Brokerage Deregulation & Equity Market Research

Off and on during almost any year, you may read some equity researcher's findings which compare the present period (you choose the year, it rarely matters) with some 'similar' period from the 1920s, or 1940s, 1960s, etc. Adjustments are made for inflation, other factors, various lags are introduced, and, voila! Some chart of market index activity from the present will coincide with a far-earlier period of equity market activity.

Past is prologue!

But is it?

Last week, for a reason I can't now recall, I was discussing equity market changes with my business partner at our weekly lunch meeting. Since our partnership exists primarily to employ my proprietary equity-related portfolio strategies in managing his assets, managerial and, to be honest, operational overheads are virtually non-existent. We handle any non-recurring or non-operational issues during one two-hour lunch meeting each week.

As we discussed the evolution of equity markets over the past thirty years, I became aware of a rather arcane fact that isn't widely publicized.

Prior to the US stock market's "Big Bang" of 1975, wherein equity brokerage rates were deregulated, a retail investor paid 7% (or perhaps 7.5%- my partner and I can't recall precisely which it was, and Googling this topic has brought me no closer to the answer) to trade equities.

For a round trip trade, i.e., selling a position, then buying another, a retail investor would thus pay a 14% commission. Not many people seem to mention this when they report on research conducted on time periods pre-dating 1975.

Why is this important? Well, the long-run annual return of the S&P500 Index is 11%. So, prior to 1975, a retail investor who traded positions began the new one 3% points in the hole, relative to the S&P. No wonder people held stocks for very long periods. The barrier to switching equity investments was greater than the expected long run annual return of the market.

Institutional investors, my partner and I reasoned, were similarly higher pre-1975 than they have become. If they were only in the 2-3% range, this, too, would have substantially moderated investor reaction to news. When each shift in positions costs you 1/3 to 1/2 of the S&P's annual return, you think very carefully about trading.

Thus, the effect of information on investor actions, whether retail or institutional, has probably changed radically since 1975. So much so, I would argue, that the two periods, pre- and post-deregulation, are incomparable for assessing market dynamics.

It is very much like the nonsensical use of static revenue-scoring tax models by the Congressional Budget Office. Every thinking, informed person knows that lower tax rates change taxpayer behaviors. Yet the CBO continues to insist on assuming that tax rate reductions have no effect on economic behavior, and, thus, 'lose' revenue on a static base of economic activity.

Thus, I tend to view equity market behaviors as essentially starting over after 1975, due to this very significant change in the cost of trading. Add in the effects of financial information becoming available to individual PCs in the 1990s, and the rise of robust, liquid equity derivatives, plus more robust institutional program trading, and I think one is hard pressed to claim that any lengthy period in equity markets since 1975 is comparable to another, until roughly 2000.

I think it's worth keeping this perspective in mind the next time you read some pundit's research on significant patterns over 60-80 years of equity market behavior.