Securities markets exist in more than sixty countries and on all continents. They have grown in number and importance with the increase in the number and size of corporations, the volume of government debt instruments, and the diffusion of ownership of corporate and government securities.
Securities markets are organizations of security dealers and brokers whose operations reduce the cost of transferring ownership of government and corporate bonds and stocks and increase the liquidity of these assets. The reduction in transaction costs is achieved by the specialization of these organizations in transmitting information relevant for the decisions of potential buyers and sellers, by the provision of standardized contracts with respect to their purchase, sale, and financing, and frequently by furnishing specialized facilities for the execution of security transactions. Securities markets—especially organized exchanges—increase the liquidity of securities by providing almost continuous information regarding market prices, maximum bids, and minimum offers. Liquidity is increased in the sense that owners of securities can have greater knowledge of the current market value of their securities. This reduces the risk of incorrectly assessing the value of one’s securities. This increase in liquidity is important not only for holders of existing securities but also for issuers of new securities who are raising capital for their enterprises.
Securities markets, especially those operating through major exchanges, have some of the characteristics of perfectly competitive markets. The things that are bought and sold—shares of common stock of the General Motors Corporation, for example—are perfect substitutes for each other, and the dissemination of information on market prices is accurate, extremely rapid, and very widespread. Information relevant for appraising the prospects of a corporation is also widely available. Further, there are many buyers and sellers, most of whom buy and sell in quantities insufficient to have a significant impact on the price. Although large institutional investors can temporarily raise the price of shares of even very large corporations by placing large “market” orders (and conversely depress the price of shares by selling), this impact can be greatly diminished by spreading the orders over a period of time. The liquidity of even very large holdings of common stock was dramatically illustrated in recent years by the sale of millions of shares of Ford Motor Company stock by the Ford Foundation with no apparent large impact on prices.
Security prices are highly sensitive to information bearing on the prospective profitability of the corporations whose shares are involved. The opportunities to profit from changes in the prices of securities have attracted the attention and the money of millions of investors and speculators and have generated many points of view about ways to predict future security prices. The numerous points of view fall into two general categories: (1) efforts to predict the profitability of firms by forecasts of general business conditions, by forecasts of costs, revenues, and profits for particular industries, and by analyses of the competitive position of particular firms, and (2) efforts to predict future prices by an analysis of the historical course of prices themselves. This latter point of view has been subjected to considerable analysis by academic economists and statisticians (Cootner 1964), and the predominant view among academic economists is that historical analyses of prices do not enhance one’s ability to predict prices. In the short run, prices are believed by many to follow a “random walk.” [SeeMARKOV CHAINS.] This academic view is at variance with the views of many members of the financial community.
The view that prices follow a random walk is consistent with a market in which numerous pieces of relevant information bearing on future prospects are frequently generated and widely and rapidly disseminated. The pieces of information themselves, however, must be causally unrelated to the historical course of security prices. Another essential condition is that prices adjust “instantaneously” to new information, since gradual adjustment would create trends.
Organized exchanges. The most important securities markets in terms of the value of securities traded are organized exchanges. Such exchanges differ from less formal markets in that they centralize communication and trading, impose rules for the admission of persons or firms privileged to trade in securities, impose rules with respect to the securities that can be traded, and closely regulate the procedures used.
By far the largest securities market in the world in terms of the dollar volume of securities traded is the New York Stock Exchange. This exchange, started in 1792 as an informal organization of 24 merchants and auctioneers dealing in securities, has grown throughout most of its history. At the end of 1966 there were 1,366 members of the exchange, most of them associated with approximately 660 organizations, including single proprietorships, partnerships, and corporations. About 1,200 companies with approximately 1,600 different issues of stock were listed, and the more than 10,000 million shares listed had an aggregate value of more than $495,000 million. In addition, about 500 companies and government agencies with approximately 1,200 different issues of bonds were listed, and these bonds had an aggregate market value of approximately $120,000 million. At the end of 1966 there were more than 250 listings of foreign securities, including both stocks and bonds,having an aggregate value of more than $9,000 million.
The value of securities listed on the New York Stock Exchange at the end of 1966 was more than four times as great as the value of securities listed on the world’s second largest exchange, The Stock Exchange (of London), which trades a larger number of issues and has more than twice as many members. The New York Stock Exchange accounts for more than 90 per cent of the dollar volume of trading on the 18 organized exchanges in the United States, and this proportion has been maintained for many years (U.S. Securities and Exchange Commission 1963a).
The number of members of the New York Stock Exchange has been fixed in recent years. Memberships, called “seats,” are bought and sold. The price of a seat in 1966 was approximately $250,000. In 1875 seats sold for as little as $4,250, and in 1929 they reached an all-time high of $625,000. To be eligible for membership, persons must meet standards established by the exchange with respect to age, citizenship, character, and knowledge of the securities business.
About one-half of the members of the New York Stock Exchange belong to organizations whose primary purpose is to act as brokers on behalf of those wishing to buy or sell listed securities. These members are paid according to a fixed shedule of brokerage fees averaging roughly one per cent of the value of the security bought or sold, although the fees vary somewhat in a prescribed manner according to the number of shares and the aggregate value of shares or according to whether the securities traded are stocks or bonds.
About one-fourth of the members are “specialists.” They are important in the operation of the New York Stock Exchange and other American exchanges, but other devices are used outside the United States, except in Japan, to perform the specialist’s function. The specialist receives information from brokers regarding offers to sell and to buy at various prices. Each specialist concentrates his activities in a small group of securities, and brokers wishing to transact business on behalf of the public typically deal with one or another of the specialists handling the stock in question, although brokers may deal directly with other brokers. The specialist secures for the seller the highest available bid and for the bidder the lowest available offer. When there is a wide discrepancy between the highest bid and the lowest offer, the specialist has the responsibility, neither fully enforceable nor precisely defined, to use his own capital to maintain a “reasonably continuous” market in such a stock. The specialist is also permitted to buy and sell securities for the account of others, thus acting as a brokers.’ broker. Regulations of the Securities and Exchange Commission (SEC) require that the specialist must execute orders on behalf of the public prior to executing them for his own account.
Part of the justification given for the existence of the system of specialists is that their trading on their own behalf increases liquidity and reduces the likelihood of large changes in prices between successive transactions. A detailed investigation of the impact of specialists on prices during the period immediately following the assassination of President Kennedy in 1963 revealed that specialists vary widely in their trading practices and in their impact on prices (U.S. Securities and Exchange Commission 1963b). A substantial number of specialists traded so as to diminish volatility, and a substantial number so as to increase it.
Approximately one-fourth of the members of the New York Stock Exchange are either odd-lot dealers or “floor brokers.” The former buy and sell blocks of stock of less than 100 shares (odd lots) from brokers representing the public. The latter assist brokers from the commission houses when the volume of business exceeds their capacity to handle it.
Most transactions involve a small enough volume of stock so that the ordinary market mechanism can be used without having a large impact on prices. Transactions, however, which involve very large numbers of shares and dollars are often handled through specialized procedures designed to lessen this impact. The most important type of block distribution is a “secondary distribution” (the sale by an underwriter or group of underwriters of a large volume of stock not for the benefit of the corporation whose shares are being sold), but “exchange distributions” (within brokerage houses) and other specialized means of dealing with large volumes of stock are growing in importance. Although the details of these various specialized methods differ, they have in common an effort to accumulate orders to buy from large numbers of investors over a period of time in order to match the large volume of stock that is being offered by a single seller. For instance, in mid-1964, 250,000 shares of a stock selling for $33 were offered by a single seller. The stock was distributed within one day through the facilities of a single brokerage organization whose customers bought all the stock. The individual purchases were bunched and executed as a package on the floor of the New York Stock Exchange. They were represented as a single transaction through the national and international communications system that virtually instantaneously transmits information on stock prices. This particular method of distributing stock is known as an “exchange distribution.”
The number of shares traded as a percentage of the number of shares listed has been declining secularly. Around 1900, the number of shares traded in a year was approximately 200 per cent of the average number of shares listed in that year, and as recently as 1929 the number of shares traded during a year exceeded the average number listed. Since World War II the number of shares traded in any year has never exceeded 25 per cent of those listed, and in recent years only about 15 per cent of listed shares have been traded in any year.
In order for the shares of a company to achieve initial listing on the New York Stock Exchange, the company must demonstrate earning power, after charges and taxes, of $1.2 million annually; must have net tangible assets of $10 million, or more than $10 million in market value for publicly held shares; and must have at least 600,000 shares publicly held and not fewer than 1,500 owners, each of whom must own at least 100 shares. Similar though less stringent criteria are applied for delisting a stock.
For numerous periods between January 1926 and December 1960 average rates of return to investors investing equal amounts of money in each of the common stocks listed on the New York Stock Exchange were generally higher than earnings in alternative investments, such as government and corporate bonds, savings accounts, and mortgages (Fisher & Lorie 1964). For the entire 35-year period, the average annual rate of return (compounded) to a tax-exempt investor, with reinvestment of dividends, was 9.0 per cent. Without reinvestment of dividends the rate was 6.9 per cent. During the decade of the 1950s, the average annual rates with and without reinvestment were about 15 per cent. (Rates of return with reinvestment may be higher, lower, or the same as without reinvestment. The rate of return is based on the relationship between a change in the value of assets and the volume of assets initially invested. Reinvestment increases both the change in value and the amount invested, and the effect on the rate of return depends on the relative magnitude of these increases.)
Data are also available on the variability of rates of return (Fisher 1965). Considering all possible purchases and sales, at monthly intervals, of all common stocks on the New York Stock Exchange for the period 1926–1960, it was found that slightly over three-fourths of the transactions were profitable and over half provided rates of return in excess of 9 per cent. Of course, this past experience is not a certain guide to the future.
The Stock Exchange (of London) lists more than 9,000 different securities that had at the end of 1963 a market value of approximately $125,000 million, about a third of which was represented by debt instruments of the government of Great Britain, Commonwealth governments, local councils, and nationalized industries. The Stock Exchange had about 3,400 members in mid-1964. The relative importance of foreign shares is greater for this stock exchange than for the New York Stock Exchange. The major difference in the method of operation of The Stock Exchange—and almost all exchanges outside the United States– as compared with the New York Stock Exchange is that brokers who buy and sell securities on behalf of the public deal with jobbers who own securities and act as wholesalers. These jobbers, who do not deal directly with the public, serve much the same purpose as the specialist on the New York Stock Exchange, but the specialist in the United States typically has a dual role—broker and dealer— while the jobber in London operates solely as a dealer adding to or depleting his inventory of the securities in which he trades. There are about 280 firms of brokers and about 65 firms of jobbers operating on The Stock Exchange.
A jobber may deal in any listed security, but most specialize in certain groups of shares, or “markets.” The chief markets are as follows: gilt-edged (government issues and other securities grouped with them); banks and insurance; shipping; foreign government bonds; American and Canadian shares; breweries; commercial and industrial; iron, coal, and steel; financial, land, and property; investment trusts; rubber and tea plantations; oil; South African mines; Rhodesian, Canadian, Australian, and miscellaneous mines; West African mines; cables and transportation.
Rates of return on British shares between 1919 and 1963, averaged by 11-year periods, were substantially higher in most of these periods—excluding wartime—than rates on consols–government bonds with no maturity date (Merrett & Sykes 1963). For the entire period, the rates on shares were 8.0 per cent in money terms and 5.8 per cent in real terms, while the comparable rates for consoles were 1.4 per cent and -1.4 per cent.
There are other important exchanges in the world, but none approaches in importance either the New York Stock Exchange or The Stock Exchange (of London). Among the other leading exchanges are the Stock Exchange of Paris, the Brussels Stock Exchange Commission, the Zurich Stock Exchange (the leading Continental market), the Dusseldorf and Frankfurt stock exchanges in the Federal Republic of Germany, the Milan Stock Exchange, the American Stock Exchange (United States), the Toronto and Montreal exchanges in Canada, and the Melbourne Stock Exchange. There are many regional exchanges in the countries whose leading exchanges are listed above, and there are many exchanges in other countries as well. The largest of these exchanges is not more than about one-fifth the size of The Stock Exchange (of London) or one-twentieth the size of the New York Stock Exchange, and most are much smaller. The mechanisms of these various exchanges differ, but the principles underlying their operation are very much like either The Stock Exchange or the New York Stock Exchange. Information about many of these exchanges can be found in Spray (1964).
Over-the-counter markets. Unlike the organized exchanges, the over-the-counter market is informal and permits unlimited right of entry by securities and virtually free access of persons into the business of dealing in unlisted securities. At the end of 1963 over 3,300 firms listed with the SEC dealt in unlisted securities. The over-the-counter market differs from the organized exchange in many ways. There is no fixed schedule of fees for buying and selling securities. Dealers more frequently buy and sell from inventories and derive their profit from markups on this inventory.
Dealers and brokers are informally organized in the National Association of Security Dealers (NASD). Under pressure from the SEC, the NASD began to publish in February 1965 wholesale or .’inter-dealer” quotations for the 1,300 issues on its national list. Accurate information on retail prices is not yet available for the over-the-counter market.
The SEC estimates that as of December 31, 1962, about 4,500 stocks in about 4,100 domestic companies were quoted only in the over-the-counter market (U.S. Securities and Exchange Commission 1963a). These stocks had an aggregate value of about $90,000 million, almost half being constituted by stocks in banks and insurance companies. The value of stocks traded over-the-counter was only about one-fourth of those traded on the New York Stock Exchange but far exceeded the value of stocks traded on any other American exchange.
The volume of stock trading over-the-counter is estimated to have grown about eightfold between 1949 and 1961, reaching $40,000 million in the latter year. Although most of the very large companies are traded on listed exchanges, this is not true of stocks in banks, insurance companies, and mutual funds, which are frequently large and seldom listed. (In 1964, a Disclosure Act was passed by Congress which may substantially increase the listing of stocks in banks and insurance companies.)
In recent years a so-called third market has increased in importance. This market involves trading in shares listed on exchanges, but the trading takes place in the over-the-counter market rather than through the exchanges. The only definitive estimate of the volume of such trading indicates that in 1961 about $2,000 million worth of stocks listed on the New York Stock Exchange were traded over-the-counter. This constituted almost 4 per cent of trading on the New York Stock Exchange. This percentage is undoubtedly increasing. The third market is growing in importance because the brokerage costs on the exchanges are fixed and do not permit quantity discounts, despite the lower cost per share of handling large orders. The over-the-counter market has no fixed schedule of fees and thereby permits large buyers and sellers to consummate transactions at lower cost than is possible on the exchanges. The increased importance of institutional investors, who frequently trade in large volumes, has contributed to the growth of the third market.
Outside the United States, most trading in securities is probably through exchanges, but some
|Table 1 - Distribution of totalmarket value of individually held stock, by income class, 1960|
|Adjusted gross incomea||Per cent of total market valuea|
|a. Excludes income not subject to federal income tax.|
|b. Percentages do not add to 100 because of rounding.|
|Source: Crockett & Friend 1963, p. 156.|
|Less than $5,000||12.4|
|$200,000 and over||11.5|
is over-the-counter and through institutions such as commercial banks. In most foreign countries, listing requirements and permission to trade on exchanges are less restrictive than in the United States.
Share ownership. In the United States the number of individuals owning stock directly has risen from about 6 million in 1954 to about 20 million in 1966. This ownership is widely distributed among all income groups, as is indicated by Table 1.
Somewhat more is known about the importance of stock ownership by institutions. Such ownership has increased rapidly both absolutely and as a percentage of all stocks, as is indicated by Table 2.
Information regarding share ownership in 60 different countries is contained in a study by the
|Table 2 - Estimated holdings of NYSE-listed stocks by financial institutions and relation to total value (billions of dollars)|
|Type of institution||1949||1956||1961||1962||1963||1964||1965|
|* Less than $50 million.|
|Source: New York Stock Exchange 1967|
|Non-insured pension funds:|
|State and local government||*||0.2||0.7||0.8||1.1||1.5||1.9|
|College and university endowments||1.1||2.4||3.7||3.3||4.0||4.5||5.1|
|Common trust funds||*||1.0||1.9||1.7||2.2||2.6||3.2|
|Mutual savings banks||0.2||0.2||0.3||0.4||0.4||0.4||0.5|
|Total market value of all NYSE-listed stock||76.3||219.2||387.8||345.8||411.3||474.3||537.5|
|Estimated per cent held by all financial institutions||12.7%||15.8%||19.0%||19.9%||20.2%||20.6%||20.7%|
New York Stock Exchange (1962). Three facts stand out: (1) there is no information about share ownership in most countries; (2) for all countries for which information is available, the number of shareholders is growing rapidly; and (3) share owners constitute a larger portion of the populations of western European countries, Japan, and the United States than of other sections of the world.
In Great Britain, it is estimated by the Wider Share Ownership Council that at the end of 1963 there were about 3.5 million individuals owning stocks directly and that about two-thirds of all adults of the United Kingdom owned stocks indirectly through various institutions. Institutional investors are of greater relative importance in Great Britain than in the United States. British institutions own about 50 per cent of all the securities listed on The Stock Exchange (of London) while the comparable figure for American institutions on the New York Stock Exchange is about 20 per cent. The greater importance of institutions in the United Kingdom is accounted for primarily by the fact that their insurance companies are not so narrowly restricted with respect to the ownership of shares.
Japan had about 4.5 million individual share owners in 1963, over eight times as many as were estimated for 1946.
The regulation of securities markets. In the United States, securities markets are regulated to some extent by state laws, but by far the most important regulation stems from the following federal statutes:
(1) The Securities Act of 1933.
(2) The Securities Exchange Act of 1934.
(3) The Public Utility Holding Company Act of 1935.
(4) The Investment Company Act and the Investment Advisers Act, both of which became effective in 1940.
(5) The Securities Act of 1964.
(For an extensive BIBLIOGRAPHY on the first four of these statutes, their amendments, and judicial decisions and administrative rulings derived from them, see Dunton 1963.)
Provisions of the federal statutes are administered by the SEC, which was established in 1934. The Securities Act of 1933 requires the disclosure of financial information judged by the SEC to be relevant for the evaluation by investors of the prospects of corporations issuing new securities. The Securities Exchange Act of 1934 regulates securities markets and the operations of security brokers and dealers. It requires registration of securities exchanges and of securities traded on such ex-changes; it restricts borrowing by brokers and dealers; it prohibits manipulation of prices of securities; it requires periodic filing of reports on listed securities and the provision of specified information and statements soliciting proxies. Exchanges make rules governing the conduct of their members, and the SEC passes upon the adequacy of such regulation.
The over-the-counter market was brought with-in the purview of the SEC through a section of the Securities Exchange Act authorizing national associations of security dealers to regulate their members. The NASD, authorized under the Securities Exchange Act, has an extensive set of rules governing the conduct of its members. The Securities Act of 1964 extends to the larger over-the-counter issues the regulations governing registration of securities, financial reporting, and the issuance of proxies that apply to issues listed on exchanges. About 2,000 over-the-counter issues are affected.
The Public Utility Holding Company Act of 1935 was designed to eliminate or control public utility holding companies that either operated in or sold securities in interstate commerce.
The Investment Company Act and the Investment Advisers Act provide for the registration and regulation of investment companies and investment advisers in order to insure a code of conduct and a level of financial responsibility acceptable to the SEC.
Since enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934, the dissemination of financial information by corporations has greatly increased, and the practices of firms buying and selling securities or advising investors have changed significantly. Much of this change has taken place through self-regulation by the organized exchanges and through the NASD.
The impact of these changes and the adequacy of existing regulation were subjected to exhaustive study by a special group established by the SEC, which the Congress had directed to conduct such a study. The study (U.S. Securities and Exchange Commission 1963b) consists of five volumes covering the operation of exchanges and the adequacy of existing regulation, the over-the-counter market, the qualifications of persons in the security industry, security credit, mutual funds, and other matters. A great deal of information, much of it quantitative, is contained in the so-called Special Study, but there is controversy as to whether there was an adequate factual basis for the recommendations that were made (Stigler 1964a; 1964b ; Friend Herman 1964; Robbins Werner 1964).
One major change resulting from the Special Study was to subject the over-the-counter market to regulation more like that imposed upon formal exchanges. For the formal exchanges, the major changes, in addition to those resulting from the Securities Act of 1964, were modifications in the regulations concerning floor traders and specialists. The intent of these new regulations was to reduce the advantage of floor traders and specialists relative to the trading public and to decrease possible conflict of interest between their role as speculators and their role of providing liquidity. The new regulations reduce the opportunity of specialists to profit from their access to “book information” about bids and offers, and to execute orders on their own behalf prior to orders on behalf of the public.
Security credit. Stocks and bonds are widely used as collateral for loans. At the end of 1964, such loans exceeded $5,000 million in the United States. This was less than one per cent of the value of all securities listed on the New York Stock Exchange. Loans based upon collateral consisting of securities are subject to special regulation in the United States. The Securities Exchange Act of 1934 required the Board of Governors of the Federal Reserve System to issue rules and regulations concerning security credit, and Regulation T accordingly was issued by them and became effective October 1, 1934. Regulation T specifies the amount of credit that can be extended by security brokers and dealers relative to the value of the collateral. At the end of 1964, such loans were limited to 30 per cent of the value of securities at the time that the loan was made. On May 1, 1936, the Board of Governors of the Federal Reserve System issued Regulation U relating to loans by banks based on collateral in the form of securities. (Extensive information about security credit can be found in Bogen & Kroos 1960.)
Security prices and business conditions. Prices of stocks generally move in the same direction as business conditions, rising during periods of expansion and falling during recessions. Prices of common stocks are considered to be a “leading” indicator in that turning points in indexes of these prices typically precede turning points in general business conditions (Moore 1961). The prices of bonds, too, generally move in the same direction as business conditions (Kessel 1965). While stock prices tend to lead general business conditions, movements in bond prices are roughly coincident with movements in business conditions.
Changes in the general price level have different effects upon the prices of stocks according to the capital structure of the underlying corporation (Kessel 1956). The general principle which explains these variations is that corporations with a large amount of net debt per dollar of equity benefit most from inflation and suffer most from deflation. Net debt is defined as a corporation’s monetary assets (cash, government securities, accounts receivable, and notes receivable) minus its liabilities (accounts payable, notes payable, mortgages, preferred stock, and bonds).
The relationship between changes in general business conditions and the prices of stocks is complex because the changes in each series affect each other. Changes in business conditions obviously affect the prosperity of corporations and hence the value of stocks in them. Conversely, changes in prices of stock affect the wealth of individuals and institutions and their willingness and capacity to spend money and to make investments and hence affect general business. From October 1929 to June 1932, the prices of stocks listed on the New York Stock Exchange declined by over 80 per cent, and this reduction of many billions of dollars in the assets of owners of stocks undoubtedly contributed to the great depression of that time.
James H. Lorie
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