizable abbreviation, when listing the stock. If you don’t recognize the abbreviation or the ticker symbol for the stock, what can you do? Today, you have a great option that wasn’t available when the first edition of this book was published: you can “consult the oracle at Google,” i.e., go to finance.
google.com and just start typing what you know. This can save a lot of time otherwise spent in looking it up, asking others if they remember the ticker, and so on. Sometimes, you may wish to identify a security through its Committee on Uniform Security Identification Procedure (CUSIP) code. CUSIPs are alphanumeric codes that uniquely identify securities. Colloquially, CUSIPs refers to the identification codes themselves. All U.S. securities have unique CUSIPs. For example, the CUSIP for IBM common stock is 45920010. The first six numbers of the CUSIP are its issuer number or
cnum; this number uniquely identifies an issuer. The seventh and eighth digits uniquely identify the security. There is a ninth digit. It is called the
check digit and it is used to mathematically ensure the accuracy of the whole CUSIP number for data transmission. IBM’s cnum is 459200. Cnums are useful if you want to get a listing of all of an issuer’s securities. This is especially important for corporate bonds and stock options, because a single issuer can have dozens of these.
National Association of Securities Dealers Automated Quotation System (Nasdaq)
Nasdaq, the leading electronic stock exchange in the United States, originally was set up by the National Association of Securities Dealers (NASD) in 1971. Its roots can be traced to the 1950s, when institutional investors first began buying large quantities of common stock. Rather than pay the high brokerage commission costs of the time, these investors traded large blocks of stock off of the exchange floor, using brokers who were not members of the exchange. Aside from saving on commissions, these large investors were trying to avoid moving the market with a large buy or sell order, thus hoping to get a better price.
With the deregulation of broker commissions in May 1975, some of these brokerage firms became members of the exchanges so that they could trade with existing members. In parallel with this development, member firms began trading blocks of stock off of the exchange floor, subject to the rules of the NYSE.
The NASD was a not-for-profit organization, founded in 1939. It was originally sponsored jointly by the Securities and Exchange Commission (SEC) and the Investment Bankers Conference, in compliance with the Maloney Act of 1938. In 1998, Nasdaq merged with the AMEX, the New York-based stock exchange that had for decades lived in the shadow of the NYSE. Nasdaq became independent from NASD in 2000; in July 2007, the NASD’s regulatory functions were combined with those of the NYSE under a new self-regulatory organization (SRO), the Financial Industry Regulatory Authority (FINRA).
Nasdaq lists more companies than any other major exchange; its market cap roughly equals that of London and Tokyo, putting them in a virtual three-way tie for second largest equity market (not counting Euronext, which is a subsidiary of NYSE Euronext). The role of the market makers in Nasdaq trading will be discussed further in Chapter Nine.
Instinet was an early innovator in electronic trading. Founded in 1969, it pioneered electronic block trading for institutional investors; offered the first quote montage for a U.S.-listed market; introduced direct market access (DMA) to U.S. exchanges; and pioneered after hours trading.
After its 1987 acquisition by Reuters PLC, a British company, in a hostile takeover, Instinet CEO Bill Lupien left to form a new alternative trading system (ATS) which ultimately became Optimark Technologies. Though Optimark failed in its ambitious attempt to transform the nature of trading and to make markets more efficient, it inspired a large number of imitators (including Liquidnet and Pipeline) and a burgeoning field of algorithmic trading that continues to grow today.
Users of ATSs include traders and brokers who work for sell-side firms, which is Wall Street jargon for brokerage firms. Sell-side firms use alternative trading systems for customer accounts and for their own internal trading. Other users are the traders who work for the buy side—mutual fund managers, pension fund managers, and other professional money managers working at banks, insurance companies, and other kinds of investment firms.
sell side
Underwriters and brokers/dealers who sell securities to retail and institutional investors.
What we have been talking about up until now is sometimes referred to as the secondary market, to distinguish it from the market for securities that have not been previously sold. These securities, which include the IPOs of corporate stock, as well as additional shares that a company may issue from time to time, are issued in the primary market. Proceeds from the sale of stock in a primary market are divided between the issuer and the underwriters, who receive a commission for assuming some of the risk associated with the new issue and facilitating its sale, either directly or through dealers.
secondary market
Market in which already issued securities trade.
Technology, Dark Pools, and the Evolution of a Unified Market
The great and continuing consolidation of exchanges is being driven by technology and deregulation. Simultaneously, the emergence of “dark pools”—electronic trading systems used by sophisticated traders in search of liquidity—have increased the fragmentation and complexity of orders and trading. The combined impact of these forces is hard to measure, much less extrapolate. Nonetheless, the evolution of a truly international market system seems increasingly likely.
