Long December

Are you a Counting Crows fan?

Karen and I saw the band years ago at Red Rocks, our fabled foothills venue. Front man Adam Duritz lived, he said, in Denver as a child.  One great song goes, “It’s a long December and there’s reason to believe that this year might be better than the last.”

On this last day of November I’m thinking back.  On November 30, 2015, marketwide short volume – daily trading on borrowed shares – was about 43%, a low number versus trailing standards. By January 2016 it had risen to 52%. At Nov 28 this year its 43%, the same as last year.

The dollar then as measured by the DXY Index was the strongest in a decade, at 100.5.  It’s at 101.0 now, a fourteen-year high.

Let’s pause. What’s a strong dollar mean? Using an analogy, a football field is one hundred yards long. Suppose your team is way behind, down 30-0. So the referees shorten the field to 60 yards to give you a chance to catch up.

A strong dollar is a long field. A weak dollar is a short field. Weak dollars shorten play by making prices rise, earnings from abroad converted back to dollars appear stronger, and borrowing cheaper.

From 2009-14, the USA played on a short field, thanks to the Federal Reserve. We were down 30-0. By latter 2014 we trailed about 30-14.  I use that score because by historical measures – housing starts, GDP growth, discretionary income, retail sales (excluding autos), industrial output, productivity and more – we are half what we were.

But we’re catching up, so the Fed is getting set to stretch the field again (Aside: We should never shorten the field. If you’re used to running 60 yards in practice but the games play at 100, your training is all wrong. A steady dollar is what we need.).

DXY

Courtesy Dow Jones Marketwatch

 

Getting back to our December comparisons, in 2015 the Fed inched the cost of overnight borrowing called the Fed Funds Rate up to 0.25%-0.50% (it settles sort of in the middle), the first hike in ten years.  This December it’s widely expected the Fed will mosey the rate up another 25-50 basis points.  Simpatico again.

In December 2015, the bond market was weak, with interest rates on the 10-year US Treasury at 2.33%, up from 1.7% in January, a 39% increase (prices and rates move inversely, so when people sell bonds, rates rise and when they buy them, rates fall). As November 2016 ends, the 10-year Treasury is 2.32%, from 1.4% in July (68% rise).

And the S&P 500 is about 5% higher now. (Speaking of stocks, don’t miss our NIRI webinar tomorrow called Hide and Seek: The Incredible But True Story of How Big Institutions Buy and Sell Your Shares.)

There is one major difference between then and now. Using our long-field/short-field analogy in a different way, when the Fed’s balance sheet has big bank reserves, that’s a short field. Low bank reserves, long field. Between early December 2015 and early January 2016, the Fed took $500 billion out of bank reserves, pushing the playing field to the full hundred yards as it tightened rates.

The whole globe rocked.

Stocks imploded and money screamed into bonds, driving rates down. For awhile at the end of January it seemed downside for the market was bottomless.

By pushing the entire $500 billion back into reserves and chopping the playing field to 60 yards, the Fed got stocks to reverse and soar all the way to the Brexit (they overdid it).

This time they’re starting December where they began January, with a long field and low reserves. They believe they can hike rates December 14 and hack the playing field down to 60 yards by boosting bank reserves, and thus next year will be better than the last.

They might be right.

I’ll tell you the risk should they get it wrong and what would set it off:  If the economy lurches sharply down – despite headlines this week there’s a real chance of a recession next year looking at trends – then the Trump Rally will be a big belly well out over the Fed’s skis as winter hits. If that happens this current year will be better than the next.

I’m hoping for a short December.

Best Of: The GRAR

Editorial Note: Happy Thanksgiving!  We hope you reflect gratefully this season, as we will.  And speaking of reflecting, you might think with markets hitting new all-time highs after the election that we’ve beaten a retreat (what the military calls without irony “advancing to the rear”) from our two-year declamation about coming risk-asset revaluation. We’re by no means complaining about gains. We think prospects for the USA merit giving thanks. 

But there will be no escaping the consequences of artificial asset-price inflation. You can’t blow a balloon full of air and suppose it’ll float forever.  Runs here in November will have a profound reversal magnified by the meteoric dollar-rise. Whether it happens in days or weeks, it’s coming. The question for the new administration will be whether it possesses the fortitude to let prices find proper equilibrium so the economy can actually find “escape velocity” finally, in its aftermath.  -TQ

Originally posted Nov 9, 2016:

Power changed hands in the USA today.

I don’t know in what way yet because I’m writing before election outcomes are known, and about something for the market that will be bigger than which person sits in the oval office or what party holds congressional sway.

The GRAR is a lousy acronym, I admit. If somebody has got a better name, holler.  We started talking about it in latter 2014.  It’s the Great Risk Asset Revaluation. We had the Great Recession. Then followed the Great Intervention. What awaits the new Congress and President is the GRAR.

I’ll give you three signs of the GRAR’s presence.  Number one, the current quarter is the first since March 2015 for a rise in earnings among the S&P 500, and the first for higher revenues since October 2014. Until now, companies have been generating lower revenues and earning less money as stocks treaded water, and the uptick still leaves us well short of previous levels.

Since 1948, these recessions in corporate financials of two or more quarters have always accompanied actual recessions and stock-retreats. The GRAR has delayed both.

Second, gains off lows this year for the Dow Jones Industrial Average have come on five stocks primarily. One could use various similar examples to make this point, but it’s advances dependent on a concentrated set of stocks.  This five – which isn’t important but you can find them – include four with falling revenues and earnings. Counterintuitive.

Finally, the market is not statistically higher (adding or subtracting marketwide intraday volatility for all prices of nearly 2% daily) than it was in December 2014.

That’s remarkable data.  It says prices are not set by fundamentals but intervention.

We might think that if earnings growth resumes, markets will likewise step off this 2014 treadmill and march upward. And that’s independent of whatever may be occurring today – soaring stocks or falling ones, reflecting electoral expectations versus outcomes.

In that regard, our data showed money before the election positioned much as it was ahead of the Brexit vote:  Active buying, market sentiment bottomed, short volume down – bullish signals.

You’ve heard the term “delayed gratification?” It means exercising self-discipline until you’re able to afford desired indulgences.  Its doppelganger is delayed consequences, which is the mistaken idea that because nothing bad arises from bad decisions that one has escaped them.

The bad decision is the middle one – The Great Intervention.  The Great Recession was a consequence arising from a failure to live within our means. When we all – governments, companies, individuals – spend less than we make, nobody ever needs a bailout.

But you don’t solve a profligacy problem by providing more access to credit.  The breathtaking expansion of global central-bank balance sheets coupled with interest rates near zero is credit-expansion. To save us from our overspending, let’s spend more.

If I held in my palms a gold coin and a paper dollar and I said to you, “Pick one,” which would you take?

If you said “the dollar bill,” I can’t help you and neither can Copernicus, who first described this phenomenon that explains the GRAR 500 years ago. Nearly everybody takes the gold, right? We inherently know it’s more valuable than the paper, even if I tell you they have the exact same value.  This principle is called Gresham’s Law today.

Credit does not have the same value as cash.  But assets in the world today have been driven to heights by credit, the expansion of which diminishes the value of cash.

What happens when the people owning high-priced assets such as stocks, bonds, apartments in New York, farmland in Nebraska and so on want to sell them?  All the cash and credit has already been consumed driving prices up in the first place.

What will follow without fail is the GRAR. Depending on who got elected, it might come sooner or later.  But without respect to the winner, it’s coming.  The correct solution for those now in power is to avoid the temptation to meet it with credit again, and to let prices become valuable and attractive. Painful yes, but healthy long-term.

That’s the path out of the GRAR. I hope our winner has the discipline to delay gratification.

Selling the Future

Karen and I are in Playa del Carmen, having left the US after the Trump election.

Just kidding! We’re celebrating…Karen’s 50th birthday first here on the lovely beaches of Quintana Roo and next in New York where we go often but never for fun. This time, no work and all play.

Speaking of work, Brian Leite, head of client services, circulated a story to the team about Carl Icahn’s election-night buys. Futures were plunging as Mrs. Clinton’s path to victory narrowed. Mr. Icahn bought.

If you’ve got a billion dollars you can most times make money.  You’d buy the cheapest sector options and futures and aim your billion at a handful of, say, small-cap banks in a giant SEC tick-size study that are likely to move up rapidly. Chase them until your financial-sector futures are in the money.  Cash out.  See, easy.

(Editorial observation: It might be argued the tick study exacerbated volatility – it’s heavily concentrated in Nasdaq stocks and that market has been more volatile. It might also be argued that low spreads rob investors of returns and pay them to traders instead.)

If you’re big you can buy and sell the future anytime. The market last week roared on strength for financials, industrials, defense and other parts of the market thought to benefit from an unshackled Trump economy.

An aside: In Denver, don’t miss my good friend Rich Barry tomorrow at NIRI on the market post-election (Rich, we’ll have a margarita for you in Old Mexico).

We track the four main reasons investors and traders buy or sell, dividing market volume among these central tendencies. Folks buy or sell stocks for their unique features (stock picking), because they’re like other stocks (asset allocation), to profit on price-differences (fast trading) and to protect or leverage trades and portfolios (risk management).

Fast trading led and inversely correlated with risk-management. It was a leveraged, speculative rally. Traders profited by trafficking short-term in people’s long-term expectations (there was a Reagan boom but it followed a tough first eighteen Reagan months that were consequences of things done long before he arrived).

Traders buy the future in the form of rights and sell it long before the future arrives, so that by the time it does the future isn’t what it used to be.

They’re grabbing in days the implied profits from a rebounding future that must unfold over months or even years. Contrast with stock-pickers and public companies. Both pursue long arcs requiring time and patience.

Aside: ModernIR and NIRI will host an incredible but true expose with Joe Saluzzi of Themis Trading and Mett Kinak of T Rowe Price Dec 1 on how big investors buy and sell stocks today. 

Why does the market favor trading the future in the present? It’s “time-priority,” meaning the fastest – the least patient – must by rule set the price of stocks, the underlying assets. We could mount a Trump-size sign over the market: Arbitrage Here.

We’re told low spreads are good for investors. No, wide spreads assign value to time. Low spreads benefit anyone wanting to leave fast. Low spreads encourage profiting on price-differences – which is high-frequency trading.

Long has the Wall Street Journal’s Jason Zweig written that patience is an investing virtue.  Last weekend’s column asked if we have the stamina to be wealthy, the clear implication being that time is our friend.

Yet market structure is the enemy of patience. Options expire today through Friday. The present value of the future lapses. With the future spent, we may give back this surge long before the Trump presidency begins, even by Thanksgiving.

I like to compare markets and monetary policy. Consider interest rates. High rates require commitment. Low borrowing costs encourage leverage for short-term opportunities.  We’ve got things backward in money and the markets alike. Time is not our friend.

Upshot?  The country is in a mood to question assumptions. We could put aside differences and agree to quit selling the future to fast traders. Stop making low spreads and high speed key tenets of a market meant to promote time and patience – the future.

The GRAR

Power changed hands in the USA today.

I don’t know in what way yet because I’m writing before election outcomes are known, and about something for the market that will be bigger than which person sits in the oval office or what party holds congressional sway.

The GRAR is a lousy acronym, I admit. If somebody has got a better name, holler.  We started talking about it in latter 2014.  It’s the Great Risk Asset Revaluation. We had the Great Recession. Then followed the Great Intervention. What awaits the new Congress and President is the GRAR.

I’ll give you three signs of the GRAR’s presence.  Number one, the current quarter is the first since March 2015 for a rise in earnings among the S&P 500, and the first for higher revenues since October 2014. Until now, companies have been generating lower revenues and earning less money as stocks treaded water, and the uptick still leaves us well short of previous levels.

Since 1948, these recessions in corporate financials of two or more quarters have always accompanied actual recessions and stock-retreats. The GRAR has delayed both.

Second, gains off lows this year for the Dow Jones Industrial Average have come on five stocks primarily. One could use various similar examples to make this point, but it’s advances dependent on a concentrated set of stocks.  This five – which isn’t important but you can find them – include four with falling revenues and earnings. Counterintuitive.

Finally, the market is not statistically higher (adding or subtracting marketwide intraday volatility for all prices of nearly 2% daily) than it was in December 2014.

That’s remarkable data.  It says prices are not set by fundamentals but intervention.

We might think that if earnings growth resumes, markets will likewise step off this 2014 treadmill and march upward. And that’s independent of whatever may be occurring today – soaring stocks or falling ones, reflecting electoral expectations versus outcomes.

In that regard, our data showed money before the election positioned much as it was ahead of the Brexit vote:  Active buying, market sentiment bottomed, short volume down – bullish signals.

You’ve heard the term “delayed gratification?” It means exercising self-discipline until you’re able to afford desired indulgences.  Its doppelganger is delayed consequences, which is the mistaken idea that because nothing bad arises from bad decisions that one has escaped them.

The bad decision is the middle one – The Great Intervention.  The Great Recession was a consequence arising from a failure to live within our means. When we all – governments, companies, individuals – spend less than we make, nobody ever needs a bailout.

But you don’t solve a profligacy problem by providing more access to credit.  The breathtaking expansion of global central-bank balance sheets coupled with interest rates near zero is credit-expansion. To save us from our overspending, let’s spend more.

If I held in my palms a gold coin and a paper dollar and I said to you, “Pick one,” which would you take?

If you said “the dollar bill,” I can’t help you and neither can Copernicus, who first described this phenomenon that explains the GRAR 500 years ago. Nearly everybody takes the gold, right? We inherently know it’s more valuable than the paper, even if I tell you they have the exact same value.  This principle is called Gresham’s Law today.

Credit does not have the same value as cash.  But assets in the world today have been driven to heights by credit, the expansion of which diminishes the value of cash.

What happens when the people owning high-priced assets such as stocks, bonds, apartments in New York, farmland in Nebraska and so on want to sell them?  All the cash and credit has already been consumed driving prices up in the first place.

What will follow without fail is the GRAR. Depending on who got elected, it might come sooner or later.  But without respect to the winner, it’s coming.  The correct solution for those now in power is to avoid the temptation to meet it with credit again, and to let prices become valuable and attractive. Painful yes, but healthy long-term.

That’s the path out of the GRAR. I hope our winner has the discipline to delay gratification.

Total Confusion

The Nasdaq will now run Goldman’s dark pool.

Walk up to any random stranger and blurt that phrase and see what happens. Nasdaq?  Goldman? Dark Pool? You’re crazy?

Bloomberg reported on Halloween that banker Goldman Sachs would turn over management of its so-called dark pool Sigma X to exchange operator Nasdaq. If you work in the equity capital markets (like the investor-relations profession) you need to understand what’s going on.

It requires a history lesson. In 1792, brokers meeting under a downtown New York buttonwood tree to do business realized that sharing customers would mean more buyers and sellers – a market.  They created the New York Stock Exchange, a “farmers market” for stocks, where interested consumers could peruse the “booths” for products they liked.

Fast forward to 1971. A national association of securities dealers created a quotation system for stocks that became the Nasdaq.

Enter Congress.

Four years after eliminating intrinsic value from money by disconnecting it from assets such as gold, the USA was in “Stagflation” (inflation without growth, something that again seems to be gaining purchase in the data) and people were borrowing shares like crazy and using derivatives in totally new ways.

Worried its new paper money lacking substance was going to derail the stock market, Congress in 1975 passed the Section 11 amendments to the Exchange Act to form a National Market System that could be better “managed.”

Before Congress intervened, stocks were traded at the markets where those shares were listed, and markets were owned by brokers.  After Congress took over, markets were gradually separated from the brokers who created them and stocks could trade anywhere (suppose regulators forced Whole Foods to carry Safeway’s private-label products).

Government moves at glacial speed but leaves the same plowed troughs as do vast wedges of frozen water.  It’s only looking behind that you see the scored landscape. Brokers wanted to match buyers and sellers, so they created exchanges. Regulators linked all those exchanges together, undermining competition while claiming to enhance it. Then regulators separated the markets created by brokers from the brokers.

That’s like a Farmers Market that bars farmers. How does the produce get there?

So faced, brokers created new private markets that were dubbed rather unceremoniously “dark pools” because they’re private members-only affairs.  Here’s the bizarre part. Goldman Sachs operates Sigma X because its customers – investors and traders – wanted to get away from the stock market!

Think about that.  In 1792, brokers pooled stock-buying to create a market. Today, customers of brokers want to avoid the stock-buying pools brokers first created, now called exchanges but which today are for-profit businesses selling data and technology and bearing little resemblance to the early stock bazaars.

Why would buyers and sellers choose a stock Speakeasy over a stock shopping mall?  Because mall shoppers can’t tell if they’re getting a deal or screwed.

But now there is so much pressure on brokers to do this or that to comply with rules that they’re afraid to operate markets. Every time they move, a regulator fines them.

In some ways, we’ve come full circle.  Brokers created exchanges.  Stocks traded on exchanges.  Regulators decided brokers were hurting customers and so separated exchanges from the brokers who created them. Now an exchange is taking over the market a broker created as a substitute for the exchange brokers originally created.

Confused? You should be! This is crazy stuff.  There are too many rules, too little transparency, free interaction.  For investor-relations professionals it means more work for your investors trying to buy shares. Markets should make it easier, not harder.  Isn’t that the point?

For forty years, public companies have been spending money and time targeting investors while ignoring the market where those investors buy shares. Effort targeting investors is for naught if they can’t buy or sell stocks efficiently. Have we got it backward?

A Rational Market

The market appears to have become the Walking Dead.

I don’t mean a collection of bodies reduced to bloody pulp by a barbed-wire encased baseball bat. That would be the Presidential election. (Aside: you who watched the new Dead episode know with nauseating certainty what I mean.)

No, market volume is a zombie compared to the summer. Volume was 6.7 billion daily shares Jun-Aug 2016.  Now we’re eking out 5.8 billion, a drag-footed, scar-faced amble.

Usually it’s the other way around.

Meanwhile, business media has been fixated (somewhat ironically) on the Passive invasion that’s digging a giant hole and burying stock-pickers. The Wall Street Journal last week ran a half-dozen stories on the death-grip indexes and exchange-traded funds have laid on investing. Not to be outdone, CNBC covered the big lurch into market passivity all last week.

Both reported how Blackrock has amassed $5 trillion of assets (while, we’d add, ignoring the sellside, discounted cash-flows and earnings calls).  A WSJ article titled Passive Can Be Very Active described how leveraged ETFs classified as passive vehicles drive immense daily volume (we told you about these things a long time ago).

But volume is moseying. So wither the wither?  It looks like Passive is responsible. Now, the market is a uniform beast in which every barcoded thing must behave like the rest or regulators fine it for looking different, by which I mean failing to trade at the averages. If any stock so much hints at departing from the crowd it’s immediately volatility-halted.

I exaggerate for dramatic effect but only some. Rules create uniformity that makes standing out difficult. So over time stocks cluster around the averages like, well, zombies. The world’s most widely traded equity by a country mile is SPY, State Street’s ETF proxy for the S&P 500.  It routinely manages $25 billion of daily volume.

But that was last summer. Monday with the November series of options and futures trading marketwide – routinely it’s hectic with new derivatives – it managed about $11 billion, just 45% of its summertime tally.

We measure the share of daily volume driven by Passive investment marketwide. It’s not down a lot, 100 basis points or so. But that’s every day. And it ripples into options and futures that counterparties back with equity-trading as placid measures mean indexes and ETFs use fewer of them to true up positions. Weaker Fast Trading follows, and anemic ETF market-making. Pretty soon it’s the walking dead.

But there’s a storyline of survival. While the corpus of passivity has shriveled like bacon in a hot pan, or perhaps more accurately like one of those flex hoses when you shut the water off, underneath there is a turgid Active current.

I mean Active investment. We’re a data-analytics firm so we measure everything.  We know each day what percentage of our clients earn new Rational Prices (fair value) when Active stock-pickers buy.

Amidst listless Passive volume, we have seen surging Rational Prices.  On Oct 13, a stunning 32.7% of our client base had new Rational Prices even as volume wilted like pumpkin leaves after the first frost.

Last Friday, the 21st, the penultimate Friday before Halloween and fittingly hosting triple-witching, an impressive 15.5% of our clients were valued rationally by Active investment.

There’s a post-mortem here, a timeless market-structure lesson. First, volume that’s not Rational distorts fair value. Stuff that pursues averages hurts stock-pickers.

And if volume decreases while Active Investment improves its price-setting authority, volume does not equal value.  What matters is the kind of money setting price. With less competition from zombies, the enterprising can make supply runs.

That’s really great news for the investor-relations profession. Our civilization will endure. You don’t need big volume. In fact, if you have big volume the old convention that “you have a big holder buying or selling” is more often wrong than right.  Active money doesn’t want others to know it’s buying. If it does, you better be wary. That’s what Activists do.

There’s more good news.  Where Passive money that puts no thought into its movement is incapable of knowing what lies ahead and can slouch unsuspecting right off cliffs, that Active money bought October brings comfort. There’s Rational Thought in that forest that so often we can’t see for the trees.

Yes, the market like the storyline in the show depends on the zombies. They move the broad measures from one point to the next. You have to be prepared for the occasional slaughter while recognizing that the humans win in the end.  Rational thought trumps.

Volume and Interest

In the five trading days ended Oct 17, 49.1% of average daily stock volume was short.

“Wait, what?” you say.  “Half the stock market is short?”

Yes, that’s right.  Short volume last topped 49% marketwide in mid-April. The market glided gently downward from there to May options-expirations. Speaking of expirations, we’re in them for October this week, so it’s a good time to talk about shorting.

Short volume hit a last marketwide low July 12 at 43%, which roughly corresponded to the high point of the Brexit Bounce.  At Nov 30 last year short volume was 42.9% and December and January were horrific for markets.  And on Jan 7, 2016, short volume was 52%. A month later the market bottomed and soared till April.

If short-volume history is a guide, the market is nearing a temporary bottom. It’s unwise to use a single data point, and we don’t (we use six key measures, plus a small supporting cast, as you clients know). The flow and behavior of money count, and we track both.

“Back up,” you say.  “You lost me at ‘short volume.’ What do you mean by that?”

Short volume is trading derived from borrowed shares.

“I read back in August on Zero Hedge that nobody’s short stocks. Trading from borrowed shares is 2% of the S&P 500, near a three-year low.”

You’re talking about short interest, the long-in-the-tooth risk-assessment tool derived from a 1975 Federal Reserve rule called Regulation T. Shorting and derivatives exploded after the US scrapped the gold standard and the Feds wanted to track margin accounts.

“Are we talking about the same short interest? The amount of total shares outstanding or float that’s borrowed and sold and not yet covered?”

Yes. Forty-one years later it’s still a standard market-risk measure. Yet it’s largely useless predictively. It didn’t shoot up until well after Bear Stearns foundered. In late 2007 it was 1.6%.

“So you’re saying it’s a crappy measure. What’s short volume then?”

Short volume is the amount of daily trading volume that’s borrowed. If a stock trades a million shares a day and short volume is 53%, then 530,000 shares of it were borrowed.  With over 40% of all market volume coming from Fast Traders wanting to own nothing, a great deal of this is short-term trading.

“Okay, I’m following. But what’s it tell me?”

Short volume signals several things but in sum it’s what you think: High short volume, lower price.  Why? Shorting is at root the continual adding of supply to the market. So if demand doesn’t keep up, price falls.

Here’s more:

High short volume means weak expectation for gains. No matter what company fundamentals are, if more volume comes from borrowed shares than owned shares, Fast Traders weighing tick data with high performance machines predict investors would rather lend shares for a return than spend money buying and holding them.

High short volume points to rotation. If the machines want to be short, they’re betting holders are selling and trying to hide it by passing shares through multiple brokers. The converse is true too: If you’ve been short and shorting falls, rotation is probably done.

Persistent high shorting reflects uncertainty about corporate strategy.  Not to pick on Tesla (because it’s not alone by any stretch) but its 200-day average short volume is 55%. Investors say it’s a trading vehicle, not an investment opportunity.  By contrast Qualcomm’s 200-day average is 42%. The two have inverse performance the past year.

Tangentially, high short volume CAN mean ETFs are seeing outflows. Exchange Traded Funds don’t directly buy or sell stocks but they create big volume because ETFs track other measures, such as indexes, that are in turn composed of other issues, such as stocks.

Traders measure deviation between ETFs and these other things and arbitrage (profit on price-differences) the spreads.  When investors sell ETF shares, ETF market makers or authorized participants (parties designated to create and redeem ETF shares) might short components to raise cash in order to buy ETF shares and retire them to rebalance supply.

In sum, short volume is a sensor situated near the beating heart of the money behind price and volume. And while algorithms driving trades today are designed to deceive, they can often be unmasked through short volume (with a couple other key measures).

For the rest of this week though, don’t be surprised if the market shows us not a beating heart but expirations-related palpitations.

Do The Math

Anybody ever said to you, “Do the math?”

Yesterday on CNBC’s Squawk Box legendary hedge-fund manager and founder of Omega Advisors Leon Cooperman said the world is crazy.  That’s anthropomorphizing the planet but I agree. He was referring to the math behind negative interest rates, which means paying people to borrow money.  That’s crazy all right, but happening.

He also said, paraphrasing, that if the population of the country grows by 0.5% and productivity increases by 1.5%, that’s 2% economic growth.  Add in 2% inflation and you have 4% “nominal” growth, meaning the numbers add up to that figure.

He said if the S&P 500 trades at 17 times forward earnings, that puts the S&P 500 at roughly 2150, about where it is now, so the market is fully valued but not stretched.

Why should you care in the IR chair? Macro factors are dominating markets, making a grasp on economics a necessary part of the investor-relations job now.

Whether Mr. Cooperman would elaborate similarly or not, I’m going to do some math for you.  Inflation means your money doesn’t go as far as it did – things cost more.  If a widget costs $1 and the next year $1.02, why? Prices rise because the cost of making widgets is increasing.

Making stuff has two basic inputs:  Money and people. Capital and labor.  If you must spend more money to make the same stuff, then unless you can raise prices or reduce the cost of labor, your margins – which is productivity or what economists call the Solow residual – will shrink.

There’s no growth if you’re selling the same number of widgets, even if revenues increase 2%. And if prices rise, there is on the fringe of your widget market some consumer who is now priced out. That’s especially true if to retain margins you cut some labor costs by letting the receptionist go.  One more person now can’t buy widgets.

And so sales slow.

The Federal Reserve is tasked with keeping unemployment low and prices stable (a bad idea but that’s another story). Its strategy is to increase the supply of money, the theory being more money prompts hiring and rising prices are better than falling prices (errant but again for another time).

One simple way to see if that’s occurring is to look at currency in circulation on the Fed’s balance sheet.  There is now $1.5 trillion of currency in circulation, up $82 billion from a year ago.  Our economy is growing at maybe 1.5%.

In 2000, US GDP growth (right ahead of the bursting Internet bubble) was 4.1%.  In 2000, currency in circulation was $589 billion, down $30 billion from 1999 when currency in circulation grew by $100 billion over the previous year. It increased $35 billion in 1998, $31 billion in 1997.

For 2013, 2014 and 2015, currency in circulation grew $74 billion, $80 billion and $97 billion, and since July 31, 2008, before the financial crisis, currency in circulation is up $645 billion, more than total currency circulating in 2000.

Back to economic basics, what happens to the cost of stuff if money doesn’t go as far as it used to?  Prices rise.  Okay, the Fed is achieving that aim. Its plan for remedying the recession was to get prices rising.

But rising prices push some people out of the market for things.  And if to make things you’ve got to put more money to work, then something has to give or productivity declines.

It’s declining.

And if stuff costs more, people who aren’t making more money can’t buy as much stuff.  What you get is weak wages, weak growth, weak productivity. Check, check, check.

Haven’t jobs numbers been solid? We have 320 million people in this country of which 152 million have jobs. If 1% leaves every year for retirement, having kids, going to school and so on, 200,000 jobs each month is 1.5% economic growth at best.

And that’s what we’ve got.

If you want a realistic view of the economy, do the math.  At some point the rising cost of things including stocks and bonds will push some consumers out of the market.  The only head-scratching thing is what math the Fed is doing, because its math is undermining, jobs, economic growth and productivity.  It seems crazy to me.

Two Faces

In Roman mythology, Janus is the two-faced god of beginnings and endings.  In Denver, Janus is the god of investing. In the news, Janus is merging with UK money manager Henderson.

The move reflects the two faces of the stock market, beginnings and endings and gates and doorways, like the figure from Rome’s old religion.  Today’s market is the inverse of the one prevailing when Tom Bailey launched Janus from a one-room Denver office in 1969, choosing the front-range town over New York to avoid Wall Street GroupThink.

For the next three decades, Janus boomed through a culture of camaraderie built around proprietary financial modeling to find the most dynamic, well-run companies. Janus was a stock-picker of the highest caliber with a penchant for bucking the crowd and going long, big.  Star fund manager Tom Marsico epitomized the Janus style with his Focus Fund backing typically 20 stocks.

Janus embraced the New Economy and chased technology. Though Marsico left in 1997 in a dispute with management, Janus, which was then owned by Kansas City Southern before spinning out publicly as part of Stilwell Financial, became the best mutual-fund company in the business, peaking at $330 billion of assets in 1999.

Then the Internet Bubble burst. In latter 2000 as tech stocks cratered, Janus was losing $1 billion a day in asset-value. In 2001, the firm cut half its staff and saw assets under management dip below $200 billion. The name Stilwell, a moniker fashioned to honor rail tycoon Arthur Stilwell, went away and the two-faced god returned as a public firm.

But the US stock market emerged from the 20th century fundamentally altered, a National Market System. Well, there is no “market system.” It’s one or the other. A market is organic commercial interaction – a dynamic environment where shrewd analysis and the search for the best is a recipe for the success that bred Janus. A system is a process and method. Success in a system turns on stripping out cost and following a model.

The National Market System today is a process and method. GroupThink. Exactly what Janus eschewed. Blackrock and Vanguard have roared past yesterday’s stock-picking heroes like Janus by stripping cost out and tracking averages, thriving at GroupThink.

It’s remarkable testament to the state of the market that being average is the key to being best. And how did we get a market where average is king? Process and method. Rules.

The Order Handling Rules in 1997 decreed that stock markets must display prices set by Electronic Communications Networks, which obliterated a fixture of exchanges back to the 1792 Buttonwood Agreement that brokers not undercut each other on price.  Regulation ATS required all trades to occur through brokers or exchanges, putting the brokers who created exchanges into competition with their progeny. Decimalization in 2001 wiped out the market-making spread necessary for investment banks to fund small-cap stock research (small-cap IPOs plunged by 90%).

Then Regulation National Market System, a product of Congressional legislation, crafted a single marketplace functioning like a data network around the best national bid or offer. A network of linked nodes isn’t competition. It’s a system. The process and method for navigating the network determines success. Machines navigate it best, so the biggest source of volume today is Fast Trading, which writes no research, carries no inventory, underwrites nothing.

In the decade ended Dec 31, 2015 spanning the creation of the National Market System, 98% of all stock-pickers have failed to beat the average – the S&P 500.  The reason isn’t prowess from passives but how indexes and ETFs strip out cost and construct portfolios around the average prices that now securities regulators require (“Best Execution”).

If you’re looking for outliers like Janus, this market is the wrong one for you (and if you seek that money as the investor-relations profession does, it’s stacked against you too). So money is rushing with great sound and fury from them and into indexes and ETFs.

Mergers are driven by effort to strip out cost.  Henderson is paying $2 billion for Janus to form a manager with $300 billion of assets – smaller than Janus in 1999. Ironically, the amount Henderson is paying equals the investment outflows from the two in 2016.  Janus CEO Dick Weil will co-head the company with Henderson CEO Andrew Formica and will move from Denver to London.

Regulators: Is there not one of you paying attention? You did this. You are wrecking the market for stock-picking, for small-caps, for American capitalism. Now you’ve driven Janus out of Denver.  We don’t need a two-faced market where just one smiles.  Keep this up and you’ll foster the mother of all backlashes.

Three Acts

Spain rocks.

We’re back from pedaling the Pyrenees and cruising the rollers of the Costa Brava on bikes, where the people, the food, the wine, the scenes, the art, the land and the sea were embracing and enriching.

To wit, we traversed 200 miles, thousands of feet of climbing and even walked some 40 miles around Barcelona and Girona and I still gained weight. But I wouldn’t trade a bite of Jamon Iberico or sip of rich red Priorat (I’ll let you look those up!).

After a night home we’re now in Chicago where I’ll speak today to the Investor Relations council for MAPI, the manufacturers’ association, on market structure, and tomorrow we’re in Austin for the NIRI Southwest Regional Conference where we sponsor and I’ll aim to rivet attendees with how IR should navigate modern markets.

Speaking of which, a perspective as September concludes this week that’s shaped by two weeks away and abroad might best work as journal entries:

Journal Entry #1:  CBOE to buy Bats Global Inc.

Years ago I sat in front of Joe Ratterman’s desk in the unassuming Lenexa, KS, BATS offices and talked about things ranging from market structure to Joe’s fondness for aircraft.  Joe is now chairman and should be able to afford a bigger plane.

But the thing to understand here is how the combination is a statement on markets. Derivatives and equities are interwoven with other asset classes. It’s what the money is doing. The market is a Rubik’s Cube where moving one square impacts others and strategies for traders and investors alike manifest in complex combinations (you clients see this all the time in our Patterns view in your Market Structure Reports).

The IR job is about building relationships with long-term money, sure. The challenge is to understand the process and method through which money moves into and out of shares. Without knowledge of the process and method, comprehension wanes – and it’s incumbent on IR to know the market. Investors and traders are not mere buyers or sellers now. Profit and protection often lie in a third dimension: Derivatives.

Journal Entry #2: The Tick Size Study. 

We reflected back to 2014 last week and revisited our comments from December that year. The exchanges at the behest of the SEC are at last embarking next month on a study of bigger spreads for buying and selling small-cap stocks to boost trading activity.

It’s a fundamentally correct idea except for one problem. And you’d think, by the way, that the Federal Reserve could grasp this pedestrian concept. Where spreads are narrow, products and services commoditize and activity moves to the path of least resistance. You understand? Low interest rates shift focus from long-term capital investment to short-term arbitrage.  Low market spreads do the same to stocks.

But the problem is the National Market System. It’s an oxymoron. Something cannot simultaneously be a market – organic commercial interaction – and a system – a process or method.  There’s either a market, or a process and method. The SEC wants to tweak the process and method to revitalize organic commercial interaction. Well, if organic commercial interaction is better, why not just eliminate the system?  The Tick Size Study is a good idea trapped within a process and method that will likely desiccate it of benefit.

Journal Entry #3:  The Market.

It too is matriculating in a process and method.  We had the Great Recession, as those who take credit for halting say.  The process and method for constraining it (for now) could be called the Great Intervention.  The third step is the Great Risk Asset Revaluation, currently underway.

In August 2014 the Fed’s balance sheet stopped expanding as the Great Intervention that followed the Great Recession halted.  In latter 2014 the stock market stopped rising. So long as the Fed’s balance sheet increased, the supply of money via credit did too, and that money chased a decreasing supply of product – stocks (because public companies are buying back more shares than they issue, collectively).  There are today fewer public companies than in 2008.  Stocks are trading roughly where they did in December 2014.

Something to ponder:  Generally when growth stocks experience slowing revenues (see Twitter for instance) or earnings, shares fall. The stock market has been in a year-long recession for both. Never in modern history has the economy not also been in recession when that occurred, nor has the market failed to retreat. That it hasn’t is testament to the inertia – a tendency to remain in a uniform state of motion – created by Intervention.

It’ll stop. And stop it must.  We’ll never have a “normal” market until then, so see it cheerfully and not with fear (inertia can last a long time too). Catch you in October.