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The Stock Market Is Rigged

 June 01, 2012 01:08 PM

(By Chris Mayer) The stock market is rigged. Lots of people think so. They think the market exists for the benefit of insiders. This is an old complaint, but it seems to hang particularly thick in the air these days.

Of course, the market is also rigged in your favor in some instances as an investor. As to which instances, we'll get to them below.

For the most part, though, I think the market is rigged against you in lots of ways. Stocks are not designed so the little guy makes money holding them. They make money for executives and board members. They make money for insiders selling out. Sometimes they make money for employees who get shares for working there. Creditors, and, of course, stock promoters, can all make money on stocks almost routinely.

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The common shareholders? Not so much.

The Facebook IPO only confirmed people's suspicions that the game is unfair. Here is the biggest IPO in the history of U.S. markets. And we learn that big banks and hedge funds got the early dope that Wall Street analysts dropped their estimate for Facebook's earnings only days before the IPO. The small investors got bupkis. Instead, they were led like pigs to slaughter.

Facebook's stock is down 29% since it opened at $42.05 per share on May 18. This is causing a lot of howling about the IPO process and those damn Wall Street banks.

Of course, you take the view that investors who fool around with hyped IPOs get what they deserve. I have sympathies in this direction. Regardless, I agree with this comment in a recent Wall Street Journal:

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"What could have been a model example of the market's strengths — an eight-year-old company with 900 million users raising billions of dollars from a cross-section of the investing public — ended up as a case study of the power wielded by insiders over outsiders."

In short, Facebook is another black eye for a market that already has a lot of black eyes. In the last dozen years, we've suffered through two 50% drops from peak to trough, plus a long list of scandals and shenanigans. Facebook just added to the feelings of disgust and revulsion people already feel toward the stock market.

You can see that revulsion in what people do. They've have been yanking a lot of money out of the market — something like $1.4 trillion since 2007 and record amounts last year. This year, the outflow continues with gusto.

Some people will use these outflows to say the market can't or won't rise. I think that's a lot of baloney. Michael Santoli of Barron's had a good column about this over the weekend: "Bears, who claim that broad investment flows are needed to hold up stocks, should note that the U.S. market just doubled in three years with retail selling into the move."

More from Santoli's column:

"Doug Ramsey of Leuthold Group wrote this month that ‘a new market high could potentially occur with no help at all from the public.' He cites the '74-'80 market, which in total rose 120% with small caps doing far better. ‘The sharp market declines of mid-2010 and mid-2011 have probably served the same purpose as the 1976-1977 decline — flushing out retail investors just as they were finally preparing to tiptoe back in.' Imagine that. Finding ourselves in a time when likening the present market moment to the malaise-stricken late ‘70s passes for an upbeat sentiment."

It's an interesting observation. Note, too, that if the S&P 500 is at today's level on Oct. 9 — which is the 10-year anniversary of the Oct. 9, 2002, bottom — then the market's return over that decade would be 5.5%. As Santoli notes, this is similar to "post-bear periods of the late '40s and late '70s — decent times to lay patient bets on equities, but not the start of bull-market manias."

Stocks, as a class, then, perhaps are getting a bad rap.

People remember the headline-grabbing stories — and usually they are the stocks that blew up. Meanwhile, there are many stocks that just keep plodding along. There are enough companies with good managers and decent businesses that give a fair shake to their owners. On a portfolio basis, such stocks can make the little guy a lot of money over time.

But you have to know where to fish. IPOs, such Facebook's, are not one of the places to go looking.

That's why I focus on Special Situations. This is a grab bag of different plays, but the unifying theme is that the odds clearly tilt in the investor's favor. Two classic Special Situations where the odds are in your favor include spinoffs and thrift conversions. If your patient, investments like these can pay off handsomely over time…

So is the market rigged? Yes. But it's not always rigged against you.


Chris Mayer
for The Penny Sleuth



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