The Outsider Trading Scandal

George Gilder
The Wall Street Journal
April 19, 2000
Print ArticleStock markets are world-wide webs of information. So why half the time do they behave like members of some candy mountain mystical sect, torn between dreams of eternal wealth and horror of a bottomless pit?

Ultimately ruling markets are data about the remorselessly real facts of supply and demand, the empirical realities of finance and the intricate, unforgiving details of technology paradigms and performance. Yet the conventional wisdom is that stock markets ride on tides of greed and fear. From the Tulip mania of the 17th century to the crash of 1987 and now the plunge of 2000, chaos and volatility have all too often ruled.

The promise of the Internet, however, is the instant spread of information. More information is available about more companies and securities than ever before. Why then, in the midst of an information age, do markets for technology stocks still behave like tulip auctions in 1630?

Well-Meaning Rule

A key reason is what I call the outsider trading scandal. The law for information disclosure by public companies and those aspiring to go public prohibits the release of materially significant news unless it is published simultaneously to the world. This well-meaning rule is supposed to create a level playing field, so that no investors have the advantage of inside knowledge. But the result is to reduce the amount of real information reflected in stock prices.

Under the existing regime, information does not bubble up from firms spontaneously in raw and ambiguous form, with executives and engineers freely expressing their views and even investing on the basis of them. It emerges instead as various forms of processed public relations, administered by lawyers.

Intended to prevent fraud and insider trading, this rule does not prevent criminals from manipulating markets. Criminals, after all, observe the law only in order to break it more ingeniously. The idea of stopping them by reducing information for everyone else makes as much sense as trying to stop terrorists by making all travelers lie at airports about the complete control of their luggage.

Less information about companies means more volatility and more vulnerability to outside events. Inside information -- the flow of intimate detail about the progress of technologies and product tests and research and development and daily sales data -- is in fact the only force that makes any long-lerm difference in stock performance. Yet it is precisely this information that is denied to public investors.

Entrepreneurial information from deep inside companies, not from the investment counsel or PR firm, is the most important real knowledge in the economy. Acquiring and comprehending it is the chief work of inside entrepreneurs. Such knowledge is by no means self evident; insiders often get it wrong. But nothing else is of much value at all. By excluding inside news from influencing the day to day movements of prices, the U.S. effectively blinds its stock markets.

What should be a steady outpouring of knowledge -- some of it hype, some confusing, most of it ambiguous like business life itself -- emerges instead as a series of media events that leave out everything interesting. Pivotal are quarterly profit-and-loss reports and merger and acquisition announcements. Such information, concentrated rather than diffused, takes the form of discrete nuggets and events -- P&L, M&A -- that are more subject to theft and manipulation. Thus the government\'s control of information creates more opportunities for insider trading. Moreover, because only acquiring companies can know all the intimate inside details about companies they are purchasing, mergers and acquisitions become the decisive moments of value recognition. Anticipating them becomes a major preoccupation of markets.

In an environment where inside information is banished from markets, much of the value is harvested not by the public but by organizations like General Electric, Cisco and Berkshire Hathaway that increasingly are not companies at all but portfolios of assets, whose strength is full access to inside knowledge about their holdings. Similarly, venture capitalists command full intimate knowledge of their target firms. Meanwhile the average investor is left in the dark.

Under these circumstances, markets are vulnerable to outside information. Deprived of knowledge, investors become paranoid and jump at every movement in the shadows. They debate the implicit punctuation in speeches by Alan Greenspan. They weigh merger rumors down to the milligram. They speculate madly on what will be the next company deemed to hold an \"ascendant technology\" by the Gilder Technology Report. They contemplate technical charts and invest on the basis of \"momentum\" -- that is, in ignorance.

With company prices moving by multiples at the rumor of a \"shadow earnings estimate,\" investors spend most of their time in a hair-trigger trance. When the Fed makes a mistake on interest rates or the government makes an error on Microsoft or immigration policy or tax rates, the markets overreact. Volatility is an effect of the very ignorance that the new information tools are designed to overcome.

Even on the World Wide Web, blind markets are covered by blind pundits. With inquiring analysts barred from any \"material\" information not divulged at once to the world, reporters focus on the personalities of executives and on financial data, necessarily retrospective and thus of little value in predicting future prices. This is the reason that the huge expansion of financial coverage on the Internet has not resulted in more rational and informed pricing of stocks. This is why the market feeds chiefly on rumors and momentum and \"technical\" analysis. In an information economy, inside information is the basis of share value. Yet inside information is barred as much as possible from the markets.

First Amendment

To realize the benefits of the World Wide Web on those information markets that focus on stocks, the current rules on the disclosure of material information should be rescinded. They are in clear violation of the First Amendment. Fraudulent manipulation of shares will remain a criminal act, and it can be prosecuted without stultifying the flow of information from companies.

Information wants to be free, and the more of it that is incorporated in the prices of shares, the more robust, and the less subject to manipulation, euphoria and panic, the market will be. Through the Internet, stock exchanges can escape the popular Keynesian characterization as a \"casino,\" and can fulfill still better their real role in the intelligent investment of capital. Greed and fear can give way to knowledge only if knowledge is not illegal.