Market Makers, Their Disappearance, and how to take Advantage of It

Reprinted from Bull & Bear Financial Report VOL. 26 NO. 06 • Sept.-October 2014
By KC Grainger & Bob Pellerin*

“True market makers are a thing of the past and this has a huge impact on the small cap mining stocks’ price movements…old support levels are not support anymore.” That is what I wrote eight years ago for the “Bull and Bear” and it still holds true.

Yet today the overall situation is for most publicly traded companies is even more challenging. Two factors are the major contributors to the disappearance of the market makers, there are tiny spreads between the bids and offers and even worse, there is little comprehensive research available for most publicly traded stocks. That lack of comprehensive research has proven to be a disaster for many small cap stocks and junior mining companies!

In the last eight years, we have seen a further decline in the volume of true market maker participation in the mid-caps and smaller cap stocks in both Canadian and American stocks. And yes, many previous market makers also called “specialists” have become active traders in the very same stocks that they previously made markets in. This change brings both positives and negatives but for too many stocks, it is not a positive development. It tends to add to volatility.

In the past on the Montreal Stock Exchange, one would see the specialists/market makers in various stocks maintaining inventories of fifty thousand to two hundred thousand shares in each stock that they made markets in. At times, the specialists would hold inventories of a million shares or more of an individual stock. We do not see that specialist market maker support today, that sort of price support for the most part is gone. However, with no market maker/specialist support, it can offer investors the opportunity to accumulate shares as they are being sold at what may very well be exceptionally undervalued price levels. The old price lows were once the domain of the specialists/market makers, now the private investor can participate.
One must understand that a market maker or “specialist” in the past would attempt to keep a well-ordered market by trying to balance the bids and offers. Their main purpose was and still is to “maintain a fair and orderly market.” They would fill a void during the times when there was not a balance of sellers verses buyers. Keep in mind that there is rarely an even balance of buyers and sellers and in less liquid stocks such as junior mining stocks, it is quite rare. The bottom line is that in many stocks, particularly small caps and juniors, there is rarely a perfect balance of buyers and sellers.

In the past, the market makers would assist buyers and sellers in the market by buying or selling or selling short in their own accounts. Their market making work would greatly enhance the liquidity of the market and diminish volatility. Naturally, they had a profit motive. They would make their profits by their experienced “market making.” Sometimes they would win, and yes, sometimes they would lose. Today, the conditions have changed even more for the market makers. Above all, in the past, they could limit or at least mitigate large declines in the prices of the specific stocks that they made markets for.

Historically, they would win more than they lost by taking advantage of their years of experience and the fact that they really saw the “inside of the market” as in who is buying and who is selling and above all else, “how much.” Principally, they saw the specific share buying and selling of investors who historically were the most successful; they had an insight that few have. Yes, they were “in the information loop.” But today, with the algorithmic trading and High Frequency Trading, front running and “in-betweens” in the markets, market making has become extremely difficult to near impossible at times. Market making is no longer the same often profitable profession that it once was.

The key to the problem is that previously, most market makers were employed by the brokerage houses that would support their trading activities with the firm’s capital and comprehensive research coverage. They would add a degree of price stability, some support to the price of a stock and usually cut down on the volatility. But today, most of the brokerage houses that still engage market makers are requiring them to be traders for the brokerage houses accounts. That is where their profits are today.

Today’s small “spreads” are a major problem! What happened? The spreads between the bids and offers have now decreased to pennies and less. That makes it quite difficult for a market maker to step in and support a market during declines as there is no longer an adequate “cushion” between the bids and offers during harsh downsides and ever increasing volatility. One should keep in mind that wider spreads are not a guarantee of trades being successful but rather it is lowering the high risk of stepping in with helpful buying support.

How to address it today? Research and patience!
Investors must realize that since there are no longer market makers supporting prices as in the past, they must expect far more volatility and price declines to price levels far below where most stocks have bottomed previously. But what makes it even more challenging is the fact that there is little comprehensive research available for the majority of publicly traded stocks. For junior mining stocks and micro-caps the situation is even more distressing; we can sadly describe it as “no research available.”

Companies should make every effort to have a clearly understandable research report of their company available. Most investors are not miners or geologists and understand little about mining. If investors cannot understand a company, they generally will not invest in it. In analyzing mining companies there are the essential questions. What and where are the company’s prime projects? What is its financial position? What is management’s share ownership? Is there institutional ownership of the company’s shares? What we are suggesting is that successful investing demands rigorous analysis.

Our approach! Due to lack of research coverage, junior mining stocks as well as mid-caps and small caps often drop and languish at prices that eventually turn out to be “steals.” One can lament and complain or take advantage by putting in bids for stocks that one finds as attractive and accumulating those stocks when they have fallen through the cracks and are undervalued. Couple the lack of supportive market makers with the fact that comprehensive research coverage is often non-existent for most companies and you have a situation that can be of benefit for the private investor. The door is wide open!

Since there is very limited research coverage for most publicly traded companies, the public is totally unaware of the vast majority of undervalued stocks. In mining stocks there is even less awareness. The public customarily only sees the narrow universe of stocks that the brokerage houses cover on a research basis. Generally, very few of their “prime recommendations” are extremely undervalued and offer the opportunity for exceptional capital gains, that is not going to change.