Collateral

I apologize.

Correlation between the market’s downward lurch and Karen’s and my return Sunday from the Arctic Circle seems mathematically irrefutable.  Shoulda stayed in Helsinki.

I wouldn’t have minded more time in the far reaches of Sweden and Finland viewing northern lights, sleeping in the Ice Hotel, riding sleds behind dogs, trekking into the mystic like Shackleton and Scott, gearing up for falling temperatures.  We unabashedly endorse Smartwool and Icebreaker base layers (and we used all we had).

Back to the market’s Arctic chill, was it that people woke Monday and said, “Shazam! This Coronavirus thing is bad!”

I’m frankly stupefied by the, shall we say, pandemic ignorance of market structure that pervades reportage.  If you’re headed to the Arctic, you prepare. If you raise reindeer, you’ve got to know what they eat (lichen). And if you’re in the capital markets, you should understand market structure.

There’s been recent talk in the online forum for NIRI, the investor-relations association, about “options surveillance.”   Options 101 is knowing the calendar.

On Aug 24, 2015, after a strong upward move for the US dollar the preceding week, the market imploded. Dow stocks fell a thousand points before ending down 588.

New options traded that day.  Demand vanished because nothing stresses interpretations of future prices – options are a right but not an obligation to buy or sell in the future – like currency volatility.

Step forward.  On Monday Feb 24, 2020, new options were trading.

Nobody showed up, predictively evident in how counterparty trading in support of options declined 5% the preceding week during expirations. Often, the increase or decrease in demand for what we call Risk Management – trades tied to leverage, portfolio insurance, and so on – during expirations is a signal for stocks.

Hundreds of trillions of dollars of swaps link to how interest rates and currency values may change in the future, plus some $10 trillion in equity swaps, and scores of trillions of other kinds of contracts. They recalibrate each month during expirations.

They’re all inextricably linked.  There is only one global reserve currency – money other central banks must own proportionally. The US dollar.

All prices are an interpretation of value defined by money. The dollar is the denominator.  Stock-prices are numerators.  Stronger dollar, smaller prices, and vice versa.

The DXY hit a one-year high last week (great for us buying euros in Finland!).

Let’s get to the nitty gritty.  If you borrow money or stocks, you post collateral.  If you hawk volatility by selling puts or calls, you have to own the stock in case you must cover the obligation.  If you buy volatility, you may be forced to buy or sell the underlying asset, like stocks, to which volatility ties.

Yesterday was Counterparty Tuesday, the day each month following the expiration of one series (Feb 21) and the start of a new one (Feb 24) when books are squared.

There’s a chain reaction. Counterparties knew last week that betting on future stock prices had dropped by roughly $1 trillion of value.  They sold associated stocks, which are for them a liability, not an investment.

Stocks plunged and everyone blamed the Coronavirus.

Now, say I borrowed money to buy derivatives last week when VIX volatility bets reset.  Then my collateral lost 4% of its value Monday. I get a call: Put up more collateral or cover my borrowing.

Will my counterparty take AAPL as collateral in a falling market?  Probably not. So I sell AAPL and pay the loan.  Now, the counterparty hedging my loan shorts stocks because I’ve quit my bet, reducing demand for stocks.

Volatility explodes, and the cost of insurance with derivatives soars.

It may indirectly be true that the cost of insurance in the form of swap contracts pegged to currencies or interest rates has been boosted on Coronavirus uncertainty.

But it’s not at all true that fear bred selling.  About 15% of market cap ties to derivatives.  If the future becomes uncertain, it can be marked to zero.  Probably not entirely – but marked down by half is still an 8% drop for stocks.

This is vital:  The effect manifests around options-expirations. Timing matters. Everybody – investors and public companies – should grasp this basic structural concept.

And it gets worse.  Because so much money in the market today is pegged to benchmarks and eschews tracking errors, a spate of volatility that’s not brought quickly to heel can spread like, well, a virus.

We’ve not seen that risk materialize in a long while because market-makers for Exchange Traded Funds that flip stocks as short-term collateral tend to buy collateral at modest discounts. A 1% decline is a buying opportunity for anyone with a horizon of a day.

Unless.  And here’s our risk: ETF market-makers can substitute cash for stocks. If they borrowed the cash, read the part on collateral again.

I expect ETF market-makers will return soon. Market Structure Sentiment peaked Feb 19, and troughs have been fast and shallow since 2018. But now you understand the risk, its magnitude, and its timing. It’s about collateral.  Not rational thought.

The Mock

Does it matter where stock-trades occur, investors and public companies?

It does to the stock exchanges.  The explosion in passive investing has driven trades toward the last price of the day, found in stock-exchanges’ closing auctions.

Why?

Index and Exchange-Traded Funds need to track a benchmark in most cases. The bane of passive investing is skewing from the mean, called a tracking-error. The last price of the day is the reference price, the official one.  Money pegging a benchmark wants it.

It’s been profitable business for the big exchanges because they charge the same price to buy or sell into the close. Often at other times there’s a fee to buy but a credit to sell (they say “adding and removing” but don’t get lost in the jargon).

Orders to buy or sell may be “market-on-close,” (we’ll call it “the mock”) meaning at the best bid to buy or offer to sell as determined by matching up supply and demand, or “limit-on-close,” orders buying or selling at a specific price or better to end the day.

If you’re nodding off now or looking for the latest news on who might’ve won the Iowa Caucus, stay with me. There’s an important market-structure lesson coming.

Cboe (the erstwhile Chicago Board Options Exchange) operates four stock markets and just received SEC approval to be part of the closing auction, formerly controlled by the NYSE for stocks listed there, and the Nasdaq for stocks listed there.

The auction will occur at Cboe’s BZX market, likely at a set fee per share. It’s important to know that BZX encourages orders to sell, paying $0.30 per hundred shares, or even $0.32 if the shares first came from retail traders.  That means firms like Two Sigma might buy trades for $0.15 from Schwab and sell them at BZX for $0.32.

Why would an exchange pay so much for a trade?  Because it sets the price – and that’s valuable data to sell, worth more than the cost of paying for the trade.

But I digress.

So the Cboe will now use prices from the NYSE and the Nasdaq to match trades market-on-close for reference purposes.  No short trades, no limit orders. Only what the market giveth or taketh away.

Naturally, the NYSE and the Nasdaq opposed the Cboe plan. We wrote about it all the way back in Aug 2017, describing the cash at stake then.  The biggies argued expanding access to the closing auction would fragment liquidity.

Anyone can use order types from all the exchanges to fill trades. What difference does it make where trades occur if the rules from the SEC say the behavior must be uniform?

It’s like those heist movies where the robbers huddle beforehand and say “synchronize watches.” The market is a collection of synchronized watches at the close.

But overlooked amid the market mumbo-jumbo are the effects on trading the rest of the time – and we need to understand, investors and public companies.

Phil Mackintosh, now chief economist at the Nasdaq and always an interesting read, says, “The data show there are a lot of other investors, traders and hedgers who are also using the close because it’s a cheap way to get sizable liquidity with minimal market impact.”

True enough, it’s not all passive. By the way, MSCI indexes rebalance for the quarter today. The issue to us is the way that much of the trading throughout the rest of the day is an effort to change the prices of big measures into the close.

Traders know money chases reference prices.  So they change prices the rest of the day by running stocks up or down, and trading index futures, options, options on futures, or baskets of ETFs, creating divergences to exploit.

This becomes the market’s chief purpose – skewing prices and bringing them back to the mean (the hubris here is a story for next time).  Everyone thinks it’s fundamentals when the behavioral data show how pervasive this short-term pursuit has become.

How to solve it? Disconnect markets. That alone would halve the arbitrage opportunity.

Since that won’t happen, the best defense is a good offense. Know what all the money is doing, all the time (we can help), and you won’t be fooled. Or mocked.

The Truth

You know it’s after Groundhog Day?  We passed Feb 2 and I don’t recall hearing the name Punxsutawney Phil (no shadow, so that means a reputed early spring).

Reminds one of the stock market. Things change so fast there’s no time for tradition.

We have important topics to cover, including the implications of the SEC’s recent decision to approve closing-auction trading at the CBOE, which doesn’t list stocks (save BATS).  Circumstances keep pushing the calendar back.

We said last week that the Coronavirus wasn’t driving stocks. It was market structure – measurable, behavioral change behind prices.

The Coronavirus is mushrooming still, and news services are full of dire warnings of global economic consequence.  Some said the plunge last Friday, the Dow Industrials diving 600 points, reflected shrinking economic expectations for 2020.

Now the market is essentially back to level in two days. The Nasdaq closed yesterday at a new record.  Did expectations of Coronavirus-driven economic sclerosis reverse course over the weekend?

It’s apparent in the Iowa caucuses that accurate outcomes matter.  The Impeachment odyssey, slipping last night into the curtains of the State of the Union address, is at root about interpretations of truth, the reliability of information, no matter the result.

We seem to live in an age where what can be known with certainty has diminished. Nowhere is it manifesting more starkly than in stocks.  Most of what we’re told drives them is unsupported by data.

A business news anchor could reasonably say, “Stocks surged today on a 10% jump in Fast Trading and a 5% decline in short volume, reflecting the pursuit of short-term arbitrage around sudden stock-volatility that created a broad array of cheap buying opportunity in derivatives.”

That would be a data-backed answer. Instead we hear, “Coronavirus fears eased.”

Inaccurate explanations are dangerous because they foster incorrect expectations.

The truth is, behavioral volatility exploded to 30% Feb 3, the most since Aug 2019. To understand behavioral volatility, picture a crowd leaving a stadium that stampedes.

Notice what Sentiment showed Feb 3. Sentiment is the capacity of the market to absorb higher and lower prices. It trades most times between 4.0-6.0, with tops over 7.0  The volatile daily read dropped below 4.0 Feb 3.

Cycles have shortened. Volatility in decline/recovery cycles is unstable.

Here’s the kicker. It was Exchange Traded Funds stampeding into stocks. Not people putting money to work in ETFs.  No, market makers for ETFs bought options in a wild orgy Monday, then caterwauled into the underlying stocks and ETFs yesterday, igniting a searing arc of market-recovery as prices for both options and ETFs ignited like fuel and raced through stocks.

That’s how TSLA screamed like a Ford GT40 (Carroll Shelby might say stocks were faster than Ferraris yesterday).  Same with a cross-section of stocks up hundreds of basis points (UNH up 7%, AMP up 6%, VMW up 4%, CAT up 4%, on it goes).

These are not rational moves. They are potentially bankrupting events for the parties selling volatility. That’s not to say the stock market’s gains are invalid.  We have the best economy in the world.

But.

Everyone – investors, investor-relations professionals, board directors, public-company executives – deserves basic accuracy around what’s driving stocks.  We expect it everywhere else (save politics!).

We’ll have to search out the truth ourselves, and it’s in the data (and we’ve got that data).

Disruption

What did you say yesterday to your executive team, investor-relations officers, if you’d sent a note Monday about mounting Coronavirus fears?

The market zoomed back, cutting losses in the S&P 500 to about 2% since Jan 17.  We said here in the Market Structure Map Jan 22 that data on market hedges that expired Jan 17 suggested stocks could be down about 2% over the proceeding week.

It’s been a week and stocks were down 2%. (If you want to know what the data say now, you’ll have to use our analytics.)

The point is, data behind prices and volume are more predictive than headlines.

NIRI, the professional association for IR, last year convened a Think Tank to examine the road ahead, and the group offered what it called The Disruption Opportunity.

If we’re to become trusted advisors to executive teams and boards, it won’t be through setting more meetings with stock-pickers but by the strategic application of data.

For instance, if Passive investment powering your stock has fallen 30% over the past 200 trading days, your executive team should know and should understand the ramifications. How will IR respond? What’s controllable? What consequences should we expect?

At a minimum, every week the executive team should be receiving regular communication from IR disruptors, a nugget, a key conclusion, about core trends driving shareholder value that may have nothing to do with fundamentals.

Take AAPL, which reported solid results yesterday after the market closed.  AAPL is the second most widely held stock in Exchange Traded Funds (there’s a nugget).  It’s over 20% of the value of the Tech sector, which in turn is nearly 24% of the S&P 500, in turn 83% of market-capitalization.

AAPL is a big engine (which for you cyclists is American rider Tejay van Garderen’s nickname).  And it always mean-reverts.

It may take time. But it’s as reliable as Rocky Mountain seasons – because the market is powered today by money that reverts to the mean. Over 85% of S&P 500 volume is something other than stock-picking.

AAPL has the widest mean-reversion gap in a half-decade now, with Passive investment down a third in the last week.  AAPL trades over 30 million shares daily, about $10 billion of stock. And 55% of that – 17 million shares, $5.5 billion of dollar volume – is on borrowed shares.

Those factors don’t mean AAPL is entering a mean-reversion cycle. But should the executive team and the board know these facts?  Well, it sure seems so, right?

And investors, would it behoove you to know too?

The Russell 1000 is 95% of market cap, the Russell 3000, over 99.9%.  That means we all own the same stocks.  You won’t beat the market by owning stocks someone else doesn’t.

How then will you win?  I’m coming to that.

IR pros, you’re the liaison to Wall Street.  You need to know how the market works, not just what your company does that differs from another. If your story is as good as somebody else’s but your stock lags, rather than rooting through the financials for reasons, look at the money driving your equity value.

Take CRM. Salesforce is a great company but underperformed its industry and the S&P 500 much of the past year – till all at once in the new year it surged.

There’s no news.  But behaviors show what caused it.  ETF demand mushroomed. CRM is in over 200 ETFs, and the S&P 500.  For a period, ETFs could get cheap CRM stock to exchange into expensive SPY shares, an arbitrage trade.  The pattern is stark.

Now that trade is done. CRM market structure signals no imminent swoon but Passive demand is down over 20% because there’s no profit in the CRM-for-ETFs swap now.

That fact is more germane to CRM’s forward price-performance than its financials.

This, IR pros, is your disruption opportunity in the c-suite. If you’re interested in seeing your market structure, ask and we’ll give you a free report.

Investors, your disruption opportunity isn’t in what you own but when you buy or sell it. Supply and demand rule that nexus, and we can measure it.   If you’d like to know about Market Structure EDGE, ask us.

Infected Stocks

Coronaviruses are common throughout the world. So says the US Centers for Disease Control and Prevention.

The market didn’t treat news of spreading cases in China and the first in the USA (from a Chinese visitor) that way though. Airline and gaming stocks convulsed yesterday.

There’s as ever a lesson for investor-relations practitioners and investors about how the stock market works now. News compounds conditions but is infrequently causal. Investors, there are opportunities in divergences. IR pros, you need to know what’s real and what’s ripple-effect, because moves in stocks may not reflect rational sentiment.

Airline and leisure stocks demonstrate it. Active Investment pushed airlines up 2.4% last week, industry data we track (with proprietary analytics) show.

But.

Shorting rose, and demand for derivatives used to protect or leverage airline investments fell 7% into last week’s options-expirations (know the calendar, folks). That’s a signal that with new options trading yesterday, counterparties would shed inventory in those stocks because demand for options was down.

Both facts – Active buying last week, weak demand for leverage – run counter to the narrative of investor-fear. The data say these stocks would have been down anyway and news is simply compounding what preceded it.

No doubt some investors knee-jerked to headlines saying investors were selling, and sold. But it’s not the cause. It’s effect.

We can’t isolate gaming in GICS data but leisure stocks shared behavioral characteristics with airlines. Investment was up last week, led by Passive money rather than Active funds (Active rose 2% too). But Risk Management, the use of leverage, declined 3%. And the pattern of demand changed.

What if the real cause for declines in these industries is the rising cost of leverage?

I’ll make my last plug for the book The Man Who Solved the Market. Near the end, one of Jim Simons’s early collaborators at Renaissance Technologies observes, “I don’t deny that earnings reports and other business news surely move markets. The problem is that so many investors focus so much on these types of news that nearly all of the results cluster very near the average.”

He added that he believed the narratives that most investors latch onto to explain price-moves were quaint, even dangerous, because they breed misplaced confidence that an investment can be adequately understood and its future divined.

I’ll give you two more examples of the hubris of using headlines to understand stocks. The S&P 500, like airline and leisure stocks, experienced a 2% decline in demand for derivatives into expirations last week. Patterns changed. Ten of eleven sectors had net selling Friday even as broad measures finished up.

If the market is down 2% this week – and I’m not saying it will fall – what’ll be blamed? Impeachment? Gloomy views from Davos? The coronavirus?

One more: Utilities. These staid stocks zoomed 4% last week, leading all sectors. They were the sole group to show five straight days of buying. We were told the market galloped on growth prospects from two big trade agreements.

So, people bought Utilities for growth?

No, not the reason. Wrapped around the growth headlines was a chorus of voices about how the market keeps going up for no apparent reason. Caution pushes investors to look for things with low volatility.

Utilities move about 1.4% daily between intraday high and low average prices. Tech stocks comprising about 24% of the S&P 500 are 2.6% volatile – 86% more!

Communication Services, the sector for Alphabet, Facebook, Twitter and Netflix, is 2.8% volatile every day, exactly 100% more volatile than Utilities.

The Healthcare sector, stuffed with biotechnology names, is 4.8% volatile, a staggering 243% greater than Utilities.

These data say low-volatility strategies from quantitative techniques, to portfolio-weightings, to Exchange-Traded Funds are disproportionately – and simultaneously – reliant on Utilities. If volatility spikes, damage will thus magnify.

IR people, you’ve got to get a handle on behaviors behind price and volume (we can show you yours!). Headlines are quaint, even dangerous, said the folks at Renaissance Technologies, who earned 39% after-fee returns every year for more than three decades.

Investors, you must, too (try our Market Structure EDGE platform). None of us will diagnose market maladies by reading headlines. The signs of pathology will be deeper and earlier. In the data.

Proportional Response

Proportional Response is the art of defusing geopolitical conflict.

Proportional Response is also efficient effort. With another earnings season underway in the stock market, efficient effort should animate both investment decisions, and investor-relations for public companies.

I’ve mentioned the book The Man Who Solved the Market, about Jim Simons, founder of Renaissance Technologies. There’s a point where an executive is explaining to potential investors how “RenTec” achieves its phenomenal returns.

The exec says, “We have a signal. Sometimes it tells us to buy Chrysler, sometimes it tells us to sell.”

The investors stare at him.

Chrysler hadn’t been a publicly traded stock for years (they invested anyway – a proportional response).

That executive – a math PhD from IBM – didn’t care about the companies behind stocks. It didn’t bear on returns. There are vast seas of money rifling through stocks with no idea what the companies behind them do.

RenTec is a quant-trading firm. Earnings calls are irrelevant save that its models might find opportunity in fleeting periods – even fractions of seconds – to trade divergences.

Divergences, tracking errors, are the bane of passive money benchmarked to indexes. If your stock veers up or down, it’ll cease for a time to be used in statistical samples for index and exchange-traded funds (ETFs).

And hedge funds obsess on risk-adjusted returns, the Sharpe Ratio (a portfolio’s return, minus the risk-free rate, divided by standard deviation), which means your fundamentals won’t be enough to keep you in a portfolio if your presence deteriorates it.

Before your eyes glaze over, I’m headed straight at a glaring point.  Active stock-pickers are machinating over financial results, answers to questions on earnings calls, corporate strategy, management capability, on it goes.

On the corporate side, IR people as I said last week build vast tomes to help execs answer earnings-call questions.

Both parties are expending immense effort to achieve results (investment returns, stock-returns). Is it proportional to outcomes?

IR people should have their executive teams prepared for Q&A. But let’s not confuse 2020 with the market in 1998 when thousands of people tuned to Yahoo! earnings calls (that was the year I started using a new search engine called Google).

It’s not 2001 when about 75% of equity assets were held by active managers and some 70% of volume was driven by fundamentals.

It’s 2020. JP Morgan claims combined indexed money, ETFs, proprietary trading and quant funds are 80% of assets. We see in our data every day that about 86% of volume comes from a motivation besides rational thought predicated on fundamental factors.

Proportional Response for IR people is a one-page fact sheet for execs with metrics, highlights, and expected Q&A.  The vast preparatory effort of 20 years ago is disproportionate to its impact on stock-performance now.

Proportional response for investors and public companies alike today should, rather than the intensive fundamental work of years past, now incorporate quantitative data science on market structure.

IR people, don’t report during options-expirations. You give traders a chance to drive brief and large changes to options prices. Those moves obscure your message and confuse investors (and cause execs to incorrectly blame IR for blowing the message).

Here’s your data science: Know your daily short-volume trends and what behaviors are corresponding to it, and how those trends compare to previous quarters. Know your market-structure Sentiment, your volatility trends, the percentages of your volume driven by Active and Passive Investment and how these compare to past periods.

Put these data in another fact sheet for your executive team and board.  Provide guidance on how price may move that reflects different motivations besides story (we have a model that does it instantly).

Measure the same data right after results and again a week and a month later. What changed? If you delivered a growth message, did growth money respond? That’s quantitatively measurable. How long before market structure metrics mean-reverted?

Investors, data science on market structure isn’t another way to invest. It’s core to predicting how prices will behave because it reflects the demographics driving supply and demand.

There are just a thousand stocks behind 95% of market cap. You won’t beat the market by owning something somebody else doesn’t. You’ll beat it by selling Overbought stocks and buying Oversold ones.  Not by buying accelerating earnings, or whatever.

The stock market today reflects broad-based mean-reversion interspersed with divergences. RenTec solved the market, we’re led to conclude, by identifying these patterns.  The proportional response for the rest of us is to learn patterns too.

What Matters

Happy New Year!

I hope you enjoyed our gift:  A two-week break from my bloviating!  We’d planned to run best-of columns and thought better, because everybody deserves a respite.

We relished the season in the Colorado mountains, as this album shows (see world-class ski-race video too).  If the album eludes you, this is Steamboat Springs 2020, and us on snowshoes, and the view up high where it’s always 3 o’clock (a superb ski run).

I’m thinking about 2020.  And I’m reading “The Man Who Solved the Market,” about quant hedge fund Renaissance Technologies, by Wall Street Journal reporter Greg Zuckerman.  You should read it, too.

About 47% in, my Kindle says, Zuckerman writes, “One day, a data-entry error caused the fund to purchase five times as many wheat-futures contracts as it intended, pushing prices higher.

“Picking up the next day’s Wall Street Journal, sheepish staffers read that analysts were attributing the price surge to fears of a poor wheat harvest.”

There’s so much going on behind stock-prices that’s something other than we think. The point for IR people and investors is why do we do what we do?

In fact, it’s a human question. We do things on the belief they count.

For instance, the quarterly “Q&A bible,” the compendium of earnings-call questions, dominated holiday discussion in NIRI eGroups.

Discourse is great.  But does all that preparatory effort matter?

If we’re spending the same time and effort in 2020 on earnings-call Q&A that we did in 2000, well, why?  In 2000, more than 70% of the money was rational. Today it’s 14%.

Tesla is up 42% the past year, which included an earnings call where CEO Elon Musk trashed an analyst during Q&A.  The Twittersphere blew up.

The stock didn’t.

You should have your executive team prepared for questions, investor-relations professionals. But you don’t need a bible in 2020 because rational behavior is a paltry part of why stocks move.

Equal to preparation for questions should be the time directed to educating your executives and board on what can move price with results, and why, and what historical data indicate are risks, and why risk exists in the first place – and if you can mitigate it by changing WHEN you report and how you notify investors.

And if you’re 10/10 Overbought and 60% short before you report, put your best VALUE foot forward. Data, not Q&A, should driver call-prep.

Human beings do things because they ostensibly matter and produce returns.  If we’re going through motions because it’s tradition, then 2020 should be the year you change tradition.

And investors. What matters to you?  Returns, right?

The average S&P 500 component moves 36% every month, intraday (1.6% each day between highest and lowest prices), change often lost in closing prices.  In a perfectly modulated, utterly quantitative Shangri-La, you’d capture ALL of that by buying low and selling high.  You could make 432% per year.

That’ll never happen. Eugene Fama, legendary University of Chicago economics professor, who’s 80 years old and still teaching, won a Nobel Prize for demonstrating the return-diminishing pugnacity of volatility.

But if there’s so much volatility, why expend immense effort finding great companies when the odds are roughly 1% that doing so will produce market-beating returns?

Wouldn’t it be smarter – wouldn’t it matter more – to surf volatility waves in today’s market?

I find in traveling around the country – we’re headed to Austin Thursday – talking to IR people and investors that they’re depressed by these things.

If what we learned doesn’t matter, should we rend garments, gnash teeth and weep?

No.

That’s like being depressed by passing time.  Time is a fact.  We can make the most of it, or we can rue its passage.  What’s it gonna be?

So what, IR people, if you don’t need a 400-page Q&A document that requires a software package to manage?  A single Word page, stored to the cloud so you can cross-reference in future quarters, is proportionate.  You’ve saved TIME to do things that MATTER.

What matters?  If you want to be in the US equity markets in 2020 as a public company, an investor-relations professional, an investor, what matters is knowing what money is doing.

It’s a law of success.  It’s not what you know about YOU that matters.  It’s what you know about life, the environment you’re in, the job you’re doing, about how to build relationships.

Right?

We should stop spending all our time understanding our businesses, and none understanding the market that assigns value to them.  That’s the flaw of IR.  Nothing more.  Let’s change it in 2020.

And you investors, why all the Sisyphean work finding great businesses without first understanding how the market transforms those businesses into products with fleeting and ever-evolving value?

If you could capture just 10% of the daily volatility of the S&P 500 by buying stuff low and selling it high, you’d win. It’s provable, useful math. That matters.

Resolve to make 2020 the year you learn what the money is doing.  It matters. We at ModernIR figured out the road map. Ask us how to start on the journey.

Time and Sentiment

Time matters.

We’ve gone 42 trading days with the ten-point Market Structure Sentiment index, our proprietary measure of the propensity of algorithms to lift or lower prices, over 5.0. That’s a growth-at-a-reasonable-price (GARP) market since Oct 17.

It’s by no means the longest. More on that in a moment.

The market seems impervious to fault lines as we move into year-ending options-expirations tomorrow through Friday, and index rebalances, and portfolio window-dressing.

It’s nothing like either 2010, the Year of the Flash Crash, or 2012, the Year of the Glitch. I wrote an editorial for IR Magazine on those, a retrospective ahead of 2020 on the last decade of market structure.

The market’s capacity to relentlessly rise through a corporate earnings recession (we’ve had three quarters of falling comparative profits), trade disputes, Presidential impeachment, on it goes, shows how both the IR profession and investors need different data in the arsenal to understand how stocks are valued.

Two other terrific IR Magazine pieces highlight the value of data to IR. We’re not alone! Reporter Tim Human describes how AI Alpha Labs uses deep-learning to help investors understand how to achieve better returns – something IR must know.

Oliver Schutzmann of Iridium Advisors says future IR will be data science – because that’s how the market works.

Speaking of data, ours for the S&P 500 show Active money the past year was the lead buying behavior 7% of the time. The worst day was Dec 19, 2018, with just one company earning what we call a new “Rational Price” from Active Investment. The best day came a month later on Jan 18, 2019, when 26% of the index had new Rational Prices.

Add selling, and Active money leads the S&P 500 behaviorally about 14% of the time.

Back to Sentiment, over the 42 days where the market has gone up, up, up on positive Sentiment, Active money led buying just 6% of the time. Exchange Traded Funds have led, our data indicate, 67% of the time, directly or indirectly.

Data points like these are requisites of the IR job the next decade. And measuring changing behavioral trends will be essential to understanding stock prices. Case in point, I saw a client’s data yesterday where Fast Traders, automated machines creating price-changes, were responsible for a 40% 2019 decline in equity value.

Machines don’t know what you do. But they can trigger negative and positive chains of events divergent from fundamentals.

In this case, trading machines blistered shares on consecutive earnings reports, which in turn pushed Passive money to leave because volatility created tracking errors, which caused market cap to fall out of the Russell 1000 – which is 95% of market value today.

Active money was incapable of overcoming the overwhelming force of Passive behavior.

Back to Sentiment and Time, before the market tipped over in the fourth quarter of 2018 Sentiment stayed around 5.0 or higher for 66 days. When it finally dipped below 4.0, a Sentiment bottom, the market was cast into tumult.

Part of the trouble was delayed portfolio rebalances. When markets go up, investors put off aligning positions to models. When the turn comes, there’s a scramble that compounds the consequence.

We’re hitting one of those crucial points this week, delayed rebalances colliding with options-expirations, index-rebalances and year-end.

We may see nothing. After all, it’s only been 42 days. Sentiment went 45 days at 5.0 or better this spring on the great January rally. There were 42 positive days from June 11 to Aug 8, too.

My final thought in the final fresh blog for 2019 (we’ll do retrospectives to finish out the year) is a monetary one. Karen reminds me that monetary policy clears a room like a fart – so you can’t talk about it often.

But it’s another data point driving market behavior. As the Federal Reserve has turned accommodative again – that is, it’s shifted from shrinking its balance sheet and raising rates to expanding assets and lowering rates – we’ve seen a corresponding fall in shorting and derivatives-leverage in stock-trading.

In fact, a steep drop for shorting coincided with a sudden spike in what’s called the Fed Funds overnight rate. Remember that? Happened in September. The rate the Fed had set near 1.5% exploded to 10% as the market ran out of cash.

Ever since it’s been troubled, the Fed Funds market. The Fed keeps injecting tens of billions of dollars into it. That market is meant to provide banks with temporary liquidity to process payrolls, taxes, credit-card payments, transaction-settlements and so on.

What if ETFs are using cash to collateralize transactions (rather than actual stocks) at the same time rising consumer debt is beginning to weigh on bank receipts and liquidity?

If that’s at all the case, time matters. We’re not worried about it – just watchful. But with so vast a part of market volume tracing to ETFs, and Sentiment getting long in the tooth, we’re cautiously wary as this fantastic trading year ends.

Hummingbird Wings

I recall reading in high school that the military’s then new jet, the FA-18 Hornet, would fall out of the sky if not for computers.

Could be that’s exaggerated but the jet’s designers pushed the wings forward, creating the probability of continual minute turbulence events too frequent for human responses.  Why do that? Because it made the plane vastly nimbler in supersonic flight.

You just had to keep the computers on or the craft would go cartwheeling to earth.

As we wrap a remarkable year for stocks in a market too fast for humans and full of trading wings whipping fleeting instances of turbulence, we’re in a curious state where the machines are keeping us all airborne.

I don’t mean the market should be lower.  Valuations are stretched but not perverse. The economy is humming and the job market is great guns. And while the industrial sector might be spongy, the winds in the main blow fair on the fruited plain.

So why any unease about stocks, a sense the market is like an FA-18 Hornet, where you hope the computers keep going (ironic, right)?

It’s not just a feeling.  We at ModernIR as you longtime readers know are not touchy-feely about data. We’re quantitative analysts. No emotion, just math.  Data show continual tweaking of ailerons abounds.

You see it in fund flows. The WSJ wrote over the weekend that $135 billion has been pulled from US equities this year. Against overall appreciation, it’s not a big number. But the point is the market rose on outflows.

And corporate earnings peaked in real terms in 2014, according to data compiled by quantitative fund manager Julex Capital. We’ve got standouts crushing it, sure.  But if earnings drive stocks, there’s a disconnect.

I’m reading the new book on Jim Simons, the “man who solved the market,” says author and WSJ reporter Greg Zuckerman. Simons founded Renaissance Technologies, which by Zuckerman’s calculations (there’s no public data) has made more than $100 billion the past three decades investing in stocks. Nobody touches that track record.

It’s a riveting book, and well-written, and rich with mathematical anecdotes and funny reflections on Simons’s intellectually peripatetic life.

Renaissance is not a stock-picking investment firm. It’s a quant shop. Its guys and gals good at solving equations with no acumen at business or income statements proved better at investing than the rest.

It’s then no baseless alchemy to propose that math lies at the heart of the stock market.

And son of a gun.

There’s just one kind of money that increased the past year.  Exchange Traded Funds (ETFs). This currency substituting for stocks is $224 billion higher than a year ago and about a trillion dollars greater the past three years.  As we learned from Milton Friedman and currency markets, more money chasing the same goods lifts prices.

Stocks declined in 2018, yet ETF shares increased by $311 billion, more than this year.  In 2017, ETF shares increased by $471 billion.

Behind those numbers is a phantasmagorical melee of ETF creations and redemptions, the ailerons keeping the market’s flight level through the turbulent minutia flying by.

I’ve explained it numerous times, so apologies to those tiring of redundancy. But ETFs are substitutes for stocks.  Brokers take a pile of stocks and give it to Blackrock, which authorizes the brokers to create and sell to the public a bunch of ETF shares valued the same as the pile of stocks.

If you sell ETF shares, the reverse happens – a broker buys the ETF shares and gives them to Blackrock in trade for some stocks of equal value.

This differential equation of continuous and variable motion doesn’t count as fund-turnover. But it’s massive – $3.2 trillion through October this year and $10.7 trillion, or a third of the market’s total value, the past three years.

Why the heck are there trillions of ETF transactions not counted as fund flows? Because our fly-by-wire stock market is dependent on this continuous thrum for stable harmonics.

That’s the hummingbird wings, the Butterfly Effect, for stocks.

We can see it.  In July a seismic ripple in behavioral patterns said the market could tumble. It did. Dec 3-5, a temblor passed through the movement of money behind prices. The market faltered.

If the ETF hive goes silent, we’ll cartwheel.  It won’t be recession, earnings, fundamentals, tariffs, Trump tweets, blah blah.  It will be whatever causes the computers to shut off for a moment.  It’s an infinitesimal thing.  But it’s why we watch with machines every day.  And one day, like a volcano in New Zealand, it’ll be there in the data.

Jim Simons proved the math is the money. It’s unstable. And that’s why, investor-relations pros and investors, market structure matters.

Boxed Yellow Pencils

“How do you think about ESG?” said my friend Moriah Shilton at a San Francisco NIRI summit some weeks back with hedge fund Citadel.

Silence. The four panelists shifted around.  A couple whispered to each other. Finally, somebody offered with a throat-clearing cough, “It doesn’t factor into our portfolio decisions.”

For those not fluent in Investor Relations (IR) Speak, ESG is “Environmental, Social, Governance.”  NIRI is the National Investor Relations Institute, professional association for the liaison between public companies and Wall Street.

ESG dominates the contemporary IR educational platform. NIRI has made a policy statement on ESG. There are at least two ESG sessions here at the NIRI Senior Round Table meeting (and NIRI national board meeting) this week in Santa Barbara.

The ESG heat isn’t coming from stock-picking investors, the “long-only” audience of public companies spending billions annually on communication through compliance-driven reports like 10Ks, 10Qs, press releases and proxies and via proactive outreach aimed at increasing share-ownership.

Nor is it, apparently, coming from hedge funds like Citadel, the other key audience – and I’d argue now the vital IR constituency because of its capacity to compete with the Great Passive Investment Wave – for public companies.

In fact, the Citadel team later said, “We vote with management on proxy matters, or we vote with our feet by selling shares.”

It’s passive money that’s obsessed with ESG. Passive investment to us is any form of capital allocation for a day or more (by contrast Fast Trading is an investment horizon of a day or less) driven by rules. That’s index investing, Exchange Traded Funds, or any variety of quantitative investment, from global macro to statistical arbitrage.

True, passives may oppose a proxy measure that doesn’t comport with an ESG platform. They will, however, continue owning the stock. Index funds pegged to a benchmark like the S&P 500 are required to own the securities comprising the benchmark.

It’s cognitively dissonant to own things you oppose.

But aren’t they trying to promote practices that make companies better stewards for stakeholders?

From my first exposure to it, good business has been sound financial management, the right people, products, markets, capital structure, the advancement of the best interests of your customers, employees, communities. These are essential strands of business DNA.

In fact, turning those into a checklist promotes the possibility that mediocre firms are treated the same as stellar ones by virtue of filling out a form.  Rules breed uniformity.

Nowhere is that more apparent than in the stock market, where rules push prices toward a mean. Track the midpoint – as Passive money does – and returns become superior by pegging the average.

The investor-relations profession, the pursuit of excellence, Warren-Buffett-style investment strategies, are about unique differentiation.  What makes a company better, superior?

Rules-based investing makes things the same. Passive money has boomed because shares of companies are increasingly products defined by shared criteria, like ESG. The more of that there is, the greater the probability the market will become homogeneous.

Without dismissing its merits, I’m perplexed by why public companies and stock-picking investors would promote shared criteria like ESG (why not differentiate with ESG if you’re so moved?).  We don’t want the stock market to become a bunch of yellow pencils in a box.

I think a form of guilt has gripped the passive-investment colossus like what manifests among the Silicon Valley nouveau riche who ofttimes with minimal effort realize vast wealth, and then feel compelled to browbeat the rest about the “greater good.”

How one favors the greater good should be individually chosen, not directed by rules.

So from atop vast heaps of assets gained through doing nothing more than tracking a benchmark, Massive Passives are compelled to berate the market over purpose.

If that purpose is an ESG checklist, the purpose is a dictated set of rules.  The very thing passive investment promotes.  Ironic, right? By subtly suggesting moral superiority, passive investment advances its own self-interest: rules-based investing.

Rather than mindlessly embracing ESG as good for all, a sentient species capable of staggering creativity and achievement through the individual pursuit of happiness that inures to the benefit of the masses owes itself moments of objective reflection.

And the question to ponder is whether a uniform ESG blanket tossed over the capital markets furthers the pursuit of the excellence the IR profession and stock-pickers seek.