Specialists, How They Use Their Merchandising Strategies And
Self-Regulation For The Manipulation Of The Stock Market
People who invest in the stock market usually
don’t spend too much time thinking about the
specialist, why he is important, and why he
should be very carefully supervised and
regulated, until such time as there is an
awesome crash in the market. At such times
the public hollers for an investigation of the
stock market. Since most of those in
government doing the investigating are
beholding to the Stock Exchange in one way
or another (via campaign contributions or
through their law firms), or hope (if they
are commissioners and chairman of the
SEC) to be employed in the securities
industry at some not to distant date, nothing
ever comes of these investigations.
Those in government charged with the
administration of the securities industry and
who conduct these investigations are fully
aware that since the turn of the century the
findings of such investigations have centered
on the fact that the deep and inexorable cries
of the stock market are caused by the failure
of specialists to operate the market in a fair
and orderly manner when acting as dealers
for themselves while in direct competition with
the investing public. According to the “Report
of the Special Study of Securities Markets
and Exchange Commission” of 1963:
Specialists are at the heart of the problem of
organization, management and disciplinary
procedures of the exchange…. the misuse of their
role in the operation of a fair, orderly auction
market and the breakdown of regulatory and
disciplinary controls over them… are part of a
complex pattern of interlocking causes and effects.
It is for this reason that any program or reform
must concentrate heavily on the dominant role of
the specialist.
In the past even the most public-spirited
investigation of the specialist system, which
was the 1963 Report, declined to
acknowledge the exact manner in which
specialists employed their merchandising
strategies to maximize profits for themselves
at the expense of individual investors. Part of
the reason is that specialists are not bound by
either the rules of the Exchange or the SEC to
inform the public or anyone else about the
specifics of all of their transactions.
The SEC’s report did, however, pointedly
insist that the specialists’ conduct did not
conform to the established code. Where their
most important practices were concerned,
specialists employed techniques, which were
impossible for the public to follow because of
the specialists’ unwillingness to provide the
public with information concerning the details
of their activities. In particular, it singled out
the specialists’ use of the short sale.
Under ordinary circumstances, an individual
buys stock in anticipation of a subsequent rise
in price, which will enable him to sell it at a
profit. When an investor sells short, he
reverses the process by first selling the stock
in anticipation of a subsequent “decline” in
price which will allow him to then buy the
stock back at a lower price. His profit (or loss)
is the difference between the price at which
he first sells the stock and the price at which
he later purchases it.
When an investor wishes to sell short, (IE) to
sell stock he does not yet own, his brokerage
firm will normally arrange to “borrow” the
stock from their or another brokerage firms
pool of securities, with the understanding that
at a later date the investor will return those
share. This investor is then able to make
delivery with his borrowed stock to the party
to whom his broker sold it. When the investor
later makes his “covering” purchase of the
stock, he is then able to return the shares he
borrowed to clear his obligation.
The act of selling stock, which an individual
does not own, is called “short selling,” while
his subsequent purchases are referred to as
“short covering.”
When a specialist uses the short sale, the
process is basically the same. There is,
however, one very important difference.
When an investor sells a stock short, he
“thinks” that the price of the stock will
decline, whereas the specialist’s short sale is
based on the certainty that he intends on
taking the price of the stock lower.
The power of the short sale can be seen in
the manner in which the instrument allows
specialists to completely control the forces of
supply and demand so that ultimately they
can raise and lower prices at will. In the
hands of the specialist the short sale is a
triumph of human ingenuity. Thanks to the
nature of the instrument and its paradoxical
functions, the short sale enables specialists to
determine the short, intermediate, and long-
term price objectives of their stocks.
As an example of how short sale rules have
been distorted for the benefit of insiders with
the aid of the SEC is as follows: In 1938 the
Commission enacted a short-selling rule that
prohibited Stock Exchange members from
“demoralizing the market” by effecting short
sales at or below a price lower than the last
sale. This rule was meant to prevent “short
sellers from accelerating a decline by
exhausting all remaining bids, offers to
buy, at one price level, causing
successively lower price levels to be
established.”
The SEC however, provides specialists with a
loophole that allows them to “demoralize the
market by selling short on downticks”
(without having to report these transactions
as short sales) whereas the investing public
can only short on upticks. (A transaction that
is executed on an uptick occurs at a higher
price than the last preceding price, while a
transaction that is executed on a downtick
occurs at a lower price than the last preceding
price.) Indeed, investors have remained
totally unaware of the myriad controls over
individual stock prices and the market as a
whole accruing to specialists through their
use of the short sale.
To those that think that my statement that the
specialist is able to manipulate stock prices at
will seems far fetched, the SEC’s Special
Study Report provides an illustration that
documents this conclusion. Quoting Bill
Meehan when he was the specialist in Ford,
the Report provides you with an insiders view
into the process in which specialists are able
virtually to guarantee a profit for themselves
in the course of a long bear market. Meehan
shows you that he was able to do this by
selling short and then lowering his stock’s
price levels at which he then “covered” his
short sales:
Not that I am a student of the charts, but I took a
look at the Ford chart and it looked very dangerous
to me. I liquidated our whole position and went
short and we maintained a short position, actually
in only three of our stocks, all the way through,
practically, during the whole period. During the
day, we would become long, but almost every
night we were short stock. [SSR, Part2, Page 113]
In order to understand the implications of
what Meehan is saying, it is important to
understand that when specialists rally stock
prices, public buying is attracted. Conversely,
when specialists drop the prices of their
stocks, the public on balance can be
expected to sell stock. Thus Meehan, in the
course of dropping the price of his stock in the
market crash of 1962, accumulated an
inventory of stock in the morning, (in all
probability most often at or near the
opening) from investors who frightened by
the decline that was taking place in the stock
and fearful of a further decline, had entered
their sell orders to sell.
Thereafter, he was able to reduce his
inventory by rallying stock prices. The rally
would attract public buying demand in
sufficient quantities to enable him not only to
liquidate his trading account “during the day”
but to also “short stock” almost every
afternoon. As you can see, his short sales
were indispensable in taking down the stock
prices profitably in a bear market, in this case
in what was one of the worst bear markets
encountered by investors in the 20th century.
Equally important to recognize is that this
example documents the manner in which the
short sale enables specialists to manipulate
their stock prices up and down at will
regardless of whether the market is a bull or
bear.
A business week article stated, “If specialists
apparent monopoly looks like a license to
steel, the specialists have an answer.” “If we
make so much money,” they argue, “why
isn’t everyone else trying to get into our
business?” When outsiders do investigate
the possibility of this, they discover that it
would probably be easier to break into Fort
Knox’s.
Each of the specialist’s privileges has a
decisive influence on the destinies of
investors; some offer him more opportunities
for profit than others. Unknown to most
investors, in addition to the profits from their
trading accounts, specialists have what are
called “long-term segregated investment
accounts.” The SEC’s Institutional Investor
Study has calculated that specialists make
between 84 to 192 percent a year on their
capital.
The article stated, however, that the study
had “ignored specialist investment
accounts.” The fact is that although the SEC
has from time to time mentioned specialists’
returns from their trading accounts, it has
always consistently refused to provide any
information concerning profits from a
specialist’s business or his investment
accounts.
Observation of specialist’s activities reveals
that once he has sold out his investment
account and established a short position at
the stock’s high, his long-term objective is
then to take stock prices down to wholesale
price levels in order to cover his short sales
and once again accumulate stock. The
establishment of these accounts is, of course,
the signal for the noticeable shift in the
specialist’s posture toward his stock’s price
trend. Once he accumulates or distributes his
stock from his investment accounts, the
manner and intent of his activities will be
biased toward advancing or lowering his
stock’s price in order to maximize his
personal profits.
Another feature of the investment account
involves the manner in which the specialist
links it with his trading account for both
distribution and tax planning purposes. The
tax advantage the investment account offers
is that it enables specialists to declare as long
term capital gains what are legitimately short
term capital gains. If for example he acquires
a position in his investment account at his
stock’s lows and advances his stock’s price to
its high in less than a 12-month capital gains
window, he can employ his investment
account to turn what would otherwise be short
term gains into long term gains.
To do this he would liquidate whatever stock
he has in his trading account at the high and
then establish a major short position in the
account. Then all he needs to do is wait until
the 12-month capital gains period passes to
qualify the accumulations in his investment
account for long term capital gains and deliver
over those shares from the investment
account in order to cover the short positions
in his trading account. In this manner he can
legally call his profits “long-term.”
It was interesting for me to learn that this
information is of little or no concern to most
investors. In fact, the comments of many are
“so what? Everyone wants to save on
taxes. Why shouldn’t he be able to just like
everyone else?” What most investors have
failed to grasp was that the issues involved
were far more important than whether or not
specialists are allowed to enjoy the tax
benefits of turning short-term gains into long-
term gains. The issue in fact, is whether or
not tens of millions of investors should be
subjected to rhythmic market booms and
busts so that specialists can establish their
capital gains. It is also worth observing that if
the matter were not of such an obvious and
pressing nature, the specialist study group
would not have so well presented the dark
side of the issue (Special Study Report, Part
2, page 133):
Purchases made on the Exchange for the purpose
of segregation into long-term investment accounts
raise problems, which go to the heart of the
specialist system. The specialist is permitted to
trade for his own account only when such trades
affirmatively contribute to the maintenance of a fair
and orderly market. Where the specialist goes into
the market with the intention of segregating the
securities purchased and not with the purpose of
creating a fair and orderly market, the trading is
clearly contrary to the statutory and regulatory
standards. Beyond this, the specialist with a long-
term position now has a stake in seeing the
securities rise in price - he has become an investor
as well as a dealer.
A further problem arises when the specialist who
maintains such long-term accounts is required to
sell stock to maintain a fair and orderly market and
he has no stock in his specialist trading account.
[If] the 12-month period of the tax statute is almost
over, the specialist may well be tempted to keep
his stock in the long-term account and neglect the
needs of the market.
In reply, the NYSE maintained that specialists
have a perfect right, like anyone else, to
accumulate stocks as investors and stated “it
believes that it is perfectly proper for the
specialist unit to carry stock in a long-term
investment account.” It terminated any
further discussions with the SEC on this
matter with the following statement that
“further discussions of this question
between the Exchange and the SEC have
been deferred.” This is the true meaning of
self-regulation.
It has been argued that great changes have
been mad since the Special Study Report of
1963. However, Arnold I Milsky, who was a
NYSE specialist for nine years and was the
head of his own consulting firm, offers some
insight into this opinion:
The Big Board is increasingly willing to let
specialists bend the rules. You’ve got increasingly
flagrant situations where if a specialist is long a
stock [that is he owns it] he simply raises the
offering price, enabling him to make more money
on his position. And if he is short a security, he
drops the bid price more precipitously, enabling
him, to cover his short sales at a better profit.
Investors should be up in arms about the way
many specialists are handling their securities.
So too, one would imagine, should the SEC.
For many years the SEC’s methods of
surveillance over the Exchange have been a
source of mystery. When for example, do
SEC officials visit the Stock Exchange, and
what checks do they maintain over the
specialists’ practices? These questions were
answered in a conversation with an un-named
SEC official:
Specialists are under the exchange. We don’t get
to concerned with them. They’re not directly
regulated by the Commission. They all operate
under self-regulation. They make their own rules;
the Commission just o.k.’s them. Only if the
Commission feels there is something not proper
does it take exception. We check broker-dealers
but we never go onto the Exchange to check out
specialists.
Understanding this we can begin to
understand why specialists are now being
allowed to do quite openly what is still
forbidden by the rules of their own Exchange.
Formerly, investment bankers and
stockbrokers, by acting as their
intermediaries, maintained their distance
between specialists and institutions. Now that
institutions are breaking these ties, specialists
are forced with a situation in which they are
pitted against each other in order to obtain
institutional business. The problem is further
compounded for specialists by the inception
of the new central market, which presents
them with the prospect of increased
competition for business from other
Exchanges. Thus institutional traders have
been faced with the curious spectacle of the
Stock Exchange’s usually arrogant,
immovable high priests scurrying around Wall
Street, soliciting business like common
stockbrokers.

For as many years as specialists have been

in business, investors have sought to obtain
data on their incomes. Not surprisingly, the
Exchange has refused to grant access to this
information. It would have been absurd for
specialists to surrender their income data
voluntarily, since it has been through the
shroud of secrecy and the lack of regulation
that they have been able to turn a humdrum
job into a several-hundred-million-dollar-a-
year-job. Not only would this data reveal
much of the specialist’s Sinbad-like voyage in
paradise, but even more importantly, when
the years were examined in which he made
his fortunes, the figures would reveal the
enormous profits for him during a bear
market cycle.

Self-regulation grants the specialist his power.

It is the myths that surround him that sustain
that power. Lacking the nourishment of fact
about the specialist system, investors have
been overfed and underprivileged by the
media’s fictions. Chief among these fictions is
the belief, firmly embedded in investor
consciousness, that the risks and financial
losses suffered by specialists far outweigh
those suffered by investors. Unfortunately,
nothing could be further from the truth.

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