Yearly Archives: 2015


Earnings season.

Late nights for IR professionals crafting corporate messages for press releases and call scripts. Early mornings on CNBC’s Squawk Box, the company CEO explaining what the beat or miss means.

One thing still goes lacking in the equation forming market expectations for 21st century stocks: How money behaves. Yesterday for instance the health care sector was down nearly 2%. Some members were off 10%. It must be poor earnings, right?

FactSet in its most recent Earnings Insight with 10% of the S&P out (that’ll jump this week) says 100% of the health care sector is above estimates. That makes no sense, you say. Buy the rumor, sell the news?

There are a lot of market aphorisms that don’t match facts.  One of our longtime clients, a tech member of the S&P 500, pre-announced Oct 15 and shares are down 20%.  “The moral of the story,” lamented the IR officer, an expert on market structure (who still doesn’t always win the timing argument), “is you don’t report during options-expirations.”

She’s right, and she knew what would happen. The old rule is you do the same thing every time so investors see consistency. The new rule is know your audience. According to the Investment Company Institute (ICI), weighted turnover in institutional investments – frequency of selling – is about 42%.  Less than half of held assets move during the year.

That matches the objectives of investor-targeting, which is to attract money that buys and holds. It does.  In mutual funds, which still have the most money, turnover is near 29% according to the ICI.

So if you’re focused on long-term investors, why do you report results during options-expirations when everybody leveraging derivatives is resetting positions?  That’s like commencing a vital political speech as a freight train roars by.  Everybody would look around and wonder what the heck you said.

I found a 2011 Vanguard document that in the fine print on page one says turnover in its mutual funds averages 35% versus 1,800% in its ETFs.

Do you understand? ETFs churn assets 34 more times than your long-term holders. Since 1997 when there were just $7 billion of assets in ETFs, these instruments have grown 41% annually for 18 straight years!  Mutual funds?  Just 5% and in fact for ten straight years money has moved out of active funds to passive ones.  All the growth in mutual funds is in indexes – which don’t follow fundamentals.

Here’s another tidbit: 43% of all US investment assets are now controlled by five firms says the ICI. That’s up 34% since 2000.  The top 25 investment firms control 74% of assets. Uniformity reigns.

Back to healthcare. That sector has been the colossus for years. Our best-performing clients by the metrics we use were in health care. In late August the sector came apart.  Imagine years of accumulation in ETFs and indexes, active investments, and quantitative schemes. Now what will they do?

Run a graph comparing growth in derivatives trading – options, futures and options on futures in multiple asset classes – and overlay US equity trading. The graphs are inversed, with derivatives up 50% since 2009, equity trading down nearly 40%. Translation: What’s growing is derivatives, in step with ETFs. Are you seeing a pattern?

I traded notes with a variety of IR officers yesterday and more than one said the S&P 500 neared a technical inflection point.  They’re reporting what they hear. But who’s following technicals? Not active investors. We should question things more.

Indexes have a statutory responsibility to do what their prospectuses say. They’re not paid to take risk but to manage capital in comportment with a model. They’re not following technicals. ETFs? Unless they’re synthetic, leveraging derivatives, they track indexes, not technicals.

That means the principal followers of technical signals are intermediaries – the money arbitraging price-spreads between indexes, ETFs, individual stocks and sectors. And any asymmetry fostered by news.

Monday Oct 19 the new series of options and futures began trading marketwide. Today VIX measures offering volatility as an asset class expire.  Healthcare between the two collapsed. It’s not fundamental but tied to derivatives. A right to buy at a future price is only valuable if prices rise. Healthcare collapsed at Aug expirations. It folded at Sept expirations. It’s down again with Oct expirations. These investments depended on derivatives rendered worthless.

The point isn’t that so much money is temporary. Plenty buys your fundamentals. But it’s not trading you.  So stop giving traders an advantage by reporting results during options-expirations. You could as well write them a check!

When you play to derivatives timetables, you hurt your holders.  Don’t expect your execs to ask you. They don’t know.  It’s up to you, investor-relations professionals, to help management get it.

Paid to Trade

“You’re giving the exchanges so much business, they should be paying you,” said Richard Keary of Global ETF Advisors in a June 2014 Financial Times article.

He was talking about Exchange Traded Funds, which drive big volumes for markets listing them, much like star athletes or Donald Trump. There’s the adage that the worth of a thing is what someone is willing to pay for it. Turns out ETFs are worth a lot to BATS Global Markets Inc. In 2014, BATS started giving free listings to ETFs with over 400,000 shares of average daily volume.

Now they’ve upped the ante.  Wall Street Journal reporter Bradley Hope in a Sep 30 article described BATS’ plan to pay as much as $400,000 annually for ETF listings. BATS now has 33 ETFs from iShares, ProShares and other sponsors. The gorilla is the NYSE’s Arca unit with over 1,600 listed derivatives.  The Nasdaq has about 180.  But BATS has found a secret sauce. It’s the biggest ETF trading venue by volume.

Exchanges profit on the opening and closing auctions. The exchange with the listing gets to hold the auction for that stock or ETF. During auctions, exchanges charge the same price to buy or sell, 10-15 cents per hundred shares, where the rest of the time they’re paying for liquidity or charging to consume it, about 29 cents each (that’s high-frequency trading at its purest, the exchanges incentivizing them to bring trades that price the whole market, making trading data valuable). Thus all the money is in the auction.

Now, what is money doing today? A great deal of it follows benchmarks like the S&P 500 or the Russell 2000. That’s indexes and ETFs. Both may also have options designed to, as the NYSE’s Arca says in its materials, “gain exposure to the performance of an index, hedge and protect a portfolio against a decline in assets, enhance returns on a portfolio [or] profit from the rise or fall of an ETF by taking advantage of leverage.”

What drives volume? Money with a mission to move daily, especially if it’s big enough to have options (or futures) too. That’s liquid ETFs. Most track underlying indexes. The best way to price benchmarks is in auctions, which offer a midpoint and minimize intermediary arbitrage. These prices often set net-asset-value calculations for indexes.

The Nasdaq is running opening and closing auctions.  BATS does too. Ditto the NYSE.  Arca, the electronic NYSE derivatives market, has three auctions.  In May this year, the SEC approved an NYSE request to hold midday auctions in low-volume stocks.

Auctions aggregate buy and sell interest. Fragmented markets (an oxymoron) do not.  And the most valuable investment vehicles driving this auction revitalization are ETFs. At BATS at least, they’re worth more than the underlying assets, stocks of companies.

If BATS wants ETFs, which are derived from underlying shares, so badly they’re willing to pay, and a market system built on a relentlessly moving best bid or offer is increasingly seeking the singularity of auction prices, what’s driving this market? Well, the uniformity of money tracking benchmarks, and derivatives.

ETFs are derivatives. They don’t listen to earnings calls or meet executives to hear the story. Now let’s think about this.  Nothing exists – ETFs, indexes, options and futures would be valueless chaff – without the 3,800 public companies comprising the US stock market. How is it the things derived from the assets – ETFs – are being paid to list, while the assets, the actual companies driving results and strategies making passive investment possible, are being charged?

And if you’re listed at the Nasdaq you don’t pay the NYSE when your shares trade there.  Ever thought about that?  The problem is public companies aren’t paying attention.  Otherwise they’d be asking why derivatives get paid to trade, and companies pay to trade.

The exchanges will say, “Oh but that would require a rule change.”  Fine. This is why we’ve been saying for ten years that public companies need to understand the market. Then you can start asking the right questions, like what’s setting my price?  And what am I paying the exchange for again?

It begins with comprehending structure.  We track it every day.

The Replicator

In the television and cinematic series Star Trek, the Replicator creates stuff.  Captain Jean-Luc Picard would instruct it to dispense “tea. Earl Grey. Hot.” This YouTube montage is homage.

Speaking of creating stuff, stocks lately saw the longest 2015 rally in step with the weakest jobs report. It came on derivatives, our data show. The OMC song “How Bizarre” says if you want to know the rest, hey, buy the rights. In stocks, the rights to things rather than the things themselves is what drove them. Traders bought rights.

That means somebody else must buy the stocks.  Exercise the right to buy with a call option and the counterparty – we track counterparties – must fulfill it with shares. One risk for markets is that dealers don’t hold supplies of shares, what’s called inventory.

Why? Rules now discourage banks from carrying risk assets like stocks and require instead owning Tier One capital like sovereign debt (how the product of overspending is safer than the rights to profits is unclear) and so banks have stopped making markets in a majority of stocks. Thus, when derivatives are used they must buy, and stocks soar.

The mortgage crisis I hope taught us to watch how markets work. Mortgages were replicated through derivatives as demand for returns on purchased and appreciating homes outstripped underlying supply. When mortgages stopped increasing and houses started to fall in value, mortgage derivatives imploded.

That risk resides now in exchange-traded funds. ETFs often sample rather than replicate indexes. For instance, yesterday a swath of American Depositary Receipts (ADRs) surged because money rushed into an ETF tracking an MSCI global index that excludes US stocks. The index has nearly 1,850 components but the ETF just over 400, or about 21% of the index’s holdings.

What, you say? The ETF doesn’t own all the stocks? Right. There are two kinds of ETFs:  Physical and synthetic.  The former either own shares or sample them, and the latter rely on derivatives to represent the value of stocks. ETFs track indexes four ways:

Full replication. The ETF buys all the stocks in the underlying index, matching comparative weighting. But it may substitute cash for some or all of the stocks.

Sampling. When the tracking index is large (as in our example above) or if the stocks are not available in sufficient quantity, an ETF may construct a representative sample of the index and own only those stocks.

Optimization. Where sampling focuses on picking stocks reflecting the index’s purpose, optimization is a quantitative approach that uses mathematical models to construct correlation in a set of securities that trade like the index whether they reflect industry characteristics or not.

Swap-replication. ETFs pay counterparties for rights to the economic value of underlying indices. No assets actually trade hands.  This is what synthetic ETFs like Direxion and Proshares use (along with futures and options).

It’s worth noting that the great majority of bond ETFs use sampling because fixed-income issues are so vast and illiquid that full replication is a physical impossibility.

Back to equities, as with all derivatives from collateralized debt obligations to floating-rate currencies, problems don’t manifest until the underlying assets stop increasing in value. Those are your shares. The broad market has generally ceased rising and we’ve had a raft of problems in ETFs.

We don’t need to panic. But ETFs are the modern-era mortgage-backed securities. They were designed to make it convenient for everyone to infinitely own a finite asset class: Stocks. That is impossible, and so, sure enough, ETFs are substituting rights for assets.

It didn’t impact us in the IR profession so long as stocks were up. Whether your shares were in an ETF or not, you benefited from the implied demand in the explosion of ETF assets. When ETFs substitute cash, the resulting rise in your share-price isn’t real.

Do you understand? The dollars didn’t buy shares.  And if ETFs are sampling indexes rather than buying them in full, radical volatility can develop between issues held and excluded.

But there’s a bigger risk. As with mortgage-backed securities, ETFs are a multiplier for underlying assets. ETFs that hold stocks don’t trade them per se. Shares of ETFs trade as a promise against its assets. And ETFs lend securities.

ETFs primarily track indexes. You can’t have one without the other. If ETFs investors leave and index investors leave and both stop lending shares to brokers for intermediaries like high-frequency traders, the structure of the market will fundamentally change.

The Fed’s view notwithstanding, markets can and must both rise and fall, and markets dependent on derivatives fall harder. It’s a lesson of history. If we in the IR profession were responsible for the widget market, we’d continually study widget-market form, function, risk and opportunity.

Investor-relations is the equity product manager. We’d better watch the equity-market replicator (and clients, we do, every day).

The Long Slide

Autumn lavished Chicago and Boston in the past week, where we were sponsoring NIRI programs. While nature celebrated the season, stocks did not, continuing a slow bleed.

In Chicago I spoke on the structure of the market today, how the liquidity is one place and the prices are another, and forcing them together gives arbitragers control.

Let me explain. The roots of both the NYSE and the Nasdaq trace to brokers. In 1792, a group of them decided to throw in together, agreeing to charge a minimum commission so as not to undercut each other on price, and to go first to the group when looking for buyers or sellers, creating a marketplace – aggregated customers. It became the NYSE.

In 1971, the National Association of Securities Dealers took a page from The Institutional Network (Instinet today, a dark pool owned by Nomura) and created an automated quotation market for its members to post buy and sell interest.  It became the Nasdaq.

Both exchanges operated one market each for equities. Both markets were comprised of the customers of the brokers belonging to them.  They were bringing buyers and sellers together – that’s the definition of a market.

Today the exchanges are owned by shareholders and the markets they run are not predicated on underlying conglomerated buy and sell interest from customers of brokers.  Rules give these markets, the exchanges, authority to set prices. The liquidity – shares owned by investors and brokers – is outside the market now.

How to get the liquidity over to where prices are? Pay traders to haul it.  If you’re a top-tier maker of Nasdaq volume, meaning your firm is bringing shares for sale to the Nasdaq equaling 1.6% of total volume, you can be paid $0.30 for each hundred shares you offer for sale.  At current volumes, firms in that bracket can make $86,000 daily for doing nothing more than moving shares from one market to another.

But there’s more. Traders earn payments for selling shares at the main Nasdaq market.  They’re conversely paid at the Nasdaq BX, another platform (formerly the Boston Stock Exchange) owned by the exchange, to buy shares, about $0.17 per hundred shares.  So traders can earn money both buying and selling shares.

Why?  To set prices. If all trades must occur between the best national bid to buy and offer to sell, and the exchanges – the NYSE does the same thing, as does BATS Global Markets – can pay traders to set the bid and the offer with small trades, then other trades by rule are drawn there to match, and the data from these trades becomes a valuable commodity to sell back to brokers, who are also required by regulations to buy it in order to know if they’re providing customers the best prices.

This is how stock markets work today. Exchanges pay traders to set prices in order to draw out orders, and then they sell the data generated from these trades, and sell technology services so traders and brokers can access prices and data rapidly.

It’s the opposite of the old market where brokers set minimum commissions and gave preference. Both those are against the law now, and the market is fractured into 50 different pieces – stock exchanges, broker-operated “dark pool” markets – and is really about setting prices and generating data.

Volatility results from one thing: Continually changing prices. Why are prices in flux?  Rules require eleven different markets to pass orders to each other if they don’t have the best price, and these markets are paying traders to constantly change it. All the trades at broker dark pools must match at prices set by exchanges, so they are continuously morphing too.

According to data from S&P Capital IQ reported in USA Today yesterday, 86% of the S&P 500 (430 of 500 issues) is down 10% or more. A quarter are off at least 30%.

Suppose you’re a big money manager like Blackrock and investors have been making redemptions for days or weeks, yet every time you sell some shares, the market shudders because all the prices race away from you, and down.

You try to control it by leaking out, leaking out, because nobody wins if prices implode when you sell.  Months ago we theorized after studying market structure for now over ten years that when the next bear market developed we’d see a long slow slide because there’s no efficient way to move money of size in the current structure (a disastrous design for anyone who gets supply, demand, scarcity and choice – basic economic concepts).

We’re in it.  The only question now is the length of the slope.

Water Down

Why are my shares down when my peers are up?

The answer most times isn’t that you’ve done something poorly that your peers are doing well. That would be true if 100% of the money in the market was sorting differences and was in fact trading you and your peers, and if the liquidity for you and your peers were identical at all times.

What is liquidity? Images of precipitation come to mind, which prompts recollection of that famous quip by whoever said it (Mark Twain gets credit but there’s no proof it was his utterance) that bankers will lend you an umbrella only when it’s sunny and take it back at the first hint of rain.

The Wall Street Journal yesterday carried a story about distressing levels of assets in big bond funds locked in positions that “lack liquidity.” Public companies, your bankers and shareholders have probably complained at some point about your “lack of liquidity.”

What it means is among the most profoundly vital yet most commonly overlooked (and misunderstood) aspects of markets. Things are finite. Public companies spend the great bulk of their investor-relations resources on Telling the Story. Websites, earnings calls, press releases, non-deal road shows, sellside conferences, targeting tools, on it goes.

But do you know how much of the product you’re selling is available to purchase? One definition of liquidity is the capacity of a market to absorb buying or selling without substantially altering a product’s value.

The WSJ’s Jason Zweig yesterday tweeted a great 1936 observation by Hungarian-born German émigré Melchior Palyi, longtime University of Chicago professor of economics: “A liquid structure never liquidates. Only the illiquid one comes under the pressure of liquidation.”

Think about that in terms of your own shares.  A liquid market can absorb the ingress and egress of capital without destroying the value of the supporting assets.

What’s your stock’s liquidity?  It’s not volume. We ran a random set of 11 stocks with market capitalization ranging from $300m-$112 billion. Mean volume for the group was 1.1m shares but varied from 50,000-5.6 million. Leaving out the biggest and smallest in each data set, we had a group with an average market cap of $6 billion, average daily volume of 755,000 shares, and average dollars per trade of $5,639.

That last figure is the true measure of liquidity. How much stock can trade without materially changing the price? In our group, it’s $5,639 worth of shares. So in a market with over $24 trillion of product for sale – US market capitalization – the going rate at any given movement is about the amount you’d spend on a Vespa motor scooter.  Now look at the dollar amount of your shares held by your top ten holders.

The stock market is incapable of handling significant movement of institutional assets. It’s a critically faulty structure if investors were to ever begin to pick up the pace of stock-redemptions. They are trying.  For the 20 trading days end Sept 18, the share of market for indexes and ETFs – Blackrock, Vanguard – is up 120 basis points over the long-run average, and stocks are down measurably.  Now, 1.2% might not seem like much but that’s more than $2 billion daily, sustained over 20 trading days. The S&P 500 is down about 5%.  At that ratio, if 10% of investors in indexes and ETFs wanted to sell, the market could decline 50%.

We’re not trying to make you afraid of water!  But this is the market for the financial product all public companies sell: Shares.  That it’s demonstrably ill-formed for a down market is partly the fault of us in the issuer community, because we’re participants and ought to be fully aware of how it works and when and where it may not, and should demand a structure supporting liquidity, not just trading.

Action items:  Know the dollar-size of your average daily trade (a metric we track), and compare it to the dollar-amount held by your biggest holders.  When your management team needs a risk-assessment, you’ll be ready.

ETF Bubble

“We’re 90% in natural gas and natural-gas liquids,” said the investor-relations officer for a NYSE-listed master-limited partnership at yesterday’s NIRI luncheon in Houston, where I spoke on ETFs. “Yet we’re tracking oil.”

In Michael Lewis’s brilliant The Big Short, a small group of people come to believe mortgages are a bubble because they’ve been extended into derivatives treated as though of equal value and composition to the homes and loans backing the mortgages. No distinction then was being made between good mortgages and bad ones, the same woe afflicting our MLP above through models like ETFs. Thus began the big short – bets that a reckoning was coming.

In the stock market the core asset is stocks of public companies. There is a finite supply, which due to widespread corporate consolidation and share-repurchases isn’t increasing. But indexes that cluster stocks into convenient risk-diffusing groups have proliferated.

At the same time, brokers once carrying shares to mark up and sell to big institutional customers have been forced out by rules, and the intermediaries now, fast traders, often have but 100 shares at a time. Without ready stock, it’s gotten very hard for institutions to buy and sell big positions.

Enter exchange-traded funds. Through ETFs, institutions transfer the risk of finding mass quantities of shares to an arcane behind-the-scenes group of custodian brokers called in ETF lingo “authorized participants.” Think of firms playing this role as running the warehouses.

Here’s how it works. Blackrock creates an ETF tracking an index. The ETF must be comprised of percentages of each of its stocks. Blackrock turns to the warehouse, the Authorized Participant (AP), who gets the components off the shelves and packages vast amounts into what are called creation units. You can’t sell ETF shares back to Blackrock. Only the AP can. For investors, ETFs must be bought or sold on the “secondary market.” That is, just like stocks.

If money buys the ETF instead of the index, wouldn’t it rise faster? Thanks to special ETF rules, no. If investors want the ETF, Blackrock has its AP manufacture more ETF units to meet demand – so supply is theoretically infinite.

ETFs in effect cut out the middle man, the stock market. How? For one, ETFs can substitute cash or securities like options and futures for stocks (and they can hold but a statistical sample of the index).

Suppose investors are buying an underlying stock like XOM, and indexes containing XOM, and ETFs tracking energy and including XOM. The sponsor asks the AP for a lot of XOM and the other components so it can whip up more ETF shares. The AP checks the warehouse, and there is no more XOM. So it substitutes cash and futures of equal value.

Second, this “warehouse” concept reflects how APs, we’re led to believe, seem to have infinite access to shares of stock (which we know is impossible). You can’t find a list of APs but experts say they’re big banks getting special permission from ETF sponsors to act for them.

I have a theory. Often in 13F regulatory filings required by the SEC, holdings for the biggest investors like Blackrock and Vanguard barely change. Positions in 13Fs usually roll up to the parent. Maybe the parent’s subunits buy and sell from each other for indexes and ETFs through the APs. It’s an explanation.

Whatever the truth, ETFs are the biggest success in modern financial history because they make it easy for investors to do something that in reality isn’t: get big exposure without altering the market. Thus, ETFs are a form of credit-extension because they offer investors access to something they otherwise couldn’t buy.

Collateralized debt-obligations did the same for mortgages – turned them into something every investor could own regardless of the number or quality of underlying mortgages.

Bubbles manifest not through valuations but when values stop rising. Let’s theorize that the market stalls for an extended period.  Investors get nervous and sell XOM and the index and the ETF. The futures held in place of XOM are now worthless. To prevent panic, the AP sells assets to cover the loss.

Markets deteriorate further. Panic starts.  The AP is tangled up in swaths of valueless derivatives (just like the CDO market). Then it defaults because its balance-sheet no longer qualifies it to serve as an AP. Bear Stearns and Lehman Brothers were big counterparties that failed. A domino effect ensued as balance sheets laden with empty paper imploded.

Public companies, know what ETFs hold your shares and whether they’re big names (we can help you). Your management teams and Boards should understand ETFs and your company’s exposure to them (and the volume multiplier). Even better, you should be tracking every day what sets price (we can do that for you).

The risk I propose here probably won’t manifest. But in the May 6, 2010 Flash Crash, 70% of halted securities were ETFs. On Aug 24, 2015 when markets nearly imploded, there were 1,000 ETF volatility halts.

We might have an ETF bubble.

Capital Caprice

Suppose gas prices changed 3% daily.

Pretty soon everyone would look for patterns in volatility and start rushing to fill tanks at low ebbs. Or maybe there’d be a Gasoline Closing Cross, where petrol consumers would cue and then all carom into the pumps to peg the best average for the day.

Daft, you say? How come we do it in equity markets?  On a recent day a big energy company was trading 85,000 times on intraday volatility of 3.2%, meaning the spread from highest to lowest price ranged 320 basis points. It traded less than 200 shares at a time but $16,000 a pop and $1.4 billion total. And 40% was middle men moving price.

So a trader wanting $1 million of stock would chance the market 63 times to get less than a percent of daily volume, with 40% of trades front-run by packs of transient intermediaries, and price would’ve changed 3% throughout the day-long effort.

What if you spent your day driving around trying to fill your gas tank and 40% of the time when you pulled into a station somebody darted into your spot? And the pump price shifted at each glance.

At some point you’d quit driving. In a sense, active investors are driving less, choosing instead ETFs, the assets for which have doubled in three years in part because they function opposite the broad market where prices are a buzzing guywire of instability.

When money flows to ETFs, brokers designated as Authorized Participants manufacture large batches of ETF stuff called creation units. As the Investment Company Institute explains (page 3), they alone interact directly with the ETF’s distributor (and the ICI says 15 sponsors have 90% of ETF assets). They’re following the “recipe” described in an ETF’s prospectus but making enough for a mess hall and supplying straight to big investors or to a chunk of sub-distributors ranging from other brokers to hedge funds and high-frequency traders.

In effect ETFs cut out the middle men (or let them in the back). They’re everything the broad market isn’t. There’s a preferential relationship (the AP) with exclusive access to the source of the money, which is the distributor of the ETFs (Blackrock, Vanguard, Invesco, Janus, BNY Mellon etc.), and the two parties know exactly who each other is.

Don’t ETFs trade like stocks? The ICI data, you might counter, show 90% of ETFs have no daily creation or redemption. That proves they’re trading vehicles, appearing or vanishing through APs at inflections unlike other shares.

If this model is booming, why is the broader market built the opposite way, clogged with intermediaries and tiny shreds of fast-moving shares obscuring perverse liquidity paucity coalescing in forced anonymity around frantic price-instability?  ETFs are created in 25,000-unit chunks but somebody buying the energy company gets 200-share snippets. Which would you take?

Why don’t public companies ask the SEC the same question? If the market for the audience we court year-round appalls upon examination, should we help active investors? (That requires understanding why ETFs are mushrooming, which IR should explain to management.)

We should wish to know why investors who believe in long-term fundamentals get one crappy market while ETFs get an advantageous another. In a bizarre upending of function, the market intended for capital-formation has been constructed to favor derivatives. ETFs don’t listen to earnings calls.

This caprice explains volatility of recent weeks. The market is bifurcated into one that works well if you use derivatives like ETFs and one that doesn’t if you don’t.

Now, you say, “But Quast. Some big ETFs nearly collapsed on Aug 24.”

While the S&P 500 have been reducing share-count by percentage points annually through big buybacks, indexes and ETFs have exploded and the use of derivatives like options and futures have set soaring new records.

Translation: Underlying assets shrink as extrapolations of those assets expand. The same thing happened in mortgages. Demand was huge so mortgages were sliced and tranched and repurposed into collateralized obligations that swelled well past underlying assets but carried the same value.  What popped that bubble wasn’t the first missed mortgage payment but an end to asset-appreciation.

Derivatives become unreliable when the underlying assets stop appreciating. Ponder that. And look back.

Options expire next week at the same time the Fed meets and may hike rates or not, and S&P indices rebalance following a period of high market gyration. Everything may sort into neat piles.  But comportment rarely follows caprice. Drama is more common.

So prepare your executives, and make it a mission to get them involved in the structure of this marketplace. It’s in your power.


One thing you learn not to say is “well it can’t go any lower.”

So said the investor-relations officer for a big energy company as we talked recently about markets. Last week we were writing after the biggest drubbing for stocks since 2008, and as the strongest rally in oil since war – Gulf One, when Saddam, Kuwait and Stormin’ Norman Schwarzkopf were center stage – commenced a quarter-century ago.

If you’re going to spend money in this market as so many public companies do, it’s best to know the derivation of its vicissitudes. Not China, the Fed, oil supplies, jobs data. Those are inputs. What determines outcomes in markets is structure. Think otherwise? Play a game by your own rules and see how others react. Rules govern behavior.

Morningstar said in July that the S&P 500 in the first quarter of 2015 spent more on buybacks ($238 billion) than it earned in profits ($228 billion), an anomaly last seen in latter 2008 when companies were losing money but still plowed $100 billion into stock. They’re buying what they know – their businesses. Why then if the market summarizes business-value do companies struggle to understand it?

The answer is they’re unclear on the rules governing it.  Take the NYSE’s Rule 48, invoked for extreme volatility, about which there’s been chatter at CNBC and elsewhere. It permits the NYSE to suspend ahead of what may be a turbulent day the usual requirement that Designated Market Makers – KCG Holdings, Barclays, IMC Financial Markets and Virtu – approve and post prices before trading starts. I’d translate invocation of the rule as: “Look, do whatever you need to.”

The DMMs may be permitted to do whatever they need to when among other things foreign markets are volatile or unusual activity afflicts the futures market. It would be the latter that triggered yesterday’s use of Rule 48, we’d guess, the fourth time now in two weeks.  So right away the exchange is telling us factors beyond the summary of business-value here in America impact our stocks. Doesn’t matter where you do business.

Rule 48 was created in December 2007 as the mortgage derivatives debacle was picking up steam and as Bear Stearns labored into its final weeks of life. It’s been amended repeatedly, last on August 13 this year by NYSE rule-filing deleting a requirement for DMMs to get exchange approval before initiating trades more than 10% different in price from the last one.

DMMs are proprietary traders – yes, even Barclays here. They’re paid to make markets and so they’re prohibited from filling customer orders for an exchange rebate. But they can “reach across” the market to buy the NYSE’s best offer or sell to its best bid (how that’s different from proprietary trading in dark pools is unclear).

The Nasdaq doesn’t have DMMs but it pays high-speed traders to set prices too. Before markets open, prices are disseminating via proprietary exchange feeds to help fast traders line up and create stable positions. The NYSE says “DMM units have increased their utilization of technology to reduce risk exposure by using algorithms to adjust prices quickly in response to market dynamics.”

Consider these facts against a volatility backdrop, and here’s what you must know:

  • Prices in US markets at the open and throughout the day are often set by fast traders who aren’t investors in your shares but aiming to profit by setting prices.
  • The biggest fast traders are global like IMC and Virtu, the latter saying it’s “embedded” in 200 global markets.
  • Fast traders connect markets globally by trading everything at once – equities, options, futures, currencies (all the stuff transacting on exchanges).
  • They’re arbitragers at root, profiting on spreads.

Here’s the capstone. The average US equity trade-size (if you don’t know yours, you should) is less than two futures contracts. In a global interconnected market, the capacity of high-speed traders to move equity prices using futures is astronomical. 

It’s ultimately about the root of all prices: Money. Currency-volatility. You saw it again this week.

A closing word on markets: The ModernIR 10-Point Behavioral Index at Aug 28 was 1.8. We’ve never registered an official reading below 2.0. A bottom likely looms though September expirations could be ugly again. And we won’t say it can’t go lower.


“I must say as to what I have seen of Texas it is the garden spot of the world.”

Davy Crockett said it and left it at the Alamo. So we’re glad to be inside Austin’s city limits sponsoring the NIRI Southwest Regional Conference.  We doubt temperatures will be kinder than New York’s last week though.

There’s a pattern to what’s unfolding in the market and it impacts us. There’s also chapter tapestry to the investor-relations profession spread unevenly over the fruited plain and knitted in spirit, a durable comforter made hardy by decades and camaraderie. We’re wired to see the world as story. It makes those in this pursuit exceptionally adept at translation.  It’s what we do.

Just as our corps is animated by the inexplicable genius of humanity, a most complex and marvelous machine, so is the evolving investment landscape.  At root, human intelligence presses the button, and the machines thus run.

I’ve given this considerable thought in preparation for my TED talk Thursday in Texas. I’ll speak on market structure of course, but it’s more. An aside, make it IR duty to hear this TED video of 15 minutes from Kevin Slavin, masterful on market structure without meaning to be.

Current stock-market distress would move Rod Serling the impresario because it’s a Twilight Zone merger of Man, money and machines. It scares us. Right? We all live by the ticker (so to speak). Our profession is interlaced but now so is the planet.

Ever played poker? You pay twenty bucks for a stack of chips and you play till you win or you’re out. Suppose we floated the value of chips. Rather than a fixed buy-in, every table’s pot value would float versus another table’s, and all the dealers at all the tables would continually add to or subtract from chips in every player’s pile to balance out positions versus players at other tables.

This is what the world is doing with currencies. Money. You need to understand it in the IR chair. We borrow money from China and then depreciate our currency and depress our interest rates to zero so the impact of borrowing will be minimal. China then devalues its currency to keep from losing money on the debt we owe.

On Aug 12, the Chinese government devalued the yuan. There are some $500 trillion of interest-rate and currency swaps globally and if a big currency moves, it’s a de facto change to interest rates.  Investors and their counterparties underwriting rights were caught out. So during options-expirations Aug 19-21, markets fell.  This is Man at work.

Now we come to Exchange Traded Funds, the chief investment vehicle of the modern era. ETFs post positions every day by law. It’s inconvenient to continuously change share-holdings so they routinely use derivatives like options and futures instead, which is permitted by law. And machines modulate it. We last had a material stock pullback in 2011, last saw a bear in 2008. ETF assets have doubled since 2012. We have no idea how ETFs will act in a down market, frankly.

But we just got a clue.  On Aug 24, the new series of options and futures marketwide began trading – and markets imploded. What happened? We think demand from ETFs for options and futures was so poor that markets simply imploded at the open. Lack of demand is as big a price-setter as selling (put that on a t-shirt).

Today, everything is connected.  If ETFs, which are ephemeral supply or demand, stop using derivatives, it means indexes are faltering, which means you and I are getting wary in our 401k’s, which means fast traders are shy about setting prices, and all of it comes back to floating currency values, pontoons upon which global consumption dances in a delicate balance.  Nobody knows what’s real.

It’s not one thing.  And yet it is.  Humans don’t like uncertainty so they transfer its risk to somebody willing to pay to cover it.  Now that process is starting to reverse after seven years.

What we don’t know is who ended up with the risk. What we do know is that IR better be able to explain it.  That’s market structure.  Not story. So don’t miss my session tomorrow in Austin.

Showing Up

Investor-relations professionals are traveling salespeople.

Now, we’re not paid commissions and I can see some of you recoiling at the imagery of rumpled suits and satchels stuffed with brushes, a voice saying, “Excuse me, ma’am, do you have a couple minutes?  I’d like to tell you about our brand new…”

Woody Allen said 80% of life is showing up when you’d prefer to stay in bed. Ads play on satellite radio claiming 80% of sales follow the fifth to twelfth contact.  Whether those figures are real, my own sales experience boils down to a single word: Effort.

There’s an article today in the Wall Street Journal about venerable stock-picker Mario Gabelli whom many of us know because of the ponderous way Gamco Investors approaches investment-selection. You can’t quit after the first meeting.

When I was sitting in the IR chair years ago, the sales guy from CCBN – later bought by Thomson Financial and today part of Nasdaq Corporate Services – sold me more stuff than everybody else combined because he was always solving problems for me. He’d observe a need and say, “We could help you do that better.”

I’ve said before that Nordstrom has the best salespeople in retail because they’re concierges. They’re expert at assessing their consumers and matching them with the right products. They’re the unflagging herald helping you pursue sartorial superiority.

This too is the soul of modern investor-relations in a world where our core audience of active stock-pickers shrinks steadily, money like desert sand before the wind blowing to indexes and ETFs. Mario Gabelli despite good performance has seen $2 billion flow from Gamco this year.

IR is about matching product to consumer. We can speak in magisterial terms of the Liaison to Wall Street but at root IR is corporate concierge. We’re Nordstrom for Fidelity or T. Rowe Price, helping them dress well.  And everybody is looking for a garment because that’s what Wall Street does. Fund managers spend other people’s money.

Let’s get right down to handing out Fuller brushes. Say you’ve positioned your company as a growth story.  You craft a growth message, pinpoint growth drivers.  Every quarter you’re delivering financial and performance metrics highlighting sequential and yearly change, percentages metering growth.

But your stock is declining for whatever reason (and we’d know in market-structure data by measuring period-over-period change in behavioral flows no differently than you do with your metrics). Maybe it’s China, the sector is out of favor, the dollar is killing you.

The fact is you’re a value product.  Target growth money when your shares are declining and you won’t sell because the product doesn’t match the consumer. Growth money buys appreciation. Value money buys opportunity. Repeat that.  And there are shades of both. Momentum is aggressive growth money, deep-value high-turnover is aggressive value money. GARP (growth at a reasonable price) is your consistency constituency (say that fast three times).

Every IRO should be cultivating a deep palette of investor-relationships across this money spectrum. These are your consumers. You follow up – knock on doors because 80% of sales take a lot of persistence and if the stats are bogus effort isn’t – with the consumers currently matched to your product.

We produce data for prioritizing this relationship-management effort.  Our action items focus on relationship-management. For instance, you have a tough earnings call and your stock declines. Afterward, you ring top holders and reassure them. It’s protocol.

But wait with the salvo to well-informed prospects you’ve cultivated strategically. Watch the data. When your Sentiment is negative – all the tides of money are out and your short volumes are low – the likelihood your price will rise is high because the first buyer will lift price.

That’s the time to call just your deep-value relationships, the 4-5 you’ve built the past couple years. You have a product to offer these consumers. Highlight value drivers – not growth details. Tell a value story.

If they act, they’ll get an immediate return (call them next only when your product is right for them, and this relationship will become symbiotic).

And now you’re a growth product and story again. Call GARP and growth relationships because your shares will be rising. That’s what you can control. Turn it into an art.  You’ll be the best IRO on the Street because the goal is a well-informed and fairly valued stock (we have metrics for that too).

Remember, 80% of success is showing up. Over and over.