Revisit the Old Major Wire Houses' Game

Physician's Money Digest, January15 2004, Volume 11, Issue 1

After almost 20 years, I still remember my initial introduction to one of the more unpleasant practices of the investment industry. Circle K was the stock being pushed by one of the major wire houses. Brokers were expected to memorize and recite the sales pitch, "To expand Chevron's business vertically, Chevron is going to buy Circle K and distribute gasoline and convenience store products." The acquisition never happened.

Dog and Pony Show

The wire house's research team developed a lame "dog and pony show" for internal use by brokers. The team assembled the brokers, bought them lunch, and suggested that the reason to buy Circle K was to build what is called "accumulation."

The sales pitch:

"If we buy enough of this stock for our clients, we would not only make money for ourselves, but we could also move the stock north. If every branch and thousands of brokers start buying Circle K, we could get this stock to move. Once everyone else starts buying, we're out."

Interestingly, the National Association of Securities Dealers' continuing education courses for brokers teaches, "Never listen to or follow the advice of a manager trying to create accumulation." The process is deceitful and attempts to manipulate market movements.

Art Imitating Life

Boiler Room

This type of presentation mimicked those in the movie (2000) about greed running amok on Wall Street. What the brokers were not necessarily aware of was that the research team, soon thereafter, was telling their internal mutal fund company, a wholly owned subsidiary, to be prepared to liquidate their positions of Circle K because they thought they were going to miss earnings. This was when I first learned of the wire house's ongoing greed tactics.

Wall Street

Wall Street

The wire house "greed factor" tactic created four things: compensation for brokers, commissions and trading activity for the wire house, and, most importantly, support for their mutual fund's price by maintaining high performance levels. This powerful type of greed was visualized in the movie (1987) with Michael Douglas. The truth behind the movie is frightening, with slick investment bankers and brokers living the famous quote, "Greed, for the lack of a better word, is good. Greed is right. Greed works."

Understanding Greed

Forbes

New York Times

The greed factor is pivotal to understanding the general public's perception of big business' ongoing affairs. This past fall, an article in reported, "The fundamental analysts have messed up big time…whom can you trust to sass out the market's future path?" At the same time, a headline read, "Two Trials on Wall Street Scandals Begin."

The controversy is driven by the incentive of huge commission compensations, which have clouded brokers' judgments. Many brokers earn lucrative incentives to inform clients of supposed opportunities they know to be false. Trips, tickets, etc, are promised to salespersons for promoting proprietary products and touting their firm's research buy list. Is this good for the market? Of course not. If you were told your house was built on rock, but found out it was built on sand, would you refer your friends to that contractor? Not likely.

Integrity is a fundamental concept in business relationships. Unfortunately, the commission compensation structure among retail brokerage firms often results in a conflict between profit motive and prudent behavior. A client's needs and investment parameters, not a firm's contest of the month, should be a financial advisor's guide.

Corrupt Stock Forecast

Corporate greed is still flowing smoothly through the pipes of the financial industry. We've seen the Nasdaq increase about 75% since its low in October 2002. Most believe that earnings expectations for Nasdaq-listed companies this year will be in the high teens. If this analysis is correct, then why are some firms and brokers coming out with research provided by major wire houses indicating earnings expectations that are much higher, appearing unattainable? Greed could again be the answer. If the companies actually hit those high earnings expectations, the stock will likely move and create increased trading volume. However, trading volumes could disproportionately increase based on investors' reaction to the irresponsible, incorrect advice they received.

Investors are likely about to witness potential market manipulations to create volatility. Incentives exist for a stock to either hit or miss expectations, both of which increase volatility and trading volume. Without volatility, there is no activity, trading, commissions, or bottom-line profits for financial institutions. So, inflated expectations are continually floated to investors. Setting expectations that are too high creates market volume, which creates more turnovers, more churning of the individual stock, more revenue, and more profits. The same bullies are back on the block revisiting an old game we call greed.

John J. Gardner is the president of Equity Research & Portfolio Evaluation Inc (ERPE), a San Francisco Bay area independent research source for institutional and individual investors. Valentine Capital Asset Management, ERPE, and Securities America are independent entities. The opinions here are of the author and not necessarily those of Valentine CRP Group or Securities America. ERPE is not an affiliate of Securities America or Valentine CRP Group. He welcomes questions or comments at 925-361-4787.