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 almost as fast as the glaciers in Glacier National Park. 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.
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 of their supply chains to disclose their use of “conflict minerals” from the Congo, even if they source nothing directly from the Congo. Meanwhile, the private companies that do business in the dark with the merchants of death in the Congo are untouched.
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. The result was a bid-ask spread so wide you could drive an IPO through it.
The wide spreads that we thought were a scandal did have one redeeming social benefit: They motivated the industry to market smaller companies to investors. The profits on trading provided incentives for brokerage firms to publish research that let more investors know about what was happening in those firms. Before investors will invest in a stock, they need to have an information environment that allows them to make sound investment decisions, and a secondary market that provides enough liquidity for them to exit when they choose. The wide spreads paid for just that. Small unknown companies face a big hurdle: How does a company go from being one out of 3,500 firms to one of the 75 in the average institutional portfolio or one of the handful in a typical retail portfolio? The old high-cost Nasdaq system provided a marketing engine that introduced those firms to the market and produced a steady flow of information to maintain investor interest.
A series of well-meaning reforms have eliminated almost all the differences between the NYSE and Nasdaq. Customer limit orders are now protected and displayed, and the tick has been reduced 92 percent, from $0.125 to $.01. We now have a single market structure that works really well for the large-cap, high-volume stocks. Transaction costs have fallen for both retail and institutions, and execution speeds are much faster.
The collapse of the bid-ask spread, along with Eliot Spitzer’s Global Settlement, led to a collapse in analyst coverage. With no analyst coverage to drum up investor interest, the U.S. public markets no longer welcome smaller companies. Smaller firms are not coming to market, and foreign companies are leaving our markets.
Shadow capital markets are slowly replacing our public capital markets. Issuers go to great lengths to avoid the burdens of public registration. Remember Facebook’s contortions to avoid the then 500-shareholder limit? Rule 144A filings are the new IPOs, but they are only available to institutional buyers. These shadow markets are noted for less transparency and high costs. It is ironic that well-meaning government attempts to protect investors and promote transparency have resulted in an outflow from our public markets into less transparent markets with less investor protection.
The increasing reliance on private, rather than public, markets creates a system of financial apartheid. Retail investors, and the mutual funds they depend upon, have fewer and fewer U.S. companies to pick from. Private equity firms get access to the future Facebooks and Googles of the world, and they extract all they can before exiting into what is left of the public markets.
So how has our government responded to this situation? Rather than examine and fix what is wrong with our public markets, the Securities and Exchange Commission changed the rules in 2007 to make it easier for firms to leave our public markets. Congress followed suit with provisions in the JOBS Act that make it easier for issuers to avoid registering in our public markets by increasing the number of shareholders that trigger an SEC registration requirement from 500 to 2,000.
What can we do about this mess? The first step is to establish widespread awareness that this is a problem and encourage constructive debate about possible solutions. There is no single magic bullet, but many things can be done. We need to re-examine the burdens we place on all public companies, large as well as small, to determine which ones further the public interest and which don’t.
We need to adopt an attitude of openness that allows for experimentation with different market structures in the small cap sector. For example, issuers in other countries are permitted to subsidize liquidity provision by market makers. It works well in other countries, so why not allow it here?
The optimal tick size is neither zero nor infinity, but somewhere in between. The optimal tick is also not the same for every stock. We need to get away from the current “one tick fits all” $0.01 tick and adopt ticks that reflect differences in liquidity across stocks. I am in favor of letting issuers pick their own tick size, as they have the proper incentives to get it right.
Mutual funds are allowed to assess “12b-1” fees on their shareholders to pay for the marketing of their funds. Why not permit issuers to assess “12b-1” fees on the trading of their stock that they could use to subsidize market makers, introducing brokers and research?
Failure to act will result in less economic growth and more unemployment, as promising businesses will not be able to raise capital the public markets. Furthermore, the club-like nature of the shadow capital markets will keep lead to increasing inequality, as the well-connected get access to all of the best investments and the rest of us get the exhaust.
James J. Angel, Ph.D., CFA, is a visiting associate professor at the Wharton School of the University of Pennsylvania, on leave from the McDonough School of Business at Georgetown University.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
