As our confidence builds collectively, things start going right again. Remember to look for the signs. Last week, all secondaries failed. (A secondary is a follow-on offering of a stock, much like an IPO, except the company is already public.)
(Many people don't really understand the terminology or the way Wall Street places merchandise. It remains a mystery. Yet it's an integral part of the game, meaning a great deal because in a world where commissions are so low both for institutions and individuals, the real payday comes in underwritings. There are two kinds of underwritings, the initial public offering and the secondary, or follow-on offering. Both have big payouts. Both need salespeople to be sold (although there are deals that don't need to be sold because they're so hot). When I was a broker, I got paid a ton of money on underwritings, sometimes as much as $4 a share for the real bad ones, the ones we knew were going to stink, or $1 or 85 cents a share for pretty good ones. Remember, if I'm making 5 cents a share on regular business, I get all fired up for the underwritings. Why is the commission so big? Because the company pays for it! Companies are pretty stupid about the whole underwriting process because they go through it only a couple of times in their lives. But brokers are very savvy because they do it every day. Some of these deals shouldn't cost anything to do they're so hot, but the issuers pay through the nose anyway. One day these deals will be done on the Web for pennies. Until then, we have to put up with this process. This article covers secondaries, the deals that are done after a company comes public. A secondary can be made up of stock issued by a company and/or stock from insiders. Insiders can sell stock several ways: They can dribble it out through Rule 144, a Securities & Exchange Commission rule that allows insiders to sell a certain percentage of their holdings. Or they can do it through a secondary, in which the shares are registered for sale and sold in a batch with others. In this era, many companies do small and highly coveted underwritings. A few months later they come back with larger follow-on offerings that allow insiders to sell. Brokerage houses host the companies on tours, get their sales force behind the underwritings (don't worry, they're very well paid, again by the sellers) and place the stock. It's where it gets placed -- what price -- that this piece focuses on. When there is strong demand for secondaries, they hold in well before they are priced. When they are white hot, the stocks run up in advance of the underwritings and get priced right in line. That kind of environment actually existed less than a month ago. Brokers would urge you to buy stocks ahead of the secondary roadshow because they were confident that there was much more demand than supply. But when the market gets soggy, with too much supply, everything changes. Secondaries get priced in line and hang around or go lower. When things are really bad, secondaries get priced "in the hole," or at a deep discount to the last sale. In a terrible market, these secondaries don't even hold when they're priced in the hole. They go lower. In the worst markets, companies cancel the secondaries because they think they are giving away the store. There can be lengthy periods during which no merchandise can get priced because things are so bad. There are periods during which business is so terrible but sellers so desperate that they put even more money as a payment for an underwriting to be sold. It still might not matter.)
Wednesday, the secondaries worked. I bought some
, a company that has been brought down unmercifully, on a secondary and was pleasantly surprised to be up nicely by the end of the day.
(This was one of the standout performers this week after the secondary. You could tell it was going to work that morning because buyers who wanted a ton of stock weren't able to get any and there were buyers in Instinet ahead of the offering. That showed you there was a short-term bottom coming. It was a fabulous tell. You need to monitor these tells. You need to know that there's demand for these big deals because it may mean that the supply-demand equation has tilted toward demand and away from supply. That's how stocks ultimately go up.)
Not only that, but many of the secondaries that were heavily underwater started lifting yesterday, like
Electronic Data Systems
, to name two that have dogged this market.
(Later in the week, when EDS passed the "print" price, or the price that the secondary came at, I was emboldened. I began to buy Sycamore and went home long the stock over the weekend. I thought it had been penalized enough by the secondary overhang, meaning that supply was dogging the stock. Overhang literally refers to shares that haven't been put into good hands.)
Why is this so important? Because it has to do with the basic supply and demand that drives the stock market. You as an individual may not realize it, but brokerage houses "position" stock for clients all of the time. That's the insider term for "they buy them when you don't want them."
(Of all of the misunderstood concepts, it's the notion of large institutions trading with big firms that leaves most people in the dark. The notion of "plugging" a firm with stock, or hitting it with a block of stock you don't want, is totally antithetical to the smaller investor because she never has a large enough position to need help getting out of it. But that is standard procedure for a large institution. You get a firm to commit capital and take you out. They do this at prices that are usually advantageous to you but not to them. That's one of the courtesies of doing millions of dollars in commissions a year. It's basically a perk of the large institutions.)
Let's take it out of the realm of personalization.
(I do this because I'm not about bashing one firm or praising another. That doesn't help. I'm trying to explain the process to you. I don't use a specific firm, so nobody thinks I'm picking on them.)
Say Cramer Brothers places a secondary of red hot
at 90 after it has come down from 140 where the secondary was announced. I'm Mr. Big Shot, manager of a giant mutual fund. Of the 4 million shares of National Gift that are being offered (2 million by the company and 2 million by insiders), I take down 50,000 shares.
(Again, this process is one of the most mysterious. When you put in for 50,000 shares of a deal and you get all 50,000, that's bad. You want people to be cut back so there is more after-market demand for a stock. It's a terrible sign when you actually get your "circle," which is the name for the order you put in for an underwriting. When I circle 50,000 shares of something, I really want 15,000. That means the underwriting is tight.)
From the get-go, this stock doesn't hold 90, which is known as the print price.
(We say "the print didn't hold" or "it's a busted deal.")
At 84, I call Cramer Brothers and we have a talk.
(84 was just a number I picked. You could have this dialogue earlier or later.)
It goes like this:
"I did $2 million in commissions with you already this year, and this National Gift is killing me. I have to take the loss. I want you to buy it from me."
(Brokers hate to get these calls. Traders hate them. They don't want to "facilitate" if they don't have to -- yes, it is called facilitating. They have to commit some of the firm's precious capital to buying something that you obviously think is going down, or you wouldn't be selling it. They are basically being asked to take a loss on merchandise. But if you do a lot of commission business, you can ask for such favors and the firms are afraid to turn you down because they are in competition with each other and this facilitating is one of the ways they differentiate themselves from the crowd.)
Cramer Brothers wants to stay in this game. So, reluctantly, he purchases your 50,000 shares back, probably at 82, as the word is out that this deal was a real dog and placed in real bad hands.
(Typically, a trader goes out on his system, over an intercom or on the Web, and says he has a size seller of National Gift. Salespeople then try to place the stock. Obviously nobody wants a size seller of a stock that is a busted underwriting. It just makes things worse. But sometimes, the discount on the pricing is so steep that it attracts people who think the stock is done going down. That happens all the time.)
Now, what does Cramer Brothers do with your 50,000 shares, plus all of the other National Gift he's had to eat from other equally angry, equally big Mr. Big Shots?
He sits on it. He takes it down. He hopes. He tries to lay off some but everybody is "full up."
(This is a trader's nightmare. He has to hold the stock if he can't find buyers, unless he wants to take an immediate loss. He might have to anyway. It's a risky, risky business being a "position" trader and I think a thankless one. But there are people who are fantastic at it, who know how to price merchandise so they don't take such a beating.)
In the business we say Cramer's "lugging." He's long. You never want to be long in a down market.
(Everybody in our business is acutely aware of whoever is hurting. That's one of the reasons why there are not more money managers doing what I do. I'm extremely vulnerable to other managers' shooting against me if I'm hurting on a position. So are these brokerage firms when they have obviously been plugged.)
If all of the brokers are all similarly situated, if they are all lugging, that's part of the unseen-to-the-naked-eye part of the stock market that can really cause a decline. You want brokers to be lean, not lugging. You want that because, ultimately, they have no staying power.
(Again, this is supply and demand. You don't want the dealers to have much inventory. You want the next buyer who comes in to have to pay up for merchandise. This is the most important consideration in figuring out the overall short-term direction of the market.)
Can you imagine how much merchandise they have to take down in a bad tape? Can you imagine how much they have to lug? Billions and billions of dollars, for which they have tremendous borrowing costs. It costs a fortune to lug, both from the carrying costs and from the losses on the merchandise that goes down.
(One of the reasons it's so hard to gauge the earnings of brokerage houses is because of losses like these. These trading losses are very hard to gauge. When business is smoking and stocks are going up, obviously there are very few of these losses; this, in a small way, has contributed to the massive earnings surprises we have seen in this segment.)
A really powerful rally rarely starts when brokerages like Cramer Brothers are lugging. They have to be lean. They have to have no merchandise. That causes institutions to reach up and buy, which, of course, is what makes a stock go up instead of down. That's why I monitor this Ben Holmes
stuff so closely. It's another clue to how the market will do in the very short term.
(You want multiple buyers for a stock and few sellers, so that a stock has to go up before an order can be completed. In the same way that position traders can buy stock, they are also asked to sell stock that they don't have in inventory. They short the stock, or sell you borrowed stock. As you would always buy because you think a stock is going to go up, this is the mirror image of the pain for the trader that results from buying bad merchandise. If National Gift is hot and your client wants "an offering" from you, you have to give it to her if you are going to maintain that relationship.)
Go back to his
articles. Call them up. They are really great. See how recent secondaries performed. They are a great barometer for the direction of the market. They are not out of the woods yet, but they are much healthier than they were a week ago. Merchandise is being placed in much firmer hands. That's good news for the bulls.
(I don't care if you never trade underwritings. This is a business of looking for clues. The best clues of the current state of supply and demand come from underwritings, so the more you can find out about them, the better.)
James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long Tibco Software and Sycamore Networks. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at