Monday, June 06, 2005

Market con(fidence)

Valedictories to expelled SEC Chairman William Donaldson make much of his success at restoring market confidence. If he has been so successful at restoring market confidence, why is the S&P 500 down 1% this year and under water 11% since January 19, 2001 when the current president’s term began?

This morning’s Wall Street Journal report of Goldman Sachs’s
overly close relationship with hedge funds reminds me that a big reason for the market’s muddle is that the word ‘con’ is a truncation of ‘confidence.’ Today’s report puts the basic problem in bright lights: Wall Street firms depend heavily on hedge funds and their own ‘proprietary trading’ for profits in an era when mass market demand for stocks is way down.

And as today’s article suggests, Wall Street firms are not always rigorous about keeping client trade intentions away from their own proprietary traders. The reason is simply: money. A March 2005 report published by Credit Suisse First Boston said that hedge funds were responsible for up to half of all activity in major markets, including the New York Stock Exchange and the London Stock Exchange. According to the same report,
Wall Street made $25 billion catering to hedge funds - lending them money, trading for them, helping to structure complex derivative transactions or lending them stock to bet against a company. That was one-eighth of Wall Street’s total revenues.

If a hedge fund or proprietary trader knows that a client is about to sell a big block of shares, they can profit from this knowledge by selling short in advance of executing the client’s trade. Such trades drive down the price of the stock – yielding lower proceeds for their clients.

Today’s article recounted how Phillip Hylander, chief of Goldman Sachs’s European stock-products group and head trader in Europe, set up one proprietary portfolio that traded in some of the stocks Goldman salesmen had recommended to hedge fund, Marshall Wace. The portfolio was called MW TIPS. After making a recommendation to the fund, a Goldman salesman would sometimes tell a proprietary trader what the recommendation was, saying, “I just tipped it,” according to people familiar with the situation.

Rather than restoring confidence, these kinds of reports make investors suspect that the market is a con.


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