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July 15, 1999

A Longer Market Day Coming Your Way
Thoughts on After Hours Trading

by Louis Corrigan (TMFSeymor)

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Warren Buffett has said it would be fine with him if the stock market were only open one day a year. On that day you could buy or sell stocks, but the rest of the year you would study businesses, looking for those firms that can deliver consistent results over the long haul. Since each buy order would commit you to owning part of a business for at least a year, investors would have a powerful incentive to choose carefully -- and Foolishly.

It's not clear that Buffett would really enjoy such a world given that short bouts of irrationality often allow contrarian investors like him to scoop up solid companies at bargain prices. What is clear is that U.S. stock markets are rapidly moving even farther away from Buffett's fantasy.

The New York Stock Exchange (NYSE) and the Nasdaq market are both talking about extending trading well beyond the current market hours running from 9:30 a.m. to 4:00 p.m. Eastern time. Meanwhile, Instinet, Island, and other electronic communications networks (ECNs) that account for a growing share of Nasdaq volume already offer after-hours trading to institutions, and several will soon provide extended hours to individual investors, as well. The 24/7 market may not be far away.

The specific proposals differ. Months ago, the NYSE had talked about opening up the after-hours club as early as next week. But on June 3, the Big Board decided it had enough on its plate for the next 12 months given that it's addressing potential Y2K glitches and preparing for the switch from fractions to decimals in the second quarter of 2000.

NYSE Chair Richard Grasso has indicated that an extra evening session for U.S. stocks could be instituted in the latter half of next year, with an early bird session introduced later. The exchange already has plans to offer extended trading for American depositary receipts (ADRs) and foreign stocks starting next June, with European stocks available for trading between 5 a.m. and 9 a.m. and Asian stocks between 5 p.m. and midnight.

Nasdaq could crash the party sooner, perhaps as early as September. The National Association of Securities Dealers (NASD), the market's parent, has been preparing since May for an evening session that would run from 5:30 p.m. to either 9:00 p.m. or 10 p.m. Initially, only the Nasdaq 100 stocks would be available for trading during the extra period.

The fact is, though, that these established players are not all that excited about after-hours trading. Wall Street firms will need to find personnel to cover the extra sessions, but there's no guarantee there will really be enough additional trading volume to justify the added expense of hiring new staff. That means some current staffers may get stuck doing double-duty for a while. And let's face it, six-and-a-half hours a day of watching the tape is more than enough for anyone hoping to maintain their sanity and a bit of family life.

Yet, competition breeds innovation among the markets for stocks just as in other industries. The upstart ECNs are really driving the move to extended hours. They currently handle about 30% of Nasdaq trades, with Reuters Group PLC's (Nasdaq: RTRSY) Instinet recently claiming 20% of Nasdaq volume, and Island, a subsidiary of leading online broker Datek, accounting for about 6%. These upstart exchanges see an opportunity to grab a larger share of the volume by making it possible for individual investors to actually trade during the evening hours when so many research stocks online and place orders for the next day.

Starting later this summer, Island will permit individuals to trade until perhaps 5:15 p.m. Younger rivals may be even more aggressive. Eclipse Trading will probably offer trading between 6 p.m. and 9 p.m., with Morgan Stanley (NYSE: MWD) and leading trading firm Bernard Madoff Investments signed on as participants. Newly public Wit Capital (Nasdaq: WITC) has plans to offer trading from 7 p.m. to 10 p.m. Archipelago LLC, backed by E*Trade (Nasdaq: EGRP) and Goldman Sachs (NYSE: GS), is also expected to start extended trading later this year.

Many companies report earnings and other significant news either before or after official market hours due to the once valid notion that such timing allowed all investors a fair chance to hear and digest the news before anyone could trade on it. Yet, thanks to Instinet and other ECNs, institutional investors can now trade on the news even as individual investors remain locked out of the action. This can be particularly frustrating to many individuals since stocks can sometimes rise or fall sharply in after-hours activity. Extending trading hours for everyone is one solution to that problem.

The ECNs also offer a theoretically attractive means of opening up trading. That's because these new entities started out as just individual brokerage firms, but they have evolved into discrete stock exchanges that keep a "book" of buy and sell orders. The ECNs act as agents, offering a space where buyers and sellers can display and match their orders and claiming a flat fee for each transaction as compensation for this service. Most ECNs apparently have no plans to deploy their own capital to buy and sell stocks, something even NYSE specialists are called on to do.

These third markets operate quite differently from Nasdaq, where market makers are self-interested and active participants, committing their own capital to sell stock at the ask (the best price to sell) and buy it at the bid (the best price to buy). The spread, or the difference between the bid and ask, is the market maker's profit.

A landmark investigation and lawsuit launched by the Securities and Exchange Commission (SEC) in the mid 1990s exposed how market makers had colluded to keep Nasdaq spreads unnaturally wide and their own profits artificially sweet. Ensuing reforms have dramatically reduced the spread for most stocks, allowing investors to get better prices when they trade. However, market makers have resisted additional reforms -- such as a central book displaying all limit orders -- because they would allow investors a chance to get even better prices but would cost Nasdaq's broker-dealers more money.

Just as nature doesn't like a wall, electronic commerce doesn't like middlemen who don't provide a service commensurate with their fees. The ECNs, then, represent a kind of revenge of market capitalism on the market makers in that these new entities arguably represent a natural evolution in the development of markets to pure electronic exchanges. And to the extent that after-hours trading, as part of this evolution, is being driven by genuine demand from individual investors who are now taking control of their own financial destiny, then it must be celebrated as the next step in an ongoing revolution that's re-centering the market around those who possess capital rather than those who have (in the past) been called on to manage it.

However, there's reason to worry that individual investors could get burned by extended trading hours. Markets function most efficiently when there's sufficient liquidity (ample numbers of buyers and sellers) to keep them running smoothly. Heavily traded stocks, such as Intel (Nasdaq: INTC), often trade at a spread of $1/8 or less. Lightly traded stocks, by contrast, can carry a spread of $1/4 or more.

ECNs offering after-hours trading will not be linked with one another as they essentially are during the main Nasdaq session today. So an evening order placed with a broker using Island will not be able to access an order placed by a broker using Eclipse. At least in the short term, until the presumed masses of mom and pop investors start jumping online each night to buy and sell, after-hours trading will surely suffer from even wider spreads than you find in a system managed by market makers. That's one reason after-hours exchanges will likely require investors to enter limit orders, setting the price they are willing to pay so that they don't end up getting swindled.

Institutional investors already encounter such problems today trading in the illiquid Instinet sessions that CNBC reports on every afternoon. It's not at all uncommon to see a major block of stock sold at several dollars below the closing New York price after a somewhat disappointing earnings report only to see the stock open the next day even above that New York close. It's certainly easier to manipulate an illiquid market, but the more pressing issue is just that illiquid markets will never offer buyers and sellers the best prices.

The absolute need to gather as much order flow as possible is why these upstart trading systems are anxious to sign up major brokerage firms to support their systems. In a sense, each ECN is hoping to become the eBay (Nasdaq: EBAY) of the stock market. The spoils will go to the firms that can gather sufficient trading volume to produce those network effects that generate even greater volume and thus better pricing, just as eBay becomes even bigger and more popular as it becomes bigger and more popular.

The other major concern, though, brings us back to Buffett. Academic studies looking at thousands of actual investors suggest that buy-and-hold investors do significantly better than the most active traders, and Buffett's own career adds authority to the data. Although longer market hours won't necessarily inspire us all to become day, night, and early morning traders, they will contribute to the increasingly widespread notion that investment capital need not be committed for more than a few hours at a time because you can trade out of your position literally any time you want to.

As a Fool who understands the outsized rewards of buying great businesses and just holding onto them for years, I have to believe that's a dangerous mindset to encourage.

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