A front page article in today's WSJ ($) reports on the SEC's continuing efforts to clamp down on the flow of inside information in the stock markets:
Merrill Lynch & Co. retail analyst Peter Caruso unexpectedly learned one July day two years ago that Home Depot Inc. sales had been weak in the prior two months. He quickly crafted a research report that reversed his bullish projection for the home-improvement chain.
But first, according to a New York Stock Exchange disciplinary proceeding, Mr. Caruso leaked the bad news at a lunch with a few big clients. A Merrill institutional saleswoman attended the lunch and told several people afterward she believed the stock would be downgraded, the document says.
Mr. Caruso also allegedly let his new information about Home Depot slip to more investors in a conference call. By day's end, investors had dumped 3.7 million shares of Home Depot and the stock was down 5.6%, according to the proceeding, which Merrill, Mr. Caruso and the saleswoman recently settled.
The next morning, Billy Williams, a retired highway engineer in Atlanta, woke up more than $2,000 poorer. His original $60,000 investment in Home Depot reached its lowest level in four years, shrinking a nest egg for his retirement and his grandchildren's college. The 66-year-old recalls thinking: "Someone must know something we don't."
Mr. Caruso was censured, fired, and fined.
But so what? They caught one guy and made his life miserable. Big deal. It's just a drop in the bucket.
The SEC's efforts to limit the flow of inside information in the capital markets is both futile and misguised. As to its futility, if money is the mother's milk of politics, information is the mnothers milk of investment markets:
Tips about stocks have always been a hot currency on Wall Street. In the 1980s, financier Ivan Boesky pleaded guilty to insider trading after paying bankers to tell him about pending mergers. But unlike that egregious case, much of the continuing Wall Street information flow to the well-connected either is legal or falls into a gray area. In a regulatory environment that limits what companies can disclose selectively, the supply of corporate insights is more coveted than ever, driving some investors to seek ever-more-creative ways to get them.
The SEC thus is playing whack-a-mole. As soon as they crack down on one channel of inside information, another one pops up:
One venue that has risen in importance: Meetings that corporate executives often hold with small groups of investors -- where useful nonpublic information sometimes slips out, inadvertently or otherwise. Brokerage firms give special treatment to big investors who pay the most commissions, and that includes inviting them to those meetings with corporate executives.
Big clients who pay big commissions are always going to have an informational advantage, just like political candidates will always find a way to get ahold of the money no matter how many campaign finance laws we pass (see, e.g., McCain-Feingold and the 527s). Get over it.
As for being misguided, the SEC seems to assume that people like Billy Williams ought to be investing in individual stocks. With all due deference, however, most folks like Mr. Williams ought to be investing in mutual funds rather than individual stocks (preferably passively managed index funds).
The case against individual investors directly investing in stocks rests on the efficient capital markets hypothesis. First, after you correct for risk, the survivorship bias, and the large number effect, nobody systematically and predictably beats the market. The empirical evidence clearly indicates, for example, that the vast majority of mutual funds that outperform the market in a given year falter in future years. Once adjustment is made for risks, it seems reasonably certain that most mutual funds do not systematically outperform the market over long periods.
Second, the mechanisms by which the market prices stock systematically favor professionalinvestors rather than individuals. The ECMH’s semi-strong form posits that current prices incorporate not only all historical information but also all current public information. This form predicts that investors can not expect to profit from studying publicly available information about particular firms because the market almost instantaneously incorporates information into the price of the firm’s stock.
When new information is released, investors with high estimates of the firm’s new net present value will buy, while those with lower estimates will sell. An equilibrium price quickly results. This process necessarily assumes that investors are engaging in precisely the behavior the ECMH predicts they should eschew, namely searching out new information and seeking to capitalize on the information’s value through stock trading. Accordingly, some suggest that there is a paradox behind the ECMH: markets may be efficient only if large numbers of investors do not believe in market efficiency. If everyone believed the ECMH, no one would engage in securities analysis to find “undervalued” or “overvalued” stocks. Only because a large number of investors engage in precisely this activity are the markets efficient.
More sophisticated analysis eliminates the apparent paradox behind the ECMH. The first analyst to correctly interpret new information can profit by being the first to buy or sell. Full-time professional investors capture enough of the value of new information to make the game one worth playing. It is trading by these investors that moves a stock’s price to a new equilibrium in response to changed information. These investors thus set the price at which other investors trade.
Individual investors almost never get the requisite information before price-setting investors. Hence, the game is simply not worth playing for them. They'd be much better off holding a diversified mutual fund.
The empirical literature supporting this argument is summarized in Chapter 3 of my Corporation Law and Economics text. You might also want to check out Burton Malkiel's classic book A Random Walk Down Wall Street. Finally, Larry Ribstein has some very good posts both on the futility of the SEC's efforts to crack down on the use of inside information and on why the SEC should not be encouraging individual investors to invest directly in stocks.
