The Stock Market is Rigged

The stock market may be rigged…but not always against you.

Lots of people believe the stock market is a playground for well-connected insiders. This is an old complaint…but it is one that seems to hang particularly thick in the air these days. The Facebook IPO only confirmed people’s suspicions that the game is unfair. Here was the biggest IPO in the history of US markets. And we learn that big banks and hedge funds got the early dope that Wall Street analysts dropped their estimates for Facebook’s earnings only days before the IPO. The small investors, who were not in the know, were led like pigs to slaughter.

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

Of course, you could take the view that investors who fool around with hyped IPOs get what they deserve. My sympathies lean in that direction. If you play with fire, you might get burned. Regardless, I agree with this comment in yesterday’s Wall Street Journal:

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 felt toward the stock market.

You can see that revulsion in what people do. They’ve 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 outflows continue with gusto.

Some people cite 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 US market just doubled in three years with retail selling into the move.

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

People remember the headline-grabbing stories about certain stocks that “blew up.” But meanwhile, there are many stocks that just keep plodding along. There are many, many 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 an ideal fishing hole.

In my investment letter, Mayer’s Special Situations, we look for opportunities that are off the beaten path, where the odds clearly tilt in the investor’s favor. Two classic Special Situations are “spinoffs” and “thrift conversions.”

A spinoff is when a parent company decides to carve out a business and give stock in this business to its shareholders as a standalone entity. Much research over the years shows that such stocks outperform the broad market.

A thrift conversion occurs when a little savings and loan (S&L or thrift) goes public. It does so by offering shares in its IPO depositors. These are not typical IPOs where the money raised goes to the selling insiders. Instead, all the money raised (less underwriting fees) in a thrift conversion goes back into the bank. At the end of the day, shareholders own the cash they put in plus a bank.

Again, research shows that thrift conversions are consistent winners over time. I have recommended five different thrift conversions to my subscribers and, so far, all five are in the plus column.

Are thrift conversions boring? Yeah, kind of. But then again, they come with a lot less risk than many stocks. Thrift conversions are for patient people who like to make money patiently… and hate losing it.

The process of how these particular Special Situations come to be almost guarantees that the odds favor you as an investor. Nothing works 100% of the time, of course. But it’s like poker. If you start with aces, you have the odds in your favor.

These are just two examples, but there are other investments — like “stub stocks,” for example — that routinely deliver the goods.

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


Chris Mayer
for The Daily Reckoning