Compensation Model

What do you get paid to do?

That’s the question the SEC may soon pose to high-frequency traders, according to a story from Bloomberg yesterday.

“The maker-taker compensation model is very much in the core of what our market structure review folks are looking at,” said SEC Chair Mary Jo White.

If you’re the CFO or investor-relations officer for a public company, you should want an answer too. Because there’s belief silence from public companies about market structure indicates agreement.

Suppose I said, “In one minute, describe your business, its key drivers and how you differentiate yourself for investors.”  I bet most of you could.

What if I asked, “How do your shares trade and where, who trades them, and how are they priced?”

“I don’t even know what ‘maker-taker’ means,” you might mumble.

It’s convention in IR to ignore the stock but that ethos has led a generation of investor-relations professionals to think they don’t need to know how the stock market functions.

“I don’t want my executives watching the stock,” you say.  “If we run a good business, the rest will take care of itself.”

The largest institutional investors in the US equity market, Blackrock and Vanguard, are asset allocators. They’re not Benjamin Graham, the intelligent investor. They track benchmarks because that’s what they’re paid to do.

Active investors are paid to find good businesses, deals, and yet nearly 90% don’t outperform indexes. Stock-pickers are not less intelligent than mathematical models. But they seek outliers in a market that rewards conformity.

Follow me, here. The biggest investors use models, sending trades through the biggest brokers, which are required to meet “best-execution standards,” a wonky way to say “give investors good results,” which is determined by performance-averages across the market – which are being driven by the biggest investors and their brokers.

Thus Blackrock and Vanguard and their brokers perpetuate standards of conformity created by regulators.  Company story becomes secondary to indexes and Exchange-Traded Funds,  investment vehicles dependent on conformity.

Which brings us back to the compensation model. Exchanges under the rule-structure get to set market prices. But they don’t have any of your shares. Ever thought of that?  Investors hold your shares in brokerage accounts primarily, but the exchanges created by brokers are now owned by shareholders. Not brokers. So if exchanges are supposed to set the price in products they don’t have…how can they do it?

Enter the maker-taker compensation model. Exchanges pay brokers to buy or sell your shares in order to set a “displayed” price for them. Generally if traders “make” shares, or sell them on an exchange, they’re paid for it, and if they “take” shares, or buy them, they’re charged (there are exceptions).

Your listing exchange is paying somebody to set the price in your shares, so it can earn revenues from selling this price-setting data back to the biggest brokers, which are required to meet “best execution” standards – which can only be determined from the price-setting data captured by the exchanges. And Blackrock and Vanguard peg that benchmark.

Do you see?  This is what Michael Lewis a year ago in Flash Boys was decrying.  You think rational money is pricing your shares. The SEC, which created this structure, wants to scrutinize who’s setting prices. That should give us all pause. Regulators either don’t comprehend what they’ve done, or worse, they do.

Why care? Because our profession cannot quantify what it’s paying for, and knowing is the premise of commerce.

Three Days

Some energy-sector clients lost 40% of market-capitalization in three days last October.

A year and a half cultivating share-appreciation and by Wednesday it’s gone.  How so?  To get there let’s take a trip.

I love driving the Llano Estacado, in Spanish “palisaded steppe” or the Staked Plains. From Boise City, OK and unfolding southward to Big Spring, TX lies an expanse fit for nomads, an unending escarpment of mottled browns and khakis flat as iron rail stretching symmetric from the horizon like a sea.

Spanish explorer Francisco Coronado wrote, “I reached some plains so vast that I did not find their limit anywhere I went.” Here Comanches were dominating horse warlords for hundreds of years. Later sprouted first the oil boom early last century around Amarillo and again in the 21st century a neoclassical renaissance punctuated by hydraulic fracturing in the Permian Basin.

The air sometimes is suffused with mercaptan, an additive redolent of rotten egg that signals the otherwise invisible presence of natural gas. But the pressure of a relentless regimen silts away on a foreshortened compass, time seeming to cease and with it the pounding of pulses and devices.  It’s refreshing somehow.

And on a map one can plot with precision a passage from Masterson to Lampasas off The Llano and know what conquering that route demands from clock and fuel gauge.

Energy stocks in August 2014 were humming along at highway speed and then shot off The Llano in October, disappearing into the haze.

(Side note: If you want to discuss this idea, we’re at the NIRI Tristate Chapter in Cincinnati Wed Mar 18 and I’m happy to entertain it!)

What happened?  There are fundamental influences on supply and demand, sure. But something else sets prices. I’ll illustrate with an example. Short interest is often measured in days-to-cover meaning shares borrowed and sold and not yet bought and returned are compared to average daily trading volume. So if you move a million shares daily and your short interest is eight million, days-to-cover is eight, which may be good or bad versus your average.

Twice in recent weeks we’ve seen big blocks in stocks, and short volumes then plunged by half in a day. Both stocks declined. Understand, short interest and short volume differ. The former is shares borrowed but not yet covered. It’s a limited measure of risk.  Carry a big portfolio at a brokerage with marginable accounts and you can appropriate half more against it under rules.

Using a proxy we developed, marketwide in the past five days short volume was about 44%, which at 6.7 billion total shares means borrowed shares were 2.95 billion. Statistically, nearly 30% of all stocks had short volume above 50%.  More shares were rented than owned in those on a given day. (more…)

Listing

Why do you need an exchange?

Between the Tiber River and the Piazza del Quirinale in Rome sit the remains of Trajan’s Market, built around 100 AD by that Roman emperor famed for militaristically expanding the empire to its zenith.

Considered the world’s first covered multistory shopping mall, Trajan’s Market, designed by Greek Damascan architect Apollodorus, ingeniously and conveniently clustered vendors and shoppers. Thus that era’s real estate industry saw the importance of location, a timeless lesson.

Taking queue from the ancients, our financial forebears on Broad Street in New York City similarly fashioned a marketplace in 1792, after for some time trading stocks under a buttonwood tree. The bazaar they birthed called the New York Stock Exchange aggregated the investors with cash and the growth enterprises needing it. Investing leapt toward the modern era.

That worked well until exuberance and mushrooming Federal Reserve currency supplies collided in 1929. Then the government said, “All right, everybody, out of the pool.”

With the Securities Act of 1933 and the Securities Exchange Act of 1934, the government sought to introduce safety to markets by eradicating fun and frivolity.  No longer would stock brokers hold court without a king, insouciantly supposing they could match buyers and sellers on merits without a bunch of paperwork with alphanumeric identifiers that governments so prefer.

As a result, some 82 years after Government ordered everybody to stand in lines and fill out forms, public companies in these here United States in 2015 need an exchange to list shares if they want the public to trade them (there are exceptions on the smaller end, the over-the-counter market, which has many thousands more companies than the big National Market System – but that’s a story for another time).

The question now is does it matter where you list your shares? We can prove in less than a blink of an eye that location, location, location is irrelevant (that should be our first clue that something is amiss) today in the equity market.

No, really.  We can show you in a split-second.  If you’ve never seen it, watch these ten milliseconds (the blink of an eye is about 300 milliseconds) of MRK trading compiled by data firm Nanex and posted to Youtube. (more…)

Assuming

Those of you in Boston, we visited accidentally this week.

Flying into LaGuardia Sunday afternoon, Mother Nature had thrown up a snowy blockade, and running low on fuel after an hour circling like a speedway pace car, we diverted to Logan. Thanks for the gas.

We caught our breath and de-iced, and the captain came on: “Ladies and gentlemen, I don’t know how this is going to go”—pilots should never start with those nine words—“but we’ll be taking off shortly. We may just circle New York and be back at Logan. Who knows?  Thanks for flying United.”

Without offense to the great state of Massachusetts the decaying glory of LaGuardia drawing nearer filled us with thankful anticipation. All’s well that ends well. But we’d assumed we’d fare better with a March New York sojourn than a January one – an assumption lacking buttressing data.

Weather may be the exception, but as a rule, challenging assumptions is an invigorating intellectual process. In his 2003 book Moneyball, Michael Lewis tells how Oakland Athletics manager Billy Beane assailed the battlements of baseball. He tested the game’s assumptions about winning by applying data to conventional wisdom.

That refreshing opportunity prevails in our profession daily. Fourteen years after I saw my first Bloomberg screenshot as an investor-relations officer under the heading “you broke through your moving averages” after I asked my listing exchange, “Why is my stock down today?” our clients still get the same answer I did.

No doubt some traders use moving averages. But the bulk of money moving markets today follows asset-allocation models as the dominance of Blackrock and Vanguard illustrate. Data from the Investment Company Institute show that over 90% of assets in 401k plans now use some sort of asset-allocation model.  Do you think these track moving averages?

Other assumed IR wisdoms unsupported by data:

  • Short interest is the best way to measure risk in shares. 
  • Big volumes mean big investors are buying or selling.
  • If my shares behave differently than my peer’s, someone sees them differently.
  • Tracking share-ownership is an effective way to understand your stock’s activity.
  • Ignore high-speed trading because it’s noise – and in fact, ignore the stock.

Have you graphed short interest and price behavior to study correlations? We have. There is no consistent predictive quality to short-interest levels. So we use other measures of risk that offer statistically significant predictive characteristics. (more…)

Taint Natural

In 1884, British comedian Arthur Roberts invented a card game of trickery and nonsense for which he coined the name “Spoof.”  In 2015, spoofing is a decidedly unfunny and ostensibly illegal trading technique in securities markets. But the joke may be on us.

Mr. Roberts made a living on the Briton public-house and music-hall circuit offering bawdy cabaret like “Tain’t Natural,” a vaudeville version of Robinson Crusoe. Today as a result we call satirizing parodies “spoofs.”

Nobody is laughing about spoofing in securities markets.  Wall Street Journal writer Bradley Hope, that paper’s new Robin to the caped-crusader Scott Patterson (IR folks should read Patterson’s “The Quants” and “Dark Pools,” available at Amazon), portrayed as “illegal bluffing” the frenetic keyboard-clicking of a derivatives trader dubbed “The Russian” in a Feb 23 front-page piece. Dodd-Frank, the Roman Coliseum of regulation, banned these fake trades.

Yet stock prices depend on fakery.  Rules mandate trading at the best national price even if you’re moved by something else.  Stock pickers may like the story at a lesser or greater price but can’t so choose. Traders with horizons of milliseconds following rules have the price gun. In order to post best prices, stock exchanges pay high-speed firms for trades (nobody cares more about price than those who exist to set it). Those then price all the rest.  Then exchanges sell the data, perpetuating a market version of robo-signing.

Like a mutating hospital supergene, this price-setting matrix replicated globally. We have two million global index products and options and futures on those and on the ETFs that track them and the components comprising them and the currencies for the countries in which they reside and on the bonds from the debtors and the governments and the commodities driving industry from milk to corn to futures on Norwegian krone – and most of this stuff trades electronically at speed.

Take a breath.

In the WSJ piece on spoofing, the Chicago proprietary-trading firm behind them, 3Red Group LLC (if the firm has three Russian founders they’ve got a sense of humor) says if it clicks fastest, that’s skill not spoofing. Melodramatic?  If only Arthur Roberts could say. (more…)

Leakage

How often do traders know news before you release it?

I was in the car listening to a business program on satellite radio, and they were talking about crazy moves in shares ahead of news.  The host, a trader and money manager, said, “Even with Reg FD and all the disclosure rules, I swear 85% of the time there’s leakage.”

In this age of mandatory dissertation in television ads of pharmaceutical side-effects, one approaches the term “leakage” with caution.  But in market-structure, the behavior of money behind price and volume today, leakage is a functional fact.  Routinely a day before important news, high-frequency trading jumps, signaling impending change and oftentimes distorting price ahead of material information.

Recently a client had a secondary offering for a big holder. Two weeks before it, the broker who would later underwrite the offering led in what we call influential order flow. Two other brokers had matching increases. Yet the company hadn’t yet determined a manager.

Both examples imply leakage. Maybe the fast traders picked up a nugget of information?  Word worked around to broker trading desks?  Both are possible. But we doubt shenanigans played a role. The tipster in both these instances and in much of what appears predictive in stock-moves is the same: Math.

High-frequency traders, the ones signaling money-moves – the reason ignoring fast trading the way so many do is like yanking the fuel gauge from your car and hucking it in the trash – aren’t people.  It’s not somebody on phone calls or in meetings. No channel-checks have been made or hedge funds plied for leads. They’re machines programmed to respond to data.

Therefore, Watson, the elementary conclusion is that the math changes before news. Now could somebody in the know be the trigger?  Sure. Machines seek central tendencies and departures from standard deviation (as do our algorithms) and a trader unaware could unwittingly tip them to a directional shift with orders that don’t look like the others.

The machines spit feeler orders like tiny drones. For example, a utility with market cap around $2 billion trades 225,000 shares daily.  Over a third of the roughly 2,000 trades yesterday were for less than 100 shares. Ten percent were 10 shares or fewer.  Once we saw six hundred-share trades move CSCO $6 in one second. High-speed trading algorithms feather the markets with the smallest possible commitments seeking directional tips.

Suppose a computer metered human traffic at New York’s Penn Station.  The computer would know that before the 2:07 to Bay Head on a westbound track, people are going to fill the station.  Now imagine the computer can determine how many cars should comprise the train, using algorithms that measure human traffic the half-hour leading into 2:07 pm.  If today the standard deviation in the pattern is up and foot traffic down, the computer will peg demand as exceptionally light and order up a very short train for the long trip down the north shore.  What if people were just late arriving? (more…)

The Reality Discount

If reality were measured like stocks in multiples of earnings, how much should we discount it?

Alert (and good-looking) reader Karen Quast sent a Feb 8 story from The Atlantic by entrepreneur Nick Hanauer, Amazon investor and founder of aQuantive, acquired by Microsoft for $6.4 billion. Called “Stock Buybacks are Killing the American Economy,” Hanauer’s treatise contends companies have shifted from investing in people and stuff to trafficking in earnings-management.

While Hanauer’s real target is sociological, he offers startling statistics compiled at theAIRnet.org. Companies in the S&P 500 have repurchased $6.9 trillion of stock the past decade including $700 billion last year.

The Sept 2014 Harvard Business Review ran a similar story by UMass professor William Lazonick called “Profits Without Prosperity.” Mr. Lazonick says S&P 500 components between 2003-2012 spent 54% of profits, or $2.4 trillion, on buybacks, and another 37% ($1.6 trillion) on dividends, thus sending 91% on to holders.  What strikes me is that companies must’ve borrowed roughly $3 trillion more for buybacks.

Hanauer also nods toward GMO Capital’s ($120 billion AUM) James Montier, whose incendiary white paper “The World’s Dumbest Idea” (drawn from a Jack Welch observation) has been the subject of contention in the investor-relations profession and beyond.  Montier claims a tally of buybacks from the 1980s forward shows firms repurchased more shares than were issued.

If that seems to defy the existence of the stock market (if more shares were bought than offered, how are there any to trade?), it doesn’t. There once were nearly 8,000 companies in the Wilshire 5000 while today it’s 3,750 (you’d think the Wilshire 5000 described the number of companies in it), a 53% freefall. But the big have gotten bigger, with US market capitalization about $2.8 trillion in 1988 and $25 trillion today (rewind to 1950 and total market cap was $92 billion – equaling just, say, Biogen Idec’s market cap now). (more…)

Function Follows Form

Let me go. I don’t want to be your hero.

Those words strung together move me now viscerally after seeing the movie Boyhood, in the running at the Academy Awards, as I write, for best of the year. I’m biased by the video for “Hero” from the band Family of the Year because it highlights rodeo, something bled into the DNA of my youth.  See both. The movie is a cinematic achievement that left us blurry. The song is one I wish I’d had the talent in youth to write.

As ever for the ear that hears and the eye that sees, there’s a lesson for investor-relations. We might have heard MSCI last week refraining those lyrics – let me go, I don’t want to be your hero – to the ValueAct team, activist investors.

Over the past few years as activism has flourished, many companies have longed to be let go but have benefited from the activist grip. Herbalife and Bill Ackman.  Hewlett-Packard and Relational Investors. Dow Chemical and Dan Loeb’s Third Point.  Tessera and Wausau Paper and a raft of others just off Starboard.  On it goes, all around.

A curious condition has laid hold of stocks in the last number of years. It used to be that results differentiated.  Deliver consistent topline and bottom-line performance, do what you say you’ll do, explain it in predictable cadence each quarter – these were a reliable recipe for capital-markets rewards. Form followed function.

Activism by its nature supposes something amiss – that a feature of the form of a company is incorrect or undervalued, or simply operated poorly. By calling attention like the old flashing blue light at Kmart (have I just dated myself?), activists have often outperformed the market.

Meanwhile, the opposite has become more than an exception.  From our own client base we could cull a meaningful percentage of companies following the formula of consistent performance yet missing bigger prizes. (more…)

The Fulcrum

The teeter-totter with the moving fulcrum never caught on.

The reason is it wasn’t a teeter-totter, which is simple addition and subtraction, but a calculus problem. The same mathematical hubris afflicted much talk surrounding US economic growth last autumn when it seemed things were booming even as oil prices were imploding.

“The problem is oil is oversupplied,” we were told, “so this is a boon for consumers.”

“What about the dollar?” we asked.

Oil prices are a three-dimensional calculus problem. Picture a teeter-totter.  On the left is supply, on the right is demand.  In the middle is the fulcrum: money. Here, the dollar.

In January 15, 2009 when the Fed began to buy mortgage-backed assets, the price of oil was near $36.  Supply and demand were relatively static but the sense was that economies globally were contracting. On Jan 8, 2010, one year later, oil was about $83. Five years removed we’re talking about the slow recovery. So how did oil double?

The explanation is the fulcrum between supply and demand. Dollars plunged in value relative to global currencies when the Fed began spending them on mortgages.  Picture a teeter-totter again. If I’m much heavier than you, and the fulcrum shifts nearer me, you can balance me on the teeter-totter.  Oil is priced in dollars. Smaller dollars, larger oil price, or vice-versa.

As the Fed shifted the fulcrum, the lever it created forced all forms of money to buy things possessing risk, like stocks, real estate, art, commodities, goods and services.

As we know through Herb Stein, if something cannot last forever it will stop. On August 14, 2014 the Fed’s balance sheet had $4.463 trillion of assets, not counting offsetting bank reserves. On Aug 21, 2014, it was $4.459 trillion, the first slippage in perhaps years.

Instantly, the dollar began rising (and oil started falling). At Jan 22, 2015, the Fed’s balance sheet is $4.55 trillion, bigger again as the Fed tries to slow dollar-appreciation. But the boulder already rolled off the ridge. The dollar is up 22% from its May 2014 low, in effect a 35% rise in the cost of capital – a de facto interest-rate increase. (more…)

The Committee

I’ve learned lots about politics the last couple weeks.

In June 2014, SEC Chair Mary Jo White said:  “We must evaluate all issues through the prism of the best interest of investors and the facilitation of capital formation for public companies. The secondary markets exist for investors and public companies, and their interests must be paramount.”

You remember that?  We wrote here about it, thinking perhaps for once a regulator wasn’t gazing over the heads of all the public companies in the room.

Last autumn, SEC Commissioner Kara Stein’s office asked me to join Chair White’s proposed Market Structure Advisory Committee, a group meant to help the SEC formulate inclusive policies. Energized by SEC rhetoric, I said I’d do it.

As time passed, we had wind through relationships in the capital markets of intense lobbying around the committee. We decided we’d do something contrary to my nature:  Keep our mouths shut.

On January 13 this year, the SEC revealed the members and I was not among them. I felt some relief, supposing CEOs of public companies with names weightier than ours had been added instead.

Then I read the list. The first person named was the co-CEO of a quantitative proprietary high-frequency-trading outfit. The head of Exchange-Traded Funds (ETF) for a broker was there, as was a former NYSE executive now at Barclays, the firm sued by the New York attorney general over trading practices. Four professors made the cut, one an ex-Senator.  People from Convergex, Citadel, Bloomberg Tradebook – all dark pools, or alternative-trading systems run by brokers. Heck, the corporate secretary for AARP somehow got on a market-structure committee. Really. (more…)