Yearly Archives: 2021

Fama Market

Eugene Fama, Booth School, Univ of Chicago

 

Do you know traders could have made 580% in the S&P 500 the past 200 days?

Public companies, your stock need not rise.  I’ll explain.

The S&P 500 is up almost 20% the last six months. The math says 454 of the 500 are up. That also means 46 stocks are down. Including some big ones like Verizon, Lockheed Martin, Procter & Gamble, Kellogg, Zoetis.

But up isn’t the point. It’s up and down. Traders could have made all the returns in the S&P 500 from October 1995 to present – about 600% – in just 200 days on volatility.

By capturing all of it perfectly, which is next to mathematically impossible. But follow me here.

Across the 500 components, average intraday volatility the past 200 days is 2.9%. That is, the typical S&P 500 stock will gyrate almost 3% from lowest to highest intraday prices.

Add that up.  Over 200 days it’s 580%.

And it bugs the bejesus out of Chief Financial Officers. As it should.  The Wall Street Journal highlighted the investor-relations profession and our own Laura Kiernan in a piece (subscription required) last week called CFOs Zero in on Shareholders as Stock Volatility Soars.

But holders aren’t behind volatility.

The University of Chicago’s Eugene Fama won a Nobel Prize on efficient markets and the effects of volatility.  He famously said, “If active managers win, it has to be at the expense of other active managers. And when you add them all up, the returns of active managers have to be literally zero, before costs. Then after costs, it’s a big negative sign.”

Why?  I’m oversimplifying but he showed that volatility risk, size risk and value risk make stock-picking inefficient and ineffectual.

The data prove it.  Most stock-pickers can’t beat the market because they don’t understand why volatility exists.

What is volatility? Changing prices. We’ve written often about it over the years as this search on the word “volatility” at the ModernIR blog shows.  Stock prices constantly change.

Why?

Regulations require it.  Think I’m overstating it? Rules for stocks require trades to occur between the best bid and offer. And regulators mandated penny spreads for stocks 20 years ago.  Thus trades can only occur at the best current price, which changes often.

The best price for stocks cannot be established by a single principle. That idea earned a Nobel Prize.  Other factors matter including volatility, size and value.  And I’d argue convenience, time-horizon, purpose. You can probably add more.

The market is only efficient for parties benefiting from constantly changing prices. Who’s that? Traders and stock exchanges. 

Profiting on price-changes is arbitrage. We have the perfect arbitrage market. How? There are almost 50 different places where trades can occur in the National Market System, a cornucopia for changing the price if you’re fast and algorithmic.

And now the market is chock full of things that look like stocks but aren’t stocks. ETFs, options, futures.  They all converge and diverge in price.  The parties feasting on this environment need prices to change all the time.

Enter the exchanges. They sell data. The data is comprised of quotes and trades. The more the price changes, the more data there is.  Heck, they lose money on trades to make it selling data.

Only trades involving different owners will settle. About 95% of my trades – I understand market mechanics and I become my own algorithm to take advantage of how it works – match at my broker’s internalizer.  No measurable ownership-change.

And Fast Traders are 54% of market volume. No ownership-change. And trades tied to derivatives are 18% of volume. Little to no ownership-change. And half the market’s volume reflects borrowed stock. No ownership-change.

Let’s review.  Shareholders don’t create volatility. They try to avoid it.  Most trades don’t result in ownership-change because the market is stuffed with efforts to profit on changing prices. And that is the definition of volatility, which exists because of rules that promote constantly changing prices.

There’s a simple fix.  Put the focus back on stable prices, by emphasizing factors other than price, such as size and value.  Call it the Fama Market.  When my dad sold cattle from our ranch, we wanted an average price for a herd, not a price per steer.

If public companies want to fix volatility, we need a different market. You can’t fix it by telling the story. And that can’t be the heart of the investor-relations job. It’s now understanding the market for shares – just as my dad knew the cattle market.

If we lack the collective verve to lobby for better markets, then we have to adapt to this one, by understanding it. We have the tools and data for both companies and investors.

Suez on Wall

The stuff Archegos used expires today. Sound like Greek?

Courtesy SEC.gov

Let me explain. A hedge fund blew up. Its counterparties are taking huge hits. There are ramifications. What happens?  Maybe nothing. Maybe everything.

First, let’s understand “counterparty.”  A counterparty accepts the risk of the opposite of your desired trade. That is, if you want to bet something rises, somebody else will necessarily have to bet it falls by selling a put – a right to sell a stock.

Do you follow? It’s why winning trades are hard.  Somebody is always taking a countermanding risk (as ever, market structure matters because you can see the ODDS on which way things go).

And public companies, bets are pervasive.  One of these lately punctured the time-space continuum of the market.  Hedge fund Archegos (“guiding light” in Greek) gambled on derivatives tied to stocks and lost.

I won’t recapitulate details. Stories abound. What matters is WHY NOW, and what does this event mean to you as public companies and investors?

We wrote about CFDs – Contracts for Difference – in 2012.  Total return swaps are a type of CFD. These contracts give funds – I don’t say “hedge funds,” because, reading prospectuses for Blackrock and others, they too can use them – a way to put money on Red 34, but where Red 34 is half the spots on the Roulette wheel.

Why would a counterparty take that bet?  Because they too – Goldman Sachs, Morgan Stanley – make bets on the outcomes to offset the risk that Red 34 comes up.  Remember, Lloyd Blankfein, erstwhile Goldman Sachs CEO, said in the aftermath of the 2008 debacle, “We’re in the risk-transfer business.”

I think it’s the HOPE of the markets biggest participants that nobody understands this stuff – because everybody would be outraged.  I’m not a cynic. I’m looking at the data. Trading unrelated to how your business performs, public companies, pops eyeballs from sockets. Investors, if you don’t know, you’ll be a popped eyeball.

Remember the mortgage-backed securities pandemic?  The movie and book The Big Short? Why would banks sell credit default swaps and then bet against the outcome they just sold?

Because you can always offload your risk.

Until you can’t.

Friday was an “until you can’t” moment for the market.  I’m surmising based on the available data that hedge funds bet certain stocks in a limited period of time expiring today – Mar 31 – would outperform some benchmark by a defined percentage.

Banks took that bet.  Other banks unaware of the size of the bet lent money to the firm making the bet, making it massively larger than anyone comprehended.

To offset risk, banks require collateral. The hedge fund in question put up its portfolio, which the banks shorted – which raised cash and hedged exposure.

I suspect the fund first pledged the SAME collateral to the banks lending money, but then actually assigned it to GS and MS, firms backing swaps.

Here’s the WHY NOW answer. As expirations drew nigh – Mar 31 – it became apparent to the banks selling the swap to the hedge fund and to the hedge fund itself that it was going to fail.  Banks holding collateral sold it.

Those with just a pledge held only the bag they’d been left holding. This is why Credit Suisse and Nomura face big losses, it seems to me (it could be some variation on this theme of course).

But that’s not the heart of the problem here.

This is the Suez Canal converging with Wall Street.

If you’ve somehow missed it, a cargo ship longer than the Empire State Building got stuck in the Suez, blocking everything. God freed it. That is, engineers used a combination of the Worm Moon, a super moon and its incumbent high tides, and a lot of tugging. It’s free now. But the damage is done.

In the stock market, as in the Suez Canal, there’s not much liquidity – not much floating things. And a handful of banks serve the bulk of transactions in Treasurys, currencies, bonds, derivatives (like swaps), commodities, equities, ETFs.

Indexes need to true up tracking right now for the quarter. They depend on these banks. Investors want to lock quarterly results. Massive futures obligations are expiring that the same banks back, to true up index-tracking.

What if something just can’t get done? Which thing do they pick to let go?

Maybe they can juggle it all.  The Suez couldn’t. Maybe Wall Street can. If not, there’s a CHANCE of severe dislocation for markets between today and Apr 6, when books will be all square.

Cash in Lieu

Public companies and investors, is the Federal Reserve using cash to hurt you?

What?  Quast, don’t you mean they’re inflating stocks?

To a point, yes. And then history kicks in. There’s no such thing as “multiple expansion,” the explanation offered for why stocks with no increase in earnings cost more.  If you’re paying more for the same thing, it’s inflation.

But that’s not what matters here. The Fed’s balance sheet is now over $7.7 trillion. “Excess reserves” held by member banks are $3.7 trillion, up $89 billion in just a week. In March 2007 excess reserves were about $5 billion.  I kid you not.

What’s this got to do with stocks?

The banks behind about 85% of customer orders for stocks, about 95% of derivatives notional value, and the bulk of the Exchange Traded Fund (ETF) shares trading in the market are the same.  And they’re Fed members.

Cash is fungible – meaning it can be used in place of other things.  Same with ETF shares. About $500 billion of ETF shares are created or redeemed every month.  ETF shares are swapped for stocks of equal value when money flows out of ETFs,  and when it flows in, stocks of equal value are provided by brokers to sponsors like Blackrock so the brokers can sell ETF shares to the public.

Follow? Except it can be cash instead.  Cash in lieu.

I mean, what is more abundant than cash now? There is so much excess money in the system thanks to the Fed’s issuance of currency that banks can find little better to do with it than leave it at the Fed for seven basis points of interest.

Or use it in place of stocks.

Buying and selling them is hard. They’re not liquid like $3.7 trillion of cash. There are transaction costs.  Suppose a bank needs to bring $10 billion of S&P 500 stocks as a prime broker to Blackrock to get it back in line with asset-allocations?  That’s a lot of work.

But what if Blackrock would be happy with $10 billion of cash, plus a few basis points of over-collateralization?  That’s cash in lieu. 

I’m not suggesting it happens all the time. But as the President would say, Come on man.  Imagine the temptation when creating and redeeming ETF shares for both parties to prefer cash.  It’s piled in drifts.

And you don’t have to settle any shares.  You don’t have to pay trading commissions.  And it’s an in-kind exchange of things of equal value. Cash for ETFs, or stocks for ETFs, either way. Tax-free.

Oh, and you won’t see any ownership-change, public companies.  

Don’t you wonder why stock-pickers – who enjoy none of these advantages – accept this disparity? Rules are supposed to level the playing field, not tilt it like a pinball machine.

Anyway, here’s the problem for public companies and investors.  These transactions aren’t recorded in cash. They’re in lieu, meaning the cash represents a basket of stocks. On the books, it’s as though Blackrock got stocks.

So, we investors and public companies think Blackrock owns a bunch of stocks – or needs to buy them. But it’s instead swapping cash in lieu.

The real market for stocks is not at all what it seems. Stocks start doing wonky things like diverging wildly.

Investors, I think you should complain about cash in lieu. It distorts our understanding of supply and demand for stocks.

And public companies, you wonder why you’re not trading with your peers? If you’re “in lieu,” you’re out.  There are more reasons, sure. But nearly all times it’s not your story. It’s this.

And it’s not fraudulent. It’s within the rules. But excess reserves of $5 billion would make substituting cash for stocks all but impossible. The more money there is, the more it will be substituted for other things of value.

It’s Gresham’s Law – bad money chases out good. Copernicus came up with that. Apparently he was known as Gresham (just kidding –Englishman Thomas Gresham, financial advisor to Queen Elizabeth I, lent his name to the rule later).  But it says people will hoard the good stuff – stocks – and spend the bad stuff.

Cash.

And so it is.

The Fed is distorting markets in ways it never considered when it dipped all assets in vast vats of dollars and left them there to soak. 

The good news is we can see it. We meter the ebb and flow of equities with Market Structure Sentiment and Short Volume (for both companies and investors). Broad Market Sentiment peaked right into expirations – telling us demand was about to fall.

It’s one more reason why market structure matters.

March 17: The machination of machines!

Couldn’t blame you if you missed it.

 

For many, these past few weeks and the ones coming up are the busiest on the IR calendar. Board presentations, ASMs, virtual analyst conferences and investor days. You just finish year-end events and Q1 reporting is rushing at you.

 

Maybe you missed last week’s Market Structure Map. Tim Quast did an excellent job sharing our most-up-to-date view on how the Market works. If you missed it you can find it at: modernir.com/msm – it’s worth revisiting and sharing with your entire IR team, including the senior-most members of your investor and media facing IR team.

 

If you are a regular reader, you may have already considered putting constraints on no-longer preeminent sell-siders (data show their primary audience – yes, including still important long-term institutional holders – Active Investment in our parlance – consistently reflects less than 9.5 percent of all trading Market wide.

 

…with all respect and due appreciation to Python (Monty) Pictures.

No today, even after the recent storied, but largely isolated uptick in retail day trader influence – its machines, acting far faster with mathematical indifference driving the pricing for nearly, if not all equities. These Fast Traders – collocated to exchange computers running increasingly tactical algorithms (53 percent of all trading in the S&P500® last week) are no longer simple amplifiers of nuanced investor behavior, they search the web for data and reference points, trading both agnostically to whether it moves your equity price up or down and increasingly with intent to seemingly do just that.

 

Similar algorithmic behaviors now amplify the trading of the contextually correct, but perhaps inferentially misleading Passive Investment segment (last week: 20 percent of all Market trading). Regular readers know our growing focus on ETF-related trading that has now come to dominate this category.

 

Certainly many traditional index funds and indexed asset allocators continue to hold major positions in our companies, but any material trading is typically around known re-balancing events – like the twice annual S&P Global™ indices re-weighting, next, after this Friday’s close.

 

ETF plan sponsors on the other hand have grown increasingly “active” in their trading behaviors. Strategic sector weighting shifts, tax-related selling, and the use of machine-driven trading seemingly more common. Their influence frequently lifts Passive Investment to the Key Behavior in client’s Market Structure reports.

 

The Market has traded with some volatility recently in anticipation of monthly option expirations – not at all unusual; our calendar of such events should be a key input in your Investor Relations planning efforts and is available here – call us to learn how to avoid calendar missteps.

 

Today begins the cycle of monthly option expirations. First the widely followed CBOE Volatility Index (VIX) index. Thursday, AM-settled options expire, mostly index products. Friday brings the main events. March single stock options, single stock futures, stock index options and stock index futures all expire Friday – a so called, “quadruple witching” day. This happens just once a quarter.

 

A wide gamut of Market participants including – model-driven ETF sponsors, Hedge Funds, derivative traders, etc., with expiring options or futures positions must decide how to redeploy funds this week.

 

Little to do with fundamental business performance or valuations, the increased volume and volatility of these routine Market events queue exaggerated machine trading and can meaningfully impact the trading and response to your Investor Relations outreach and messaging. Good news often gets lost. The impact of less good news – often amplified. Its important to know what’s making the difference. Ask us how.

 

PD Grueber

Reg Efdy and Thee

The Securities and Exchange Commission is in danger of becoming the Dept of Silly Walks.

Let me explain why I’m calling the SEC Monty Python. And it matters to you, public companies and investors.

Speaking of disclosure: I’m on the NIRI National Ethics Council, and we’re debating this matter.  What I’m saying here is, as usual, my own view.

So back in the go-go late 1990s, “sellside” analysts like Henr

Courtesy Monty Python’s Flying Circus, 1970.

y Blodget and Mary Meeker were the superstars of research. Public companies could be seen groveling at sellside thrones.

And simultaneously, sometimes tens of thousands of retail investors would join a new-fangled communication tool public companies were using, the earnings-call webcast.

And insider-trading was the hottest of buttons for regulators.  They were concerned companies were telling sellside analysts and big institutional investors things before the little guys would hear them.  The disturbing spectacle of the Big Guys getting an edge over the Little Guys.

Nothing smokes the cigar of regulators faster than that.

So in August 2000, the SEC passed Regulation Fair Disclosure requiring public companies not to tell some people stuff that could alter valuation or stock-performance without telling everybody else.

In enacting the rule, the SEC said:  

As reflected in recent publicized reports, many issuers are disclosing important nonpublic information, such as advance warnings of earnings results, to securities analysts or selected institutional investors or both, before making full disclosure of the same information to the general public. Where this has happened, those who were privy to the information beforehand were able to make a profit or avoid a loss at the expense of those kept in the dark.

Step forward to 2021.  The SEC last week brought a Reg FD enforcement against members of the investor-relations team at AT&T for supposed material nonpublic disclosures to analysts and big investors five years ago.

AT&T is contesting these findings in a tartly worded missive.

So now we get to the Ministry of Silly Walks and how it’s dragging its gangly limbs about in comic fashion.  First, if it takes you five years to figure out enforcement is needed, you’ve already made a mockery of the process.

Now, consider the stock market in 2000.  Almost 90% of investment assets were actively managed – overseen by people finding what would set one company apart from another and lead to better investment returns.  And 80% of volume was Active. And market intermediaries like Citadel Securities barely existed.

And in 2000, stocks were not decimalized.  Markets were not connected electronically and forced to share prices and customers and stock-listings so that everything trades everywhere, all the time.

In 2021, about 65% of investment assets are now passively managed using models.  Over $5 trillion in the US alone resides in Exchange Traded Funds (ETFs), stock substitutes backed by cash and securities that trade in place of actual stocks.

And trading machines using lightning-quick techniques from collocating servers right next to the exchanges’ to microwaves and fiberoptics drive over 50% of volume.

And guess where selective disclosures and informational advantages reside now?  You got it.  ETFs.  And Fast Traders.  ETFs know which direction the supply and demand for shares is moving, and they transact off-market with a handful of Authorized Participants in giant blocks called Creation Units.

Imagine if big investors gathered with big companies and traded information in smoky backrooms.  It would at minimum violate Reg FD.  It would no doubt prompt outrage.

So, why is it okay for ETFs and their brokers to do this at the rate of $500 billion per month?  It’s an insurmountable advantage harming non-ETF fund managers.

Second, Fast Traders buy retail stock orders so us little guys can trade for free and in fractional shares.  But Fast Traders can see the limit-order pipeline. Nobody else can.  That’s material nonpublic information, and it permits them to profit at others’ expense.

Why is it okay for the quickest firms to have a first look?  Notice how the operators of big traders own sports teams and $100 million houses?  There’s a reason.  It’s called Informational Advantage.

Third, as I’ve said repeatedly, automated market-makers, a fancy name for parties between buyers and sellers, can short shares without locating them, and they don’t have to square books for more than 30 days.  As we described, it’s how GME went up 1,000%.

Finally, next week indexes and ETFs will have to rebalance, and a raft of options and futures expire. And about ten big banks handle all that stuff – and know which direction it’s going.

A handful have a massive advantage over everybody else – the very thing regulations are meant to prevent. Sure, we get free trading, cheap ETFs and the appearance of liquidity.

But it’s not a fair market – and that’s why this AT&T case is silly.  It’s cognitively dissonant and hypocritical to permit rampant market exploitation while culling a five-year old file from the last regime to score political points.

Reg FD is a quaint relic from a time that no longer exists.  Maybe the SEC should regulate to how the market works now?

The Missing Wall

If your house was missing a wall, would you worry whether the front door was locked?

Well, the stock market is missing a wall. 

And yes, the image here is not a missing wall but the walls you can ski at Steamboat.

To our story, investors and public companies need to understand what it means to have a market with a gaping maw in its structure.  Imagine if you went around the house before bedtime shutting off lights, closing windows, locking the front door.

And a wall was missing.

That’s funny like The Truman Show.  Yet glaring structural flaws are no laughing matter.  For investor relations, the profession linking Wall Street to public companies, the job is keeping the house in order.

The lights and windows represent things long done to promote differentiators.  Earnings calls.  Non-deal roadshows (that means visiting holders without pitching a stock or debt offering). Analyst days.  Investor-targeting. Perception studies. On it goes.

You’d be surprised at the work and effort directed at these missions, you who are not in the profession.  We have an entire body of knowledge around the discipline of investor-communication, internally and externally.  Sums spent on tools and services and regulatory compliance and listing fees and so on total billions of dollars annually.

Keeping the house up is a full-time job. But the house is missing a wall. And too often the profession acts like everything is fine.

Evidence of it splashed again through the stock market yesterday. Rocket Companies (NYSE:RKT) slammed into at least three trading-volatility halts en route to a 71% gain.

It’s a great company.  CEO Jay Farner – I heard him on Squawk Box via Sirius Radio last Friday after results as I was descending from the Eisenhower Tunnel to Silverthorne off the Continental Divide – is so impressive. The cynosure of a prepared spokesperson.

And they’re a rocket, no doubt. RKT had $17 billion of revenue and $9 billion of net income, a 53% margin. Who knew selling loans was a more profitable business than selling data?

But.

That’s not what juiced RKT.  Sure, it was up Feb 26, up again Mar 1. But Active investment – the money focused on fundamentals – was 6.8% of RKT volume Mar 1.  So 93.2% of it was something else.

What’s more, Short Volume exploded at the very time rumors surged across the media that we had another Gamestop (GME) here, another “short squeeze,” now in RKT.

I’ll explain everything, so stay with me.

On Feb 19, Short Volume, the percentage of daily trading representing borrowed stock, was 29% of RKT volume.  By Feb 26 as the stock began to jump, it was 55%.

This is the draft you feel, public companies. This is the missing wall leaving you utterly exposed to what’s outside your control, no matter how much you spend, no matter the windows and doors you lock.

Investors, we’ll get to the meaning for you too.

There is only one way for a stock to rise.  Somebody sells stock at a higher price.  Not what you expected?  You thought I’d say, “Somebody must be willing to pay more.”

Yes. That’s true.  But suppose no owners want to sell, because they believe a mortgage company growing more than 100% year over year with 53% margins is a stock to hold.  And suppose the shorts don’t react.

Where does stock come from then?

Answer: That explosion in Short Volume we saw before the stock skyrocketed.

Somebody SHORTED the stock to make it available for sale at a higher price.  Sound cognitively dissonant?  It’s not. It’s called a “market-making exemption.”

We’ve written about it often before.  Read what we wrote on GME.

Truth is, most of the time when investors buy stock, somebody shorts it first and buys it back for the buyer.  At any moment, this can happen to any of you, public companies. And it doesn’t require high short interest – that 1975 measure still in use like a Soviet relic.

No, it can happen on belief. It can happen on nothing more than a machine-driven updraft.  And it could as easily be a downdraft.  What’s to stop market-makers from creating stock to SELL instead of buy? Correct. Nothing.

No matter what your story, your fundamentals, Fast Traders sitting in the middle can create shares out of whole cloth, because regulators have given them leeway to do so, and your stock can behave in unimaginable ways.

Public companies, if you directed 10% of what you spend on story and compliance to targeting Congress for a solution, we might shore up structure.

A solution starts with understanding the problem. And we do.  We can help you (and your board and c-suite).

Investors, your turn.  Market structure is to me the most important trading factor because it trumps everything else.  If you were modeling RKT market structure, you’d have seen the entry point Feb 22.

How many more situations like these will it take before we start looking at the missing wall? 

Maxine Waters

I knew it would come to this. Rep. Maxine Waters would be on CNBC talking about market structure.

Last week during options expirations, Congress paraded supposed culprits in the Great Gamestop Mania before itself.  And it wasn’t about financial misdeeds, somebody leading shareholders astray. No, it was about MARKET STRUCTURE.

What’s market structure?  The behavior of money behind price and volume, in context of rules.  What makes stocks tick.  How the market works.  Pick your thing.  But it’s got nothing to do with STORY.

The stock market is driven by supply and demand, which are largely governed by rules and machines.  Scrawl that on a mirror.

And Investor Relations in 2021 should be about advising the executive team and board on valuation, strategy, uses of shareholder capital, and capital-formation in this market.

That’s a lot bigger job than “telling the story.”  The story doesn’t directly connect to the supply or demand in your shares and what drives both.

GME didn’t go to $483 because of high short interest.  It skyrocketed because market structure enabled demand far larger than the availability of actual, physical shares to be accommodated at ever-higher prices.

Sure, in the process hedge funds short GME on a rational basis were nearly bankrupted. Had the supply of GME been limited to its shares outstanding, the price would not have risen so high.  Why? There would have been nothing left to buy. If you can’t buy it, the price can’t rise.

Right now, short interest says IFF is the most shorted stock in the market.  But it’s NOT the most shorted stock.  I’ll explain.

IFF Short VOLUME, the part of supply dependent on borrowed stock, has been close to 70% for more than 200 trading days.  Trading machines will find stocks with a predictable propensity to rise or fall.

What’s more, as we’ve explained before, market makers, a fancy name for the person at the airport taxi stand you don’t need who hails a cab for you from the line sitting right there, can manipulate supply and demand by creating shares out of thin air.

Traders, you can never, ever, ever beat them.  Because the regulators said so.  What do we mean?  Well, that market makers are exempt from the rules that apply to you.  It means you can’t win, and it means there isn’t a uniform rule, uniform justice. Why is that okay?

Public companies, the regulators and the rules favor the machines.  So while you spend over $5 billion annually complying with rules, and much more trying to get “governance” and “targeting” right, we might get more purchase, so to speak, from that money by spending it lobbying Congress to make the market fair for us.

So.

What’s really the most shorted stock?  Screening out ones that hardly trade, it’s PRO.  It’s 86% short.  Least shorted is PNM, in a big green deal (good name for a rock band) with AGR.  PNM is 7% short — that is, of its trading volume, a tenth of IFF’s.

Knowing these facts is also part of investor relations in 2021.  And trading stocks.  In the same way that knowing what made your company better fundamentally was key to the job, so now is knowing your characteristics.

Traders, it’s the same as knowing it was time to leave TSLA Jan 22.  You can always come back when TSLA market structure turns.  And if Maxine Waters is asking questions, you should be in cash.

Big Cheese Grater

Good offense beats good defense.

These five words are the heartbeat of the Saban Dynasty in football at Alabama – and the reason for the Gamestop trade in the stock market.

Promise, this piece isn’t about sports. It’s about how retail traders killed institutions.

It takes some history. Go back to 1995, and the spread charged by brokers executing your trade was about 13%, or an eighth of a dollar.  That’s on top of the commission you paid.

Along came Electronic Communications Networks (ECNs) offering to match trades at a fraction of that spread automatically using computers.  They took 50% of trading from exchanges.

The exchanges responded in three ways.

Follow me here. I’m explaining why GME went up 1,000% and why retail money is running circles around institutions.  Everybody in the markets should understand it.

Back to the exchanges.  They first cried foul to regulators and sued ECNs.  Then they bought the ECNs (ECNs Brut, Island and Archipelago became technology engines for the Nasdaq and the NYSE).

And they adopted two ECN pillars:  They began paying high-speed traders to set prices, and they invested in algorithmic technology to help big institutional customers fill trades in a stock market infested with small orders and fast trades.

Step forward.  The SEC sniffed the wind and first required stocks to trade at a penny spread and then forced all the markets together under Regulation National Market System, thinking it would address what the ECNs had highlighted: The market wanted smaller intermediary spreads.

Still with me?  GME went up 1,000% because of what we’re talking about here, and institutions have been left out in the cold (public companies, you need to know this!).  I’m getting to it. Don’t quit!

Back to our story, institutional investors and the brokers helping them execute trades invested billions of dollars in computerized trading systems that would split up big orders – like a million shares – into tiny 100-share trades that, and this is key, wouldn’t chase after deviations in price.

I liken it to seeing the market as a cheese grater and institutional orders as a block of cheese. Technologists figured that a stock market forced into tiny spreads and trades would mean constantly changing prices. So why not fashion algorithms that would position the block of cheese of buys and sells like tiny trades – all the teeth on the grater?

Genius!

And so exchanges crafted order types to help big brokers and their customers match the cheese of orders to the grater of the market.

It was a compromise, not an act of service.  After all, exchanges continued to pay traders to be the best bid or offer – the going rate is around 25 cents per hundred shares still – so the cheese graters for big institutions would sit unseen behind the displayed prices for stocks, grating away and filling trades at midpoint prices.

And then along came the Reddit mob.

The unwitting genius behind the crowd is that it doesn’t know market structure. It just followed greed, a human impulse. That is, the aim of the Reddit gang is to run prices up. The aim of the Big Cheese Grater is to fill orders as prices run up and DOWN.

The whole structure of the stock market, with blessing and help from regulators, encourages prices to move both up and down.

It all fits together.  Traders will always make 100 shares of every stock available if prices move up and down.  If prices move up and down, exchanges make billions selling data. And Fast Traders, the supply chain of the stock market, need prices to move up and down to profit going long and short.

Good offense beats good defense.

Buys are offense. Algorithms are defense. And the former flat out OWNED the latter, because the Reddit traders, without understanding what they were doing, chose only offense. They demonstrated a nervy willingness to chase prices higher that utterly demolished algorithms designed, like cheese graters, to capture up-and-down moves.

Intermediaries wanting to make $0.003 per trade didn’t care if the cheese grater malfunctioned. So they fed the mob frenzy what it wanted. Higher prices.

And this can happen every day, any day. In anything.

The problem for public companies is your big investors need to put $2 billion into the market within a price-range to get a return. A retail trader just needs 10% on 100 shares.

You see? It’s a problem 30 years in the making. Now it’s here.

What fixes it? That’s a topic for another day. But it’s coming. It’s Regulation National Market System II.  We’ll see it within two years.

Metastable

Editorial Note:  A giant thank you to Client Services Director Perry Grueber for penning last week’s Map.  He’ll be back regularly, by popular demand. This week you’re stuck again with me. -TQ

Something is worth what another is willing to pay for it.

That’s the lesson of the maelstrom in financial markets, from wood pulp futures, to bitcoin, to GME, to AMC, to wherever the next Dutch tulip bulb of the 21st century showers the shocked with inflationary sparks.

Before we get to that, we’re back from riding the trade winds around Antigua, where high season in the Caribbean looks like turnout for a vegan tour at an abattoir. Nobody is there.  And the Caribbean has no central bank doling out cash for sitting home trading in a Robinhood account.  We did our best to offer economic support.

I’ve posted some photos of our circumnavigation here.

Oh, and you’ll recall that my Jan 27 Map said, “Congrats, Tom Brady. We old folks relish your indomitable way.”  When you’re going to sea, always bet on the buccaneers. And the old guy.

We were saying a thing is worth what somebody is willing to pay.

Yesterday GME closed at $50.31.  On the Benzinga Premarket Prep Show Jan 25, right before we grabbed our flipflops and duffle bags and bolted with our Covid19 negatives for the airport, I told the audience, “Market Structure shows GME is going to go up.”

I didn’t know it would rise to $483 while we were at sea.  But somebody was willing to pay more. Until they weren’t.

Right now, AMC, BB, BBBY, NOK, and so on, are outliers.  What if the scatterplot gets crowded?

Most of the people on what Karen calls the “What Do You Think of THIS Stock?” TV shows are still talking about the PE ratio. Earnings growth. Secular trends. Economic drivers. You get the idea.

Investor-relations people, are you prepared for a market full of Gamestops – surging highs, avalanche tumbles? How about you, investors? 

In physics and electronics, “metastability” is the capacity of a system to persist in unstable equilibrium. That is, it seems solid but it’s not.  Like the stock market.

Don’t blame Reddit.  I love the flexed muscle of the masses.  I’d like to see it in society elsewhere, frankly.  A horde of people who refuse to be told what to do or told they can’t.  A mob of unruly traders is wholly American.

But all those people, and all the rest of us in the capital markets, ought to understand the metastability that makes a GME or an AMC possible.

Most retail orders are sold to intermediaries trading at extreme speeds.  Those firms aren’t calculating PE ratios. They’ll pay somebody for a trade so long as they know somebody else in the pipeline is willing to pay more.

Hordes of limit orders hit the pipeline, and intermediaries see the whole hierarchy. They race prices up, skipping swaths of limits by raising the price past them. So those traders, if they’re greedy and willing to chase, jump out of line and enter new, higher limit orders.

And mania ensues because somebody is willing to pay more. 

When the high-speed intermediaries see that limit orders to buy and sell are equalizing, they stop filling limit orders, they short stocks, and they skip limit orders on the way down, and the whole cavalcade reverses.

And it’s not just retail flow or big high-speed penny-pickers in the middle. Quant firms do it. Hedge funds do it.

Two factors make a metastable stock market possible.  First, rules require a spread between the bid to buy and offer to sell.  So somebody will always have a split-second motivation to pay more for something than somebody else.

Indeed, it’s what regulators intended. How do you foster a market that never runs out of goods? Give them a reason to always buy and sell (exchanges pay them for best prices to boot). And regulators let those Fast Traders manufacture shares – short them – that don’t exist, and persist at it for weeks.

The market is nearly riskless at any price for the raciest members moving unseen through the Reddit ranks. They bought the trades. They know what everybody is doing.

And that’s why we have a metastable market.

The alternative? You might not be able to buy FB or sell NFLX at times.

Would we rather have a false market with ever-present orders or a real market occasionally without them? Regulators chose the former. So did the Federal Reserve, by the way.

And that’s why everybody in the US stock market better know how it works. We do. Ask us for help, public companies, and investors.

IS REPORTING NOW JUST A SIDESHOW?

“Looking good, Valentine!” “Feeling good, Louis!” A gentleman’s bet. But maybe not so fast.

Farce met Street last week with good reason distracting many in the Finance and public company arenas. Far better chronicled elsewhere (here a good one on Benzinga’s Monday Pre-Market Prep – pls skip the clunky ad), but this weekend I couldn’t resist the parallels to 1983’s Trading Places – I’ll leave you to Twitter, your browser or favorite streaming service and bring the focus to Market Structure.

With all rights to Messrs. Russo, Landis, Harris, Weingrod, Aykroyd, Murphy, Ms. Curtis and Paramount, et al.

We start February with a significant percentage of our clients yet to report quarterly and year-end results and to confirm their forward-looking expectations. Tough challenge in a Market seemingly growing more disinterested.

No question your IR team is working long hours with counselors and non-public facing finance, accounting and marketing coworkers to develop a cogent, clear message, to tie-out results and craft outlook statements and public disclosures; all too often, a thankless job.

It doesn’t help that the Market and the trading in individual equities are seemingly chaotic and unpredictable. But are they? As a subscriber you’re likely conversant in Market Structure – our view of the Market here at ModernIR (if no, read on and please reach out to our Zach Yeager to set up a demo). So like the polar bear swimmers here in Minnesota let’s dive in – we’ll be quick.

Here’s how the Market has evolved in the first month of 2021 – changes in the demographics of trading:

Note the Passive Investment retreat – would have been fair to expect the opposite with all the month-end true-ups for ETFs, Index and Quant Funds – but it’s a repeating month-end behavior recently followed by buying. The surge of volatility arose from increased Fast Trading – machine-driven High Frequency trading, and yes, some Retail day trading.

Both categories are largely populated by algorithmically driven trading platforms; “Passive” (a largely  anachronistic designation – and far from it or the buy and hold strategies the name conjures) today constantly recalibrate collateral holdings with dominate behaviors suggesting little long-term primary focus. “Fast Trading” – pure execution speed, volume-based trading; its goal beyond vast incremental profits – no overnight balance sheet exposure.

Short Volume trading rather than building, declined and Sentiment remained persistently positive (5.0 = Neutral) and never negative. Does this sound disorganized? For forces dominating early Q1/21 equity trading this was a strong, dynamic and likely very profitable period.

The cruel truth – machine trading is no gentlemen’s bet. Brilliant in execution, these efforts have one goal – to game inherent trading advantages over slower moving Market participants – folks that demand conference calls, executive time, build and tie-out spreadsheet models and trade in non-Market-disruptive fashion – the traditional IR audience. The system rewards this – topic for another time.

From a pure trading standpoint, traders behind 9 out 10 trades in the final day of January trading placed minimal value on traditional IR efforts as their bots rocket through Short Seller reports and quarterly management call transcripts, scan real-time news feeds and playbacks for tradable intonation in your executives’ delivery and make mathematical judgments about the first 100 words of each press release.

As IR professionals its incumbent that we, rather than be demoralized by the evolution and dominance of short-term trading, engage, and become intimately versed in these data and these Market realities. The competitive advantage is in understanding and minimizing false conclusions in decision-making. Management and the constituents of long-term investors – yes, they are still legion – and expect no less.

Let us show you how.

Perry Grueber filling in for Tim Quast