Day to Day

Here in CO we can count on sun much of the time but we still watch the weather forecast.

It would be a real pain to drag the skis out and drive up the mountain only to find the resorts bereft of snow.  For one, it’s an hour and a half on I-70 through the Eisenhower Tunnel to Summit County and the Arapahoe Basin, Keystone, Breckenridge and Copper Mountain ski resorts (and double that to our fave, Steamboat).

“You could use social media, Tim.  You can have the resorts text you about conditions.  You can go to,,—”

Right, I know that. I’m making a point about dealing with things as they come without thinking about the future. What’s called living day-to-day.  Some of us might want to do that. Get away from the schedule, the rat race. But it’s not a life strategy.

How come we do it with stocks?

Let me explain. Investor-relations folks, for the moment I’m talking to you.  (Investors, listen and see how it applies.) This is typically what you’ll get if you ask an exchange what’s happening with your stock:

The stock opened just above the blah blah blah level then broke out to the upside before basing around noon as profit-takers took over. The bulk of the volume occurred in the morning hours. There was one block, the opening trade, and BAML led most actives (880k), along with Interactive Brokers (615k), GSCO (325k) and JPM (70k).  IBKR often handles retail while the rest generally trade for institutions.

I’m not picking on exchanges. I’m asking what this tells you? It’s the same information I was getting fifteen years ago. No comparative forecast, no indication of what behavior set price, no trends, patterns. It’s a narrative suggesting the day is an end unto itself.

This is lugging skis to Breck on a shorts and flip-flops day.

Compare to the oft-maligned weatherperson.  They’re not always right but they give reliable forecasts. It’s math.  The weather keeps changing but we don’t stop reading forecasts. Right?

Like the weather, the stock market is continually changing. And like weather it’s got measurable patterns because it too is governed by mathematical principles.

Patterns abound. We give Wall Street general expectations of financial trends and patterns through guidance. The Peloton stationary web-connected exercise bike we love gives us troves of trend and pattern data on our performances (sometimes to our chagrin).

I know executives love trends and patterns because they tell me. They like to know what’s coming because they’re people responsible for outcomes and it’s how they think. They appreciate seeing patterns behind price-moves.

We have your trends, patterns and forecasts.  If you’d like to see them, let me know.

The stock market isn’t a set of disconnected events one upon the next called trading days that begin at zero, crescendo, and conclude at a finish line. It’s impossible for everything material to investment behavior to wrap by 4:00 p.m. Eastern Time each day. There’s a pattern at work you can be sure. The average stock trades 13,000 times per day in 200-share increments (and the last price of the day is the 13,000th then).

I’ll share some patterns and trends to finish. Broadly, the key behavior the past week driving big gains and yesterday’s intraday volatility is Risk Mgmt – the use of derivatives to protect and leverage portfolios. Second is Passive Investment. That combination means ETFs are responsible (passive money, plus a risk-transfer effort by market-makers).

Options expire tomorrow through Friday. The Sentiment trend in the market is white-hot growth behavior slamming into a ceiling, based on past trends and patterns. Shorting is rising, intraday volatility is rising.

While the market has persistent upside fervor, near-term volatility is baked in via behavior and options-expirations regardless of a government shutdown. Trends and patterns show it. It may change again next week. That’s how the market works.

If you’re an observer it’s nice to know what’s coming. If you’re an investor, it’s very material to know patterns and trends because your money is on the line. And if you’re in investor-relations, it’s your job.  You don’t want to live it day-to-day. That’s not a strategy.

Can It Last?

It’s the number one question.  Tack “how long” on the front.

I’m asked all the time: “Tim, do you think the stock market is sustainable? Are fundamentals driving it or is this a bubble? Stock buybacks?  The Fed is behind it, right? Isn’t bitcoin proof of irrational exuberance?”

And everybody with an opinion is asked, and answers. I’ve offered mine (read The 5.5 Market from last week) and I’ll add today what we’ve further learned about the behavior of money.

Speaking of money, Karen and I joke that we miss the recession. Hotels were a bargain.  They gave you free tickets to shows if you just came to Las Vegas. Vacations were affordable (I’m not making light of great stock returns but if we give it all back, how is that helpful?).

Now suppose at the same time interest rates would rise. People and companies with too much debt would suffer, sure. But society would save money and take on less debt. That’s what higher interest rates encourage. From Hammurabi in Babylon until fairly recently we understood this to be the formula for prosperity.

“Quast, do you know nothing about contemporary behavioral economics? What kind of idiot would think it’s better to save money and avoid debt?  Economists agree that debt and spending drive the global consumption economy.”

Ask your financial advisor if you should borrow money and spend more, or save money and invest it.  So how come the Federal Reserve encourages borrowing and spending?

Recessions have purpose – and they’re packed with opportunity!  Seriously. They reset the economic calculus.

I’ll give you an example from the Wall Street Journal yesterday, which reported that here in Denver we have 16,000 vacant metro apartments, most in the luxury category. And 22,000 more are being built. Since they’re unaffordable, the city has launched a program to subsidize rents.

This is the kind of warped outcome one gets from promoting debt and spending, and it’s influencing our stock market too. I’m not the least worried because I know boundless opportunity awaits when prices reset, and that’s the right way to see it.  Warren Buffett said it’s unwise to pay more for a thing than it’s worth.  All right, I look forward to attractive prices ahead.

And prices are products of the behavior of money.  Last week we described how the market could not correctly be credited with rational valuation because stock-picking was not the principal behavior. Over the past ten years, all the NET new inflows into US equities have gone to index and exchange-traded funds. They follow a benchmark. They don’t pick stocks.

They also rarely sell them. If things are bought and not sold, prices rise.  There is a paucity of stocks for sale. In its 2016 prospectus for the S&P 500 ETF SPY, State Street said its turnover – proportion of holdings bought and sold – was 4%.  The fund that year, the latest available, had $197 billion in net asset value. Four percent is about $8 billion.

Yet SPY traded $25 billion daily in 2016 (still does!), about three times the entire annual fund turnover. Explanation? Right there on page 2 of the prospectus: The Trust’s portfolio turnover rate does not include securities received or delivered from processing creations or redemptions of Units.

On page 30 we learn this:  For the year ended September 30, 2016, the Trust had in-kind contributions, in-kind redemptions, purchases and sales of investment securities of $177,227,631,568, $167,729,988,725, $7,783,624,798, and $6,444,954,759, respectively.

Translating to English, it means brokers called Authorized Participants created $177 billion worth of new ETF shares by exchanging assemblages of stocks for them that were not counted as sales by SPY. It counted sales of only about $8 billion – as I said above.

The functional turnover rate for SPY is closer to 100%. If it really was, the market would be volatile. Prices would fall as shares hit the market. SPY drives 10% of the entire stock market’s dollar volume.

But what trades is ETF shares. The creation and redemption process occurs away from the market in some secretive block-transaction fashion that means the natural buying or selling that would otherwise be done is not happening.

Selling lowers prices. The absence of selling, the replacement of selling with trading in ETF shares predicated primarily on price-differences – arbitrage – produces a market that relentlessly rises with very little volatility.

And which notably means investors don’t actually own anything when they buy ETF shares. If they did, that $177 billion SPY exchanged for ETF shares would carry a taxable ownership interest, and transaction costs. It doesn’t.

Think about that.

When the recession comes because of this bizarre displacement of actual buying and selling by derivatives, I look greatly forward to all the bargains, the affordable vacation homes in desirable places, the cheap stocks, and the free show tickets in Las Vegas.

I just can’t tell you when. The wise are always prepared.

The 5.5 Market

The capital markets are riven with acronyms.

One of the first you learn in IR (acronym for investor relations) is “GARP.” Growth at a Reasonable Price.  As 2018 begins, GARP is a great way to describe the stock market, just as it was in 2017. Will it continue?

Let’s set ground rules. What “reasonable” means varies with circumstances but the idea is you’re paying a fair price for appreciation, what investors want and companies hope to deliver.

If arguments were colors, you could hear every hue of the rainbow on whether stocks are overpriced or not. Here at ModernIR, we’re statisticians studying how money behaves. We measure what it’s doing rather than whether it should be doing what it’s doing.

What I’ve learned from observing data is that there is an elegant and uniform explanation for why we have a GARP market. I’ll come to it in a moment.

But to ModernIR GARP is a number: 5.5/10.0 on the ModernIR Behavioral Sentiment Index.  Take the FAANGGs – Facebook, Amazon, Apple, Netflix, the two Alphabets. For 2017, the ModernIR BSI is 5.44 for them. The Russell 1000 is 5.48.  The BSI comprised of our client base with more energy and telecom is 5.39 for 2017.

As 2018 begins, it’s 5.6. All these numbers are within two-tenths of a point. It’s a GARP market.

It means it’s a little better than neutral, which is GARP investment.  For instance, if an economy’s population grew, and the ratio of people employed remained constant, and purchasing power outpaced inflation, you’d have a GARP economy.  Buying and holding it would mean appreciation.

Don’t think too long about that one. You’ll become disturbed by incongruity – but that’s a separate story. We’re after an elegant and uniform explanation to why our market runs according to GARP.

CNBC’s Jim Cramer believes it’s this: “There aren’t enough shares!!!”

It’s a point we’ve made too.  Both the number of companies in the US stock market and the total number of outstanding shares has been in steady decline while the amount of money chasing the shrinking product pool continues to rise.

Is inflation the elegant explanation? More money chasing fewer goods? Discounting fundamentals entirely seems incorrect.

But money chases the goods, and what form is money taking? A passive form. Statistically, 100% of the net inflows to stocks the past decade have gone to index and exchange-traded funds. Over that time, stock pickers have lost trillions.

Therefore, the money chasing the goods is pegging a benchmark, not picking outperformers. And by far the big winner is ETFs. What can ETFs do that no other investment vehicle can? They can substitute shares representing stocks, so they don’t have to buy or sell them like other investors do.

More ETF shares are created to accommodate inflows, and then destroyed during outflows, so ETFs bob on the surface of the market, which otherwise fluctuates with supply and demand.

And since all the new money is using ETFs, the entire market has become the bobber.  ETFs create the capacity for ever more money to have access to the same underlying goods. And that is why the market is up, all other things being equal.

It struck me over the holidays that the structure of ETFs, which depends on arbitrage – profiting on price-differences – would inevitably produce a declining market IF the number of shares or public companies or both were expanding. Arbitrage would consume appreciation, leading to an investor exodus from ETFs.

Thus, the elegant explanation for our GARP market is that ETFs arbitrage stocks back to the mean, which is 5.0, and rising flows of capital and shrinking numbers of public companies combine to breed a 5.5 market. GARP.

Why? Because there are ever more ETF shares to accommodate flows to ETFs. For stocks it means multiple-expansion, since ETFs, unlike IPOs, do not create shares of more value-creating enterprises. They only give more money access to the same stocks.

What stops it? The same thing that haunts the global currency system. If at any point, global currencies stop expanding, the prices of all assets could plummet. Why? Because expanding currency supplies drive up prices and create credit, so people keep borrowing more money to buy things. If that process freezes up, prices will implode. Witness 2008.

For ETFs, the danger is as simple as a market in which inflows stop.  What would cause that?  I don’t know right now!  But for the moment it’s not something to fear. We’re in a GARP world.


The legal community was euphoric Tuesday on word stock exchanges listing your shares, public companies, aren’t immune from lawsuits claiming rules favor high-speed traders.

Bloomberg reported (news breaking so no updated link yet but case history is here) that a federal appeals court has overturned a lower ruling protecting exchanges from suits brought by investors and brokers claiming they were disadvantaged in markets through exchange practices ranging from data feeds to complex order types giving fast machines an edge.

The lawsuits hinge, I’m gathering, on a requirement in the Securities Act that exchange rules not discriminate against any constituency.

It’s something public companies should recognize. You’re an exchange constituency. If investors and traders have an expectation of advanced services, what about public companies?  You’re still calling people to ask why shares are up or down. You could do that in 1932, before the Securities Act passed Congress.

It’s conceivable that 2018 could be a great year for public companies in the way 2017 has been a great year for investors. Few (save Carl Icahn and some others) imagined on Nov 7, 2016 stocks were about to soar.  Euphoria now seems to abound like pot shops here in Denver on what we call the Green Mile from Alameda to Evans south on Broadway.

For companies it’s terrific when shares soar too (though LFIN, which debuted the 13th at roughly $5 and announced the 15th it was buying some blockchain outfit and then promptly roared to $130 and $4 billion of market cap without any revenue and via 21 volatility trading halts, is not exactly the sort of soaring that’s sustainable).

What’s needed more than slamming into the ceiling of all-time high Shiller PE ratios (not there yet but closing) is better disclosure.

Since 1975 not one thing has been modified in 13F investor disclosures. Back then we had rotary phones, human beings executed trades, and on May Day that year an obscure investment firm formed in Malvern, PA, calling itself The Vanguard Group.

Step forward to today and investors are still reporting holdings 45 days after quarter-end while Vanguard manages trillions, markets relentlessly morph, and high-speed firms rent 100 shares of your stock, trade it 5,000 times, volume is 500,000 shares, you think it’s big holders, and at the end of the day they own nothing.

Seem appropriate to you, this mismatch?  It’s decidedly not euphoric that public companies have been left out. One could say discriminated against?  Hm. SEC, are you listening?

So maybe in 2018 we can fix it. No need for Congress to act. Dodd-Frank did that in 2010 by creating a mandate for monthly short-position disclosures. Should long positions be disclosed 45 days after quarter-end? Or instead how about disclosing both long and short positions monthly?

That’s still well slower than machines but it would get us into the 21st century. How about it, SEC? Is this the Era of Transparency or is it just the Era of Euphoria?

Speaking of which, will euphoria last? So long as money pumps into Exchange Traded Funds, which don’t create any new shares of public companies but instead create shares of ETFs that reflect dollars chasing the same shrinking set of public companies that currently exists, yes. That’s a euphoric condition.

It’s also inflation. The reason the market behaves like Shangri-La is because the entire market is leveraged like a…well, like a currency that expands far more rapidly than the underlying economy.  Federal Reserve, are you paying attention?

Past all that, I think there’s plenty of reason for euphoria not only about better disclosure in 2018 but in the current season. Good things are happening economically.  There’s a lot of eggnog ahead.  Bowl games to watch while consuming adult beverages.  Chestnuts roasting on an open fire.

But euphoria wears off. We’ll talk about that next year.  Have an awesome holiday season!

Looking Back: Dec 2015

In New York City, it’s beginning to look a lot like Christmas around Rockefeller Center and it feels more like it here than in Denver where we hear yesterday it was 66 degrees (on Dec 12!).

In the weather forecast today is a probable Federal Reserve rate hike, followed by index-options expirations Thursday, quad-witching Friday along with quarterly index rebalances, and volatility expirations next Wednesday.

The market’s Teflon character the past year means we have to go back to Dec 2015 to recall risk. Remember when the Fed lifted rates for the first time since 2006?  We went to sea to avoid the fallout. Read on. -TQ


Dec 9, 2015: The Vacuum

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how they’re priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

Paid Access

A day ski pass to Vail will now set you back $160-$190. It’s rich but I’m glad the SEC isn’t studying skiing access fees. It is however about to consider trading access fees and you should know, public companies and investors. These are the gears of the market.

We all probably suppose stock exchanges make money by owning turf and controlling access. Right? Pete Seibert, Earl Eaton and their Denver investors had a similar ski vision when in 1962 they bought a hunk of Colorado mountain down from the pass through which Charles Vail had run Highway 6. Control turf, charge for access.

In stock trading it started that way too. The Buttonwood Agreement by 24 brokers in 1792 that became the NYSE was carving out turf. Brokers agreed to give each other first look at customer orders and to charge a minimum commission.

This became the stock-exchange model. To trade at one, you had to have access, like a ski pass. Floor firms were called two-dollar brokers, the minimum commission. If you wanted to offer customers more services – say, beer at Fraunces Tavern with a stock trade – you could charge more. But not less.  No undercutting on price.

In the ski business, Nederland, Loveland, Wolf Creek and other ski slopes along the continental divide will undercut, letting you in for half Vail’s cost – but Vail wraps world-class value-adds around its access fees, like Mountain Standard and The Sebastian.

Suppose all the ski resorts could charge only a maximum rate for passes and were forced to send their customers to any mountain having a better price.  It would be inconvenient for travelers arriving in Vail via I-70 to learn that, no, the best ski price is now at Purgatory in Durango, five hours by car.

And it would be like today’s stock market (save for speed). The three big exchange groups, plus the newest entrant IEX, and tiny Chicago Stock Exchange, comprising currently 12 separate market centers, can charge a maximum price of $0.30/100 shares for access to trade. And still they all undercut on price.

That’s because rules require trades to match between the marketwide Best Bid or Offer (BBO) – the best price. As Vail would do in our imaginary scenario, exchanges must continually send their customers to another exchange with the best price.

How to set the best price? You can only cut price so much.  More people will still go to Vail because it’s close to Denver on the Interstate, than to Purgatory, halfway between Montrose, CO and Farmington, NM off highway 550.

Now suppose Purgatory paid to chopper you in from Vail. It might not move you out of The Sebastian, but you’d again have the stock exchanges today. While access fees are capped (and undercut), exchanges can pay traders to bring orders to them.

That’s called a rebate. Exchanges pay brokers incentives to set prices because if they can’t attract the BBO part of the time, they don’t match trades, don’t capture market share, can’t generate valuable data to sell to brokers (Only IEX is eschewing rebates).

The problem for investors and companies is that trades motivated by rebates are like shill bids at art auctions (which by the way are prohibited). They set the best price for everybody else yet the shill bidder doesn’t want to own the painting – or the shares. That’s high-frequency trading. It’s 40% of market volume on average and can be 60%.

Bloomberg reported yesterday the SEC is planning to study access fees through a pilot trading program next year. We’re encouraged that it may include a group of securities with no rebates. But the initial framework begun in 2016 under Mary Jo White aimed to lower access fees, and the study right now contains those plans.

Why? Exchanges are already lowering them. How about setting a floor on access fees so exchanges can make a decent return matching trades and don’t have to engage in surreptitious incentive programs to compete? I got the idea from the Buttonwood Agreement and 200 years of history.

Say all exchanges charge baseline access fees. If this exchange or that wants to wrap more value around fees – better data or more technology or beer – they can charge more.

Whatever happens, we hope (and I asked Chairman Clayton by email) the SEC makes an issuer committee part of the process. Without your shares, public companies, there’s no market. We should have a say. That’s why we have to know how it works!

Prospectively Passive

In the past week as stocks jetpacked higher, Passive Investment was 36% of trading volume. The data counter a message Passive managers like Blackrock are propagating: We don’t trade, we just follow stock-pickers.

That’s not just untrue. It contradicts basic facts.

Let me explain using IVV, Blackrock’s S&P 500 Exchange Traded Fund (ETF). The prospectus intimates Blackrock pays no licensing fees to index creator S&P Dow Jones. State Street’s competing SPY pays 0.0303% of assets.

That difference alone gives Blackrock, which charges just 4 basis points, a 50% cost edge over SPY. But why no licensing charge? Because IVV claims to track “an index of large capitalization stocks” replicating performance in the S&P 500 (which is over 82% of market cap), but without becoming the S&P 500.

Blackrock says it “uses a representative sampling indexing strategy…that collectively has an investment profile similar to that of the Underlying Index.”

Similar but not the same. Clever.

The IVV prospectus says it intends to generally invest 90% of assets in a representative sample of the index it aims to track (the S&P 500).

The remaining 10% goes to “certain futures, options and swap contracts, cash and cash equivalents, including shares of money market funds advised by (Blackrock), as well as in securities not included in the Underlying Index, but which (Blackrock) believes will help the Fund track the Underlying Index.”

I’m not picking on Blackrock. but I don’t think people understand what’s going on. Blackrock is in effect acting like a hedge fund while claiming it sits on stocks and doesn’t turn them over. It’s leveraging its asset base and plying every advantage the rules offer.

The prospectus says it may loan a third of assets, plus any collateral it receives, and it uses “certain futures, options and swap contracts.” Blackrock and its ilk have exploded share-borrowing to more than 40% of all trading volume now. Lending produces profits.

The second layer to peel off this passive onion is “Authorized Participants.”  Both Blackrock and competitor State Street claim they sell infrequently, 5% and 4% respectively.

But it’s sleight of hand. In geopolitics Iran claims it’s not meddling. But it backs Hezbollah, Hamas and others, which actively meddle. Proxies.

IVV fluctuates over 9% every month, tallying daily highs and lows, implying tracking the underlying requires turnover exceeding 100%. If the fund buys and sells only 5% of the time, how could it fulfill its regulatory requirement?

There’s an answer. ETFs farm out index-tracking to proxies.  Blackrock’s Hezbollah – come on, have a sense of humor – is its Authorized Participants (which I’m not calling terrorists).

Every ETF prospectus will have a segment like this: “Only certain institutional investors (typically market makers or other broker-dealers) are permitted to purchase or redeem Units directly with the Trust, and they may do so only in large blocks of 50,000 Units known as ‘Creation Units.’”

Translation: ETFs permit big funds like Blackrock to transfer tracking responsibility to “certain institutional investors” that can front-run inflows and outflows and which perform rebalancing to track underlying measures.

Don’t see the problem? I’ll spell it out. Blackrock tells the public it doesn’t buy or sell much, yet 100% of assets are turning over through a handful of privileged parties who know if there are fund buyers and sellers and can always bet correctly.

With markets continually rising, everybody wins including the rest of us excluded from this club, because the market has only risen for nine years.

But ETFs with statistical samples of broad measures will have two flaws when the market turns.  First, they’ll lack sufficient assets to cover selling when stocks devalue because they dabble, leaving rebalancing to parties wanting to profit on movement rather than through investment.

Second, Authorized Participants will get early directional reads, jumping ahead of you.

Lesson? Don’t believe it when you hear Blackrock claiming to follow Active money. Read the prospectus. They’ve got an edge. It’s helping us all right now. But beware passive dominance. It’ll matter when stocks at some point slide – so be early.

Squab and Thanks

About 60% of US trading takes place on stock exchanges, the other 40% in private broker-operated markets. Should you be worried that nearly half of trading isn’t transparent?

It’s Thanksgiving week so there’s no need for worry! We’re in Vail marking the occasion because everything is better up high, and we’re grateful. And I think we’re entering a period of marked cooperation among exchanges, brokers, regulators and issuers, reason to be optimistic.  More on that in a moment.

Back to the question, worry stirs because there’s a notion that stock-trading in private markets called dark pools gets missed in reporting. Put that fear to rest. All trades are reported so there’s a consolidated volume figure for the day.

Let’s take an example.  Alcoa, you’re it, because your ticker is AA and easy to study. AA recently has traded about five million shares daily. Fidessa’s Fragulator says 59% of AA trading is at stock exchanges, with about 26% at NYSE-operated venues and the rest scattered across other stock markets.

The remaining 41% matches at dark pools or with brokers getting stock-trading orders internally and pairing buyers and sellers within the firm.

All trades are aggregated under reporting rules to create the observable five million shares of daily AA trading volume.

Why are investors and traders going multiple places to buy or sell AA instead of trading in one place?  A bit more math shows us.  AA trades over 28,000 times every day in roughly 175-share increments.

Data from Finra on how AA trades in dark pools or matches privately at brokers (gets “internalized”) shows trade sizes of 531 shares and 329 shares respectively.

That means the average AA trade at exchanges is tiny, near 100 shares. Arbitragers are behind a lot of those because they want to buy and sell as little as needed to change the price. While average market trade size is about 200 shares, a chunk of stocks trade under 100 shares at a time on average – a huge challenge for investors.

And there you have it. Big investors trying to buy and sell in size have no choice but to go where the average trade may be three to five times larger. It’s just efficient. That tells us too that there’s proportionally more investment behavior at brokers than what you see at exchanges.

What’s the good news here?  I don’t think I’ve seen exchanges so united behind bettering conditions for investors. All of them have publicly called on regulators for better market rules that help public companies do what they’re trying to do: Match compelling stories to long-term money via the mechanism of a public stock market.

That’s cause for thanks this season. I’ll go one further: I think we might in 2018-19 see Shangri-La:  A revamped 13F reporting structure with monthly long and short positions. The idea is percolating.

So, eat your stuffing and squab soaked in gravy, and go your way this 2017 Thanksgiving with happiness.  The market is weird, yes. Overpriced, yes. But there’s good news out there too.

Supine Risk

We’re in New York this week while companies gather in Dallas for the annual NAREIT conference, the association for real estate investment trusts.

Real estate is about 3% of the S&P 500. By comparison, Technology is 23%, the largest by a wide margin over healthcare and financials (a combined 27%).  Yet large REIT Exchange Traded Funds hold more assets than big Tech ETFs, with the top ten for each managing $54 billion and $46 billion respectively.

The implication is disproportionate influence in real estate from passive investment. With market sentiment the weakest in more than a year by our measures, I’m prompted to reflect on something we’ve discussed before: Risk in passive investment.

One might suppose that investments following models are less risky than portfolios built by selecting stocks on fundamental factors. Singling out businesses leaves one open to wrong decisions while baskets diffuse risk. Right? Look at Vanguard’s success.

Yes. But missing in these assumptions is what happens when concentrated assets are bought and sold. The biggest real estate funds are mainly at Vanguard, Blackrock, State Street and Schwab. It’s probably true across the whole market.

Behind ETFs, stocks are concentrated too. We’ve described how the top thousand stocks are more than 90% of market volume, capitalization and analyst coverage. Just 8% of assets are in the Russell 2000, the bottom two tiers of the Russell 3000. And there are barely more than 3,300 companies in the Wilshire 5000 now.

Lesson: Everything is big. One reason may be that money buys without selling. Inflows are topping outflows (hint: That has now stopped for the first time in over a year), so indexes aren’t paying out capital gains, skewing returns, as Jason Zweig wrote in the Wall Street Journal Nov 10.

Mr. Zweig highlights the PNC S&P 500 Index Fund, which is distributing 22% of assets as a taxable gain because people have been selling it.  The fund has performed about a third of a percent behind peers. Add in capital gains and the sliver becomes a maw.

Mr. Zweig notes that some big funds including the Vanguard 500 Index and the State Street Institutional S&P 500 Index Fund haven’t paid out capital gains in more than 15 years. If investors aren’t cashing out, assets aren’t sold, capital gains aren’t generated, and results don’t reflect underlying tax liability.

To me there’s a bigger passive risk still. With more money chasing the goods than selling them, things perpetually rise, turning investor-relations professionals and investors alike into winners, but begging the question: What happens when it stops?

I’ve always liked Stein’s Law as a bellwether for reality. If something cannot last forever, said Herb Stein, father of famous son Ben, it will stop. Since it cannot be true that there will always be buyers without sellers, the prudent should size up what happens when giant, concentrated owners shift from buying to selling.

To whom do they sell?

And how can we have buyers without sellers?  Mr. Zweig talks about that too, indirectly. We’ve written directly about it (and I’ve discussed it with Mr. Zweig).  Indexes and ETFs may substitute actual shareholdings with something else, like derivatives. If you can’t find an asset to buy, you buy a right to the asset. This idea torpedoed the mortgage market. You’d think we’d learn.

There’s a rich irony to me in equities now.  During the financial crisis, regulators bemoaned the long and risky shadows cast by giant banks too big to fail because failure would flatten swaths of the global economy.

That was just banks. Lenders.

What we’ve got now is the same thing in the equity market, but risk has transmitted to the assets we all depend on – not just the loans that leverage dependency.

It’s the most profound reason for future policymakers (Jay Powell and Steven Mnuchin) to avoid the mistakes made by the Bernanke Generation of central bankers, who depressed interest rates to zero out of frantic and preternatural fear of failure.

The absence of reasonable interest rates devalues money and pushes it into assets at such a profound rate that for very long stretches the only thing occurring is buying. Result: Everything is giant, and concentrated – the exact opposite of the way one diffuses risk.

When it stops there are no buyers left.

How to get out of a problem of this magnitude?  Quietly. If enough people tiptoe away, there will be buyers when everything is properly priced again.  The hard part is knowing when, because passive risk reposes supine.


We’re in San Francisco at the NIRI meeting, warming up with winter coming to Denver and as summer carries airily on in stocks.

What metrics do you use to evaluate your own shares, investor-relations folks, or ones you own, investors?

I don’t mean fundamentals like cash flow, growth, balance sheet data. Those describe businesses. Stocks are by and large products.

If you bristle at that assertion, it’s just math. JP Morgan and Goldman Sachs have either outright said or intimated that about 10% of their trading volumes come from fundamental investment (our data show 13.5% the past five days). Implication: The other 90% is driven by something else.

This disconnect between how investors and public companies think about stocks and what sets stock prices is to me the root of the struggle for stock pickers and IR professionals alike today.

For instance, the winds are starting to whip around the regulatory regime in Europe called MiFID II, an acronym profusion that considers securities “financial instruments” and will dramatically expand focus on data and prices – two things that power short-term trading.

For proof, one expert discussing MiFID II at TABB Forum said derivatives are “ideally suited” to the regime because they’re statistical. And a high-speed trading firm who will remain anonymous here because we like the folks running it sees MiFID II as a great trading opportunity.

Back to the question: What are your metrics?  It might not be what you’re thinking but it appears to me that the metrics most widely used by investors and companies to evaluate stocks are price and volume. Right?

But price and volume are consequences, not metrics. Think of it this way: What if meteorologists had gone to Puerto Rico and surveyed the damage and reported back that there must’ve been a hurricane?

That’s not very helpful, right? No, meteorologists forecasted the storm’s path. They offered predictive weather metrics. Forecasts didn’t prevent damage but did help people prepare.

The components of the DJIA are trading about 27 times earnings, as I wrote last week. Not adjusted earnings or expected earnings. Plain old net income. It’s a consequence of the underlying behaviors.

By understanding behaviors, we can prepare, both as investors and public companies, for what’s ahead, and gain better understanding of how the market works today.

I can summarize fifteen years of studying the evolution of the US equity market: machines are creating prices, and investors are tracking the averages. That combination creates valuations human beings studying businesses would generally find too rich.

How? Rules. Take MiFID II. It’s a system of regulation that advantages the pursuit of price based on market data, not fundamentals. In the US market, stock regulations require an intermediary for every trade. That also puts the focus on short-term prices.

Then every day by the close, all the money wanting to track some benchmark wants the best average price. So short-term price-setters can keep raising the price, and money tracking averages keeps paying it.  It’s not a choice.  It’s compliance.

In the past five days, data show the average spread between intraday high and low prices is a staggering 3%.  Yet the VIX spent most of that time below 10 and traded down to 9!

How? Machines change prices all day long, and at the close everything rushes to the average, so the VIX says there’s no volatility when volatility is rampant. Since machines are pursuing the same buy low, sell high, strategy that investors hope to execute save they do it in fractions of seconds, the prices most times end higher.

But it’s not rational thought doing the evaluating.

The lesson for IR folks and investors alike is that a market with prices set this way cannot be trusted to render accurate fundamental evaluation of business worth.

What causes it to break? Machines stop setting prices.  What causes that? There’s a topic for a future edition!  Stay tuned.