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July 2, 2013

Small Cap Revival

Bigger trading increments could boost trading small stocks

By James J. Angel

The continued shrinking of the U.S. equity market is rapidly creating a financial apartheid, in which well-connected private investors get access to the best investment opportunities while the public equity markets get the leftovers.

The number of firms in the U.S. public equity market is shrinking. The Wilshire 5000 index, which includes virtually all U.S. exchange-listed companies, has shrunk to 3,560 as of April 30, 2012. At the current rate of shrinkage, there won't be 500 U.S. companies left for even the S&P 500 by 2060. The shutting-down of our public equity markets for smaller stocks reduces the supply of capital to these firms, capital needed to fund investment and jobs.

James Angel, Georgetown

How did we get into this mess, and what can we do about it? Many factors have contributed to this shrinkage.

Some might say it was just a decade of bad market performance. However, most other countries experienced growth in the number of domestic companies in their markets during this time. Others might point to the demise of the dot-com boom. However, there were only about 500 dot-com companies. This does not explain the loss of nearly 3,500 other U.S. exchange-listed companies.

Private equity has clearly risen in the last decade, but is that a cause of or a reaction to the shrinkage in our public markets? I believe it is more of a reaction; companies in need of capital no longer find the public markets a viable source of funding, so they turn to private equity.

One thing that is clear is that we place much higher compliance burdens on public companies than on private companies. Sarbanes-Oxley is still with us, although the JOBS Act gives emerging-growth companies a temporary pass. Dodd-Frankenstein now requires public companies to perform expensive audits while private companies that do business in the dark do not.

One of the big drivers of the shrinkage in our public markets is that we no longer have a different market structure specialized for smaller companies, like we did in the bad old days. The old Nasdaq dealer market had a very different market structure from the old NYSE auction market. In the old Nasdaq dealer market, only dealer quotes were disseminated to the general public. Customers had no way of getting wide exposure for their limit orders and competing with the dealers.