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Specialists, How They Use Their Merchandising Strategies And

Self-Regulation For The Manipulation Of The Stock Market


People who invest in the stock market usually strategies to maximize profits for themselves
don’t spend too much time thinking about the at the expense of individual investors. Part of
specialist, why he is important, and why he the reason is that specialists are not bound by
should be very carefully supervised and either the rules of the Exchange or the SEC to
regulated, until such time as there is an inform the public or anyone else about the
awesome crash in the market. At such times specifics of all of their transactions.
the public hollers for an investigation of the
stock market. Since most of those in The SEC’s report did, however, pointedly
government doing the investigating are insist that the specialists’ conduct did not
beholding to the Stock Exchange in one way conform to the established code. Where their
or another (via campaign contributions or most important practices were concerned,
through their law firms), or hope (if they specialists employed techniques, which were
are commissioners and chairman of the impossible for the public to follow because of
SEC) to be employed in the securities the specialists’ unwillingness to provide the
industry at some not to distant date, nothing public with information concerning the details
ever comes of these investigations. of their activities. In particular, it singled out
the specialists’ use of the short sale.
Those in government charged with the
administration of the securities industry and Under ordinary circumstances, an individual
who conduct these investigations are fully buys stock in anticipation of a subsequent rise
aware that since the turn of the century the in price, which will enable him to sell it at a
findings of such investigations have centered profit. When an investor sells short, he
on the fact that the deep and inexorable cries reverses the process by first selling the stock
of the stock market are caused by the failure in anticipation of a subsequent “decline” in
of specialists to operate the market in a fair price which will allow him to then buy the
and orderly manner when acting as dealers stock back at a lower price. His profit (or loss)
for themselves while in direct competition with is the difference between the price at which
the investing public. According to the “Report he first sells the stock and the price at which
of the Special Study of Securities Markets he later purchases it.
and Exchange Commission” of 1963:
When an investor wishes to sell short, (IE) to
Specialists are at the heart of the problem of sell stock he does not yet own, his brokerage
organization, management and disciplinary firm will normally arrange to “borrow” the
procedures of the exchange…. the misuse of their
role in the operation of a fair, orderly auction stock from their or another brokerage firms
market and the breakdown of regulatory and pool of securities, with the understanding that
disciplinary controls over them… are part of a at a later date the investor will return those
complex pattern of interlocking causes and effects. share. This investor is then able to make
It is for this reason that any program or reform delivery with his borrowed stock to the party
must concentrate heavily on the dominant role of
the specialist. to whom his broker sold it. When the investor
later makes his “covering” purchase of the
In the past even the most public-spirited stock, he is then able to return the shares he
investigation of the specialist system, which borrowed to clear his obligation.
was the 1963 Report, declined to
acknowledge the exact manner in which The act of selling stock, which an individual
specialists employed their merchandising does not own, is called “short selling,” while
his subsequent purchases are referred to as totally unaware of the myriad controls over
“short covering.” individual stock prices and the market as a
whole accruing to specialists through their
When a specialist uses the short sale, the use of the short sale.
process is basically the same. There is,
however, one very important difference. To those that think that my statement that the
When an investor sells a stock short, he specialist is able to manipulate stock prices at
“thinks” that the price of the stock will will seems far fetched, the SEC’s Special
decline, whereas the specialist’s short sale is Study Report provides an illustration that
based on the certainty that he intends on documents this conclusion. Quoting Bill
taking the price of the stock lower. Meehan when he was the specialist in Ford,
the Report provides you with an insiders view
The power of the short sale can be seen in into the process in which specialists are able
the manner in which the instrument allows virtually to guarantee a profit for themselves
specialists to completely control the forces of in the course of a long bear market. Meehan
supply and demand so that ultimately they shows you that he was able to do this by
can raise and lower prices at will. In the selling short and then lowering his stock’s
hands of the specialist the short sale is a price levels at which he then “covered” his
triumph of human ingenuity. Thanks to the short sales:
nature of the instrument and its paradoxical
functions, the short sale enables specialists to Not that I am a student of the charts, but I took a
determine the short, intermediate, and long- look at the Ford chart and it looked very dangerous
to me. I liquidated our whole position and went
term price objectives of their stocks. short and we maintained a short position, actually
in only three of our stocks, all the way through,
As an example of how short sale rules have practically, during the whole period. During the
been distorted for the benefit of insiders with day, we would become long, but almost every
the aid of the SEC is as follows: In 1938 the night we were short stock. [SSR, Part2, Page 113]
Commission enacted a short-selling rule that
prohibited Stock Exchange members from In order to understand the implications of
“demoralizing the market” by effecting short what Meehan is saying, it is important to
sales at or below a price lower than the last understand that when specialists rally stock
sale. This rule was meant to prevent “short prices, public buying is attracted. Conversely,
sellers from accelerating a decline by when specialists drop the prices of their
exhausting all remaining bids, offers to stocks, the public on balance can be
buy, at one price level, causing expected to sell stock. Thus Meehan, in the
successively lower price levels to be course of dropping the price of his stock in the
established.” market crash of 1962, accumulated an
inventory of stock in the morning, (in all
The SEC however, provides specialists with a probability most often at or near the
loophole that allows them to “demoralize the opening) from investors who frightened by
market by selling short on downticks” the decline that was taking place in the stock
(without having to report these transactions and fearful of a further decline, had entered
as short sales) whereas the investing public their sell orders to sell.
can only short on upticks. (A transaction that
is executed on an uptick occurs at a higher Thereafter, he was able to reduce his
price than the last preceding price, while a inventory by rallying stock prices. The rally
transaction that is executed on a downtick would attract public buying demand in
occurs at a lower price than the last preceding sufficient quantities to enable him not only to
price.) Indeed, investors have remained liquidate his trading account “during the day”
but to also “short stock” almost every then to take stock prices down to wholesale
afternoon. As you can see, his short sales price levels in order to cover his short sales
were indispensable in taking down the stock and once again accumulate stock. The
prices profitably in a bear market, in this case establishment of these accounts is, of course,
in what was one of the worst bear markets the signal for the noticeable shift in the
encountered by investors in the 20th century. specialist’s posture toward his stock’s price
Equally important to recognize is that this trend. Once he accumulates or distributes his
example documents the manner in which the stock from his investment accounts, the
short sale enables specialists to manipulate manner and intent of his activities will be
their stock prices up and down at will biased toward advancing or lowering his
regardless of whether the market is a bull or stock’s price in order to maximize his
bear. personal profits.

A business week article stated, “If specialists Another feature of the investment account
apparent monopoly looks like a license to involves the manner in which the specialist
steel, the specialists have an answer.” “If we links it with his trading account for both
make so much money,” they argue, “why distribution and tax planning purposes. The
isn’t everyone else trying to get into our tax advantage the investment account offers
business?” When outsiders do investigate is that it enables specialists to declare as long
the possibility of this, they discover that it term capital gains what are legitimately short
would probably be easier to break into Fort term capital gains. If for example he acquires
Knox’s. a position in his investment account at his
stock’s lows and advances his stock’s price to
Each of the specialist’s privileges has a its high in less than a 12-month capital gains
decisive influence on the destinies of window, he can employ his investment
investors; some offer him more opportunities account to turn what would otherwise be short
for profit than others. Unknown to most term gains into long term gains.
investors, in addition to the profits from their
trading accounts, specialists have what are To do this he would liquidate whatever stock
called “long-term segregated investment he has in his trading account at the high and
accounts.” The SEC’s Institutional Investor then establish a major short position in the
Study has calculated that specialists make account. Then all he needs to do is wait until
between 84 to 192 percent a year on their the 12-month capital gains period passes to
capital. qualify the accumulations in his investment
account for long term capital gains and deliver
The article stated, however, that the study over those shares from the investment
had “ignored specialist investment account in order to cover the short positions
accounts.” The fact is that although the SEC in his trading account. In this manner he can
has from time to time mentioned specialists’ legally call his profits “long-term.”
returns from their trading accounts, it has
always consistently refused to provide any It was interesting for me to learn that this
information concerning profits from a information is of little or no concern to most
specialist’s business or his investment investors. In fact, the comments of many are
accounts. “so what? Everyone wants to save on
taxes. Why shouldn’t he be able to just like
Observation of specialist’s activities reveals everyone else?” What most investors have
that once he has sold out his investment failed to grasp was that the issues involved
account and established a short position at were far more important than whether or not
the stock’s high, his long-term objective is specialists are allowed to enjoy the tax
benefits of turning short-term gains into long- NYSE specialist for nine years and was the
term gains. The issue in fact, is whether or head of his own consulting firm, offers some
not tens of millions of investors should be insight into this opinion:
subjected to rhythmic market booms and
busts so that specialists can establish their The Big Board is increasingly willing to let
capital gains. It is also worth observing that if specialists bend the rules. You’ve got increasingly
flagrant situations where if a specialist is long a
the matter were not of such an obvious and stock [that is he owns it] he simply raises the
pressing nature, the specialist study group offering price, enabling him to make more money
would not have so well presented the dark on his position. And if he is short a security, he
side of the issue (Special Study Report, Part drops the bid price more precipitously, enabling
2, page 133): him, to cover his short sales at a better profit.
Investors should be up in arms about the way
many specialists are handling their securities.
Purchases made on the Exchange for the purpose
of segregation into long-term investment accounts
raise problems, which go to the heart of the So too, one would imagine, should the SEC.
specialist system. The specialist is permitted to For many years the SEC’s methods of
trade for his own account only when such trades surveillance over the Exchange have been a
affirmatively contribute to the maintenance of a fair source of mystery. When for example, do
and orderly market. Where the specialist goes into
the market with the intention of segregating the SEC officials visit the Stock Exchange, and
securities purchased and not with the purpose of what checks do they maintain over the
creating a fair and orderly market, the trading is specialists’ practices? These questions were
clearly contrary to the statutory and regulatory answered in a conversation with an un-named
standards. Beyond this, the specialist with a long- SEC official:
term position now has a stake in seeing the
securities rise in price - he has become an investor
as well as a dealer. Specialists are under the exchange. We don’t get
to concerned with them. They’re not directly
A further problem arises when the specialist who regulated by the Commission. They all operate
maintains such long-term accounts is required to under self-regulation. They make their own rules;
sell stock to maintain a fair and orderly market and the Commission just o.k.’s them. Only if the
he has no stock in his specialist trading account. Commission feels there is something not proper
[If] the 12-month period of the tax statute is almost does it take exception. We check broker-dealers
over, the specialist may well be tempted to keep but we never go onto the Exchange to check out
his stock in the long-term account and neglect the specialists.
needs of the market.
Understanding this we can begin to
In reply, the NYSE maintained that specialists understand why specialists are now being
have a perfect right, like anyone else, to allowed to do quite openly what is still
accumulate stocks as investors and stated “it forbidden by the rules of their own Exchange.
believes that it is perfectly proper for the
specialist unit to carry stock in a long-term Formerly, investment bankers and
investment account.” It terminated any stockbrokers, by acting as their
further discussions with the SEC on this intermediaries, maintained their distance
matter with the following statement that between specialists and institutions. Now that
“further discussions of this question institutions are breaking these ties, specialists
between the Exchange and the SEC have are forced with a situation in which they are
been deferred.” This is the true meaning of pitted against each other in order to obtain
self-regulation. institutional business. The problem is further
compounded for specialists by the inception
It has been argued that great changes have of the new central market, which presents
been mad since the Special Study Report of them with the prospect of increased
1963. However, Arnold I Milsky, who was a competition for business from other
Exchanges. Thus institutional traders have
been faced with the curious spectacle of the
Stock Exchange’s usually arrogant,
immovable high priests scurrying around Wall
Street, soliciting business like common
stockbrokers.

For as many years as specialists have been


in business, investors have sought to obtain
data on their incomes. Not surprisingly, the
Exchange has refused to grant access to this
information. It would have been absurd for
specialists to surrender their income data
voluntarily, since it has been through the
shroud of secrecy and the lack of regulation
that they have been able to turn a humdrum
job into a several-hundred-million-dollar-a-
year-job. Not only would this data reveal
much of the specialist’s Sinbad-like voyage in
paradise, but even more importantly, when
the years were examined in which he made
his fortunes, the figures would reveal the
enormous profits for him during a bear
market cycle.

Self-regulation grants the specialist his power.


It is the myths that surround him that sustain
that power. Lacking the nourishment of fact
about the specialist system, investors have
been overfed and underprivileged by the
media’s fictions. Chief among these fictions is
the belief, firmly embedded in investor
consciousness, that the risks and financial
losses suffered by specialists far outweigh
those suffered by investors. Unfortunately,
nothing could be further from the truth.

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