Gilding the Trend

Is index-investing the death knell for investor relations?

According to S&P Dow Jones – which, you REITs, will be breaking out your sector from Financials Aug 31, as will MSCI – over the ten years ended Dec 2015 a staggering 98% of all active investment managers in the USA underperformed the S&P 500.

These outfits are indexers and will make the case for models. But there’s an obvious rub for the profession pitching stories to stock-pickers.  If the folks listening are trailing the benchmarks, investors will move to passive investing.  And they are, in droves. If your team loses all the time, people quit coming to the games.

There’s a tendency in the IR profession to want to shove our heads in the sand about this disturbing condition.  If we can keep quiet, keep doing what we’ve done, maybe the problem will go away or management will remain unaware of it.

That’s no strategy!  Let me gild this trend in gold for the IR profession. Who is our audience?  The money.  Right?  The IR goal is a well-informed market and a fairly valued stock.  So long as you have measures (and we do here at ModernIR!) that will tell you when these conditions exist and how to keep them there, there’s no need for stress at the state of stock-picking.

Make no mistake:  Telling the story will never go away. We need the Active demographic. You have to cultivate a diverse set of styles among stock-pickers. But it can no longer be your sole endeavor. Where 25 years ago the dominant force was bottom-up investing, today’s principal price-setting investment behavior is Asset Allocation – indexes and exchange-traded funds.

Fine! So be it.  The IR profession must adapt.  We’ve seen evolution in the role over the past decade with a swath of public companies giving IR auxiliary duties ranging from communications to financial planning and analysis. Now IR must add data analysis.

Let me explain. If the money is following models, then model the money.  You can’t talk to that sort of investment about what distinguishes you.  Blackrock and Vanguard don’t listen to earnings calls. Who cares? You can track money quantitatively with a great deal more accuracy and a whole lot less work to boot than trooping all over the planet seeing stock-pickers, most of whom will fail to perform as well as SPY, the world’s most actively traded equity – which is a passive investment.

We live in a world where data and technology have converged everywhere from your kitchen to your retirement portfolio. It’s time the IR profession caught up.  Invesco owns PowerSharesJanus owns VelocityShares. The buyside is adapting. We’d better, too.

So what should you do?  The simplest, easiest and most affordable solution is to use Market Structure Analytics, which we invented to demographically profile all the money driving your equity. You can know every day what percentage of your volume is from Asset Allocation (and three other big behaviors).

Not everyone can, I realize! If nothing else, start today educating your management about ETFs.  Go to and find out how many are associated with your shares. Explain that investments of this kind are dominating equity inflows, and consider it a badge of honor if they’ve got more than 5% of your equity collectively.

There’s a lot to grasp about ETFs. And if you’re a longtime reader you know my rub with them: They’re derivatives. Set that aside for now.  Our profession must shift from defense to offense.

It begins with leading management into the equity market we’ve got rather than letting them discover it themselves. They’ll wonder why you didn’t explain it.

Rational Signals

The market message appears to be: If you want to know the rest, buy the rights.

While rival Nintendo is banking on Pokemon Go, Sony bought the rights to Michael Jackson’s music catalog for an eye-popping $750 million. This may explain the sudden evaporation of Jackson family discord. Cash cures ills.

In the equity market, everybody buys the rights to indexes and exchange-traded funds. TABB Group says indexes and ETFs drove 57% of June options volume, with ETFs over 45% of that and indexes the balance. TABB credits money “rushing into broad-market portfolio protection” around the Brexit.

Could be.  But that view supposes options are insurance only.  They’re also ways to extend reach to assets, tools for improving how portfolios track underlying measures and substitutes for stock positions. I’ve wondered about the Russell rebalances occurring June 24 as the Brexit swooned everything, and whether indexers were outsized options buyers in place of equity rebalancing – which then aided sharp recovery as calls were used.

We can see which behaviors set price every day.  On June 24, the day of the dive, Asset Allocation – indexes and ETFs primarily – dominated.  On June 27 Fast Traders led but right behind them was Risk Management, or counterparties for options and futures.

The tail can wag the dog. The Bank for International Settlements tracks exchange-traded options and futures notional values. Globally, it’s $73 trillion (equaling all equity markets) and what’s traded publicly is about half the total options and futures market.

Sifma, the lobbying arm of the US financial industry, pegs interest-rate derivatives, another form of rights, at more than $500 trillion. You’d think with interest rates groveling globally (and about 30% of all government bonds actually digging holes) that transferring risk would be a yawn.  Apparently not.  You can add another $100 trillion in foreign-exchange, equity and credit-default swaps tracked by Sifma and the BIS.

Today VIX derivatives expire. The CBOE gauge measures volatility in the S&P 500.  Yesterday VXX and UVXY, exchanged traded products (themselves derivatives), traded a combined 90 million shares, among the most actively traded stocks. Yet the VIX is unstirred, closing below 12. Why are people buying volatility when there’s none? For perspective, it peaked last August over 40 and traded between 25-30 in January and February this year and again with the Brexit in late June.

The answer is if the VIX is the hot potato of risk, the idea here isn’t to hedge it but to trade the hot potato. And for a fear gauge the VIX is a lousy leading indicator.  It seems only to point backward at risk, jumping when it’s too late to move. Maybe that’s why everybody buys rights?  One thing is sure: If you’re watching options for rational signals, you’ll be more than half wrong.  Might as well flip a coin.

We learned long ago that rational signs come only from rational behavior. In the past week right through options-expirations starting Thursday the 14th, Active Investment was in a dead heat with Risk Management, the counterparties for rights. That means hedge funds were everywhere trying to make up ground by pairing equities and options.

But options have expired.  Do hedge funds double down or is the trade over?  Short volume has ebbed to levels last seen in November, which one might think is bullish – yet it was the opposite then.

Lesson: The staggering size of rights to things tells us focus has shifted from investment to arbitrage. With indexes and ETFs dominating, the arbitrage opportunity is between the mean, the average, and the things that diverge from it – such as rights.

Don’t expect the VIX to tell you when risk looms. Far better to see when investors stop pairing shares and rights, signaling that the trade is over.

ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

Let me frame that statement with backstory. I consider it our mission to help you understand market behavior. The biggest currently is arbitrage – taking advantage of price-differences. Insert that phrase wherever you see the word.  We mean that much of the money behind volume is doing that.  Yesterday eleven of the 25 most active stocks were Exchange-Traded Funds (ETFs). Four were American Depositary Receipts (ADRs).

Both these and high-frequency trading turn on taking advantage of price-differences. Both offer the capacity to capitalize on changing prices – ADRs relative to ordinary-share conversions, and ETFs relative to the net asset value of the ETF and the prices of components. In a sense both are stock-backed securities built on conversions.

For high-speed traders, arbitrage lies in the act of setting prices at different markets. Rules require trades to match between the best bid to buy and offer to sell (called the NBBO). Generally exchanges pay traders to sell and charge them to buy.

In fact, the SEC suspended an NYSE rule because it may permit traders to take advantage of price-differences (something we’ve long contended). We’ll come to that at the end.

Next, ETFs are constructed on arbitrage – price-differences. Say Blackrock sponsors an ETF to track a technology index. Blackrock sells a bunch of ETF shares to a broker like Morgan Stanley, which provides Blackrock with either commensurate stocks comprising the tech index or a substitute, principally cash, and sells ETF shares to the public.

If there’s demand, Morgan Stanley creates more ETF shares in exchange for components or cash, and then sells them. Conversely, if people are selling the ETF, Morgan Stanley buys the ETF shares and sells them back to Blackrock, which pays with stocks or cash.

The trick is keeping assets and stock-prices of components aligned. ETFs post asset positions daily. Divergences create both risk and opportunity for the sponsor and the broker alike. Blackrock cites its derivatives-hedging strategies as a standard risk associated with ETF investing. I’m convinced that a key reason why ETFs have low management fees is that the components can be lent, shorted, or leveraged with derivatives so as to contribute to returns for both the sponsor and the broker.

On the flip side, if markets are volatile as they have been post-Brexit and really since latter 2014, either party could lose money on unexpected moves. So both hedge.

For arbitragers, a perfect market is one with little direction and lots of volatility. Despite this week’s move to new market highs, there remains statistically little real market movement in the past two years. If a market is up or down 2% daily, does it over time gain, lose or stay the same?

Run it in Excel. You’ll see that a market declines over time. Thus arbitragers short securities using rapid tactics to minimize time-decay. If you want a distraction, Google “ETF arbitrage shorting” and read how traders short leveraged ETFs to make money without respect to the market at large.

In fact, this is the root problem: Taking advantage of price-differences is by nature a short-term strategy. Sixteen of the most actively traded 25 stocks yesterday (64% of the total!) were priced heavily by arbitrage, some by high-speed traders and some by investors and the market-makers for ETFs.

Offering further support for arbitrage ubiquity, the market is routinely 45-50% short on a given day. Short volume this week dipped below 45% for the first time since December, perhaps signaling an arbitrage squeeze and certainly offering evidence that arbitragers hate a runaway market.

If the market rises on arbitrage, it means parties SUPPLYING hedges are losing money. Those are big banks and hedge funds and insurance companies. Who’d take the market on a run to undermine arbitrage that’s eating away at balance sheets (big banks and hedge funds have suffered)?  Counterparties.

In our behavioral data Active investment is down and counterparties have been weak too, likely cutting back on participation. That comports with fund data showing net outflows of $70-$80 billion from US equities this year even as the market reverts to highs. The only two behaviors up the past 50 trading days are Fast Trading (arbitrage) and Asset Allocation (market-makers and brokers for ETFs and other quantitative vehicles). Yet more evidence. And both are principally quantitative.

Assemble these statistics and you see why the market seems oblivious to everything from US racial unrest, to a bankrupt Puerto Rico, to foundering global growth and teetering banks.  The market is running on arbitrage.

What’s the good news, you ask?  The SEC is aware of rising risk. It suspended an NYSE rule-filing on fees at the exchange’s Amex Options market after concluding the structure may incentivize arbitrage.  The SEC is scrutinizing leveraged ETFs and could end them.

But most important is the timeless self-regulation of knowledge. If we’re all aware of what’s driving the market then maybe the arbitragers will be their own undoing without taking the rest of us with them.

Up and Down

If money leaves, how is it stocks rise?

After all, most suppose the market is premised on buying leading to higher prices and selling producing lower ones. And humanity has also held through the ages that a thing seeming too good to be true probably is.

In that vein, Lipper US Fund Flows, a Thomson Reuters unit, tracked billions in outflows from US mutual and exchange-traded funds in equities throughout June including about $7 billion from US equities the week of June 29.

As the Brits fled the European Union so did money from stocks, which offered a stomach-curdling free-fall reminiscent of the Summit Plummet at Disney’s Blizzard Beach. Doom loomed.

Instantly, US equities boomeranged back, a weird financial-markets mulligan. Pundits cheered. Most of us prefer to be richer rather than poorer so heralding rising stocks is natural. But shouldn’t we want to understand why they’re up? Particularly if we’re getting contradictory data such as higher prices from less money?

Could it be short-covering? ModernIR tracks daily short volume, and it was 45.7% of all trading for  the week ended June 13, 45.8% at June 27, and by last Friday had risen to 46.7%. Higher, not lower (yes, nearly half the volume is short).

How about fundamentals? A rosier future economic view can cheer current money. Ah, but from the Federal Reserve, to the Organization for Economic Cooperation and Development, to the International Monetary Fund, hoary heads of the dismal science see deepening malaise worsened by the Brexit, creaky European banks, possible copycat flight from the Eurozone – even a slowdown for the USA.

If things that should drive stocks up are down and yet stocks are up anyway, what might we predict ahead?  There’s a saying that it’s better to keep one’s mouth closed and look like a fool than to open it and remove all doubt.  Forecasting the future is a fool’s errand.

But drawing sound conclusions never goes out of style. Economist Herb Stein, father of Ben, coined Stein’s Law:  If something cannot last forever, it will stop.

Stocks by nature reflect things that can’t last. They go up and down.  And the market is not really up. On Dec 29, 2014, the S&P 500 closed at 2090 and on July 5, 2016 finished at 2088. Stocks are now characterized by short-term ebbs and flows.

The pursuit of short-term price-changes is arbitrage, which isn’t additive investment behavior. Can a market characterized by declining money flows, weakening fundamentals and arbitrage, with no material gain in over eighteen months, gather steam?  Anything is possible. But it’s not a sound conclusion.

Plus, stocks are a mirror for something larger. We call it the Great Risk Asset Revaluation.  Starting in 2009, the Federal Reserve bought trillions’ worth of government and mortgage debt with dollars it created. Much of that money found its way via banks into risk assets – things with variable valuation – such as stocks, bonds, real estate and commodities like oil. Prices for these soared.

And then it all stopped.  See Stein’s Law. At Sep 3, 1998, the Fed’s balance sheet was about $500 billion.  At Sep 4, 2008, it was $900 billion.  At Aug 21, 2014, it was $4.5 trillion. And at June 30, 2016, it was $4.5 trillion.  The Fed’s balance sheet stopped expanding in latter 2014.  Since then, the US stock market has not risen and the global economy has been thrown into turmoil.

It’s all about the money.  Not how much is in the stock market but what the value of the US dollar is relative to other currencies. When the Fed ceases expanding its balance sheet, the dollar appreciates. It’s math. The bad news is that prices of risk assets will reset correspondingly lower.  The good news is that it’s the way back to reality.

When?  In the housing crisis, it was two years after home prices stopped rising that the bottom fell out of the mortgage-backed securities market.  In August it’ll be two years since the Fed’s balance sheet stalled.  Oil alone has repriced so far.

Whenever the Stock Reset comes (and much will be done to stop it), we’ll all survive it – and real opportunity will again abound. Besides, who wants a market that seems too good to be true?

Teasing Us All

A line in the 1973 song Lord Mr. Ford goes, “All the cars placed end to end would reach to the moon and back again, and there’d probably be some fool pull out to pass.”

Such is the delicate balance of global finance and economics that if somebody wheels out of line like the UK did from the European Union last week, a pileup ensues.

We should wonder why the heck everything is so fragile, especially stocks. Humans were engaged in commerce long before bureaucratic bodies decreed a need for pacts and zones. The USA was trading globally back when everyone funded government with the very tariffs now vilified. We did better then, the May trade deficit of $60 billion says.

To contend that global trade will suffer setbacks if the UK leaves the EU is like saying every pro athlete must have the same agent. There must be something else here.  Sherlock Holmes, that fictional feature of Scotsman Arthur Conan Doyle’s imagination, said that after eliminating the impossible, what remains, no matter how implausible, is the answer.

For instance, when you eliminate the impossible about the stock market, the implausible remaining fact is that it’s mostly priced by arbitragers. That was the case Monday in the data, where the Dow Jones Industrials shed 260 points on arbitrage (last Friday though, macro money via indexes and ETFs panicked at the disco). Naturally arbitragers reversed course yesterday. If traders drive the market down and nobody sells, they conclude money is hoping for a bounce – so they offer one.

The market has devolved into a series of reactions to expectations versus outcomes. No wonder.  So have political and monetary policies. As the Brexit recedes and something else arises (perhaps a reactionary Japanese currency-devaluation rattling US stocks again) we’ll continue to bounce from rail to rail down the road, occasionally keeping it between the lines, because policy-makers are managing to minutia.

Ever got a credit card with a teaser rate?  The low promotional cost is intended to prompt a reaction from you.  The card company wants consumption to follow.  Who benefits? You could say, “I got some stuff I wouldn’t otherwise be able to afford.”

True enough. But should you buy things on credit you can’t afford, and if you do, would you expect to be more prosperous as a result or less so?  We’ll come to it in a moment.

The beneficiary is the credit-card company, which hopes to drive revenue in the present through transactions, and revenue in the future if or when the interest-rate normalizes.

Central banks since 2009 have been engaged in a grand teaser-rate experiment. In effect the Fed and others offered the planet a low introductory rate. Who benefits?  We humans got stuff we couldn’t otherwise afford such as mortgages (bought by the Fed to boot), new cars and refrigerators. But does spending borrowed money lead to future prosperity?

If you’ve ever had a financial planner or a grandparent, you know that the secret to future prosperity is the exact opposite – saving money now instead of spending it.

What I would like to know, Janet Yellen, Larry Summers, Austan Goolsbee, Greg Ip, Steve Liesman, Jon Hilsenrath and the rest of you super-smart economists is if we know that saving today is the key to future prosperity, why are you supporting monetary policy that encourages spending now for future prosperity?  Both things can’t be true.

Think about the Federal Reserve and interest rates. We’re all waiting for the impossible.  If we’ve had a low introductory rate for seven years prompting everyone from companies to consumers to spend and borrow today, how in the world could it be true that normalizing rates would promote economic growth?

The problem, however, isn’t normal rates but the original policy of a years-long teaser rate getting people to spend. It’s why everything is so fragile. Markets and economies are perched on a temporary condition: An introductory rate.

Who in our analogy is the credit-card company benefiting from our spending? Governments.  They measure consumption – spending – as economic growth.  If there is economic growth, governments can claim to have solved problems and then can continue to promise citizens more stuff in the future, which will require yet more economic growth to fund it. This way they stay in charge and get everybody doing the same things.

The Brexit is a crack in the grand teaser-rate plan. That’s why it’s rattling markets. Teaser rates that promote spending do not create actual growth and will not produce prosperity. Yet the savings and thrift that do are not only discouraged but inhibited.

If we’ve all figured that out, expect a rough time in coming months for stocks because the truth at first hurts. If we haven’t, then the implausible will continue until it becomes impossible. Or somebody else wheels out of line.

The IEX Machete

We humans don’t like change.

We become accustomed to uncomfortable shoes, kinks in the neck each morning, the monotony of sameness. Were we recorded we’d likely be surprised to hear ourselves making excuses for why what we don’t like must continue. The USA’s Declaration of Independence lamented how people are disposed to suffer ills rather than change them.

The rise of IEX, the Investors Exchange, embodies that ethos. Late last Friday the enterprising folks canonized by Michael Lewis in his book Flash Boys won longsuffering reward when the Securities and Exchange Commission granted the alternative trading system status as a US stock exchange able to host listings.

We’ve become disposed to suffer ills. It’s been 45 years since companies wanting to list shares publicly with a US national stock market had more than two choices (OTC Markets Group and NYSE MKT, I’m not slighting either of you here). That’s remarkable in a country that prides itself on entrepreneurialism and innovation, and testament to both the byzantine form the market has taken and the entrenched nature of the competition.

Comments on IEX’s exchange application are supportive save for vitriol from would-be peers reminiscent of the invective and condescension of some activist investors (think Icahn and Ackman).

Contrast with the behavior of golfing professionals at last weekend’s US Open. Dustin Johnson won his first major despite a controversial penalty, and his fellow competitors rallied behind him despite what we could call “losing market-share.”  Contender Bubba Watson on CNBC’s Squawk Box said he was with fans shouting “Dus-tin! Dus-tin!”

That’s mature professionalism. By contrast, IEX joins the green jackets of the stock-exchange business to derogations from peers. They’ve lobbied for every penalty stroke.

We mean no offense to the incumbents. But it’s embarrassing. Our stock market obsessed with speed and crammed with arbitrage and mostly inhospitable to the active “long-only” (few now are purely long) investors companies spend all their time and resources courting is meaningfully a product of legacy exchanges. We’ve been sold a bill of goods.

The Duopoly is loath to admit IEX or share the power they’ve exercised over the listing process. Why? If innovation and choice are byproducts of free markets, incumbent opposition should raise eyebrows (kudos to the SEC for reinforcing the mechanism of a free and open market that exists for issuers and investors). They’ve chosen easy regulatory monopoly instead, and it’s made them arrogant.

Without restraint through competition and transparency, the market has become a tangle of vines smothering differentiation between companies and promoting arbitrage over investment. The proof is in plunging ranks of public companies, confusion everywhere about what’s setting prices (we’ve cured that malady by the way), and a general migration of stock-prices toward means without regard to fundamentals (those who blame regulation I get it, but the market itself is the problem).

We’ve lost sight of original purpose. So welcome to the jungle, IEX.  We could use a sharp machete.

Vinnie the Face

How do you know macroeconomists have a sense of humor?  They use decimal points.

While you ponder, it’s that time again when the Federal Reserve meets to wring its figurative hands over decimal points, VIX expirations hit as volatility explodes anew, and Brits consider telling Europe to pound sand.  Wait, that last part is new.

And by the way, what’s with these negative interest rates everywhere?

I’d prefer to tell you how computerized high-speed market-makers have made “the rapid and frequent amending or withdrawing of orders…an essential feature of a common earnings model known as market making,” according to Dutch regulators studying fast trading (that nugget courtesy of Sal Arnuk at Themis Trading). If you as a human do that, they throw you in jail for spoofing. If it’s a machine programmed by humans, all’s well.

We’ll instead talk macro factors today because they’re dominating. Negative interest rates, the Brexit, currencies, stocks, share a seamless narrative.

First, the Brexit looms like a hailstorm in Limon, Colorado, not because the UK and Europe are terminating trade. No, nerves are rattled because it represents a fracture in the “we’re all in this together” narrative underpinning global monetary policy. All that’s needed – infinitely – if everybody lives within their means are currencies that don’t lose value over time. There’s not a single one like that right now.

Suppose on your street some neighbors were prosperous and others deep in financial trouble, and block leaders built a coalition around a mantra: The only way for us all to prosper is if the neighbors with money give some to the neighbors without.

It altruistic. It’s also untrue.  That will ensure nobody prospers. The EU strategy has been to get countries like the UK to agree to principles that let wastrel nations offload their profligacy on responsible ones.  It doesn’t matter how one views it ideologically. What matters is the math and the math doesn’t work.

The UK is threatening to quit the block coalition on a belief that the best way to ensure that the UK prospers is to stop taking responsibility for others.

Negative interest rates tie to the EU strategy. Contrary to what you hear from droning economists and central bankers, low interest rates aren’t driven by low growth prospects. If growth prospects are low and therefore risky, capital costs should be high.  Low growth is a product of lost purchasing power, defined as “what your money buys.” If what your money buys diminishes, you’ll be buying less, which leads to low growth.

The reason money buys less is because governments are filching from their citizens by trading money for debt, and falling behind on their payments.

I’ll explain in simple terms.  If you miss a credit card payment, your creditor doesn’t receive money it’s owed. Driving interest rates to zero is tantamount to skipping payments because it reduces the amount owed.  Interest is money owed.

Suppose you told your credit card company, “I will pay you only 1% interest.” That would be nice but generally debtors don’t get to set the terms.

The world’s largest debtors are governments, and they do get to control the terms.  What’s more, they alone create money. Heard of the California Gold Rush, the Alaska Gold Rush?  Why none now?  Governments outlawed the use of gold as money. Gold is valuable, yes. But it’s not legal tender. So you can’t mine for legal tender anymore.

It’s a great gig if you can get it, spending all you want and borrowing and telling creditors what you’ll pay, and then whipping up a batch of cash to buy out your own debt.

Except even governments can’t just prestidigitate cash like a single item in a double-entry ledger. It used to be central banks offset created cash with things like gold.  Now, the entire global monetary system including the dollar, euro, UK pound, Japanese yen, Chinese yuan, etc., is backed by debt.

What does that mean?  To create money, central banks manufacture it and trade it for debt. Why? Because much of what is measured as growth today is really just rising prices. So if prices stop rising, growth stalls, and economies slip into recession and then governments have an even harder time funding bloated budgets.

More money chasing goods drives up prices. So central banks attempt to encourage spending and borrowing by creating money to buy the debts of their governments and now private companies too. The idea is to relieve banks and businesses of debts, thus enabling them to borrow and spend more, which, the thinking goes, will produce growth.

This cycle creates extreme demand for debt, which becomes so valuable that the interest rates on it turn negative.  What happens to ordinary people who borrow and spend beyond their means is the opposite. The cost of debt keeps rising until you’re paying Vinnie the Face the 20% weekly vig in an alley as he smacks a baseball bat in a hand.

So you see, it’s all related. The strangest part is that all financial crises are products of overspending.  Yet governments and central banks cannot manufacture money to save us from our largess unless we rack up debts they can buy with manufactured money.

It’s like an episode of CNBC’s American Greed in which people engage in bizarre and irrational behavior to perpetuate fraud. The world’s money is entirely dependent on more debt. It manifests for you and me in how little our money buys now.  That’s stealing as sure as someone reached in your wallet and took money out. I was just commiserating with a client about the cost of NIRI National.  Our money doesn’t go as far as it did.

What’s it mean for the equity market? It fills up with arbitragers, who see uncertainty as opportunity rather than threat.  They’re not trading fundamentals but fluctuations. They can sustain stocks for a while. But sooner or later Vinnie the Face shows up with a bat.

Busily Productive

“We try not to confuse busy with productive.”

Thus spake the head of investor-relations for an Israeli tech company years ago, and as we wrap the 2016 NIRI National Conference here in June-gloomy but ever awesome San Diego, I recall it anew.

IR for those of you who don’t know is the job that sits at the confluence of the inflow of capital to companies with shares trading publicly and the outflow of information to the buyers and sellers of shares. With investing gaining popularity in the 1960s, companies organized the effort of courting the former and formalizing the latter, and IR was born.

Attracting investors and communicating effectively will remain a bedrock of our profession until the second-to-last public company is consumed by the one giant firm owning everything and in turn owned by one exchange-traded fund leviathan (let’s hope that future never arrives!).

Most IR spending goes to telling the story and targeting investors, the historical yin and yang of IR.  But how are your shares priced?  Do you know?  Is our profession confusing busy with productive?

Let’s review. IR targets investors suited to the story.  We track corporate peers to find areas needing improvement and ways in which we outperform.  I did this too as a telecom IRO (investor relations officer). Your investment thesis defines unique exceptionalism.

Yet trades are measured by averages, indexes and ETFs hew to the mean, and high-speed traders setting prices want to own nothing.  While you’re trying to rise above, all the algorithms are bending your price back to the middle. It’s one reason why indexes beats stock-pickers: Market structure punishes outliers while active money seeks them.

The only NIRI session I was able to attend this year (we’re busying seeing customers, colleagues and friends during the conference) was a tense paneled polemic (moderated adroitly by one of our profession’s scions, Prudential’s Theresa Molloy) with IEX, hero of Flash Boys with a June 17 SEC deadline on its exchange application, and incumbents the NYSE and the Nasdaq.

Without offense to our market-structure friends at the exchanges, it’s stunning how the legacy firms lobby to preserve speed. Here’s what I mean. When the NYSE and the Nasdaq savage IEX for suggesting that slowing prices down by 350 microseconds is unfair, they are bleating a truth: Their dominance depends on privileges for fast traders.

I’ll reiterate how the market works:  Exchanges don’t aggregate supply and demand, they fracture buying and selling by running multiple markets rather than one. Suppose Nordstrom at the mall split into three stores located at either end and in the middle, with different products in each.  It would inconvenience shoppers, who would have to buy clothes one place and then troop to the far end for shoes. But if Nordstrom was selling data on customer patterns in the mall, it would be a great strategy.

Exchanges pay fast traders to set prices.  Prices are data.  Exchanges make billions selling data.  When IEX says it won’t influence the movement of money by paying for prices but instead will match buyers and sellers fairly and charge them both the same price – which none of the other exchanges do – the truth should be obvious to everyone.

It’s this:  Exchanges are deliberately spreading buyers and sellers apart to sell data. Fast traders are paid by exchanges to create great clouds of tiny trades reflecting narrowly separated prices – the exact opposite of the efficiency of size.

Exchanges sell that price data back to brokers, which are required to give best prices to customers, which they can only demonstrate by buying price data and making sure they match trades at averages of these prices, which means the prices are going to be average, which means the entire market is defined by fast traders and averages.  No wonder Blackrock is enormous. The structure serves it better than stock-pickers – IR’s audience.

This is a racket.  You IR folks are running your executives around the globe at great cost telling the story, targeting investors, tracking ownership-change. Yet the market is built on artificial prices intended to generate data revenue. Structure trumps story.

Stop confusing busy with productive.  Again, telling the story will never go away. But learn what sets your price.

We’ve solved that problem for you.  We announced our Market Structure Analytics Best Practices Guide last Friday, and our new Tableau-powered Market Structure Report.  Five Best Practices. Six Key Metrics. Do these and you’ll be a better IR practitioner in the 21st century – and maybe we’ll cease to be gamed when CEOs understand the market. Five Best Practices (drop me a note for our Guide):

Knowledge. Make it your mission to know how the stock market works.

Measurement.  Measure the market according to how it works, not using some metric created in the 1980s. We have six metrics. That’s all you need to know what matters.

Communication.  Proactively inform your management team about how the six metrics change over time so they stop believing things about the market that aren’t true.

A Good Offense.  Use metrics to drive relationships on the buyside. More meetings confuses busy with productive; develop a better follow-up plan.

A Good Defense.  Since markets don’t work anymore, Activism – a disruption of market structure – is perhaps the most popular active value thesis now.  Activists have had 35 years to learn how to hide from Surveillance.  They don’t know how starkly Market Structure Analytics capture their movements.

Let’s stop being pawns. Without public companies the market does not exist. That’s serious leverage.  Maybe it’s time to starting using it.

Ring of Fire

Yesterday China’s stock-futures market Flash-Crashed 10% and recovered in the same single minute.

For those new to market structure, the term “Flash Crash” references a hyperbolic rout and recovery in US equities May 6, 2010 in which the Dow 30 erased a thousand points and gained most of that back, all in 20 minutes. It’s vital to understand the cause, whether you’re the investor-relations officer for a public company or an investor.

China blamed a futures trade for prompting Tuesday’s fleeting plunge. A year ago, China’s stock-futures market had exploded into the planet’s busiest. Then as its equity market was imploding last summer, the government cracked down on futures trading. China also moved to devalue its currency in August last year, ahead of a dizzying Aug 24 plunge in US equities that saw trading in hundreds of Exchange Traded Funds (ETFs) halted as share-prices and fund asset-values veered sharply apart.

Trading in 2016 Chinese stock futures is a shadow of its 2015 glory but yet again sharp volatility in derivatives followed a currency move. Monday as the USA marked Memorial Day the People’s Bank of China pegged the yuan, China’s currency, at the lowest relative level versus the dollar since the Euro crisis of 2011, which also brought rocking volatility to US stocks.  A similar move Aug 12 preceded last summer’s global stock-market stammer.

Every time there’s an earthquake in Japan or Indonesia, it seems like another follows in Chile or New Zealand.  What geologists call the “Ring of Fire” runs from Chile and Peru up along the west coast of the United States and out through the Aleutian Islands of Alaska and down past Japan and Southeast Asia to the South Pacific and New Zealand.

The more things interconnect, the greater the risk. Tectonic connections are a fact of life on this planet, and we adapt.  But we’ve turned global securities markets into a sort of ring of fire as well. In geology, we link tectonic events and observable consequences. In global securities markets, we don’t yet give the magma of money its due.

Globalization helped to intertwine the planet, sure. But it’s not the fault line. All the money denominating everything from your house to Chinese futures is linked via the dollar, the globe’s “reserve currency,” meaning it’s the House Money, the one every country’s central bank must have. If for instance a country’s currency is falling, it can sell dollars and other currencies and buy its own to improve the ratio and thus the value.

Two consequences arise that feed directly back to US public companies and investors.  Suppose the world’s markets were all tied together with a single string and each market had a little coil to play out. That’s currency. Money.  If one market is doing well, the others may be tempted to tug on the string in order to be pulled along, or to let out some string to change the balance of investment flows.

The process becomes an end unto itself.  The connecting currency string is tugged and played in an effort to promote global equilibrium in prices of assets and performance of economies. So arbitrage develops, which is investing in the expectations of outcomes rather than the outcomes themselves. Focus shifts from long-term returns to how things may change based on this economic data point or that central-bank policy shift.

The fissures that develop can be minute monetary arbitrage imbalances like China’s futures flash crash yesterday.  Or much larger and harder to see, like trillions of dollars in ETFs focused on a stock market trading 15% over long-term valuations that rest on economic growth half that of historical averages.

Before the May 2010 Flash Crash, the Euro was falling sharply as Greece neared collapse.  Before 2011 market turmoil globally, the Euro was again shuddering and some thought it was in danger of failing as a currency (that risk remains).  In Japan, the stock market is up 80% since the government there embarked in 2012 on a massive currency expansion. Now this year, the government having paused that expansion, it’s down 10%.  Has the market corrected or is it inflated?  Is the problem the economy or the money?

On the globe’s geological Ring of Fire, unless we achieve some monumental technological advance, living on it comes with risk and no amount of adjustment in human behavior will have an iota of impact. It’s tectonic.

In the stock market, fundamentals matter. But beneath lies a larger consideration. Markets are linked by currencies and central banks toying with strings.  The lesson for public companies and investors alike is that a grand unifying theme exists, like the physical fact of a Ring of Fire: Watch the string.

And there was a tremor in China again.

Bait and Switch

If I could explain monetary policy using mainly actual English words, would you still rather slit your wrists than read it?

Tough one, huh. As you consider it, people everywhere are wondering if the Federal Reserve will lift interest rates in June. You’ve no doubt heard the chatter at the grocery store and in line at Starbucks.

No? Well, since the Fed looms over the stock market like a thunderhead on the plains, we better weigh it too. Whatever the Fed decides, it’ll be contradictory.

Here’s why. Suppose you got a credit card with a low introductory rate meant to encourage you to use it. You rack up bills at Nordstrom and Amazon. To thank you for doing as it hoped – spending – your card company raises the rate.  Now you’re paying a lot more interest.  So you spend less, to the dismay of Nordstrom and Amazon.

The Fed is the credit card company and you and your spending beneficiaries are the economy. But where the credit-card company wants future income via interest on your spending, the Fed hopes sustained teaser rates will drive permanent growth by causing businesses to hire people and make more stuff.  Ah, but teaser-rate spending is temporal.

The logical hard-drive crash gets worse. The Fed follows how much you make and spend. To track inflation, it meters the latter with what’s called “Personal Consumption Expenditures” (PCE). But PCE is also the largest part of how we measure economic growth. How can it be both?

Good question – and one I’ve not heard an economist ask a central banker. But it implies that much of GDP is just higher prices. Your money doesn’t go as far as it did.

Think about it. The Fed on one hand targets inflation around 2% (PCE is 1.6%), trying to create it with teaser-rate credit-card spending. But if it passes 2%, then the Fed wants to slow it down – and yet personal consumption is key to economic growth.

The credit card company must say when your teaser rate ends.  The Fed?  It’s kept everyone guessing, periodically yanking us this way or that, for seven years. Perhaps the reason the Fed is in a logical do-loop is because measuring consumption as both growth and inflation is an impossible balancing act.

Economic growth was 0.5% in the first quarter, and PCE is 1.6%.  If prices are rising faster than economic growth, isn’t that actually contraction?  Rising debt and rising prices are the enemies of prosperity because they diminish the capacity of consumers to buy things. Yet the Fed encourages rising debt and rising prices.

No wonder the stock market is consumed with arbitrage. And now, US consumers have as much debt as in 2007 but can afford it less because money doesn’t go as far.

What should the Fed do? Raising rates is baiting and switching. Not raising is robbing savers (and inflation steals from everyone). The Fed should not have offered a seven-year teaser rate without telling anyone. But the damage is done. Let’s stop.  Purchasing power is the engine of wealth, so we need monetary policy that preserves the value of money – the opposite of current programs. Let’s reverse course.

Hard? Yes. But it beats a do-loop of rising prices and rising debt.