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Specialist Investment Accounts
The ability of specialists to possess and totrade in their own investment accountsshould be a source of great consternation toinvestors. It is very easy to understand thisphenomenon once one understands that arevolving door exists between the StockExchange and the SEC. For example, justprior to the investigation of E.F. Hutton for thousands of frauds in 1981, John Shad,the Vice Chairman of E.F. Hutton, wasappointed Chairman of the SEC. Having leftthe SEC, he is returned to the investmentbusiness as Chairman of Drexel, Burnham.The revolving door is one reason why thespecialist system has been allowed toperfect its goals of profit maximizationrather than the goals appropriate to itsfunction as a fiduciary.Rather than serving in accordance with their statutory requirements as fiduciariesspecialists are allowed by the SEC to act incompetition with investors. Their ability totrade and invest for themselves has giventhem a stake in the direction in which theymove stock prices. At the same time, themere existence of their trading andinvestment accounts leads to certainpredictable patterns of behavior byspecialists specifically, patterns of behavior which tend to maximize their profits. This, inturn, gives the astute investor, who is willingto make the effort to learn these behavior patterns, an important key to unlock themarkets future.Of course, the ultimate solution to theproblem of the specialist system is to dowhat has been done in other institutionalframeworks where conflicts of interestwould be detrimental. For hundreds of years, it’s been the maxim of Englishcommon law that no man should serve as judge and jury in his own case. Everyone,even if he or she has never studied the law,understands intuitively why this should beso. Indeed, one of the triumphs of our legalsystem is that it has erected structuralsafeguards to blunt the natural tendency of men to pursue their own self-interest in asituation where it’s not appropriate.If the system has failed in the case of theStock Exchanges, it is because the SEC theagency that is supposed to regulate andmake the laws governing the Exchanges,expressly provides for the securitiesindustry’s representatives to dominate itsadvisory boards and act as its chairmanand commissioners. In effect, theExchanges make the regulations to whichthey are presumably subject to.Thus there exists within the Exchangeestablishment an institutional arrangementwhich not only does
not
thwart thetendencies to self-interest, but whichencourages it. The result is an institution,which exists for the benefit of those who areable to manipulate its institutional privilegesto their own advantage. To fully understandthe problem, it’s important to recognize thatit begins with the individual known as thespecialist. Specialists do not work for theExchange they
are
the Exchange.They are the brokers on the floor of theStock Exchange given the responsibility “
tomaintain a fair and orderly market
” for thestocks assigned to them. There are severalhundred specialists on the floor of theExchange, divided into approximately 50units. Each unit handles the buy and sellorders in as few as 10 issues to as many as50 or more stocks. Since each specialistunit is located at one locale on theExchange floor “
called the post
”, all buyand sell orders for issues are handled atone spot.The orders placed with one’s broker eventually find their way to the specialist onthe floor of the Stock Exchange. One of hisfunctions is to then match as best he can
 
the public’s buy and sell orders. Because allorders flow through him, the specialist issuppose to possess the best overview of the demand and supply factors that shoulddetermine the price of the issues assignedto him. He is, therefore, charged with theuniquely sensitive task of setting anappropriate or fair price for his stocks.When the investor hears that GM hasclosed up ½ or that IBM has moved down 2¼, he should understand that this literallymeans the specialist-set price in IBM was 2¼ points lower on the second day than thefirst. We shall see, however, that more thanpublic supply and demand factors impingeupon the specialist’s decision-makingprocess of what price to set for his issue.To understand the source of these other factors, it is necessary to explore a bitfurther the nature of the specialist’soperations. Those few individuals who knowanything about the specialist probably haveheard that he is supposed to maintain a fair and orderly market. One way he issupposed to accomplish this is to act as asource of market liquidity.Every stock that is traded on the New YorkStock Exchange is assigned to a specialist,and every specialist stands as a miniaturewarehousing operation for the stocks he’sbeen assigned. Theoretically, any “excess”public demand for an issue would be met byselling distribution from the specialist’sprinciple warehouse, better known as histrading account. On the other hand, whenthere is “to much” public supply or publicselling, the specialist is supposed to openhis warehouse (trading account) to mop upor accumulate these excess quantities of stock.Whatever legitimacy specialists tradingaccounts might have because of there rolein maintaining market liquidity, they morethan lose once one discovers that inaddition to a trading account maintained for warehousing purposes, the specialist is alsoallowed to maintain an investment account.The existence of this account gives thespecialist the same trading incentives asany profit-seeking figure. He wants to buylow, to sell high and to do so with aminimum of tax consequences. The onlytrouble is that he is not just any profitseeking figure.The specialists access to the most sensitivemarket data, the universe of demand andsupply orders, as well as his ability to setthe price of his issue, puts him in a situationwhere it is impossible for him to fulfill hisduty as a fiduciary. The equivalent situationin the legal world would be to let one act asa judge in his own case.A special investigators team of theSecurities and Exchange Commissionrecognized the inherent conflict of interestsin 1963 when it studied the market crash of 1962. In its report, the commission wrote,“
 purchases made on the Exchange for the purpose of segregation into long terminvestment accounts raised problems which goto the heart of the specialists system” 
. Thespecialist is permitted to trade for his ownaccount only when such trades affirmativelycontribute to the maintenance of a fair andorderly market. Where the specialist goesinto the market with the intention of segregating the securities purchased andnot with the purpose of creating a fair andorderly market, the trading is clearlycontrary to the statutory and regulatorystandards. “Beyond this, the specialist witha long-term position now has a stake inseeing that the security rises in price - - hehas become an “investor” as well as adealer.”“
 A further problem arises when the specialist who maintains such long-term accounts isrequired to sell stock to maintain a fair and orderly market and he has no stock in hisspecialist trading account. (If) the 12 month period of the tax statute is almost over, thespecialist may well be tempted to keep his stock in the long-term account and neglect the needsof the market 
”.
 
Of course, the last point, about the 12month statute, was written at a time whenthere were special tax incentives to hold anissue for a period of time. The period hasand continues to be as long as a year.Since specialists are investors and are justas anxious to minimize the taxconsequences of their trading as you and I,we also believe that bullish phases of themarket in the future will tend to matchwhatever period of time is deemednecessary to obtain favorable tax treatment.Not surprisingly, the Chairman andCommissioners of the SEC chose to ignorethe reforms recommended by the staff theyhad gathered to carry out Congress’smandate for an investigation of the StockExchange practices.Human nature being what it is, one shouldnot be surprised to see the specialist usehis unique position to further his owninterests - - which he does every minute of every day.
It is no exaggeration to statethat by the very nature of the situation inwhich they have placed themselves,specialists conduct insider trading fromthe moment the opening bell rings untilthe moment the market closes
!There has, of course, been a stream of troubling news flowing from Wall Street asthe improprieties of figures such as DavidLevine, Roger Winans, Ivan Beosky, BoydJeffries, Mike Milken, and others have beendisclosed. The direct harm caused toindividuals and corporations by the illegalactions of these men cannot beunderestimated. It is ironic, however, thatthe fact of the discovery of their misdeedshas had an unrecognized consequence. Ithas reassured the small investor that thefinancial establishment’s regulatoryagencies are actively and productivelyworking on his behalf. More than ever, heprobably believes that the system works - -that all which stands between him and theoperation of squeaky clean securitiesmarkets are the occasional misdeeds of these so-called insiders. Nothing could befurther from the truth. This country’sregulatory agencies, such as the SEC, areconcentrating their energies on the wrong“
insiders
”. Thus, the investing public hasdeveloped a false sense of security in theintegrity of the financial markets.If one begins, using the premise that themarket’s true insiders are Stock Exchangespecialists, and that they will do anythingthey can to profit from their position at thecenter of the market, then certain points of departure begin to emerge from other sortsof market analysis. The most important of those is our focus on the specialist as amerchant seeking to buy low and to sellhigh for his investment account.If the specialist has for the most part beenaccumulating in his investment accounts,he can be expected to use his control over price to rally his issue. If the specialist hassold stock from his investment account and,furthermore, if he has sold short, then thespecialist can be expected to use hiscontrol over price to drop the price of hisstocks.Since I believe one can do no better thanto piggyback the actions which specialistsare taking for their investment accounts, myapproach centers on determining whether specialist have been accumulating,distributing, selling short or covering earlier short sales in these accounts. I thenconform my strategies as closely aspossible to those specialists.Of course, the question which logicallyarises is whether there is some way toidentify which of these specialistmerchandising operations is underway - - aspecialist fingerprint that would enable youor I to identify such specialist transactions. Inoticed on the ticker tape that time after time big blocks of stock were traded both atthe top and the bottom of the stock’s price
of 00

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