This article is going to be a departure from my usual discussion of equity based Closed-End funds (CEFs) and instead, I'm going to step into the general state-of-the markets discussion which seems to getting a lot of headlines lately.
There's a lot of talk about today's market following in the footsteps of the 1929 market crash which led to the Great Depression. I'm not sure in an age of computer driven trading, global exchanges and more packaged investment products today than ever before, that you can even make a comparison to an era in which individual orders were taken by hand, other than to say that their graphs look similar. The fact is that the structure and foundations of the markets today are so completely different than they were back in the late 1920's, it would be like comparing the complexity of today's world with that of a caveman's.
One advantage that today's markets have over yesteryear's can be capsulized in one word ... excess liquidity. Liquidity can be a saving grace when its being added to the market or a slow bleed when its being withdrawn. The Federal Reserve is certainly the 800-lb gorilla when it comes to liquidity in the markets but liquidity can show up in many forms and influence many investment classes. Anyone who has traded Closed-End funds (CEFs) knows that liquidity, or the lack thereof, can be the driving force behind their market price performances resulting in premium or discount valuations that even trump their Net Asset Value (NAV) performances.
In the fall of 2008 when the financial markets were in crisis mode and the S&P 500 was down some -50% year over year, CEFs were trading at up to -30% market price discounts due to their relatively smaller trading volumes and lack of liquidity even though many of those same fund's NAV's were actually holding up much better than their benchmarks and the broader market indices. In this situation however, liquidity was the driving force in their market price underperformance.
When you invest in CEFs, you get a unique insight as to how liquidity can affect your investments and in just one year after the financial crisis, many of those same CEFs that were trading at -30% discounts in late 2008 and early 2009 were trading at premium valuations, resulting in total returns of up to 100% or more (market price appreciation plus distributions). No other fund category could claim those kind of year-over-year returns; not mutual funds and not ETFs. And just what caused the turnaround in the markets from early 2009? Liquidity of course, in the form of capital injections better known as the Troubled Asset Relief Program (TARP) finally approved by Congress in October of 2008, the first of many liquidity injections that the markets would see over the next 5-years.
Let's Go Further Back In Time
I wasn't around in 1929 but I was in 2000 and I remember that period very well. The late 1990's was a period in which the computer and technology industry was enjoying its initial growth spurt and was propelling NASDAQ stocks into the stratosphere. From November of 1999 to March of 2000, covering a period of less than five months, the NASDAQ went from around 3000 to 5000 for a gain of about 66%. For the year in 1999, the NASDAQ was up an astounding 85.4%. Companies focused on B2B, B2C or Y2K, as the acronyms were known back then, were all the rage and if your stock wasn't trading at over $100 per share, then you just weren't a part of the new technology revolution.
Companies such as Network Solutions (NSOL), Inktomi (INKT), Ariba (NASDAQ:ARBA), PMC Sierra (NASDAQ:PMCS), DoubleClick (DCLK) and more well known names today like Qualcomm (NASDAQ:QCOM) and Broadcom (NASDAQ:BRCM) were trading at stock price levels never seen before and stock splits were common place, occurring once, twice and even up to three times a year. These were the halcyon days of the computer industry and when the Y2K (year 2000) concerns about mass chaos when computers clicked over to the new century on January 1st turned out to be a non-event, the NASDAQ was propelled even further.
However, while everyone was rejoicing that Y2K was finally in the rear view mirror of the markets and that indeed, the 21st century was going to usher in a new period of technological advancement and breakthroughs ... which it was as the telecommunication and internet industries were yet to even get started really, there was one little noticed development that was going to have a profound affect on the US markets, even as the NASDAQ hit an all-time high of 5,048 on March 10th, 2000.
Liquidity And The Conversion From Fractions To Decimals
What was lost in the news flow during this period at the start of the new century was the long awaited conversion of the US exchanges, including the New York Stock Exchange (NYSE) and the NASDAQ, from trading in fractions to trading in decimals. The Securities and Exchange Commission (SEC) had been wanting this conversion to take place for some time and after much discussion and delays, the SEC finally established April 9th of 2001 as the deadline for all US exchanges to convert from fractions to decimals, though preparations were obviously being put in place well before then. The NYSE started its conversion in August of 2000 and by February, 2001, all NYSE stocks were trading in decimals. The NASDAQ would not complete its conversion until March of 2001 but by then, the NASDAQ had already fallen to about 2,500.
So let's review all this. The NASDAQ essentially doubled in price from 1999 to March of 2000 and then went all the way back down to where it started less than a year later. All of this happened even before the terrorist attacks of 9/11/2001. So was it all a big tech bubble or was part of the story an adjustment by the markets in preparation for a fundamental change in how the US markets traded? A change that was going to require much more liquidity in the markets to keep the markets afloat.
Hard to say since the Federal Reserve was raising interest rates during this period as well, but one thing is for certain...anyone who knew how the US markets functioned, i.e. the very same firms that were market makers and could set the bid/ask price of securities, probably knew that the conversion from fractions to decimals was going to have a profound impact on pricing and liquidity in the marketplaces, particularly on the electronic based NASDAQ.
Before 2001 when NASDAQ stocks were still priced in fractions, it wasn't unusual to see 1/2 point, 3/4 point to even 1 point or more spreads between the bid/ask of a stock. This was a huge profit center for investment firms and market makers who held inventory in these stocks and were making $0.25/share (1/4 point), $0.50/share (1/2 point) up to $1/share (1 point) on shares traded. It was also a huge reason for the run-up in the NASDAQ to 5,000 because an equal amount of volume in the markets trading in fractions, say back in 2000, could move the markets up or down with greater impact than today with the markets trading in decimals.
The conversion to decimals after 2001 changed all that as penny spreads, much more common in today's markets, meant not only that investment firms and market makers weren't going to make nearly as much money on the spreads anymore (imagine going from $1.00/share to $0.01/share) but it was going to take a lot more liquidity to move stocks up with penny spreads as opposed to fractions. One could even argue that this loss of a major profit center for investment banks and brokerages forced them to look to other areas to make up the difference in transactional business, such as packaging mortgage backed securities, which ultimately led to the 2008 financial crisis years later.
Why 2014 Is More Like 2000 (In My Opinion)
Now I don't have fancy graphs or statistics to show you how I base 2014 to be more like 2000 than 1929 or any other year for that matter. Call it a gut feeling more than anything else since the only common denominator that I am basing my opinion on is a change in market liquidity that is seemingly on the horizon. Going from fractions to decimals back in 2001 may not have much to do with tapering by the Federal Reserve today but the end result is that both should impact liquidity in the markets.
Like today, not too many investors in March of 2000 were too concerned about a market crash even though there was widespread talk of a bubble in NASDAQ stocks at the time based on non-existent earnings for many dot com technology companies. Perhaps many investors just thought a healthy correction was the worst that could happen but that the fundamentals of the technology sector were strong and that the industry was on the precipice of a technology revolution that would transform the world. They were right, of course...but interest rates and market liquidity were going to have a say first over that technology revolution and it was going to take many years and many interest rate cuts and liquidity infusions before the NASDAQ was going to come even close to that 5,000 high water mark from March of 2000.
The conversion from fractions to decimals was great for consumers and small investors though it came at a steep cost to financial firms. In the period of time it took for financial firms to realize what those financial costs were going to be, they were already cashing in on the technology stock boom, probably aware that they would not see those inflated prices based on fractions again for years.
Even as the NASDAQ dropped 355 points in one day on April 14th, 2000, down -34% from its high set only about a month earlier, I'm sure many shellshocked investors could not have imagined that the markets were reacting not only to an overpriced technology sector and a higher interest rate environment but also to a fundamental change in how the US markets were going to trade in the not too distant future.
The conversion from fractions to decimals was in essence, a huge liquidity adjustment for the markets going forward and it would take the Federal Reserve not only to lower interest rates to essentially zero but to inject hundreds of billions of dollars in liquidity to get the markets back up to where they once were. There is little doubt in my mind that if the markets had continued to trade in fractions over the last 13 years, we would have eclipsed 5,048 in the NASDAQ a long time ago with all of the support the Federal Reserve has provided.
A Beiber Believer Market
Certainly, the technology sector has come a long ways since the 2000 dot com boom and bust and market prices based on earnings and growth has a lot more to do with current valuations than ever before. But I wouldn't minimize the influence of what an inordinate amount of liquidity has played in the current price of the markets.
The Federal Reserve has done everything it can to pump liquidity into the markets either directly or indirectly and any indication that that trend will be reversed will ultimately start to take its toll on the market. So far, the Fed's tapering of its Quantitative Easing (QE) program has had little affect on the upward trajectory of the markets though I would remind investors that the first interest rate raises by the Federal Reserve in the latter half of 1999 had little affect on the markets at first as well.
I can't help but see parallels with today's NASDAQ market with that of 2000. A technology boom resulting in stratospheric market prices, a preponderance of technology mergers & IPOs and a Federal Reserve at a seemingly crossroads of reducing liquidity. All of this is eerily similar. Now I am not predicting a market crash and if anything, markets trading in decimals should help to minimize any sudden drops short of a financial crisis, but it also should make the markets more vulnerable to any actions by the Federal Reserve to reign in liquidity as so much of the current valuation is Fed induced.
Even if you don't subscribe to the fractions to decimal part of my thesis which required so much more liquidity to move the markets back up, you should recognize that if indeed the Federal Reserve is more confident about the US economy and continues to taper it's QE, it is only a matter of time before interest rates become the next topic of conversation.
So far, nothing has derailed this market juggernaut but I will remind readers of how quickly things can change and leave you with this quote from The Street back on March 16th, 2001.
Nasdaq's contention that's it's ready for decimal trading is endorsed by Bernard Madoff, owner of one the exchange's chief market-making firms, Bernard L. Madoff Investment Securities.
"Technologically, we're probably OK with this from the industry standpoint," Madoff says. "I'm very comfortable with Nasdaq's capabilities."