Futher to the manipulation theory or should I say reality...something has to done!
TGR: This growing difficulty of putting money directly into a corporate treasury where it can be put to work to create new wealth seems at odds with what you call an unholy celebration of a trading culture divorced from fundamentals. Trading profits are understood as the reward for imposing discipline on inefficient markets, which is generally acknowledged as a positive contribution. Why are you hostile toward this trading culture in the arena of resource juniors?
John Kaiser: In principle I am not against arbitrage trading when inefficient markets offer such opportunities. After all, I style myself as a bottom-fisher and spec value hunter, which would not be a productive pursuit if the junior resource sector were efficient. One has to distinguish between structural and incidental inefficiencies. In a truly competitive environment inefficiencies erupt as brief windows of opportunity that close rapidly. I'm not talking about inside information, just the inefficient or incorrect processing of public information. Whoever spots and exploits the inefficiency first makes a profit. The ability to milk an incidental inefficiency is limited by the speed with which others notice your good fortune and edge in on it. That is a transparent market at work.
In contrast, a structural inefficiency is one that does not disappear through competition generated by its identification. It is the collaborative fleecing of a victim where the spoils are systemically shared by the so-called arbitragers who are not competing with each other, but rather collectively against the victim.
The Canadian junior resource sector has been invaded by such a structural inefficiency. The trading culture that has turned 40% of the US market into algorithmic-type trading has now wandered into the Canadian junior arena. Computerized programs and human proprietary traders armed with computers are stalking the system. When money flows in, they scuffle over to it and harvest it by selling stock they do not even own, flattening the position by the end of the day. The regulators allow these "directionally neutral" accounts that have the privilege of not tagging short sales as such because the intent is to cover short positions by the end of the day.
In a traditional short account the investor places a bet based on a perceived disconnect between the market's valuation of a company and the value of the company based on fundamentals alone. Such a short seller must maintain the short position for more than a single day, and to do that he or she must borrow stock, which is not always easy to do. This type of short seller plays a valuable role in the stock market because such short positions represent useful information for the market, which is why the regulators insist that they be tagged as short sales.
TGR: Historically short selling has been restricted by the uptick rule, which stated that you cannot sell short at a price that is lower than the last different price. But American regulators eliminated the uptick rule in 2007 and the Canadian regulators have followed suit. Why do you think this is bad news for the resource juniors?
John Kaiser: The uptick rule was eliminated to facilitate high frequency trading where the goal is to arbitrage price differences between equities and various structured products such as index funds, exchange traded funds, options and futures. This requires computer assisted simultaneous buying and selling of related securities in different markets. This is impossible to do legally on a meaningful scale if the uptick rule applies to short sales in equity markets.
In the case of the resource juniors, there are few arbitrage opportunities because options only get written on a handful of stocks, only a few stocks are inter-listed on NYSE MKT and none are components of publicly traded structured products. However, in the name of competition the Canadian regulators forced the TMX Group, the parent of the TSX and TSX.V exchanges on which the resource juniors trade, to allow trading through alternative trading systems operated by third parties. Instead of just one electronic order book where the principle of first-come-first-serve rules, and transparency in market depth and trading activity is absolute, now we have a market fragmented by parallel order books. Each brokerage has its own system for routing client orders through this mess of order books. Furthermore, clients can specify into which alternative trading system their orders get placed. Both algorithmic and proprietary human traders can arbitrage these parallel order books.
The uptick rule only works when there is strict sequentiality in order execution, which continuously defines the last price traded. In such a system a sell order tagged as a short sale cannot be executed if it would be at a lower price than the last different traded price. But if orders can be executed in parallel trading systems, you cannot establish a definitive sequence of different prices so that the uptick rule can be enforced. The Canadians eliminated the uptick rule for short selling so that orders involving the same security can be transacted on competing trading platforms.
TGR: How does this create a structural inefficiency in the junior resource market?
John Kaiser: The current setup makes it possible for traders to strip out money flowing into the system without contributing any offsetting value. The rationale for accommodating algo and human prop trading is that this creates liquidity. Perversely, some of these trading systems even pay for these day trading orders while penalizing real investors putting on longer-term positions based on fundamentals. The trouble for the resource juniors is that the day traders are not interested in project fundamentals; they are focused only on volatility and capital flows. By being able to sell short stock without tagging it as such they can intercept money moving into the stock from fundamental investors. Obviously to profit they need to unwind the short position. This is just a matter of waiting for the inflow of new money to end, and then pounding the bid side of the order books with further short sale orders until the failed rally triggers a cascade of selling by despairing long shareholders, which allows the day trader's short positions to be covered the same day.
When fundamental speculators, that is, people who are betting on the fundamental outcome of whatever the company is trying to do, have to compete against such traders, the fundamental speculators disappear. This makes it difficult for the resource juniors to establish a higher trading price in response to positive fundamental developments and fund further work at those higher prices. Include the regulatory efforts to curtail the flow of private placement funding in the name of protecting investors, and you end up with the junior stuck on a dilution treadmill, issuing more stock to a shrinking pool of "accredited investors" at the same or lower prices despite making fundamental progress. Because ongoing equity financing is the key to delivering a definitive fundamental success in the form of a deposit that can be turned into a profitable mine, this "structural inefficiency" further skews the playing field in favor of traders. Allowing these supposed liquidity creators into the system has actually caused liquidity to evaporate.
The end game for this situation is that eventually fundamentals-oriented investors will withdraw entirely from the junior resource sector, leaving only the algo and human prop traders to battle each other. That may create the appearance of a thriving market for a while, but none of the capital in play flows into corporate treasuries. If the companies cannot produce fundamental successes, there is no reason for investors seeking winning bets on fundamental outcomes to pay attention to the junior resource sector. Furthermore, these day traders have become pretty good at recognizing when they are battling each other. Once it becomes apparent that they are cannibalizing each other rather than preying on real investors, they flee. Then there will be only very large spreads with little stock on either the bid or offer side, in effect a dead market. This is the institutional failure of the Canadian junior resource market that I fear.