Stock market bubbles and fiddles

Thursday, 16 January 2014 00:00 -     - {{hitsCtrl.values.hits}}

Shares can play an important role in saving for the future. The conventional advice of financial pundits in the UK is to keep a part of one’s savings in shares, a part in property and a part in secure fixed interest bonds. In Sri Lanka generally, shares get the smallest part. In fact a very small part (1%) of the population owns any shares. One of the causes for such a low investment in shares is a fear that the market is manipulated and the investment is not secure. It is interesting to have a brief dip into the murky waters of market manipulation. The best way of exploring this is to look at some famous bubbles and fiddles. Much has been written about them as they help to illustrate clearly the underlying factors and forces that can lead to the blooms and slumps in shares.   Stock market bubbles When I see the word bubble it always brings to mind the picture of a soap bubble. It has a lovely tinge of colour and it grows larger and larger and then it bursts and is all gone. Stock market bubbles are bit like soap bubbles. Share prices go up and up and everything looks rosy and then the bubble bursts and it all comes tumbling down. There have been major bubbles through the centuries. One of the earliest and very famous is the Dutch Tulip bubble.       Dutch Tulip bubble The Dutch have always grown tulips and the tulip bubble took place in the 1600s. In the 17th century, Holland was a powerful trading nation with colonies around the world (including Sri Lanka). A new rare Tulip bulb from somewhere in the old Ottoman empire was imported into Holland. There was a lot of interest in this new tulip bulb and the importer instead of planting it sold it for a large profit. It takes time to grow new bulbs and the tulip growers went in for forward sales of the rare tulip bulbs. That is they promised to deliver the bulbs at some future date. Holland had an organised stock exchange and these sale contracts were traded. The prices kept rising and people were scrambling to buy these contracts as it was a sure fire means of selling them on and making a profit. The market was driven not by any interest in horticulture. It was driven by the greed to make quick money. Then one day a man holding a number of contracts could not get a price and he panicked and reduced the price as he had mortgaged all he had to raise money to buy these contracts. When people saw the price decline there was panic and they all scrambled to sell, and the price came tumbling down and. In the end tulip contracts sold for no more than the normal price for rare tulip bulbs. The Dutch Tulip bulb bubble helps to illustrate that bubbles are not driven by the intrinsic underlying value of the asset. It is driven by greed and the desire to make a quick buck.     The Dot Com bubble A relatively more recent bubble was the Dot Com bubble in the USA in the late 1990s. This was triggered by a growing sense of excitement about the Internet. Not many had any clear picture of what it could do or how it would create sales and profits, but nevertheless there was this mushy belief that something exciting called the Internet was born. Netscape was the market leader for web browsers and it went public in 1995 at a price of $ 28. At the end of the first day’s trading, the price was $ 71. This set fire to the imagination about the financial potential of the Internet. In 1997 the Nasdaq index was 2746. By 2000, driven by IT stocks, it had risen to 5400. By the end of 2000 the bubble had burst and the index collapsed to 1114. During the bubble there were 390 IPOs. Most of them with no clear plans for generating earnings but any IT firm that went public found a gullible investing public ready to gobble up the shares. But within three years it became clear that these IT firms were not going to generate earnings to support their share price and then there was the mad rush to get out of IT stocks and the bubble burst. The learning from this like with the Tulip bubble was that it was driven by greed for quick profits. When it became clear that there were no credible underlying earnings to support the price, people began to exit the shares and the price collapsed.       From bubbles to fiddles A fiddle is something that may not be a crime under the law but is a little dodgy and is best put under the all embracing term fiddle. In the 1980s Michael Milliken (who was with Dexel, a well known investment bank in the USA at that time) acquired a great reputation in the USA for what came to be described as junk bonds. The junk bond is an interesting ploy. A controlling interest is progressively acquired in a company with a poor balance sheet. This meant it was acquired at a cheap price. This company then issued bonds at a high rate of interest. The company had no earnings to pay the interest on the bonds and there were no assets to back the bonds. That’s the reason they were called junk bonds. Milliken was able to get his contacts to subscribe to these bonds. That was the Milliken magic. Many others perhaps had similar ideas but they did not have Milliken’s ability to sell these junk bonds. When the cash was in, he made a hostile bid for a good company with a cash flow that could pay the interest and progressively redeem the bonds. He did this successfully for many years. Somewhere the line of what is illegal must have been crossed as he was convicted and sent to Jail. He also had to a pay a huge fine. Notwithstanding the fact that he was a multi-millionaire when he was sent to Jail. He was a multi millionaire when he came out of Jail! Did someone say that crime does not pay? Those who were protagonists for junk bonds argued that this process of raising funds helped to revitalise good companies that had gone to sleep and therefore it was beneficial to society. Others argued that the use of an illegal process cannot be justified even though the end result was good for society. Regulators will always stay with this view.       The fiddles bucket The fiddles bucket has many interesting ploys in it. A brisk gallop, picking up on a few will help to shed light on this fascinating area. Pumping and dumping is a popular fiddle. This need not always be a mega activity played only by the big boys in the market. Even small retail investors are at it. However big or small, the basic process is the same. This is how it goes. An investor puts a parcel for sale at a price above the current trading price. This is promptly picked up by his partner. He then does the same thing. This process can go on for some time. When the price has gone up and there is a belief in the market that this is a good share that has been increasing in price, they unload their shares and make the profit. When the daily share reports indicate that a share price has moved by very small sale, sometime only one share that is, a sure sign that a small retail investor is trying to make a small killing. This is generally tried with shares that have a low price. If a Rs. 20 share is pushed up by Rs. 2, then it is a quick 10% gain! A variation is to push the price down by the same process and to then enter the market and buy at the lower price. Brokers can move the market by recommending “buy” to their clients. Similarly they can move the price down by recommending to their clients that they should exit some shares. A more sophisticated approach is to use the brokers research reports over a period of time to keep putting the gloss on a share or to do the reverse and to keep tarnishing a share.       Insider trading This is the one area regulators around the world have success in getting convictions. The cleverer ploys appear to escape! That is a fair conclusion if one goes by the reports of convictions. There are very few if any reports of convictions for anything other than insider trading. Insider trading is where a person gets information that is not in the public domain and uses this information and buys or sells a share and makes a profit. A recent famous case was Raj Rajaratnam who had the Galleon fund operating in the USA. He was convicted and sent to jail for getting insider information about news that would move a share price and then making large trades before the news became public and thereby made large profits. It is said the he was a billionaire before he went to jail. He too, like Millken, will probably be at least a multi millionaire when he comes out of Jail! Whilst various manipulations are theoretically possible, a combined effort by the SEC, CSE, Brokers and quoted companies should ensure that manipulations that hurt investors do not happen, to avoid the lack of confidence in the stock market.

Recent columns