It didn’t receive much in the way of attention, but last week the U.S. Securities and Exchange Commission (SEC) announced its intention to end the pilot program testing five-cent bid/ask spreads. The program mandated minimum quotations and trading increments for stocks of certain smaller companies. It was originally scheduled to expire on October 2, 2018. Since October 2 is a Tuesday, the program will effectively be terminated at the end of next week, on Friday, September 28, 2018.
I expect those of you who invest in smaller-company stocks will be happy to say good riddance to this program. It mandated wider spreads on certain stocks, up to a nickel. Specifically, and as we explained in the June 2015 AAII Journal, the pilot program put selected stocks into one of four groups. Group 1 mandated five-cent quotation spreads, but stocks in this group could trade different price increments. Group 2 stocks traded at five-cent minimum increments but could also trade at the midpoint of the five-cent bid/ask spread. Group 3 stocks had to trade at the quoted price. Stocks in the fourth group—the control group—were not subject to the pilot program’s rules.
The five-cent spread was incurred when transacting in certain stocks for AAII’s model portfolios. Those of you investing in smaller-company stocks likely incurred it too. It was an added transaction cost. It was also an example of legislative intentions not working out in the real world.
The SEC started the program after the House of Representatives passed bipartisan legislation requiring wider stock quote increments on smaller companies. The intent was to boost job growth. Wider spreads were envisioned as drawing attention and investor dollars to so-called emerging company stocks. By widening the spreads, proponents hoped to create a more attractive market for these securities, including more published research about them. It didn’t happen.
Rather (as we’ll discuss in next month’s AAII Journal), “Test-Group stocks generally saw less volume, executed in fewer, larger transactions with less message traffic, short-term order cancellations and quote volatility … Price improvement increased, but not by a large-enough margin to counteract the wider tick, resulting in higher effective spreads,” observed the Financial Industry Regulatory Authority (FINRA) in a report about the pilot program.
Trading shifted away from the major exchanges to other platforms where traders and institutional firms could get better execution prices. This reduced the number of cancelled orders, but also left individual investors—who lacked the ability to control where their orders are filled—paying the wider bid/ask spreads. At the same time, growth in volume for the test group securities “lagged that of the Control Group.”
As explained above, the cost of wider spreads was justified by its proponents as leading to a more active market with more research published about the smaller stocks. In reality, the pilot program “did not appear to increase the number of market makers, on average, in Test-Group securities,” wrote FINRA.
Citadel Securities was more critical in its assessment of the pilot program, as some of you may have read in this week’s Barron’s. Citing data in the FINRA report, the market making firm opined, “Unfortunately for investors, any changes in price-improvement fell far short of countering the increase in quoted spreads. So where did the money go? It appears to have gone to the market makers.”
- Panel Advises Against Mandated Spreads for Small-Cap Stocks – Opposition to the pilot program existed before it was implemented, as this 2014 AAII Journal Briefly Noted article shows.
- How Much Small Cap Should Be in Your Portfolio? – Even with the historically higher returns, there are reasons why some investors may not want to overweight small-cap stocks.
- Examining the Shadow Stock Value and Size Factors – Our model is one of the oldest real-money examples of how the value and size premiums can be combined into a single strategy.
- Identifying and Screening for Vice and Virtue Stocks – Using so-called sin stocks and environmental, social and governance (ESG) stocks as examples, we show how to use thematic approaches to identify potentially attractive stocks.
Roadrunner Transportation Systems Inc. (RRTS) was removed from the Model Shadow Stock Portfolio. The company’s recently filed 10-K reports with the SEC—which had been delayed due to prior restatements—showed continuing losses for 2016 and 2017. The proceeds from the sale were not large enough to warrant a new addition to the portfolio, so a replacement stock has not been purchased.
The portfolio posted a strong gain in August, up 7.8% for the month and is now up 5.7% year to date as of August 31, 2018. The S&P 500 index, as measured through the Vanguard S&P 500 Index fund, gained 3.3% during August. The Vanguard Small Cap Index fund also added 3.3% on a total-return basis, while the DFA U.S. Micro Cap fund (DFSCX) gained 3.8%.
Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 15.7% versus the Vanguard 500 Index fund’s gain of 9.7% per year. Over the same period, the Vanguard Small Cap Index fund posted an average annual gain of 10.5%.
We’ll get our initial look at third-quarter earnings with eight members of the S&P 500 scheduled to report. Included in this group is Dow Jones Industrial component Nike Inc. (NKE), which will report on Tuesday.
A shift in sector and industry classifications, including the renaming and expansion of the telecom sector into the communications services sector will take place as of the close of trading on September 28. The changes will affect many online, media and advertising companies as well as several sector funds. See Sector Classification Change Could Alter Some ETFs in the August AAII Journal for more information.
The Federal Open Market Committee (FOMC) will hold a two-day meeting starting on Tuesday. The FOMC is expected to announce its third quarter-point (0.25%) increase in interest rates for this year. The meeting statement and updated committee member forecasts will be released at approximately 2:00 p.m. Eastern Time on Wednesday. A quarterly press conference with Chairman Jerome (“Jay”) Powell will be held at 2:30 p.m.
Elsewhere on the economic calendar, the July S&P Corelogic Case-Shiller home price index and the Conference Board’s September consumer confidence survey will be released on Tuesday. Wednesday will feature August new homes sales. August durable goods orders, the final revision to second-quarter GDP, August international trade and August pending home sales will be released on Thursday. Friday will feature August personal income and outlays, the September Chicago Purchasing Managers’ Index (PMI) and the University of Michigan’s final September consumer sentiment survey.
One Federal Reserve official will make a public appearance: New York president John Williams on Friday.
The Treasury Department will auction $37 billion of two-year notes on Monday, $17 billion of two-year floating rate notes (FRNs) and $38 billion of five-year notes on Tuesday and $31 billion of seven-year notes on Thursday.
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Individual investors’ expectations for the short-term direction of the stock market are largely unchanged from a week ago. The latest AAII Sentiment Survey shows a slight increase in neutral sentiment and a slight decrease in pessimism.
Bullish sentiment, expectations that stock prices will rise over the next six months, held steady at 32.0%. The historical average is 38.5%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose by a modest 0.8 percentage points to 35.9%. Neutral sentiment remains above its historical average of 31.0% for the 30th time in 31 weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, declined by 0.8 percentage points to 32.0%. This is only the fourth time this year that pessimism is above its historical average of 30.5% on consecutive weeks.
At current levels, all three indicators are well within their typical historical ranges.
Tariffs and the possibility of an escalating trade war remain front and center on the minds of many individual investors. Also influencing sentiment are Washington politics (including President Donald Trump), midterm elections, economic growth, interest rates (including monetary policy), valuations and corporate profits.
This week’s special question asked AAII members what they thought about the stock market’s return to a relatively low state of volatility. Responses were mixed. (The S&P 500 index has gone approximately 50 days without closing up or down by 1% or more.) Nearly two out of five respondents (37%) do not think the current calm will continue. Many of these respondents say they expect volatility to jump after the November midterm elections. Slightly more than 14% of respondents describe themselves as being pleased with the low level of volatility. Approximately 9% are either surprised by the current calm or say they don’t understand why the markets are so calm given the macro backdrop. About 6% say volatility does not impact their investing decisions. A small group of respondents indicate that they do not perceive the market as currently being calm.
Here’s a sampling of the responses:
- “I doubt this will persist.”
- “I don’t think much about volatility because I am a long-term investor.”
- “It could be the calm before the storm. I think the midterm elections will have an impact.”
- “I’m surprised given all the political and trade issues going on.”
- “Low volatility is always good in my opinion.”
Bullish: 32.0%, no change
Neutral: 35.9%, up 0.8 points
Bearish: 32%, down 0.8 points
Local Chapter Meetings
September 13, 2018 Mr. Market Has Reverted Back to a Calm State
September 6, 2018 Helpful Steps My Late Father-in-Law Took
August 30, 2018 Despite Problems With Short-Term Thinking, We Should Keep Quarterly Earnings
August 23, 2018 What You Can Expect at the AAII Conference