Specialists, How They Use Their Merchandising Strategies by Richard Ney

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Specialists, How They Use Their Merchandising Strategies AndSelf-Regulation For The Manipulation Of The Stock Market

People who invest in the stock market usuallydon’t spend too much time thinking about thespecialist, why he is important, and why heshould be very carefully supervised andregulated, until such time as there is anawesome crash in the market. At such timesthe public hollers for an investigation of thestock market. Since most of those ingovernment doing the investigating arebeholding to the Stock Exchange in one wayor another (

via campaign contributions or through their law firms

), or hope (

if they are commissioners and chairman of theSEC

) to be employed in the securitiesindustry at some not to distant date, nothingever comes of these investigations.Those in government charged with theadministration of the securities industry andwho conduct these investigations are fullyaware that since the turn of the century thefindings of such investigations have centeredon the fact that the deep and inexorable criesof the stock market are caused by the failureof specialists to operate the market in a fair and orderly manner when acting as dealersfor themselves while in direct competition withthe investing public. According to the “

Reportof the Special Study of Securities Marketsand Exchange Commission” of 1963

:

Specialists are at the heart of the problem of organization, management and disciplinary procedures of the exchange…. the misuse of their role in the operation of a fair, orderly auctionmarket and the breakdown of regulatory and disciplinary controls over them… are part of acomplex pattern of interlocking causes and effects.It is for this reason that any program or reformmust concentrate heavily on the dominant role of the specialist.

In the past even the most public-spiritedinvestigation of the specialist system, whichwas the 1963 Report, declined toacknowledge the exact manner in whichspecialists employed their merchandisingstrategies to maximize profits for themselvesat the expense of individual investors. Part of the reason is that specialists are not bound byeither the rules of the Exchange or the SEC toinform the public or anyone else about thespecifics of all of their transactions.The SEC’s report did, however, pointedlyinsist that the specialists’ conduct did notconform to the established code. Where their most important practices were concerned,specialists employed techniques, which wereimpossible for the public to follow because of the specialists’ unwillingness to provide thepublic with information concerning the detailsof their activities. In particular, it singled outthe specialists’ use of the short sale.Under ordinary circumstances, an individualbuys stock in anticipation of a subsequent risein price, which will enable him to sell it at aprofit. When an investor sells short, hereverses the process by first selling the stockin anticipation of a subsequent “

decline

” inprice which will allow him to then buy thestock back at a lower price. His profit (or loss)is the difference between the price at whichhe first sells the stock and the price at whichhe later purchases it.When an investor wishes to sell short, (IE) tosell stock he does not yet own, his brokeragefirm will normally arrange to “

borrow

” thestock from their or another brokerage firmspool of securities, with the understanding thatat a later date the investor will return thoseshare. This investor is then able to makedelivery with his borrowed stock to the partyto whom his broker sold it. When the investor later makes his “

covering

” purchase of thestock, he is then able to return the shares heborrowed to clear his obligation.The act of selling stock, which an individualdoes not own, is called “

short selling

,” while

his subsequent purchases are referred to as“

short covering

.”When a specialist uses the short sale, theprocess is basically the same. There is,however, one very important difference.When an investor sells a stock short, he“

thinks

” that the price of the stock willdecline, whereas the specialist’s short sale isbased on the certainty that he intends ontaking the price of the stock lower.The power of the short sale can be seen inthe manner in which the instrument allowsspecialists to completely control the forces of supply and demand so that ultimately theycan raise and lower prices at will. In thehands of the specialist the short sale is atriumph of human ingenuity. Thanks to thenature of the instrument and its paradoxicalfunctions, the short sale enables specialists todetermine the short, intermediate, and long-term price objectives of their stocks.As an example of how short sale rules havebeen distorted for the benefit of insiders withthe aid of the SEC is as follows: In 1938 theCommission enacted a short-selling rule thatprohibited Stock Exchange members from“

demoralizing the market

” by effecting shortsales at or below a price lower than the lastsale. This rule was meant to prevent “

shortsellers from accelerating a decline byexhausting all remaining bids, offers tobuy, at one price level, causingsuccessively lower price levels to beestablished

.”The SEC however, provides specialists with aloophole that allows them to “

demoralize themarket by selling short on downticks

”(without having to report these transactionsas short sales) whereas the investing publiccan only short on upticks. (A transaction thatis executed on an uptick occurs at a higher price than the last preceding price, while atransaction that is executed on a downtickoccurs at a lower price than the last precedingprice.) Indeed, investors have remainedtotally unaware of the myriad controls over individual stock prices and the market as awhole accruing to specialists through their use of the short sale.To those that think that my statement that thespecialist is able to manipulate stock prices atwill seems far fetched, the SEC’s SpecialStudy Report provides an illustration thatdocuments this conclusion. Quoting BillMeehan when he was the specialist in Ford,the Report provides you with an insiders viewinto the process in which specialists are ablevirtually to guarantee a profit for themselvesin the course of a long bear market. Meehanshows you that he was able to do this byselling short and then lowering his stock’sprice levels at which he then “

covered

” hisshort sales:

Not that I am a student of the charts, but I took alook at the Ford chart and it looked very dangerousto me. I liquidated our whole position and went short and we maintained a short position, actually in only three of our stocks, all the way through, practically, during the whole period. During theday, we would become long, but almost every night we were short stock. [SSR, Part2, Page 113]

In order to understand the implications of what Meehan is saying, it is important tounderstand that when specialists rally stockprices, public buying is attracted. Conversely,when specialists drop the prices of their stocks, the public on balance can beexpected to sell stock. Thus Meehan, in thecourse of dropping the price of his stock in themarket crash of 1962, accumulated aninventory of stock in the morning, (

in allprobability most often at or near theopening

) from investors who frightened bythe decline that was taking place in the stockand fearful of a further decline, had enteredtheir sell orders to sell.Thereafter, he was able to reduce hisinventory by rallying stock prices. The rallywould attract public buying demand insufficient quantities to enable him not only toliquidate his trading account “

during the day

”

but to also “

short stock

” almost everyafternoon. As you can see, his short saleswere indispensable in taking down the stockprices profitably in a bear market, in this casein what was one of the worst bear marketsencountered by investors in the 20

th

century.Equally important to recognize is that thisexample documents the manner in which theshort sale enables specialists to manipulatetheir stock prices up and down at willregardless of whether the market is a bull or bear.A business week article stated, “If specialistsapparent monopoly looks like a license tosteel, the specialists have an answer.” “

If wemake so much money

,” they argue, “

whyisn’t everyone else trying to get into our business?

” When outsiders do investigatethe possibility of this, they discover that itwould probably be easier to break into FortKnox’s.Each of the specialist’s privileges has adecisive influence on the destinies of investors; some offer him more opportunitiesfor profit than others. Unknown to mostinvestors, in addition to the profits from their trading accounts, specialists have what arecalled “

long-term segregated investmentaccounts

.” The SEC’s Institutional Investor Study has calculated that specialists makebetween 84 to 192 percent a year on their capital.The article stated, however, that the studyhad “

ignored specialist investmentaccounts

.” The fact is that although the SEChas from time to time mentioned specialists’returns from their trading accounts, it hasalways consistently refused to provide anyinformation concerning profits from aspecialist’s business or his investmentaccounts.Observation of specialist’s activities revealsthat once he has sold out his investmentaccount and established a short position atthe stock’s high, his long-term objective isthen to take stock prices down to wholesaleprice levels in order to cover his short salesand once again accumulate stock. Theestablishment of these accounts is, of course,the signal for the noticeable shift in thespecialist’s posture toward his stock’s pricetrend. Once he accumulates or distributes hisstock from his investment accounts, themanner and intent of his activities will bebiased toward advancing or lowering hisstock’s price in order to maximize hispersonal profits.Another feature of the investment accountinvolves the manner in which the specialistlinks it with his trading account for bothdistribution and tax planning purposes. Thetax advantage the investment account offersis that it enables specialists to declare as longterm capital gains what are legitimately shortterm capital gains. If for example he acquiresa position in his investment account at hisstock’s lows and advances his stock’s price toits high in less than a 12-month capital gainswindow, he can employ his investmentaccount to turn what would otherwise be shortterm gains into long term gains.To do this he would liquidate whatever stockhe has in his trading account at the high andthen establish a major short position in theaccount. Then all he needs to do is wait untilthe 12-month capital gains period passes toqualify the accumulations in his investmentaccount for long term capital gains and deliver over those shares from the investmentaccount in order to cover the short positionsin his trading account. In this manner he canlegally call his profits “

long-term

.”It was interesting for me to learn that thisinformation is of little or no concern to mostinvestors. In fact, the comments of many are“

so what? Everyone wants to save ontaxes. Why shouldn’t he be able to just likeeveryone else?

” What most investors havefailed to grasp was that the issues involvedwere far more important than whether or notspecialists are allowed to enjoy the tax

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