<FOOLISH FOUR PORTFOLIO>

The Gap Up
Annoying, isn't it?

by Ann Coleman (TMFAnnC)

Reston, VA (June 8, 1999) -- Strange as it seems, and it's no stranger than many things about the way markets work, a stock's opening price in the morning may be very different from the price that it closed at just the day before. I suspect that this is one of the reasons for the persistent idea that stock prices are set by some entity, like a supermarket stock boy madly stamping prices on boxes of stocks.

It doesn't work that way, of course -- it couldn't. Stocks trade far too fast for prices to be controlled, although, as with most generalizations, that is only a partially true statement. The stock market is an auction, and the prices you see reported are nothing more than the last price someone was willing to pay for that company. Each trade establishes a new trade. But if that is true, how can the price go up when the auction is closed? In particular, how can the Foolish Four stocks "gap up" on the first trading day of the year as much as Chris Rugaber's study documented them doing the last couple of years?

First, let's review just how prices are set during trading. As I said, the markets are auctions. People who own stocks that they wish to sell can put in an order to sell them "at the market," meaning the highest price available when their order hits the top of the queue, or they can set a "limit" by specifying the lowest price that they will accept for their shares. That lowest specified price is called the "ask." Makes sense.

Those wishing to buy stock can put in an order to buy "at the market," meaning at the lowest price being offered when their turn comes, or they can specify the highest price that they are willing to pay. That limit price is called the "bid."

"Market Makers" (on Nasdaq) or "Specialists" (on the New York Stock Exchange) are brokers who "make a market" for certain stocks. They match up the orders and process the trades. Naturally, they don't do this for nothing. How market makers and specialists make money is something we will have to tackle another time. At the moment, let's just grant that they make a "comfortable" living and go on.

In return for that comfortable living, they agree to provide liquidity, meaning that if a market order to buy comes in and no shares are available, they will sell shares from their own account at the price established by the last trade. Likewise, if someone wants to sell at the market and there are no buyers, they will buy the shares for their own account at the established price.

On the NYSE there is one specialist for each stock. Nasdaq stocks may have several Market makers, all linked by computers. These traders report each trade to their exchange, and those reports establish the current price. They also track bid and ask orders that are above or below the current price. There may be large numbers of orders at various prices that are carried on the books waiting for their price to come up.

Let's say you place an order to buy 100 shares of General Motors <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %> "at the market." Your broker relays your order to the specialist. If, when your order hits the top of the queue, there are no "sell at the market" orders waiting in line, the specialist matches your order with the lowest "ask" order on his books. Your trade is reported and a new price (probably higher, darn it) is established until the next trade.

If you entered a limit order to buy and your bid was below the current price, it would not execute until there were no other higher bids (or market orders) on the books -- and even then, an order to sell at that price or "at the market" would have to come in. The specialist is under no obligation to fill limit orders that are not at the market, although he may at his discretion.

Of course the complications are endless. For more details (without which you can live a full and productive life, I might add) here are some resources from our FAQ:

Bid/ask Prices

Types of Orders

But our topic today is that pesky "gap up" that hits the high yield Dow stocks on the first trading day of the year. Well, you probably thought the markets opened at 9:30 a.m., didn't you? Not quite. Market makers and specialists are allowed to enter orders starting at 9 a.m. Although no trades take place until the opening bell, the bidding starts a half hour early. That gives the computers time to sort everything out and make the first trade at the best price that has been bid.

In the case of the high-yield Dow stocks, apparently a large number of orders come in before the market opens on the first trading day of the year, most likely from Unit Investment Trusts and mutual funds following the Dogs of the Dow strategy. Since "everyone" knows about this surge in demand now, the ask orders start out high and the first order to be filled is likely to be considerably higher than the closing price on December 31. Demand always drives up price.

If you are starting to think you should be buying high-yield stocks in December and selling them the first day of January, hang on a minute, though. Since this has become a fairly obvious market inefficiency in the last couple of years, I would expect that the effect will start to moderate. Some unit investment trusts are set up so that they have to buy at certain times, but I would expect that that will change as well and that anyone who can buy early will buy early -- or a few days later -- and the gap up will gap back down.

It will be fun to watch come the new millennium.

Fool on and prosper!



Today's Stock Lists | 1999 Dow Returns

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Today's Stock Lists | 1999 Dow Returns

06/8/99 Close
Stock  Change   Last
--------------------
CAT  -1  1/8   62.13
JPM  -2  1/4   131.13
MMM  -1  1/4   89.44
IP   +   5/16  50.31


                  Day    Month   Year   History
        FOOL-4   -1.12%   3.64%  25.84%  27.71%
        DJIA     -1.32%   1.95%  17.64%  17.17%
        S&P 500  -1.29%   1.19%   7.49%   7.75%
        NASDAQ   -1.97%   0.16%  12.85%  14.40%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     62.13    44.21%
 12/24/98    9 JP Morgan    105.51    131.13    24.28%
 12/24/98   14 3M            73.57     89.44    21.57%
 12/24/98   22 Int'l Paper   43.55     50.31    15.53%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1491.00   $457.00
 12/24/98    9 JP Morgan    949.62   1180.13   $230.51
 12/24/98   14 3M          1030.00   1252.13   $222.13
 12/24/98   22 Int'l Paper  958.12   1106.88   $148.76

              Dividends Received      $49.99
                             Cash     $28.26
                            TOTAL   $5108.38