August 24, 2010

There Are Spreads and There Are Spreads

Why do many stock prices move intraday by 3-5% or more when price spreads are in pennies?

Before we answer, we enjoyed New Orleans last week, despite humidity that had us struggling to distinguish the surrounding atmosphere from Lake Pontchartrain.

The NIRI Southwest Regional Conference concluded with brisk canvassing of key issues, wrapping on “would you choose an IR career again?” (Unanimous yes from panelists)

Bourbon Street hopped as usual, tourists with beer in cups labeled “giant donkey,” in so many words. We heard from the bartender at Pierre Maspero’s that the Lower 9th Ward and Chalmette still aren’t the same, folks picking up and moving across the lake to Covington. Many for-sale signs in the Quarter. We strolled by Brad and Angelina’s, who’ve done their part and taken one sign down. They didn’t look to be home.

So here’s your New Orleans Analogy about market structure. When the levees broke, water spread out, and equalized. The law of diffusion spreads molecules to fill available space. Physics. There are spreads, and there are spreads. Imagine how handy it would have been if at the spots where levees ruptured, the water just stayed in place, a sort of Moses effect. Alas.

The Game column in today’s Wall Street Journal by Dennis Berman notes how Senator Ted Kaufman thinks the SEC should revisit whether narrow spreads help investors. Good article, we recommend it. It brings us to our opening question. Often, a percentage of our client base moves in intraday aggregate by more than 5%. Size doesn’t matter. I can think of a client who reported a couple weeks ago and missed expectations widely that’s up 18% from after the call. Another client in the same timeframe beat, and is down 19%.

How? Did the minds of investors radically shift in days, such that intrinsic value, without one update to a metric, has shrunk or inflated by factors? What accounts for monumental value gaps from minute market spreads?

At the thought of what answer may come, you may grope for your monolithic moke of a brew (labeled otherwise in the Quarter) to gulp some down. Relax. No complicated constructs here. The answer is simple: by controlling both prices and volatility at the point of entry through the national best bid or offer and penny pricing increments, we create giant pricing wrinkles that move not according to fundamentals – fundamentals don’t set entry and exit points – but according to the levees.

Put another way, if the levees direct the flood away from equities to, say, US Treasuries, then all the business acumen on the planet will not keep your price frozen there at your rational price, Moses at the Red Sea, while the waters rush on.

You will be re-priced by everything else in the market. Is that fair? According to current rules, it is. We’re improving competition, so say those crafting them. If you like that, then be prepared to suffer market slings and arrows in spite of fine fortune.

Something to consider diffusing into that letter we suggested last week you pen for your C-suite on market structure: why not a test market that does the opposite of what we’re doing? No intermediaries. If you buy it, you own it. No price controls. You may bid or offer what you wish, and if someone agrees, more power to the both of you. No circuit breakers – let caveat emptor do its cleansing thing when or if it must. Voluntary membership by public companies, who get to offer a set number of shares there.

Why not? The levees didn’t work in New Orleans and constricting prices and behavior isn’t working in the markets. Sure, it might take the spirit of Andrew Jackson from 1812 in the Big Easy. But that worked out pretty well.

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