Yearly Archives: 2013

The Short Fed Story

Is the Federal Reserve fueling stock-market gains?

When St. Louis Fed president James Bullard addressed the Bowling Green, KY, Chamber of Commerce in February 2011, he pinpointed correlation between Ben Bernanke’s September 2010 Jackson Hole speech on “QE2,” the Fed’s second easy-money program, and the stock-market rebound that followed. Classical effects of monetary easing include rising equity prices, Mr. Bullard said.

The Fed wanted market appreciation because people feel better when the stuff they own seems more valuable. But I think we’re having the wrong debate. The question isn’t if Fed intervention increases stock prices, but this: Can prices set by middle men last?

Before actor Daniel Craig became the new James Bond he starred in a caper flick called Layer Cake that posited a rubric: The art of the deal is being a good middle man. The Fed is the ultimate global middle man. Since the dollar is the world’s reserve currency, the Fed as night manager of the cost and availability of dollars can affect everybody’s money. After all, save where barter still prevails, doing business involves money. Variability in its value is the fulcrum for the great planetary teeter-totter of commerce. The risk for the Fed is distorting global values with borrowing and intermediation.

In the stock market, we’re told it’s been a terrible year for “the shorts” – speculators who borrow shares and sell them on hopes of covering at a lower future price. The common measure is short interest, a twice-monthly metric denoting stocks borrowed, sold, and not yet covered. Historically, that’s about 5% of shares comprising the S&P 500. (more…)

Retail Reality

Do retail investors matter?

Depends what you mean. They’re important and valuable as investors. I once headed investor relations for a company with thousands of retail holders. I was president of an IR services firm that focused on retail-targeting strategies.

But when people ask me if retail investors have a chance in the market, my answer is monosyllabic: No. Scottrade, the online brokerage, runs ads featuring clients claiming that “I don’t trade like everyone else. I trade like me.” That seems to suggest retail traders can craft unique schemes that stand apart. While it’s theoretically conceivable for a retail order to price the market under rules requiring “market” orders to meet at the best national offer to sell, in practice it’s remote. Retail orders are passengers on market trains.

I’ll explain. Scottrade says in its order-routing filings that 100% of its trades are non-directed – they don’t specify execution venues. The average Scottrade customer is thus statistically most likely to trade not like you or me or him or her, but like Knight Securities, since that’s where a quarter of Scottrade orders go.

Another chunk from Scottrade lands at Citadel, the high-speed hedge-fund owned platform. Citigroup gets the largest portion but it’s divided between limit orders at Lavaflow, Citi’s fast-trading facility, and market orders at Citigroup’s agency desk (suggesting Citi powers arbitrage).

About 15% of orders shoot through Direct Edge, the high-frequency-trading exchange that’s merging with BATS, another sizzling execution venue. And for options and futures and NYSE stocks, about 7% of Scottrade’s orders route to G1 Securities that until recently was owned by rival E*Trade, which has sold it Susquehanna, a quantitative trader. Yup, folks who hoped to “trade like me” were actually trading like E*Trade. (more…)

The Dark Exchange

I’m reminded of a joke (groans).

A man is sent to prison. As he settles into his captive routine he’s struck by a midafternoon affair among his jailed fellows. One would shout out, “Number 4!” The others would laugh.

His cellmate, seeing the newbie’s consternation, explained: “We’ve been here so long we’ve numbered the jokes instead of saying the whole thing. Here, you try. Number 7 is a really funny one.”

“What, just shout it?”

“Yeah, exactly.”

“Number 7!”

Silence.

The cellmate shook his head. He said, “Some people just can’t tell a joke.”

Speaking of numbered jokes, the NYSE filed with regulators to offer new order types – regulated ways to trade stocks – designed to attract large institutional orders now flowing to “dark pools,” or marketplaces operated by brokers where prices aren’t displayed. The exchange has long battled rules in markets that promote trading in dark pools, arguing that these shadowy elements of the national market system inhibit price-discovery.

Let’s translate to English. The NYSE is a big stock supermarket with aisles carrying the products your equity shopper needs, where prices and amounts for sale are clearly displayed. Across the parking lot there’s an unmarked warehouse, pitch black inside, with doors at both ends.

You can duck into the supermarket and check prices and supplies for particular products, and then hurry over to the warehouse and run through it holding out your hands. You might emerge with the products you wanted at prices matching those in the supermarket. (more…)

BEST OF MSM – A Movable Feast

Happy Thanksgiving! Here’s a phrase Karen’s grandmother coined that you may find useful this time of year:  “We ate to dullness.” 

Since many of you are appropriately absent this week from the IR chair (or whichever office you occupy), we’ll revisit past turf. Among the most widely read Market Structure Maps of 2013 was this below from July 3. The images from our Provence cycling trip exercised influence, but sort through to the lesson.

I was reminded of it the last few days with three public companies you’d recognize. Each had the same scenario:  Declines in price of magnitude unjustified by news or facts – which had shareholders as flummoxed as the IROs.

What happens between buyers and sellers, before they ever meet each other, can have as consequential an impact as the act of changing ownership. Sometimes more. Witness the so-called Flash Crash of May 6, 2010. Shill bidders disappeared, leaving a vacuum that filled with nothing until a thousand DJIA points evaporated. That’s not selling; that’s the conveyor belt connecting our fragmented market just – poof! – vanishing.

Another major structural fact today is that investors are obsessed with risk. Read on.  Best, -TQ

July 3, 2013

We’re back from touring Provence aboard cycling saddles, weighing heavier on the pedals after warmly embracing regional food and drink. Lavender air, stone-walled villages perched over vineyards, crisp mornings and warm days, endless twilight, chilled Viogniers from small-lot Luberon wineries. If these things appeal, go.

In Avignon we feasted at Moutardier in the shadow of the Palais du Papes, the palace of the Roman Catholic popes in the 14th century. From tiny hilltop Oppede-le-Vieux with roots to earliest AD written in moldering stone and worn cobble we surveyed the region’s agricultural riches. After a long climb up, we saw why Gordes is where the rich and famous from Paris and Monte Carlo go to relax. And on Day 5 I scratched off the master life list riding fabled Mont Ventoux, which will host the Tour de France on Bastille Day, July 14. What a trip.

Meanwhile back at the equity-market ranch, things got wobbly. We warned before departing that options-expirations June 19-21 held high risk because markets had consumed arbitrage upside and new swaps rules would make the process of re-risking unusually testy. Markets tumbled.

The Fed? Sure, Ben Bernanke’s comments unnerved markets. But if we could see it in the data before the downdraft occurred, then there’s something else besides the reactions of traders and investors at work. (more…)

The Long and Short

In the timeless 1987 movie The Princess Bride, Vizzini the Sicilian, played riotously with a lisp by Wallace Shawn, keeps declaring things “inconceivable!”

Swordsman Inigo Montoya, portrayed then by Homeland’s Mandy Patinkin, finally says, “You keep using that word. I do not think it means what you think it means.”

You could say the same for short interest. It’s not what you think it means. Stay with me to the end, and you’ll see.

On August 2, 2012, Knight Capital Group’s algorithms failed. Monday at TABB Forum, Anthony Masso, CEO at trading risk-analytics provider Succession Systems, described how the SEC’s recent settlement with Knight successor KCG Holdings clarified a risk standard called the Market Access Rule. It requires brokers to have systems that forestall actions that may imperil themselves or others in the market. I’d paraphrase the law this way: “We order you to take whatever actions are necessary to prevent bad stuff. Thank you.”

That’s not what got my attention. The settlement reveals details about Knight’s errant trades. The broker bought, or went long, $3.5 billion of stocks; and shorted, or sold, about $3.2 billion. In less than an hour, its systems executed four million trades in 174 different stocks to create these positions.

This one tidbit is a tumbler unlocking vast secrets about market behavior. Knight’s algorithms were observably designed to build long and short positions of similar size principally to supply the storefronts of the stock market. When these positions failed to modulate, markets rushed into the vacuum, crushing Knight’s balance sheet.

Here’s the delicate balance in proprietary high-speed trading. Get it wrong by less than 10% and you’re done. Knight got it wrong. This same fragile trestle trains markets over the chasm each day. We’re all riding the rail.

ModernIR tracks short volume using algorithms. The daily average the past 50 days marketwide is 41%, not far off long/short equilibrium. Combined volumes on exchanges and dark pools total about 6.3 billion shares daily, meaning 2.5 billion shares each day are short.

Short interest in the S&P 500 is nearer 5% on average, though components can reach levels that roughly match daily short volume. The difference between interest and volume is that volume is just borrowed, while interest remains sold and outstanding.

Our data show that 11% of public companies have short volume above 50% of total volume. The highest in our client base the last five days was 61%. We’ve seen levels reach 85%, meaning nearly nine of every ten trades involved short shares – rented trading inventory. The lowest we saw was in a series of Class B shares trading just a few thousand per day where still 15% were short.

Elevated short interest can mean speculators are betting on a downturn. But it could as well be searing daytime demand for trading “inventory” – bowling shoes to put on for the day, for the game, traders and intermediaries finding renting cheaper than owning.

What concerns me is that short volume by definition in Regulation T is credit. So the market is heavily dependent on borrowing, just like the entire global financial system.

You have to see volume differently. Half of it is borrowed. Rented. Bowling shoes. High short interest is a product of frenetic demand on short horizons – not a certificate guaranteeing imminent pressure.

But realize that a hiccup in long/short balances can move your shares sharply – and it’s got nothing to do with ownership, or even shorting in the conventional sense. Inconceivable? No. And you know now what I mean.

Wag the Dog

Today a new era begins.

One day in May 1792, 24 brokers gathered beneath a buttonwood tree in lower New York City and agreed to confederate in conducting their stock-in-trade. Thus began the New York Stock Exchange.

Today, the NYSE is slated to cease trading publicly. The InterContinental Exchange – The ICE – cleared final regulatory hurdles and closed the transaction.

It’s a study, an archetype, of the monumental change these last 15 upending years in equities, that The ICE is a derivatives market that didn’t exist when the Order Handling Rules in 1997 fundamentally shifted market orientation from investing to intermediation.

You’ve heard the cliché about the tail wagging the dog? Derivatives depend for existence on some underlying thing, an asset. Where derivatives have exploded in securities markets everywhere, equity assets have shrunk, not in value but in number. Keep this thought in mind. We’ll come to its significance.

According to SIFMA, the trade association for US capital markets, interest-rate derivatives alone reflect about $600 trillion of notional value. Compare to assets from US investment companies directed at US equities, according to consultancy Towers Watson and the Investment Company Institute: Roughly $11.4 trillion from a total $34.2 trillion under management. Dwarfed.

Sure, other assets in US equities originate internationally. But there’s been a colossal shift since 1972 (an ironic numerical anagram), when derivatives began to percolate globally as first the dollar and then the raft of global currencies departed from mooring gold, creating value uncertainty that had to be hedged in securities markets.

The pace gained steam in the 1990s and in equities it coincided with a reversal in the number of public companies in the National Market System. That figure peaked near 8,000 in 1998, data from Wilshire Associates shows. (more…)

Kansas and Your Stock

We were in Kansas again.

We set a personal record, visiting the state twice last week. Even Wichita is nice this time of year, as this photo shows Saturday from our downtown Hyatt Regency room on the Arkansas River – don’t ask me why that river’s in Kansas.

IR pros, you’re not in Kansas anymore. The phrase popularized by Wizard of Oz author Frank Baum in 1900 remains metaphorically relevant. It means: “Things are not what they used to be,” or even better, “Rather than complaining, recognize reality and deal with it.”

It’s apropos to your stock. A vital but overlooked fact about stock prices is what actually sets them. It’s rarely investors alone. Ever heard a stock recap on the news that said stocks were up because intermediaries bid up short-term prices to trick investors? It happens all the time.

Growing up on a cattle ranch in eastern Oregon, we raised 300 hundred tons of hay. That’s a lot. But feeding 50 pounds of it per animal every day for five months to a herd of a thousand head, it’s a fraction of what’s needed.

So you buy. You may use a hay broker or you might go direct to growers, and it could take more than one. You want the right quality. Not grass, but alfalfa with its higher protein content, better for the hard winters in the Snake River Breaks.

Then you have to move it from Nevada or Georgia where you bought it. You might get a package deal, with the hay shipped and stacked for an all-in per-ton price. You might truck it separately if the deal’s better. But you’ll need truckers.

Costs are complicated. The weather during growing season, the supply of cattle in the market carrying over the winter, competition in the hay-growing industry, the price of fuel, government deals with foreign countries impacting the expected price for beef in the spring – all these determine what you pay for hay. My dad used to crunch numbers in his model for carrying costs to the target sale date. Expenses for feeding cattle could fluctuate wildly, sometimes doubling from one season to the next, requiring careful management. (more…)

Behind the Trade

We were in King Soopers and they were out of lemons.

For those of you elsewhere in the country and world, King Soopers is a Kroger-run grocery chain and I’m sure you’re thinking as I did when I first saw one, “Who names a store King Soopers?”

I bet you’re also thinking, how do you run out of lemons? Answer: deliveries hadn’t arrived. We take for granted that stuff will be on the shelves. Having lived a year in Sri Lanka in college, where oftentimes there wasn’t anything on the shelf because no shipments had come, I grasp limited liquidity.

When stocks rise in price, we figure there must be more buyers than sellers. When they decline, the opposite must be true. You laugh, yes. But how do shares get on shelves in the first place?

A long time ago, there were just a couple stores, like the New York Stock Exchange, owned by the firms who stocked the shelves – literally. Brokers had books of business comprised of owners of shares. In 1792 under a buttonwood tree in lower downtown New York City one May day, 24 brokers agreed to confederate, recognizing that pooling business would create a marketplace. The NYSE was born (next week it becomes a subsidiary of derivatives market The ICE). (more…)

Risk-Free Return

Everybody is talking about the weather. Why doesn’t somebody do something?

This witticism on human futility is often attributed to Mark Twain but traces to Twain’s friend and collaborator Charles Dudley Warner. A century later, it’s still funny.

There’s a lot of hand-wringing going on about interest rates, which from the IR chair may seem irrelevant until you consider that your equity cost of capital cannot be calculated without knowing the risk-free rate.

That and a piece in Institutional Investor Magazine some weeks back brought to my view by alert reader Pam Murphy got me thinking about how investors are behaving – which hits closer to investor-relations than anything.

When I say hands are wrung about rates, I mean will they go up? We’ve not had normalized costs of capital since…hm, good question. Go to treasurydirect.gov and check rates for I-Bonds, the federal-government savings coupon. I-Bonds pay a combination of a fixed rate plus an inflation adjustment. Guess what the fixed rate is? 0.00%. The inflation-adjusted return May-Oct 2013 is 1.18%.EE-Bonds with no inflation adjustment yield 0.20% annually. This is a 20-year maturity instrument. Prior to 1995, these bonds averaged ten-year maturities and never paid less than 4% annually, often over 7%. If the I-Bond pegs inflation at 1.18% every six months, translating to 2.36% annually, is the risk-free rate of return a -2.16%? (more…)

Irrelevant Sideshows

They keep you from getting lost in irrelevant sideshows.

That’s how University of Chicago economics professor John Cochrane described the benefits of asset-price models in a WSJ piece yesterday about Nobel winners Eugene Fama, Lars Peter Hansen and Robert Shiller.

Two alert readers sent me notes when the Royal Swedish Academy of Sciences proclaimed the recipients. Our models here also depend on measuring prices and behaviors in combination, concepts these fellows pioneered.

Like the cowboy adage on how to double your money (fold it over and put it back in your pocket – something Washington DC could stand to grasp), both John Cochrane’s quip and the work these gentlemen have done simplifies the complex.

We can thank them for much of what we know today about financial-market behavior, from the rational to the psychological. We understand that markets are generally efficient but occasionally random, that risk affects investment behavior and outcomes and how we perceive value.

Behavioral finance owes them too for its modern prominence in everything from high-frequency trading models to the Federal Reserve’s beige book of key economic indicators.

We today broadly recognize Robert Shiller’s Case-Shiller Home-Price Index, which measures average prices against the rate of change in them. Shiller’s work in the 1970s served as seedbed for behavioral finance.

Investor-relations at root is fostering fair value. Yet here we arrive at a remarkable confluence of rationality and psychology. IR embraces the rational-investor thesis but generally rejects behavioral finance – the basis for arbitrage – when quantifying market-behavior. One is relevant, the other a distraction not worth measuring. Yet Nobel Prizes have been awarded for work demonstrating behavioral effects in asset-price models. (more…)