On the Value of Secondary and Primary Markets

My main thesis here is that secondary and primary markets benefit investors in different ways, but that they are equally valuable to investors, and the public at large. Government policy should not discriminate in favor of one or the other.

I come at this topic from the point of view of someone who has been both a bond and stock investor professionally. When managing bonds, one boss of mine would say, “Primary market levels validate trading levels in the secondary market.” His point was that in the bond market, since a large proportion of the dollar value of transactions came from new issues, those deals in the primary markets were a good indication of where trades should go on in the secondary market for similar pieces of paper. He had a point; bigger markets should dominate smaller similar markets in discerning overall price/yield movements.

In the primary markets, deals have to come a little cheap on average in order to get deals done. That cheapness is necessary in order to get a lot of liquidity from investors at once. But that level of cheapness attracts flippers, i.e., people who buy the cheap new issue, and sell it away for a quick profit in the secondary markets. Bond underwriter syndicates do what they can to detect flippers, but some almost always get in. Even so, the flippers have some value. They reveal the level of discounting inherent in the offering process; when the discounting is high, there’s a lot of fear in the marketplace, and new deals stand a decent chance of performing well. Vice-versa when discounting is low, or even worse, when a new deal “backs up” and closes below the IPO price.

One way to tell how hot the market is, is how rapidly deals close. Seven minutes? Days?  Mania and Lethargy are common attitudes for the market.  Normal behavior is, well, abnormal.  Abnormal behavior provides clues into what is likely to happen next, even if the timing is difficult.  Hot IPO markets eventually go cold, and vice-versa.

The secondary markets provide valuable clues for the primary market as to where deals should be priced, whether equity or debt.  Even if the primary market were dominated by buy-and-hold investors (more common in bonds, less common in stocks), the speculation inherent in much secondary trading provides real value to the IPO syndicates, and longer-term investors.

Longer-term investors who buy-and-hold, or sell-and-sit-on-cash provide clues to speculators as well. The longer-term investors are the ones who create “support” and “resistance” levels.  They care about valuation.

Secondary markets need primary (IPO) markets also.  Without the possibility of a company being bought out, share prices tend to suffer.  When few new companies go public, it is often a sign that the secondary markets are cheap.

My main point here is both markets are valuable, and they need each other.  Speculation is an inescapable part of the capital markets, and it should not be legally discouraged.  (Note: I am not about to become a speculator; I am a longer-term investor, and will stay that way.)

How does the system discourage speculation?  There are differential rates of taxation based on holding period, or investment class. My view is that all income, no matter how generated, should be taxed at the same rate.  All income generation is equally valuable, whether it comes quickly or slowly.

So, when I read drivel like this fellow Lawrence Mitchell is putting out, advocating high taxes on short-term investing, I sit back and say, “You’re not thinking systematically.  You’ve only thought through the first order effects; the remaining effects have eluded you.”  Imagine a system where we are all forced to become buy-and-hold investors through tax policy.  Where would the price signals for the primary markets come from?  Where would liquidity come from?  Would activist investing shrink, with the honesty that it helps to bring?  Who would be willing to step up to an IPO if he knew that tax policy favored him holding for ten years?  What would happen to venture capital if the secondary markets dried up because of tax policy?  Where would their exit door be?

A world composed of only long-term investors would not be as rich of world as we have now.  Though many short-term investors are only “noise traders,” the ability of short-term investors to take advantage of market dislocations helps stabilize the markets.  There should be no penalty to short-term investing versus long-term investing.

Now, if that’s not controversial enough, perhaps I will write a post where I say that tax policy should not favor savings over consumption.  Let people make their own decisions on buying and selling, and let the IRS take a consistent cut, but social policy through tax preferences is for the most part not a good idea.