Times and Seasons

You need examples.

I was wishing a longtime friend who turns 50 Sep 20 a happy what they call on Game of Thrones “Name Day,” and it called to mind those words. We were college freshmen 31 years ago – how time flies – and I thought back to my Logic and Philosophy professor.

He’d say in his thick Greek accent, “You need examples.  You cannot illustrate anything well with merely theory, nor can you prove something without support.”

In the stock market, examples are vital for separating theory from fact. And for helping investor-relations professionals and investors alike move past thinking “the market is complicated so my eyes glaze over” to realizing it’s just a grocery store for stocks.

With a rigid set of prescribed rules for consumers.  You can watch consumers comply. Some race around the store grabbing this or that. Others mosey the aisles loading the cart.

Timing plays a huge role. It’s not random.

I’ll give you an example.  Monday I was trading notes with a client whose shares are Overbought, pegging ten on our 10-point Sentiment scale, and 65% short.

Okay, here we go. What does “Overbought” mean? Let’s use an analogy. You know I love using spinach, right.  Overbought means all the spinach on the grocery store shelf is gone.  If the store is out of spinach, people stop consuming spinach.

What alone can override an overbought spinach market is willingness to pay UP for more spinach by driving to another store. Most consumers won’t. They’ll buy something else.

All analogies break down but you see the point?  We can measure the interplay of price and behaviors in shares so we know when they’re Overbought, Oversold, or about right — Neutral.

Now let’s introduce timing into the equation.  Monday was the one day all month with new options on stocks and other securities officially trading.  Our example stock was up 4%.  Yet it’s Overbought and 65% short.

What’s “65% short?”  That means 65% of trading volume is coming from borrowed shares. Traders are borrowing and selling shares every day to profit on short-term price-changes. It’s more than half the trading volume.

A quick and timely aside here:  We were in Chicago Friday for the NIRI chapter’s annual IR Workshop and the last panel – an awesome one spearheaded by Snap-On’s Leslie Kratcoski, an IR superstar – included the head of prime brokerage for BNP Paribas.  Among many other things, prime brokers lend securities. BNP is also a big derivatives counterparty.

Those elements dovetail in our example. The stock was Overbought and 65% short yet soared 4% yesterday. Short squeeze (forced buying), yes. But we now know WHY.

News didn’t drive price up 4%.  It was a classic case of big moves, no news. One could cast about and come up with something indirect. But let’s understand how the grocery store for your shares continuously reveals purpose.

The CONDITIONS necessary for the stock to move up 4% existed BEFORE the move.  This is why it’s vital to measure consistently.  If you’re not measuring, you’re guessing.

Why would the stock soar with new options trading?  There is demand for derivatives tied to the company’s stock. Parties short had to buy in – cover positions.  Why? Because the counterparty needed shares to back new derivatives positions (naked puts or calls are much riskier).

The stock jumped 4% because that’s how much higher the price had to move to bring new spinach, so to speak, into the market, the grocery store. Nobody wanted to sell at current prices – the stock was Overbought. Up 4%, sellers were induced to offer shares.

On any other day of the month these events would not have coalesced. I suspect hedge funds behind the bets had no idea their cloak of secrecy would be yanked off.

Once you spend a little time measuring and understanding the market, you can know in a minute or two what’s setting price. And now we know to watch into October expirations because hedge funds have made a sizeable bet, likely up (if they’re wrong they’ll be sellers ahead of expirations – and we’ll watch short volume).

Speaking of timing, options expirations for September wraps officially today with VIX and other volatility trades lapsing. The market has been on a tear. Come Thu-Fri, we’ll get a first taste of autumn.  Next week brings window-dressing for the month and quarter.

Our Sentiment Index marked a double top through expirations. About 80% of the time, an up market into expirations is a down market after, and with surging Sentiment, down could be dramatic say five or so trading days from now.

You’ll have to tell me how it goes! Karen and I are off to mark time riding bikes from Munich to Salzburg through the Bavarian Alps, a way to measure my impending 50th birthday next month.  We call it The Four B’s:  Beer, bread, brats and bikes. We’ll report back the week of Oct 9.

A Big Deal

Tim, I’m listening,” said this conference attendee, “and I’m wondering if I made the wrong career choice.” He said, “Am I going to be a compliance officer?”

We were in Boston, Karen and I, marking our wedding anniversary where the romance began: at a NIRI conference, this one on investor-relations fundamentals for newbies. I was covering market structure – the behavior of money behind price and volume – and what’s necessary to know today in IR (it wouldn’t hurt investors to know too).

It prompts reflection. The National Investor Relations Institute’s program on the fundamentals of IR that Karen and I both attended over a decade ago differed tectonically. Then, most of the money in the market was fundamental.

Companies prided themselves on closing the books fast each quarter and reporting results when peers did – or quicker.  I remember Tim Koogle hosting thousands on the Yahoo! earnings call about a week after quarter-end, the company setting a torrid pace wrapping financial results and reporting them.

Most of the money was buying results, not gambling on expectations versus outcomes. There were no high-frequency traders, no dark pools, limited derivatives arbitrage, no hint yet that passive investment using a model to track averages instead of paying humans to find better companies would be a big deal.

I’ve over these many years moved from student to faculty. I had just described the stock market today for a professional crop preparing to take IR reins, no doubt among it those who years from now will be the teachers.

I explained that the stock market possesses curious and unique characteristics. When you go to the grocery store and buy, say, a bag of spinach, you suppose the price on it is the same you’ll pay at the cash register. Imagine instead at the checkout stand the price you thought you were paying was not the same you were getting charged.

Go another step further. You had to buy it by the leaf, and someone jumped ahead of you and handed you each leaf, charging a small fee for every one.

That’s the stock market now. There is always by law a spread between the bid to buy and offer to sell, and every interaction is intermediated so regulators have a transaction trail.

I explained to the startled attendees unaware that their shares were priced this way that in my town, Denver, real estate is hot. Prices keep rising. People list houses for sale – call it the best offer to sell – and someone will offer a higher price than asked.

In the stock market today, unlike when I began in the profession, it’s against the law for anyone to bid to buy your shares for a price greater than the best offer. That’s a crossed market. Nor can the prices be the same. That’s a locked market. Verboten.

So in this market, I said, trillion of dollars have shifted from trying to find the best products in the grocery store to tracking average prices for everything. This is what indexes and exchange-traded funds do – they track the averages.

By following averages and cutting out cost associated with researching which things in the grocery store are best, money trying to be average is outperforming investors trying to buy superior products. So it’s mushroomed.

And, I said, you can’t convince the mathematical models tracking the averages to include you.  You can only influence them with governance – how you comply with all the rules burdening public companies these days, even as money is ignoring fundamental performance and choose average prices.

That’s when the question came.  See the first paragraph.

I said, “I’m glad you asked.”  Karen says I need to talk less about the problems in our profession and more about the opportunities.  Here was a chance.

“It’s the greatest time in history to be in our profession,” I said.

Here’s why. Then, we championed story, a communications job. Today IR is a true management function because money buying story is only a small part of volume. IR demands data and analytics and proactive reporting to the management and Board of Directors so they recognize that the market is driven as much by setting prices as it is by financial results.

There are $11.5 trillion of assets at Blackrock, Vanguard and State Street alone ignoring earnings calls and – importantly – the sellside.  IR courts investors and the sellside.

It’s time to expand the role beyond the message. Periods of tectonic change offer sweeping professional opportunity. Investors should think the same way: How does the market work, who succeeds in it and why, and is that helpful to our interests?

IR gets to answer that question.  It’s a big deal.  Welcome to the new IR.

Acronym Techniques

The stock market is full of acronyms.

Last month, Chicago-based DRW bought Austin’s RGM. It’s a merger of fast giants – or ones who thought they might be giants (opaque musical reference) and once were, and might be again.

You see a lot of acronyms in the high-speed proprietary trading business. Getco became KCG, now Virtu.  HRT remains one of the biggest firms trading supersonically – Hudson River Trading.  TRC Markets is Tower Research. There’s GTS. IMC.  EWT is gone, absorbed by high-speed firm Virtu.

Vanished also is ATD, the pioneering electronic platform created by the founder of Interactive Brokers bought first by Citi and then by Citadel, another high-speed firm.  Mantara bought UNX.

If I missed any vital acronyms, apologies.

RGM embodied HFT – high frequency trading, another acronym. Robbie Robinette studied physics at the University of Texas. Richard Gorelick is a lawyer, and in today’s markets one of the letters of your trading acronym should be backed by jurisprudence.  It’s all about rules. Mark Melton wrote artificial intelligence software.

They were RGM. They built trading systems to react to real-time events. We estimate the peak was 2010. They were crushing it, perhaps making hundreds of millions.  By 2012 in the data we track they’d been passed by Quantlabs, HRT and other firms.

Donald R. Wilson in 1992 was a kid trading options in Chicago when he founded DRW. Today it’s a high-speed trader in futures across 40 global markets with 750 employees, real estate ventures, and a major lawsuit with the Commodities Futures Trading Commission that seeks to bar Wilson from the industry.  Oral arguments were heard in December and the parties await word. DRW confidence must be high. They’re a buyer.

What does it mean for you, investors and public companies? History teaches and so we return to it.

From the early 1990s when both Don Wilson and I were youngsters out of college (we’re the same age so what am I doing with my life?) until roughly 2005, software companies called “Electronic Communications Networks” pounded stock exchanges, taking perhaps half the trading business.

The exchanges cried foul, sued – and then bought and became the ECNs. Today’s stock market structure in large part reflects the pursuit of speed and price, which began then. The entire structure has become high speed, diminishing returns for the acronyms.

Exchange are still paying close to $3 billion in annual trading rebates, incentives to bring orders to markets. Yet the amount earned by high-speed firms has imploded from over $7 billion by estimates in 2009 to less than $1 billion today.

Where are dollars going? Opportunity has shrunk as everyone has gotten faster. Exchanges and brokers that are still the heart of the market ecosystem have again adapted as they did before, becoming the acronyms that ae disappearing.  They are Speed.

Exchanges are selling speed via colocation services, and the data that speed needs. And big brokers with customers have learned to apply high-speed trading methods – let’s call them acronym techniques – to offload risk and exposure when they’re principals for customer orders.

There’s nothing illegal about it. Brokers are free to transfer risk while working orders. But now they can make money not via commissions but in offsetting risk with speed.

And speed is the opposite of the way great things are created.  Your company’s success is no short-term event.  The Neuschwanstein Castle in Bavaria (which we will visit on our cycling trip in the Bavarian Alps later this month) took 23 years to complete.

Your house. Your career.  Your investment portfolio. Your reputation. Your relationships.  Your expertise. Your craft.  What of these happened in fractions of seconds? Technology should improve outcomes but more speed isn’t always better.

Acronyms of high-speed trading have slipped yes, but remain mighty – 39% of US stock market volume the past five days. Fifteen are still pounding pulp out of prices.

But increasingly investors are adopting speed strategies driven by quick directional shifts. We are exchanging patience and time for instant gratification.

With that comes risk. As the acronyms wane in ranks the chance of a sudden shock to equity prices increases, because prices in the market depend on short horizons.

And your stock is an acronym.

Harvey Market Structure

We’ve said many prayers for friends, family and colleagues in Texas and Louisiana and will continue in the wake of Harvey. There’s a lesson from it about stocks today too.

Is paying attention to the weather forecast important?  The weather guessers were eerily accurate and I think most would agree that had Harvey hit without warning, outcomes would be factors more harrowing despite current widespread devastation.

The point of the forecasts was to prepare for outcomes, not to alter the path of the storm. Would that the latter were possible but it’s beyond our control. (Could we have lined up all the portable fans in Texas on a giant power strip fronting the gulf and blown that thing back to sea? No).

Just one thing drives me batty talking to public-company executives about market structure. It’s when they say: “If I can’t change it, why do I care about it?”

If we only measure what we can change, why do we track storms? Why mark birthdays?

In all matters human, measuring is the essential task underpinning correct conclusions, awareness, planning for the future, and separating what’s in our control from what’s not.

I’ll give you another comparative:  The solar eclipse on Aug 21.  Thanks to a rare preserved Mayan book called the Dresden Codex kept in Germany, it’s now been historically proven that Mayans could predict solar eclipses.

Their records written hundreds of years ago projected one July 11, 1991, long after they themselves were gone. Sure enough. It’s impressive that people who didn’t know the sun is 400 times larger than the moon or that the moon is 400 times nearer – creating a perfect match periodically – could do it.

But we can infer from archaeological records that they and others like the Aztecs may have used superior knowledge to dupe the less-informed.

More simplistically, a lack of understanding can produce incorrect conclusions. The fearful masses believed when the sun began to fade that the gods were angry. The rulers likely reinforced the idea to retain power.

If you don’t know an eclipse or a hurricane is coming in your shares, you conclude that a version of the angry gods explanation is behind a fall:  It must be something happening today, some news, misunderstanding of story, miscommunication by the IR team.

That’s generally untrue. Like hurricanes and eclipses, the stock market today is mathematical.  Human beings can push buttons to buy or sell things but trades are either “marketable,” or wanting to be the best buy or sell price, or “nonmarketable” and willing to wait for price to arrive.

Any order that is marketable must be automated, rules say. Automated trades are math. The market is riven with mathematical automated trades for all sorts of things and those trades, unless interdicted by something that changes, will perform in predictable ways, thanks to rules – like the ones that permit us to predict hurricanes and eclipses.

Without knowledge of those rules – market structure – you can be duped. And you are routinely duped by high-frequency traders who claim publicly to be “providing liquidity” when we observe with models all the time that they do the opposite, pushing prices higher when there are buyers and lower (and shorting stocks) when there are sellers.

If you’re routinely checking the weather forecast for your stock, you’re less likely to be duped. That’s Market Structure 101.

You may be dismayed to learn that most of your volume is driven by something other than your company’s fundamentals (unless you have lousy fundamentals, and indexes and ETFs don’t know and so value you the same as superior peers).  But you won’t be fooled again, to borrow as I’m wont to do, a song title.

The good news about market structure versus mother nature is that we can change market structure when enough of us understand that rules have been written to benefit intermediaries at the expense of investors and companies.  Knowing and seeing must come first – which requires measuring, just like satellites that tracked Harvey.

With nature, all we can do is prepare. But preparation in all things including market structure always beats its absence.

Hidden Volatility

Volatility plunged yesterday after spiking last week to a 2017 zenith thus far. But what does it mean?

“Everybody was buying vol into expirations, Tim,” you say. “Now they’re not.”

Buying vol?

“Volatility. You know.”

It’s been a long time since we talked about volatility as an asset class. We all think of stocks as an asset class, fixed income as an asset class, and so on.  But volatility?

The CBOE, Chicago Board Options Exchange, created the VIX to drive investment in volatility, or how prices change. The VIX reflects the implied forward volatility of the S&P 500, extrapolated from prices investors and traders are paying for stock futures. The lower the number the less it implies, and vice versa.

(If you want to know more, Vance Harwood offers an understandable dissection of volatility and the VIX.)

For both investor-relations professionals and investors, there’s a lesson.  Any effort to understand the stock market must consider not just buying or selling of stocks, but buying or selling of the gaps between stocks. That’s volatility.

It to me also points to a flaw in using options and futures to understand forward prices. They are mechanisms for buying volatility, not for pricing assets.

Proof is in the VIX itself. As a predictor it’s deplorable. It can only tell us about current conditions (though it’s a win for driving volatility trading). Suppose local TV news said: “Stay tuned for yesterday’s weather forecast.”

(NOTE: We’ll talk about trading dynamics at the NIRI Southwest Regional Conference here in Austin on Lady Bird Lake Aug 24-25 in breakout sessions. Join us!)

Shorting shares for fleeting periods is also a form of investing in volatility. I can think of a great example in our client base. Earlier this year it was a rock star, posting unrelenting gains. But it’s a company in an industry languishing this summer, and the stock is down.

Naturally one would think, “Investors are selling because fundamentals are weak.”

But the data show nothing of the sort! Short volume has been over 70% of trading volume this summer, and arbitrage is up 12% while investment has fallen.

Isn’t that important for management to understand? Yes, investing declined. But the drop alone prompted quantitative volatility traders to merchandise this company – and everyone is blaming the wrong thing. It’s not investors in stocks. It’s investors in volatility. Holders weren’t selling.

“But Tim,” you say. “There isn’t any volatility. Except for last week the VIX has had all the enthusiasm of a spent balloon.”

The VIX reflects closing prices. At the close, all the money wanting to be average – indexes and ETFs tracking broad measures – takes the midpoint of the bid and offer.

Do you know what’s happening intraday?  Stocks are moving 2.5% from average high to low. If the VIX were calculated using intraday prices, it would be a staggering 75 instead of 11.35, where it closed yesterday.

What’s going on? Prices are relentlessly changing. Suppose the price of everything you bought in the grocery store changed 2.5% by the time you worked your way from produce to dairy products?

Volatility is inefficiency. It increases the cost of capital (replace beta with your intraday volatility and you’ll think differently about what equity costs).  Its risk isn’t linear, manifesting intraday with no apparent consequence for long periods.

Until all at once prices collapse.

There’s more to it, but widespread volatility means prices are unstable. The stock market is a taut wire that up close vibrates chaotically. Last week, sudden slack manifested in that wire, and markets lurched. It snapped back this week as arbitragers slurped volatility.

It’s only when the wire keeps developing more slack that we run into trouble. The source of slack is mispriced assets – a separate discussion for later. For now, learn from the wire rather than the tape.  The VIX is a laconic signal incapable of forecasts.

And your stock, if it’s hewing to the mean, offers volatility traders up to 2.5% returns every day (50% in a month), and your closing price need never change.

When you slip or pop, it might be the volatility wire slapping around.  Keep that in mind.

Auctioning Profits

What’s the closing auction worth?

A member of the investor-relations profession last week posted a story for community discussion on a CBOE BATS proposal to open day-end auctions to exchanges that don’t have listings.

Right now rules say only the listing venue, largely the Nasdaq and the NYSE, can host end-of-day trades that many investors count on for prices that best track broad measures like the S&P 500 and Dow Jones Industrial Average.  BATS is trying to change it.

First, what’s the closing auction? Near the end of the trading day, exchanges that list stocks start providing data on buy and sell orders that want to get the last and best price.  All three big exchange groups host them – the NYSE, Nasdaq, BATS – and new entrant IEX has gotten tacit approval for its closing auction ahead of listings.

All three big groups have rules around what kinds of orders are included, but generally they are “market on close,” or a trade that takes the best price to buy or sell, or “limit on close” trades that only execute if the specified price matches the market.

BATS is the earliest in providing data and starts sending five-second updates on buy and sell imbalances at 3p ET. The NYSE and the Nasdaq follow at 3:45 and 3:50p ET respectively, also every five seconds.  Have you noticed how prices can change significantly in the last hour and especially last 15 minutes? There’s your reason.

Oversimplifying, right at 4p ET everywhere, buy and sell interest is matched at an average price. The NYSE calls it an auction, BATS uses a Dutch Auction (averaging all prices, excluding outliers) and the Nasdaq calls it the Closing Cross.

Now it gets interesting. This mass closing trade for NYSE stocks happens only at the NYSE and ditto for Nasdaq-listed shares.  BATS has proposed to the SEC that they be able to match trades in NYSE and Nasdaq stocks in the closing auction.

This at root is why exchanges want your stock-listing, public companies. It’s where the money is made.

The listing exchanges are outraged. Who can blame them? All the more when you understand the economics. Save at the open and close, trading at the exchange is a low-margin and often money-losing business.

They pay high-speed firms to set the best bid to buy or offer to sell. They’d flinch at my description but that’s the truth. Rules cap what exchanges can charge for trades at $0.30/100 shares.  But they can pay incentives well beyond that. The big exchanges have incentive tiers and platforms for high-volume customers paying up to $0.45/100 shares. They lose money on these.

Why would they do that? Because all trades in your stocks must match between the NBBO – the national best bid or offer. It’s a central tenet of Reg NMS, which governs markets. Exchanges pay some traders to be honey that attracts the bees.

The exceptions are the opening and closing auctions. Here, all the order flow ends up between the bid and offer by rule at some average price, and exchanges do not pay incentives because they have a monopoly in their listed stocks.

In fact, they charge about $0.09/100 to both the buyer and the seller ($0.18 total), meaning they make more in the auctions than any other time. Easy money.

Nearly 10% of trading occurs in the closing auction because it offers indexes and ETFs trying to “peg the benchmark” the best chance of getting prices nearest the index they’re tracking.

With about 6.5 billion shares trading daily marketwide and roughly 2.6 billion of it at the NYSE and Nasdaq, and 10% of that in the close, you can get to roughly $150 million of potential revenue annually for the big exchanges in these auctions. These are our estimates, mind.

But that’s not the half of it. Literally. Hosting the closing auctions drives two other vital revenue streams for big exchanges. First is a share of revenue from the Consolidated Tape Association.

The Tape Plan, as it’s called, divides revenue from data generated by stock tickers (you look up a ticker, you’re driving exchange revenue). It’s hundreds of millions of dollars yearly for members.  It’s apportioned by quote-share and trade-share in stock symbols. The closing auction gives the NYSE and Nasdaq a disproportionate part.

Second and data-related, prices from the closing auction comprise valuable data, and brokers are required to buy it to prove they matched best prices. The most precious product exchanges sell is data. And it’s vital to profits, since trading is a commodity.

The Nasdaq earned $108 million of net income in fiscal 2016, NYSE parent ICE, which is less reliant on equity trading, about $250 million. Take $250-$300 million (that they split) away – figuring data is double closing-auction trading revenue – by fragmenting the close, and the bottom line for both is hampered.

It’s an estimate. But follow the money and this is where it leads.

I can make the argument both ways. Fragmenting imbalance data by spreading the auctions out could mean mispricing. That to me is the leading argument against the BATS proposal.  Conversely, BATS would argue that it’s using the same pricing data so it merely increases access and removes an unfair advantage from listing exchanges – which could help you pay lower listing fees, issuers.

The bottom line is you need to know how the market works. Otherwise you cede control of it to parties wanting to profit on your prices.  That’s not in the best interest of your shareholders.

Time for Change

Seventy-two years ago today, the United States dropped the second atomic weapon in four days, bringing world war in Asia to dramatic conclusion.

Current relations with North Korea demonstrate the intractability of human nature. While human nature is unchanging, markets are the opposite. Yesterday famed bond investor Jeff Gundlach of DoubleLine Capital declared that his highest conviction trade is a bear bet on the S&P 500 and a bull bet on a higher VIX.

The VIX, the fear gauge, reflects implied volatility in the S&P 500 calculated by the CBOE via options. Everyone is short volatility, Mr. Gundlach says.  It can’t last he says.

Yet intraday volatility – the spread between average high and low prices during the trading day – has reached a staggering 2.9%. That’s 45% beyond the historical average of about 2%.  How can intraday prices reflect savaging by arbitragers while the VIX, predicated on closing prices, signals a placid surface?

One word: Change.  The market has been convulsed by it the past ten years.

Regulation National Market System in 2007 transformed the stock market into a foot race for average price. A year later, the global payments system heaved seismically.  High-frequency trading arced like fireworks on the 4th of July.

For public companies, reporting duties that ramped with Reg FD in 2000 and soared with Sarbanes-Oxley in 2002, were drenched yet more with Dodd-Frank in 2010.

At the same time that companies were being compelled to provide ever more information, investors were shifting by the trillions to indexes and exchange-traded funds that ignore fundamentals. Now, Blackrock, Vanguard and State Street, largely deaf to story, are top ten holders of nearly every US equity.

For public companies it’s been like paying to cater a party for a hundred and having your mom and brother show up. Stuck transfixed, frozen in time from the summer of 1975, was Form 13F.

You didn’t know where I was headed, did you!  Yesterday I had an earnest phone discussion with three professionals from the SEC (I’m leaking this information straight from the source, no anonymity required).  They were good listeners and interlocutors, nice people, and genuinely interested folks.

The discussion happened because I’d earlier sent a note to new SEC Chair Jay Clayton saying there was no more urgent need in the equity market than the modernization of Form 13F. Within a week I heard from two different SEC groups. That says the new SEC chair cares about you, public companies.

I shared my written testimony (thank you, Joe Saluzzi at Themis Trading. None of us would be anywhere without you and Sal.) from the June House Financial Services Committee hearing, highlighting one thing:

It’s been 42 years since we updated disclosure standards for investors.  This is not human nature we’re talking about, something timeless, changeless. It’s keeping up with the times – and we’re not.  The SEC chair who gets these standards current with how markets work is an SEC chair who goes down in history for changing the world.

I said the same to the three SEC staffers. I said, “There is no greater goodwill gesture regulators could extend to companies, which have borne ever higher compliance costs for coming on 20 years now even as the ears of investors have gone deaf, than helping them know in timely fashion who owns, and shorts, shares.”

They said, “Investors will push back.”

I said, “Dodd-Frank orders disclosures of short positions monthly. It hasn’t yet been implemented, and we don’t know what Dodd-Frank will be in coming years. But one thing is clear:  Congress thought monthly short disclosure was fine. Are we then to have long positions disclosed 45 days after quarter-end? That’s cognitively dissonant.”

They didn’t demur.

I said, “Companies fear you, you know that? You need to make it clear that you want them to engage. General counsels are loath to see their companies’ names in the same sentence as your acronym. You need to let them know you want to hear from them.”

They said, “We absolutely want to hear from companies.”

They think there’s merit to a stock market issuer advisory committee, another suggestion we offered Congress in June. This SEC edition wants to see business thrive. It’s the agenda.

Do we realize how great an opportunity for change is in front of us?  It’s that big, public companies. You could know at last, after 42 long years, who owns your shares every month, and who is long or short.  The world the way it is.

How to make it happen?  Not us. We’re market structure experts. Not policy experts. You’ve got to get behind NIRI, our professional association.

I bet if a thousand companies asked the SEC to ask Congress to make 13Fs monthly…it would happen in the next two years.  Maybe one.

It’s time for change.

Livermore Lesson

A guy from Cumbria in the UK has built a Twitter Tape Machine.

Programmer Adam Vaughan was long intrigued by ticker tape, the stock market technology standard from 1869, when Thomas Edison patented a version better than inventor Edward Calahan’s, until the 1960s when TV and computers made paper tape spitting out price and volume for stocks obsolete.

Mr. Vaughan built his device from spare parts and networked it to check his Twitter feed every thirty seconds and burn anything new onto a strip of thermal cash-register paper. No ink. No checking the device. Tear off the strip and read.

It’s a goofy idea. Isn’t it better to scroll a phone screen with your index finger?  But you can order the Twitter Tape Machine if you’re moved.

Sometimes we need absurdity to shine brightly before we see things.  Nobody reads ticker tape anymore. And yet. Price and volume scrolling on screens is still the standard.

Jesse Livermore started trading stocks in 1891 after working as a board boy transferring figures from ticker tape to the quotation board at Paine Webber. In his tumultuous life speculating in stocks, he famously made $100 million shorting the 1929 crash – the equivalent today, using an income measure of worth, of about $7 billion.

He’d be the John Paulson, the George Soros, of then. Before the riches, on May 9, 1901 Livermore lost $50,000. He later said, “The ticker beat me by lagging so far behind the market. The divergence between the printed and the actual prices undid me.”

A hundred years ago the top high-frequency trader of his time saw opportunity in the gap between posted and actual prices. Today we call that “latency arbitrage,” one form of profiting on price-differences by spotting lagging price patterns. You need machines in the National Market System to win the gap trade, and firms like Tower Research and Hudson River Trading have made it an automated science.

Livermore made and lost fortunes, going bankrupt three times, living large and then committing suicide in 1940, saying in a note his life was a failure. Ticker tape won in the end.

But Livermore was an outlier. Most of the prices and volume on the tape then came from committed investment.  It’s to me fantastically ironic that the SEC was formed in the 1930s to mitigate nefarious “bucket shop” short-term manipulation – and now under a heavy regulatory regime half the market’s volume is a form of exploitation via short-term price-moves. Every one of those costs you minutely, investors and companies.

Leveraged ETFs, investment funds sanctioned by the SEC that use derivatives to deliver one-day directional bets, are arbitrage. Speed traders exploiting slow and fast prices, intraday volatility, divergences from the mean tracked by passive investments, are arbitraging, profiting on price-differences.

Where Livermore was on the cutting edge in 1929 shorting stocks, today 45% of ALL daily market volume is short – from borrowed shares.  Routinely now we see shorting running up as prices rise and down as prices fall. Traders make money via a sort of above-the-surface, below-the-surface trade that works best in a placid VIX environment.

If speculators exploit the tape – price and volume – why do price and volume remain the convention for measuring what investors think? In a market riven with arbitrage?

On every investor-relations website are displayed price and volume. Ticker tape. As if that connotes fair value when we know so much volume, the relentlessly changing prices (our clients average 14,000 trades daily – 14,000 theoretical different prices!), reflect arbitrage.

It’s absurd if you think about it. In 1901 Jesse Livermore could exploit patterns in the tape, and the tape showed price and volume. In 2017, price and volume remain the key data points public companies use to measure the market. But exploitation has exploded.

Investors and public companies alike should be going BEHIND price and volume to the patterns, trends, drivers. Price and volume are consequences. Patterns are the future for well-informed constituents. I suspect even Jesse Livermore would agree.

Our new Key Metrics Report released yesterday for clients puts the focus not on price and volume but six metrics stacked by period, so one can see when the Livermores are leading, or Active investors committed to story.  Instead of searching the tape, scroll to see patterns in Rational Price, Engagement, Short Volume, Key Behavior, Sentiment.

Best, patterns signal what’s coming. There are patterns in weather, patterns in stocks, because mathematical principles govern both. And all things in this universe.

I imagine a day when on websites everywhere are Rational Prices instead of just market price and volume.  And more. But one step at a time!  First, learn your patterns. It’s the future. Price and volume are prologue, like the past.

Earning the Answers

It’s 8am Eastern Time and you’re in a conference room. Earnings season.

Executives around the table. The serious ones in suits and ties like usual. Others in shorts or jeans. Everybody reading the call script one more time. 

“You think we’ll get that question about inventory levels?” the COO says. 

“What’s the stock gonna do today?” says your CEO. 

All of us who’ve been in the investor-relations chair understand the quarterly grind. We practice, prepare, canvass probable questions, rehearse answers.  Try to get the execs to read the script aloud. We listen to competitors’ calls, seeking key queries.

Yet 85% of the volume in the market is driven by money paying no attention to calls.

“Not during earnings,” you say. “Active money is the lead then.” 

If it is, that’s a victory. It’s an anecdotal observation rather than hard statistical fact, but my experience with the data suggests less than 20% of public companies have Active money leading as price-setter on earnings days. 

I’m reminded of a classic example. One of our clients had screaming Sentiment – 10/10 on our index, slamming into the ceiling – and 68% short volume ahead of results. We warned that without the proverbial walk-off grand slam, nothing would stop a drop. 

Active money led, setting a new Rational Price, our measure of fair value, though shares closed down. In proceeding days the stock lost 8%. It wasn’t the story. It was the sector. Tech tanked. And shorting. And Sentiment.

Which leads us back to the carefully crafted earnings call. We’ve got a variety of clients with Activist investors, and I’ll give you two sharply contrasting outcomes that illustrate the importance of the answer to both your COO’s and CEO’s questions. 

One has been slashing and burning expenses (it’s what you do when somebody horns in with money and personality).  Still, heading into the call shorting was 69% and investors were wary. The company has a history of sharp pullbacks on results.

The only bull bets were from machines that leveraged hard into shares. No thought, just a calculated outcome.

Did you see the Wall Street Journal article yesterday on a massive VIX bet?  Some anonymous trader has wagered about $265 million that the VIX will be over 25 in October.  The trader could win big or lose big.

It’s the same thing. Traders, both humans and machines, bet on volatility, exacerbated by results.  Fast Traders wagered our client would jump about 8% (we could forecast it).  They were right. The buying that drove initial response came from quantitative money. Machines read the data and bought, and shorting dropped 20% in a day.

Rational investors have since been profit-takers.  Price moved so much on bets that buy-and-hold money turned seller.

In the other instance, price fell 15%. Risk Management was 15% of market capitalization ahead of the call because Activism tends to boost the value of the future – reflected in derivatives. But Activists have short attention spans. If you’re two quarters in without any meaningful catalyst, you’re asking for trouble.

Well, that was apparent in the data. They were 60% short every day for 50 days ahead of results, the equivalent of a tapping foot and a rolling eye. If you don’t give that audience a catalyst they’re going to take their futures and forwards and go home. 

Results missed and management guided down, and ALL of that 15% came out of market cap. Investors didn’t sell? No. How does it help long money to sell and slaughter price? They’d wreck months or years of commitment in a minute.

But the future was marked to zero because event-driven money dropped its rights to shares. And 15% of market cap held that way vanished.

The degree of uncertainty in all prices, not just ones at earnings season, are increasing because machines are betting on volatility, long and short, price-spreads.

It’s not rational. It’s gambling. Moral of the story? Prepare well, yes.  But prepare proportionally.  Keep it simple. A minority of the money listens now and cannot overcome the power of arbitrage (we need a better market. Another story.).

You might recoil at the idea. But if the market has changed, shouldn’t we too? Correlate outcomes to effort. Learn market structure. Measure the money. Set expectations. Prepare. But prepare wisely. Efficiently. Don’t confuse busy with productive.  

For your COO, the answer is yes, we’ll get that question, and for your CEO, the answer probably has no bearing on how shares will behave. Keep the answer short. (And yes, we can forecast how shares will behave and what will set price. Ask us.)

Realistic Expectation

How do you set realistic expectations about your shares for management?

I’ll give you examples.  One of our clients had a cyberattack and disclosed the impact, a material one degrading expected quarterly results.  What to expect?

Shares are up on strong volume.

That’s great but it makes execs scratch their heads. And the reverse can happen.

“The division heads tell their teams that growth will translate into share-price gains,” the investor-relations director told me. “They deliver, and the stock goes down 7%.”

I was having this conversation in Silicon Valley.  In fact, I had it twice the same day.

It illustrates a market transformation affecting investor-relations and investors. Fundamentals cannot be counted on to drive corresponding shareholder value.  Active stock-pickers and IR professionals have been slow to adapt, harming outcomes for both.

I was at the whiteboard in a conference room with another technology IR head, who was comparing revenue and margin drivers for his company and its key peers.

“How do I get these numbers to translate into the share price?” he said.

“You’re making the job harder than it has to be today,” I said. “And you might create unrealistic expectations from management for IR and for the company.”

There’s one more implication (we’ll answer them all before we wrap). Things like stocks behaving unexpectedly shouldn’t be ignored or glossed over.

For example, we found water dripping from the air-handler housing in the basement for the central air-conditioning system at our house. Great timing. July.

We could say, “Huh. That’s not what we were expecting.” And go on about what we’re doing.  But that’s a poor strategy, leaving us open to bigger troubles ahead.

When your stock doesn’t act as you expect, it’s water dripping from your air-handler, telling you, IR folks and investors, you’re missing something vital about the market.

Admit it.  Most of us know the market has got a drippy coil. But we go on with what we’ve been doing. We’d rather ignore the leak in the basement than address it.

For whom is that bigger trouble?  Your management team, IR. And your returns, investors. We should change what we’re doing, and revise expectations.

“I don’t want expectations for our stock,” you say. Would a board hire a CEO candidate who said, ‘Don’t expect anything from me’?

Back to our examples. In the cyberattack, Active money bought the news (bad clarity trumps okay uncertainty) but passive investment drove subsequent gains. The IR head appropriately differentiated the two and set expectations about trends and drivers. That’s good 21st century IR.

In the second example, don’t let the notion that growth will drive appreciation become an unmet expectation. Growth may boost the stock. But the IR Officer can go on the offensive with internal presentations showing how the market works and what role Story plays in setting price.

It’s up to IR to help management understand. If 80% of the time something besides Story sets price, doesn’t everybody internally have a right to know?  Don’t disillusion the team by letting incorrect expectations survive. That’s bigger trouble.

At the whiteboard with our IRO wanting to get the market to value results better, what about doing the opposite? It’s easier, less stressful, data-driven. Let the market tell YOU what it values. If 20% of the market values your numbers, measure when that 20% sets price. (We do that with Rational Price and Engagement metrics.)

Then measure how the rest of the money behaves that doesn’t pay attention to Story, and show your management team its trends and drivers. Now you’ll know when it’s about you, your management team will have data-driven views of what the money is really doing, and you, there in the IR chair, will have wider internal value.  And less stress.

That’s the right kind of realistic expectation.

What’s the market’s leaky coil? Two things.  Passive investment is asset-management, not results-driven stock-selection. Prices expand or contract with the rate of capital inflows and outflows for indexes and ETFs. You don’t control it. It controls you.

And over 50% of daily volume comes from fleeting effort to profit on price-differences or protect and leverage portfolios and trades (often in combo). It prices your stocks without wanting to own them.

And speaking of expectations, options are expiring today through Friday. It’s rarely about you when that’s happening. Set that realistic internal expectation (and stop reporting results the third week of each new quarter).