Yearly Archives: 2017

IR Power

“What’s eye are?  I haven’t seen that acronym.”

So said a friend unfamiliar with this arcane profession at public companies responsible for Wall Street relationships.  IR, for you investors who don’t know, is the role that coordinates earnings calls and builds the shareholder base behind traded shares.

Investor Relations is a vocation in transition because of the passive tide sweeping investment, money that can’t be actively built into a shareholder base. Money in models is deaf to persuasion. The IR job is Story. The market more and more is Structure.

But IR underestimates its power. There’s a paradox unfolding in the capital markets.  I liken it to shopping malls and Amazon.  Used to be, people flocked to department stores where earnest clerks matched people to products.

We still do it, sure. But nowadays seas of cash slosh onto the web and over to Amazon without a concierge. It’s passive shopping.  It’s moved by what we need or want and not by service, save that Amazon is expert at getting your stuff in your hands well and fast.

“You were saying we underestimate our power,” you reply, IR pro. “How?”

You’ve seen the Choice Hotels ad?  A guy with an authoritative voice declares that the Choice people should use four words: “Badda-book, badda-boom.”

The advertisement is humorously stereotyping the consultants, high-powered and high-paid pros who arrive on corporate premises to, buttressed by credibility and prestige, instruct managers on what they must do.

Whether it’s marketing and communications or management like McKinsey & Co., they command psychological currency because of real and perceived credibility, and confident assertion.

Might these people be buffaloing us? There’s probably some of that. But the point is they command respect and value with authority and expertise.

All right, apply that to IR.  Especially now, with the profession in a sort of identity crisis. It’s become the ampersand role.  You’re head of IR &…fill in the blank.  Strategy.  Corporate Development.  Treasury.  Financial Planning & Analysis.  Communications.

The ampersand isn’t causing the crisis. It’s the money.  Bloomberg reporters following the passive craze say indexes and Exchange Traded Funds (ETFs) may surpass active stock funds soon for assets under management.

They already crush stock-pickers as price-setters.  Passive investment is nearly twice as likely to set your price every day as your story.  Buy and hold money buys and holds. Your story isn’t changing daily.  But prices are. Sentiment is. Macro factors are. Risk is.  These and more breed relentless shifting in passive behavior, especially ETFs.

And here’s the IR powerplay.  You are the authoritative voice, the badda-book badda-boom on capital markets internally. With the behavior of money changing, you’re in the best position to be the expert on its evolution. To lead.

If you were the management consultant, you would lay out a plan and benchmarks for organizational transformation. If you were the widget product manager, you’d be providing executives regular data on the widget market and its drivers. You wouldn’t wait for the CEO to say, “Can you pull data together on what’s happening with widgets?”

Sometimes IR people pride themselves on how management never asks about the stock.  If you’re the expert, silence is not your friend. Get out in front of this transformation and lead it.  Don’t let them watch the stock, but help them consistently measure it.

What set of vital facts about passive investment should your management team understand? If you don’t have answers, insist on the resources needed to get them.

Don’t be timid. Don’t wait for management to say, “We want you to study and report back.” It’s too late then. You’ve moved from the expert to the analyst.

Instead, set the pace. See it as a chance to learn to use analytics to describe the market.  Make it a mission to wield your IR power as this passive theme changes our profession.

And we’ll catch you in two weeks!  We’re off to ride the tides on the Belizean reef, a weeklong Corona commercial catamaraning the islands.  We’ll report back.

As we leave, Market Sentiment has again bottomed so stocks rose with Monday’s MSCI rebalances and probably rise through expirations Wed-Fri before mean-reverting again. How many mean-reversions can a bull market handle?

Half the Market

I’ve seen at least four Wall Street Journal stories in May alone about a quiescent VIX.

The CBOE’s volatility index derived from options pricing on the S&P 500 hit a low Monday last seen in Dec 1993, the WSJ said (subscription required). It moved lower still yesterday, 9.58 intraday.

Implicit in the storyline is a bull market, since one roared from 1993 to the bursting of the dot-com bubble. But the conclusion violates the Law of Small Numbers, the human propensity to assign undue value to insignificant data sets.  As proof, the VIX was a hair’s breadth from record low in Jan 2007.

Remember that? Lehman, little did we know, was failing. The financial crisis thereafter manifested in markets like a Hollywood blockbuster action movie where the hero outruns the explosion as the structure dissolves in showering computer-generated fantasia.

Since we can make equal bull or bear cases with the same data, it supports neither.

Aside: The investor-relations profession has a notorious proclivity toward the Law of Small Numbers. Stock’s down 3%, so we call somebody to learn why. You’re chasing the exception. Track instead the central tendency in the whole data set so you can see what changed before the stock fell 3%.

And assigning rational motivation to the VIX defies the data.  Less than 20% of daily market volume comes from rational thought. The rest is tracking the mean, arbitraging spreads back to the mean, or hedging departures from the mean.

Where everything is average, volatility vanishes. Thus a dead VIX fits. It offers little predictive value (save higher volatility always follows very low) and simply points to low spreads.

The reason is market structure. Passive investment tracks benchmarks and so seeks the mean – average price. Arbitragers look for departures from the mean to trade for profit. The market is riven with arbitrage so few mean-divergences survive to the close. But boy is there opportunity. You’ll see soon.

Meanwhile, those managing risk offload exposure to someone else, which produces equal and offsetting trading – which reinforces the mean.

And here’s a shocker. We track daily share-borrowing – shorting – as a percentage of total trading volume. Short shares are 48.1% of volume, which means long trades are 51.9%. In other words, nearly half the market is short.

Locked markets, or trades where the bid to buy equals the asking price to sell, are prohibited, so there will always be a spread, a dab of volatility. Arbitragers are almost guaranteed gains by being long and short everywhere.

We also measure intraday volatility, the spread between average intraday high and low prices. It’s 2.5% – astonishing arbitrage fodder.

For perspective, the S&P 500 rose 0.5% the last ten sessions. That means stocks are 400% more volatile every day than the ten-day change in closing prices.

Arbitragers are making tremendous gains by consuming intraday volatility.

It may be that Exchange-Traded Fund (ETF) market-makers are responsible. It explains why ETF costs are so low: Arbitrage gains are additive.

And ETF sponsors can rent out liquidity, shares accounting for the 48% of trading that’s borrowed – boosting returns. There’s support in the data. We track passive-investment patterns and correlate them to short volume, and there’s agreement.

ETF market-makers have four arbitrage opportunities: a) ETF net asset value versus ETF price; b) ETF versus underlying index; c) ETF price versus prices of components of the index; d) ETF price versus options and futures on components and the index.

By the close, ETFs and indexes want to peg the measure so divergences converge at average.

It’s a circumstantial case. But evidence piles up that ETFs are consuming spreads while simultaneously driving stock-prices and deflating the VIX.

What’s the risk?  Mortgage-backed securities did the same thing to real estate.  There was a finite asset, homes. With cheap mortgages, lots of money wanted exposure. So home loans were securitized – replicated – to expand demand, delivering great returns to those selling them. It worked till home prices stopped rising. Then replicated value evaporated. Half the market.

There are less than 3,600 US public companies when ETFs, multiple share classes and closed-end funds are removed. Low rates have created high demand. To expand access, ETFs replicate exposure, and are booming. It works so long as stocks rise.

When that stops at some sure point, extrapolated value will be marked to zero. Half the market.  Won’t arbitragers save the day? Not if volatility jumps as average prices plunge.

Expectations vs Outcomes

“Earnings beat expectations but revenues missed.”

Variations on this theme pervade the business airwaves here during earnings, currently at fever pitch.  Stocks bounce around in response. Soaring heights, crushing depths, and instances where stocks moved opposite of what the company expected.

Why?

Well, everyone is doing it – betting on expectations versus outcomes.  The Federal Reserve Open Market Committee meeting wraps today and much musing and a lot of financial betting swirls around what Chair Yellen is expected to offer as outcome.

Then Friday the world stops at 8:30am ET, holding its breath to see if the expectation for April US jobs matches the outcome.

And by the way, I will join Rick Santelli in Chicago Thursday morning, in between, on Squawk on the Street to pontificate fleetingly and I hope meaningfully.

Obsession with expectations versus outcomes in equity markets and across the planar vastness of economic and monetary data blots out long-term vision and fixes attention on directional bets.

It’s not investment. And it’s no way to plan the future, this mass financial pirouette around a data point.  But it’s the market we’ve got. We must understand it, like it or not.

Back to your stock. The reason that after you beat and raise your stock falls is what occurred ahead of your call.

It may have nothing to do with how you performed versus consensus. For proof, droves from the sellside are looking for IR jobs because trillions of dollars migrating from active portfolios into indexes and ETFs aren’t using sellside research. Or listening to calls.

It reminds me of the Roadrunner cartoons, Wile E. Coyote running off the cliff. Remember? Parts of Wile E. drop in order, the last thing remaining, his blinking eyes.

That’s to me like results versus consensus.  The eyes of Wile E. Coyote, last vestige of something fallen off the cliff of colossal change to investment and trading behavior. The sellside still has everybody thinking outcomes versus expectations matter to investors.

No, they matter to the hordes with directional bets – over 40% of the market.

They bet long or short, or on the spread between high and low prices. They may have fixed for floating swaps that pay if you beat, leading counterparties to sell your shares – and the bettors are short your stock too, so they make a fee on the bet and more covering as your stock falls.

And the CEO says to you, “What the heck?”

If your stock is 50% short (we measure it) and slamming the ceiling of Sentiment due to a marketwide derivatives surge after expirations – which happened Apr 24-25 – it doesn’t matter if you crush consensus. Structure trumps Story. Price will fall because bets have already paid thanks to the broad market.

The market makes sense when you understand what sets price.

Active investment leads less than 20% of the time. The juggernaut of indexes and ETFs rumbles through at about 34%, and it’s now distorting share-borrowing and Risk Management. The latter is 13-16% of your market cap – hopes for the future that can sour or surge on any little data point.

Let’s bring it back to the Fed and jobs and the economy. I said your stock will move based on what happened beforehand.  That can be a day or two, or a week or two.

The economy is massive. It will move on what happened beforehand too but the arc is years. No matter what may be occurring now, which in turn will manifest in the future.

The threat to the US economy and stocks is a lack of appreciation that tomorrow is a consequence of yesterday, not of tomorrow.  For the better part of a decade, furious fiscal and monetary effort promoted borrowing and spending so people would consume more.

But the consequence of borrowing and spending is debt and a lack of money. Which causes the economy to contract in the future. Stocks are pumped on past steroids. If the economy beats and raises, everything can still fall because of what happened yesterday.

We must first navigate consequences of yesterday before reaching the fruits from today.

Same for you. The stock market is awash in bets on divergences, even more when financial results mean opportunity blooms. Your active money clangs around in there, often as confused as you.

Your challenge and opportunity, IR professionals? Helping management develop an expectation of market form that matches the outcome of its function now.

Man vs Machine

If you’ve never been to Sedona, AZ in April, go but guard yourself because it will lay hold on your spirit and make it captive to unrelenting beauty.

How does the French election, yet unfinished, help US stocks?

Wait, no. It’s not the French election causing US stocks to soar, we’re told. It’s corporate earnings. Investors are loving good numbers.

Except investors didn’t set prices Monday when the market surged. Fast Traders did. The machines.

Saying the market is up because investors like Macron’s chances to win the French presidency reflects nothing fundamental. It’s an explanation fitted to an outcome.  Saying investors are gushing over corporate earnings is also finding a cause for an effect.

What data support the conclusion stocks jumped because people prefer the Frenchman Macron over the Frenchwoman Le Pen?  What data say investors are pouring money into stock because of strong earnings?  Earnings aren’t strong. They’re just better than weak results a year ago.

The data supporting those views, it turns out, is the market itself.  It’s up. So it must be that investors like something. The French election.  No?  How about US corporate earnings?  Market direction becomes a cause for humans, even when humans are not its cause.

Many suppose prices in the stock market can’t be set by machines. The opposite is true. Prices in the market can’t be set by humans. Under Regulation National Market System, it’s impossible for a human being to walk around the stock market trying to make a trade.

The rules say any “marketable trade,” a stock order wanting to be the best bid to buy or offer to sell, must be run by machines. Why? Because a human cannot keep pace with the market’s speed, and the order must be able to move fluidly to best price, So, the regulators said, it must be automated. Run by machines.

No matter where shares are listed, your stock can trade anywhere, from a private market operated by Credit Suisse, to the newest exchange, IEX.  The rules say simply that orders to buy and sell must move seamlessly to wherever the best price resides.

Well, humans devised machines with one purpose: setting price.  Humans themselves can set prices, sure. But they try to be in the middle, between the best bid to buy and offer to sell.  Yet we go on treating both events as though they are the same.

Understanding both the broad market and your own shares requires recognizing that while self-driving cars are a ways off yet, self-driving stocks are here now. When we all sit around talking about it, trying to find some rational explanation, we become weirder than the market. It’s as though we’re making excuses for the monster we crafted.

Since Fast Traders who want to own nothing set the pace, don’t be surprised if the pace disappears all at once.  And ask yourself every day: Are humans setting my stock price today, or is it the machines?  The answer is eminently measurable.

Predictive Knowledge

Why don’t I trade like my peers?

The CEO is sure it’s because investors don’t understand something – how you manage inventory, your internal rate of return targets. Pick something.

Investors ask the same question. Why does that stock lag the group? For answers, they root through financials, technology, leadership, position in the market, to find the reason for the discount (or opportunity).

What if these assumptions are wrong?

At prompting from friend and colleague Karla Kimrey in the Rocky Mountain NIRI chapter (which we sponsor) who knows I’m a data geek, I’m reading Michael Lewis’s The Undoing Project, his latest. It’s a sort of sequel to Moneyball, about how baseball’s Oakland A’s changed professional sports with data analytics (read both and you’ll see that ModernIR is Moneyball for IR).

The Undoing Project focuses on why incorrect assumptions prevail.  I don’t have the punch line yet because I’m still reading. But I get the point already and it’s apropos for both investor-relations professionals and investors in markets that often seem to defy what we assume is the rationale behind stocks and the whole market.

Perception overwhelms reality.

The CEO, the IR professionals, investors, are all focused on the same thing. The collective assumption is that any outcome varying from expectations is a deficiency in story.  Personal perceptions have shaped our interpretation of the market’s behavior.

Yet statistically, rational thought is a minority in market volume – about 14% of it, give or take. When markets surged Monday, the Dow Jones Industrials up 183 points, we were told it was enthusiasm about earnings.

The data showed the opposite – Asset Allocation. Money that pays no attention to earnings. It’s 33% of market volume.

Why would it buy now? Because options are expiring today through Friday (and derivatives directly influence 13% of trading volume marketwide).  Asset Allocation uses options and futures to nimbly track benchmarks, and with markets down it’s probable that derivative positions were converted to the actual stocks.

But then it’s over.  Mission accomplished.  Yesterday the market gave back 114 points to go with 138 points last Thursday. The qualitative assumption – the gut instinct – that earnings enthusiasm lifted stocks Monday was not supported by subsequent data.

Daryl Morey, general manager of the Houston Rockets, gives The Undoing Project a literary push in the early pages. An MIT man and not a basketball player, Morey came into the job because team owner Leslie Alexander wanted “a Moneyball type of guy.”

He sought data-driven results.  And it worked.  Houston is in the top ranks for success with draft picks and getting to the playoffs, and other teams have copied them.

Morey says knowledge is prediction. We learn things to understand what may happen. It’s a great way to think about it. Suppose it works in IR and investing too.

It starts with questioning assumptions.  What gut instincts do you hold about your stock that you can’t support with data?  How do they compare to the data on market volume?

I know there’s a swath of people in every walk including IR and investing who think data is BS. Who cares? they’d say.  I go with my instincts. Besides, what difference does it make if we know or don’t?

Knowledge is prediction. Data align perception and reality. In Undoing, Lewis uses the Muller-Lyer illusion. Your mind perceives one line longer. Nay. Measurements prove it.

I’ll leave you with this data on the market. I wrote last week about volatility insurance.  Now we’ve got volatility.  Insurance policies are expiring right now, with the VIX today kicking off April expirations through Friday. Our Sentiment Index trend is like mid-2014.

We don’t know what may come. But we’re thinking ahead. Assumptions are necessary but should be the smallest part of expectation.

That’s a good rule of thumb in life, investing and IR (and if you want help thinking about what IR assumptions may be wrong, ask us. We may not have the answer. But we’ve got great data analytics to help sort reality from perception).

Volatility Insurance

In Texas everything is bigger including the dry-aged beef ribs at Hubbell & Hudson in the Woodlands and the lazy river at Houston’s Marriott Marquis, shaped familiarly.

We were visiting clients and friends before quarterly reporting begins again. Speaking of which, ever been surprised by how stocks behave with results?

We see in the data that often the cause isn’t owners of assets – holders of stocks – but providers of insurance. To guard against the chance of surprises, investors and traders use insurance, generally in the form of derivatives, like options. 

Played Monopoly, the board game? A Get Out of Jail Free card is a right but not an obligation to do something in the future that depends on an outcome, in this case landing on the “go to jail” space. It’s only valuable if that event occurs. It’s a derivatives contract.

At earnings, if you shift the focus from growth – topline – to value – managing what’s between the topline and the bottom line – the worth of future growth can evaporate even if investors don’t sell a share.

Investors with portfolio insurance use their Get Out of Jail Free cards, perhaps comprised of S&P 500 index futures. The insurance provider, a bank or fund, delivers futures and offsets its exposure by selling and shorting your shares. It can drop your price 10-20%.

Writers Chris Whittall and Jon Sindreu last Friday in the Wall Street Journal offered the most compelling piece (may require registration — send me a note if you can’t read it) I’ve seen on this concept of insurance in stocks.

Investors of all ilks, not just hedge funds, protect assets against the unknown, as we all do. We buy life, auto, health, home insurance.  We seek a Get Out of Jail Free card for ourselves and our actions.

In stocks, we track this propensity as Risk Management, one of the four key behaviors setting market prices. It’s real and by our measures north of 13% of total market cap.

But the market has been a flat sea.  No volatility.  This despite a new President, geopolitical intrigue, global acts of terror, a Federal Reserve stretching after eight Rumpelstiltskin years, and a chasm between markets and fundamentals.

Whittall and Sindreu theorize that opposing actions between buyers and sellers of insurance explains the strange placidity in markets where the VIX, the so-called Fear Gauge derived from prices of options on stocks, has been near record lows.

The thinking goes that the process of buying and selling insurance is itself the explanation for absence of froth. Because markets seem inured to threats, investors stop buying insurance such as put options against surprise moves, and instead look to sell insurance to generate a fee. They write puts or calls, which generate cash returns.

Banks take the other side of the trade because that’s what banks do. They’re now betting volatility will rise. To offset the risk they’re wrong, they buy the underlying: stocks. If volatility rises the bet pays, but the bank loses on the shares, which fall. 

This combination of events, it’s supposed, is contributing to imperturbable markets. Everything nets to zero except the stock-purchases by banks and cash returns generated by investors selling insurance, so there’s no volatility and markets tend to rise.

Except that’s not investment. It’s trafficking in get-out-of-jail-free cards.

And despite low volatility, there’s a cost. We’ve long said there will be a Lehman moment for a market dominated by Risk Management.

We’ve seen hedge funds struggle. They’re big players in the insurance game. And banks have labored at trading. Maybe it’s due to insurance losses. Think Credit Suisse, Deutsche Bank, HSBC.  Someone else?

From Nov 9-Mar 1 the behavior we call Risk Management led as price-setter marketwide, followed closely by Active Investment. The combination points to what’s been described: One party selling insurance on risk, another buying it, and a continual truing up of wins and losses.  

Now, for perspective, the VIX is a lousy alarm system. It tells us only what’s occurred. And intraday volatility, the spread between daily high and low prices across the market, is 2.2%, far higher than closing prices imply.

We may reach a day where banks stop buying insurance from selling investors, if indeed that’s what’s been occurring.  Stocks will cease rising.  Investors will want to buy insurance but the banks won’t sell it.  Then real assets, not insurance, will be sold.

It’s why we track Risk Management as a market demographic, and you should too.  You can’t prevent risk. But you can see it change.

Blackrobotics

The point isn’t that Blackrock picked robots over humans.  The point comes later. 

If you missed the news, last week the Wall Street Journal’s Sarah Krouse reported that Blackrock will revamp its $275 billion business for selecting individual stocks, turning over most decisions to machines (ejecting scores of human managers).

For perspective, that’s about 5% of Blackrock’s $5.1 trillion in assets. The other 95% is quantitative already, relying on models that group stocks around characteristics ranging from market capitalization to volatility.

Spanning 330 Blackrock iShares Exchange-Traded Funds (ETFs) are 14 primary clusters of characteristics that define investments. What Blackrock calls its “core” set are 25 ETFs managing $317 billion, more than the entirety of its active stock-picking business. Core investment describes what Blackrock sees as essentials for a diversified portfolio.

Blackrock views investing as a mixture of ingredients, a recipe of stocks.  The world’s largest asset manager thinks it’s better at crafting recipes than picking this or that flavor, like Fidelity has done for decades. 

But who is most affected by the rise of Blackrobotics?  We come to the point.  Two major market constituencies are either marginalized or reshaped: Public companies and sellside stock researchers.

“Sellside” means it’s the part of the market selling securities rather than buying them. Blackrock is on the buyside – investors who put money into stocks. The sellside has always helped investors by keeping stocks on hand like Merrill Lynch and Morgan Stanley used to do, and processing stock trades.

The sellside since brokers first fashioned the New York Stock Exchange also armed investors with valuable information through stock analysis. Analysts were once the big stars wielding power via savvy perspectives on businesses and industries. Everybody wanted to be Henry Blodget talking up internet stocks on CNBC.

Following the implosion of the dot-com boom of the 90s, regulators blamed stock analysts and enforced a ban on the use of valuable research preferentially, a mainstay for brokers back two centuries. So the sellside shifted to investing in technology rather than people, and the use of trading algorithms exploded.

Brokers – Raymond James to Credit Suisse, Stifel to JP Morgan – have long had a symbiotic relationship with public companies. Brokers underwrite stock offerings, placing them with their clients, the big investors.  After initial public offerings, analysts track the evolution of these businesses by writing research and issuing stock ratings. 

That’s Wall Street.  It reflects the best symbiosis of creative energy and capital the world has ever seen. Analysts issue ratings on stocks, and companies craft earnings calls and press releases every quarter, and money buys this combination. The energy of it hisses through the pipes and plumbing of the stock market. 

Blackrock uses none of it. It’s not tuning to calls or consuming bank research. Neither does Vanguard. Or State Street. Together these firms command some $11.5 trillion of assets eschewing the orthodoxy of Wall Street.

Public companies spend hundreds of millions annually on a vast array of efforts aimed at informing stock analysts and the investors who follow what they say and write. Earnings calls and webcasts, websites for investors, news via wire services, continuous travel to visit investors and analysts.

It’s the heart of what we call investor relations.

What Blackrobotics – Blackrock’s machines – mean to public companies is that some effort and spending are misaligned with the form and function of the market. It’s time to adapt. The job changed the moment Vanguard launched the first index fund in 1975.  You just didn’t know it until now. 

How do I change it, you ask? You can’t. Public companies should expend effort proportionate with the behavior of money. The trillions not tuning to calls or reading brokerage research deserve attention but not a message.

If money is using a recipe, track the ingredients and how they affect valuation, and report on it regularly to management. Get ahead of it before management asks.

It’s neither hard nor scary. What made index investing a great idea, to paraphrase Vanguard founder Jack Bogle, was that it was difficult for investors to be disappointed in it.  Same applies to IR and passive investing. What makes data analysis alluring is that it’s a management function and it’s hard to be disappointed in it.

(Note: If you want help, ask us. We use machines to measure machines and it’s simple and powerful and puts IR in charge of a market run by them. I talked about it yesterday at the NIRI Capital Area chapter).  

I’m not sure how capital forms in this environment. Wall Street lacks plumbing. Thus, companies grow privately and become index investments via IPOs, exiting as giants that are instantly part of the thousand biggest in which all the money concentrates.  

It’s not the end of the world, this rise of the machines.  But Blackrobotics come at a cost.  We all must adapt. It’s far less stressful embracing the future than missing the past.

Race Condition

You might think today’s title is about physical fitness.

No, ModernIR is an equity data analytics firm, not a personal trainer. I first heard the term “race conditions” used to describe stock-trading at TABB Forum, the traders’ community, in comments around an October 2012 article there by HFT expert Haim Bodek on why high-frequency traders have an advantage.

Reader Dave Cummings said, responding to it, “When Reg NMS was debated, several people very knowledgeable about market structure (including myself) argued against locked, crossed, and trade-through rules because of the side-effects caused by race conditions between fragmented markets.”

Emphasis mine.  You say who is Dave Cummings and what is this jargon that has me wanting to bludgeon my noggin on a wall?

I hope Mr. Cummings won’t mind my resurrecting his point. He started both BATS Global Inc., the stock exchange the CBOE is buying that by market-share the last five trading days nosed out the NYSE with 20.7% of US volume versus the venerated Buttonwood bourse’s 19.9% (the Nasdaq had 17.7%, IEX 2.2%, and nearly 40% was in broker pools), and speedy proprietary (no customers, trades its own capital) firm TradeBot.

He knows market structure.

We come to the jargon. Don’t tune out, investor-relations people and investors, because you need to understand the market to function well in it. Right?

Most people don’t know what Dave knows (that could go on a T-shirt). Mr. Cummings was explaining that trading rules prohibit the bid to buy and the offer to sell from being the same. A locked market. Crossed markets are out too, by law. You can’t make a bid to buy that is higher than the offer to sell.

And this “trade through” thing means brokers can’t continue buying stock at $20 one place if it’s now available for $19.99 another place.

I’ve said before that there’s no such thing as a “fragmented market.” A market by definition is aggregation. The stock market today is a series of interconnected conclaves all forced to do the same thing with the same products and prices. You understand? You can buy Nasdaq stocks at the NYSE and vice versa and only at the best price everywhere.

ModernIR builds software and runs lots of data-warehousing functions so we know race conditions. It’s when something doesn’t happen in proper sequence, you might say.

For instance, a data warehouse must be updated on schedule before an algorithm processes a routine. Some hiccup in the network slows the population of the data warehouse, so the algorithm fails because data haven’t shown up. Race condition.

The stock market is similarly a series of dependent processes, some of which will inescapably fail. Why would we create a stock market with a known propensity for process errors? Exactly. But let’s focus on what this means to investors and public companies.

It means the market is barred from behaving rationally in some circumstances. What if I want to pay more for something? Or say I don’t mind getting an inferior price for the convenience of staying in one place.

Plus, can we trust prices? What if yesterday’s big gains were a product of a race condition? I’m not saying they were. But we measure discrete market behaviors setting prices. Counterparties for derivatives were heavy buyers Monday when the stock market swooned sharply and then recovered most of its losses by the close.

These big banks or insurers bought because investors had portfolio insurance to guard against losses. That’s not investment behavior.

What then if equity trades tied to derivatives didn’t populate someplace and the market zoomed yesterday on a process error? Again, I’m not saying it did.  But the things Mr. Cummings warned would create errors in markets are cornerstones of the regulations behind the National Market System.

And why can’t a bid and offer be the same? Forcing them to be different means an intermediary is part of every trade. That’s why 40% of trading is in dark pools – to escape shill bids by trading intermediaries.

Why would Congress – which created the National Market System – mandate a middle man for stocks, when to get a good deal you cut the middle man out? Think about that with health care (or with government itself, which is the ultimate middle man).

But I digress.

We have a stock market the requires an intermediary, prohibits buying and selling at the same price (unless at the midpoint between them, which is the average, which is why index-investing is crushing stock-picking), and stops investors from paying the price they want and forces them instead to take a different price.

In Denver real estate, the bid to buy is often higher than the offer to sell because there aren’t enough houses. Don’t you want people paying more for your shares rather than less? So why do rules require the opposite?

I want us all thinking about whether the stock market serves our best interests in current form where passive investment is taking over everything.

I’ll be talking about that to the NIRI Capital Area chapter Apr 4, so come say hi. And we’ll be at NIRI Boston tonight self-congratulating with the rest of the sponsoring vendors in Sponsorpalooza.  You all in Minneapolis, good seeing you last week!

I just hope there are no race conditions in our travel plans from Denver today.

High Speed Risk

Is the era of high-frequency trading over? 

While you ponder whether “High Speed Risk” might be a good name for your garage rock band, let’s reflect on stocks. We said last week: “Our Sentiment is negative for the first time since the election. It’s a weather forecast.  No need for panic, only preparation.”

We measure the short-term movement of money with a 10-point scale. It was about 5.0 or higher from the election until Mar 9, 80 trading days. Last week it dipped below 4.5.

And weather arrived yesterday before today’s VIX expirations. It’s not news about the Trump administration.  It’s the end of a long, leveraged run. Monthly options and futures expired Friday the 17th.  New options traded Monday, Mar 20.

Yesterday was what we call Counterparty Tuesday. If counterparties have estimated demand Monday for new options incorrectly, they true up on Tuesday. Since markets fell, counterparties overshot demand.  

Derivatives have featured prominently in gains since the election. Investors have been buying both stocks and rights to more of them in the future. That additional implied future demand breeds higher current stock prices.

For the first time since the election, investors didn’t buy more future rights.  Does this mark an end to that pattern?  Certainly for the moment.  And it dovetails with the state of high-frequency trading.

For you new readers, let’s canvass high-frequency trading.  In 2007 after Regulation National Market System, a firm calling itself Octeg splashed through the data. In Intel alone, Octeg was driving 35% of monthly volume, crushing Goldman Sachs.

Who is Octeg, we wondered? The firm defied what we knew about brokers, which always wanted to hang a sign out, advertise that they had products for sale. We couldn’t find even a phone number for Octeg.  It was like stumbling on an unmarked warehouse in the suburbs packed to the ceiling with all the stuff you tried to buy at the mall.

While rooting through regulatory filings we found an address in Chicago and then another firm in the same suite called Global Electronic Trading Co (GETCO). 

And then we got it.  Octeg was GETCO spelled backward. The two were the same firm.

Getco dominated trading through the financial crisis, profiting on two ideas. First, exchanges began paying traders to sell shares on their markets. Think of it like a store coupon: Do business with us and we’ll give you a discount. Getco cashed coupons. In gargantuan manner. Exchanges paid them in coupons for relentless volume.

Second, Getco realized that it could be first to set price. So why not set as many prices as possible, forcing big institutions to chop their trades into smaller pieces?

Volume exploded. 

But it wasn’t investment.  Getco had no customers. It was using computers and mathematical calculations to continuously set prices in the stock market, getting paid to buy and sell stocks while simultaneously changing the price ever faster to force big investors into chopping up stock orders into smaller pieces so Getco and its burgeoning ilk could sit in the middle buying low and selling high in fractions of seconds.

At the pinnacle in 2009, we pegged this behavior, high frequency trading, at 70% of volume. Now high-frequency trading by our measures is less than 40% of volume.

The entire market the past decade is built on it. On the floor of the NYSE, four big high-speed firms price all NYSE stocks at the open. At the Nasdaq, a larger number does the same, trading prices for coupons.

The problem is high-frequency traders don’t have customers. They aren’t “working orders” for investors. They are buying low and selling high in fleeting fashion, for profit. Mistake these prices for ones from investors, and you mentally misprice stocks.   

You read that high-frequency traders are “market makers.” They’re “furnishing liquidity.” Traders with no customers can’t make markets. They can only exploit what others in the market don’t know. In 2007, it was easy. Now it’s not.

That’s because big stock brokers are doing the same thing with Exchange Traded Funds, rapidly repricing them, and index funds, and the stocks comprising them, and the options and futures derived from them. The big brokers are better at it than high-frequency traders because they have customers and can make longer directional plays by reading what customers are doing.

In a market without high-frequency trading, all stocks would trade like Berkshire Hathaway Class A shares.  About 400 shares daily.  It would be better for investors. But all the exchanges would go broke. Ironic, isn’t it?

High-frequency trading isn’t done. But with the market we’ve got, the harder it is for high-speed machines to price stocks, the greater the risk of big moves.

Weathering Change

Everyone complains about the weather but nobody does anything about it.

Mark Twain often gets credit for the clever quip but Twain’s friend Charles Dudley Warner said it.  We’re not here to talk weather though the east coast is wishing someone would do something about it.

Like the weather, there’s a relentlessness to stock-market evolution from fundamentally powered capital-formation to procurement process in which vast sums plug into models that pick, pack and stack stocks in precisely indexed packages.

Blackrock, Vanguard and State Street oversee $11.5 trillion that’s generally blind to sellside research and deaf to the corporate story. It’s a force of nature, more like a weather pattern than investment behavior.

Investor-relations folks say: “What do we do about it?”

Alert reader Karen Quast found a paper from Goldman Sachs advising Boards to respond to the rise of passive investment:

The recent decline in active single-stock investing raises important considerations for corporate boards of directors. The decline has been driven by a shift toward ‘passive investing’ and other forms of rule-based investing, such as index funds, factor-based investing, quantitative investing and exchange-traded funds (ETFs).

The decline of active investing means that, in many cases, stock prices have become more correlated and more closely linked to a company’s ‘characteristics,’ such as its index membership, ETF inclusion or quantitative-factor attributes. As a result, companies’ stock prices have become less correlated to their own fundamental performance.

Goldman Sachs is urging preparation. You can’t change the weather. You can only weather the change. The weather forecast isn’t a call to arms. It’s information we use to adapt to conditions. We prepare for discomfort.  We set realistic expectations.

That’s how investor-relations should view passive investment. We call it Asset Allocation because it’s a behavior that directs dollars to equities according to a model apportioning resources for opportunity and risk.

One way to help the board and the management prepare is to present the idea that there’s not just one behavior buying and selling shares. We ran data for an anonymous company whose share-price is 4% higher today than a year ago, trailing the broad market.

There are four purposes behind buying and selling, one of which is Asset Allocation, and all have equal capacity to set price. After all, market rules today prohibit preference (IR people should understand rules governing how shares are priced and traded and we’ll be discussing it at the Twin Cities NIRI chapter next week – join us!).

There are 50 weeks and in each a behavior led, and bought or sold (one week, Active Investment led and price didn’t change, rotation from growth to value).

It’s eye-opening. The behavior “winning” the most weeks was Fast Trading, short-term machines profiting on price-differences rather than investing.  It led 16 weeks, or 32% of the year, and bought more frequently than it sold.

Active Investment – your stock pickers – and Asset Allocation (indexes, ETFs, quantitative investors) were tied, leading 12 weeks each, but where Asset Allocation bought and sold equally, Active Investment sold more than it bought.

Finally, Risk Mgmt, counterparties to portfolio insurance and trading leverage with derivatives, led 10 weeks, or 20% of the year, but bought 70% of the time.  Put them together and the reason the stock is up a little is because the combined demographics behind price and volume bought 26 times and sold 23 times.

You laugh?  These data are telling! If not for other behaviors, Active Investors would have lowered price. Maybe that’s a message for the board and management team – but show this data to them and it will forever change how they think about the market.

The point isn’t changing the market but understanding how it works, measuring it consistently and adapting to reality.  Fundamentals do not rule now.

But with data analytics, it remains profoundly under the purview of investor-relations. That should bring great comfort to all of us in the profession.  Passive investment isn’t something to fear but to measure.

Market Sentiment:  The Federal Reserve likely hikes rates today, and options expire tomorrow and Friday, the latter the first quad-witching session of 2017. Also, S&P and Nasdaq indexes rebalance. VIX expirations still loom next week.

And our Sentiment is negative for the first time since the election. It’s a weather forecast.  No need for panic, only preparation. We’ll all weather change.