Balancing Act

If you want to know what a business is capable of doing, look at its balance sheet.

If you want to know what the Federal Reserve is capable of doing too, look at its balance sheet. Having scrutinized it, Karen and I are leaving today to ride bikes in the Pyrenees and will return if the Fed survives.

Just kidding.  Except for the Pyrenees. We’ll report back on Catalonia in a couple weeks.

Meanwhile, there is again a glaring focus on the Fed as markets shudder. Clients know our Sentiment Index had a “four handle” at 4.9/10.0 Sept 8, the first negative read since early July. Volatility bloomed. As with weather, the market reflects preceding patterns.

It’s the same with the Fed’s balance sheet. Monday with Rick Santelli on CNBC’s Squawk on the Street I attempted to describe in a handful of seconds that the Fed can breathe in and breath out and impact rates and market stability.

Simplifying, the Fed has two levers for pushing rates up and down. When the Fed buys assets like mortgages or Treasuries from the big banks supporting our payments system (called the primary dealers), the supply of money expands, which makes credit cheaper and pushes down rates.  These are bank reserves.

On the opposite side, the Fed can borrow money from banks, tightening supply and prompting an increase in borrowing costs.  These are called Reverse Repurchase Agreements (RRPs).

We described last week how both changed little over the two decades preceding 2008. Tweaking one or the other was simple and economical. Need to tighten 2-3%? Boost RRPs by $10 billion.

But now bank reserves are $2.3 trillion, 26,000% more than historical levels. RRPs are 1000% higher than history at $300 billion. The three-to-one ratio the Fed long maintained is now one-to-26.

These facts produce a paradox that traps the Fed. Twenty-five basis points, the increase expected when or if the Fed moves, is no biggie against $10 billion of reserves.  But the Fed pays interest on reserves (and RRPs). Now 50 basis points, the rate would jump 50%.

The interest expense alone boggles the mind. Plus, the government will lose money. A rider on the December transportation-funding bill passed by Congress requires the Fed to send earnings on its massive portfolio over $10 billion to the US Treasury general fund.

Do you see? The data driving the Fed aren’t economic but financial. It’s about the Fed’s balance sheet. And government coffers, dented if the Fed starts paying more interest.

They may still hike but it’s a hindrance. And there’s more. The same giant banks providing margin accounts to traders and derivatives to institutional investors are partners called primary dealers helping implement Fed policy. When the Fed moved $100 billion to RRPs out of excess reserves Sept 1 at the same time that its balance sheet shrank slightly, the impact rippled through all the banks financing hedges and margin-trading.

That ripple is the current tsunami hitting the stock market. The Fed has already unwound these RRPs, returning $100 billion to excess reserves. But the damage was done. The Fed tried similar tactics in December last year when it hiked for the first time since 2006, and markets caved in January and the Fed had to pump up excess reserves by $500 billion – much more than it had moved out of the money supply – before markets stopped falling.

And the Fed oversteered.  Markets shot like a rocket into May, flummoxing all. Our Sentiment pegged the positive needle for weeks.

The same happened around the Brexit vote. The Fed was in the process of tightening by lowering excess reserves and lifting RRPs.  The markets imploded. In two weeks, the Fed reversed. The market shot up, once more prompting global head-scratching.

The Fed cannot seem to calibrate its levers without overshooting or undershooting and in any case creating chaos in stocks and bonds. There is no better evidence of the folly in the size of its balance sheet.

Is there a way out? Sure. The Fed could write off 80% of its balance sheet and put us back to pre-crisis leverage.  But interest rates would explode and the entire globe would fall into depression because that would be a restructuring, a technical default.

Is there another way out?  Yes. Normalize rates and take our chances. But that demands a fortitude that’s missing in the sort of jittery lever-yanking one can observe on the Fed’s balance sheet.

The Blue Whale

Last week US jobs were weak and the market welcomed the news.   

We tend to laugh or snort when stocks do the opposite of what they should. But if the market is powered by an economy that’s weaker than expected, why should it rise?

And if you’re an investor-relations professional or in the investment business, you need to understand these outcomes even if you’d prefer to go to the dentist for molar removal.

“It’s the Fed,” you say, rubbing your jaw. 

All right, it’s the Federal Reserve.  What does that mean?

“I’m not sure,” you say.

“What do you think it means?”

“That when The Fed raises rates the economy is better and borrowing will cost more.”

Stop. What?

Study the data pouring forth from the government and the private sector and you’ll see that when you’re doing better, borrowing costs…wait for it…LESS.  

Yes, a strong credit score – a good personal economy – means you pay less to borrow than those with weak personal economies.  Miss a payment and the rate slams UP.

“Yeah, but what the Fed was trying to do was get people to spend,” you explain. “They keep rates low to juice the economy with consumption, and when it starts to overheat and there’s too much borrowing, then they slow it down by raising rates.” 

Okay. I follow that.  But why is it a good idea to get people to spend if borrowing too much money is what created the financial crisis?  And where’s the growth by the way?

“Look,” you say.  “I’ve got a dental appointment I need to get to.” 

The Fed has got everyone thinking it’s the Millennium Falcon in Star Wars and the economic data are TIE Fighters to line up in the sights and then…boom!  We hike rates. 

That’s as absurd as fueling economic recovery with a seven-year teaser rate prompting people to borrow and spend.

Forget that. Here’s the real dilemma for the Fed. Last Thursday before the jobs data the Fed’s balance sheet shrank to the smallest level since I believe Oct 9, 2014 when it was $4.496 trillion.  It was $4.503 trillion, down about $20 billion week over week.  And Reverse Repurchases exploded to $442 billion, $100 billion more than a week earlier.

That’s tightening.  With an “RRP,” the Fed borrows from banks to take money out of the counted supply.  When bank reserves rise because the Fed buys debts, the money supply increases.  It’s like fishing line. Let some out, reel some in.

So maybe the Fed wants to raise rates and then if the dollar spikes and assets like stocks and bonds fall, it can reverse these and flood markets with money. After all, when the Fed hiked by 25 basis points last December, stocks and bonds nearly imploded. Remember January 2016?

But here’s the problem.  Prior to 2008, bank reserves ran about $10 billion (and didn’t change in a decade).  RRPs ran about $35 billion, twice the size of reserves, and changed maybe $3 billion over a whole year.  Moving rates 100 basis points was no biggie, like hauling in a minnow on your steelhead fishing line.

Now the Fed has $442 billion of RRPs and it’s paying about 25 basis point of interest on them.  Bank reserves that pre-crisis were $10 billion are today $2.3 trillion, 26,000% higher.  Now the Fed has a fly rod with test line and it’s trying to land a blue whale.

It’s potentially catastrophic. If the Fed raises to 50 basis points, unless there’s a better place for bank reserves to go, money could stampede to RRPs, causing the dollar to skyrocket and stocks and bonds (and oil) to implode – as they nearly did in January. 

The Fed doesn’t HAVE to take the money it borrows via RRPs, but it says about $2 trillion of Treasuries (collateral) are eligible. The Fed can tighten confidently only if there’s enough demand from the economy to keep the blue whale away. 

Look around. The Bear Stearns Moment of the Week is the bankruptcy of Hanjin Shipping.  It’s among the ten biggest shipping companies in the world, moving the goods of global commerce. When Bear Stearns and Lehman failed we discovered the world had a financial crisis. When Hanjin folds, you have a budding economic crisis. 

So that’s the truth. What matters isn’t if there are 150,000 jobs (which isn’t enough to offset the traditional attrition rule-of-thumb of 1% of the workforce so don’t be fooled) but what the blue whale will do.  Disturb it and things start coming apart.

The Fed doesn’t want to do that, but it can’t figure out how to get the blue whale off the hook either.  And this you see is a much bigger deal than if you make your numbers. The market wants to know the Fed will keep feeding it line. Or a line. 

 

Market Serfdom

Last week a stock strategist said passive investment is worse than Marxism.

That’s a way to get attention at risk of offending Marxists. It did (get attention). CNBC covered it. Jason Zweig did too in the Wall Street Journal weekend edition.

It’s relevant to investor relations because passive investment is sweeping the planet. We call it “the elephant in the room” because public companies sometimes seem paralyzed as mass capital inured to the sellside and results and road shows floods stocks.

The shift is huge. Mr. Zweig noted that in the past year $300 billion left active stock-picking portfolios as $400 billion flowed to indexes and exchange-traded funds.  Over the trailing decade, data from the Investment Company Institute show it’s trillion of dollars routing from active funds to passive vehicles.

You’ve seen the Betterment ads?  This “robo advisor” let’s investors precisely tailor exposure to various assets the same way architects use CAD systems to design structures.

At Sanford Bernstein in London, senior analyst Inigo Fraser-Jenkins released a report borrowing economist Friedrich Hayek’s phrasing called “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” I thought immediately of “The Princess Bride” as I’d never encountered anyone named Inigo save Montoya (Mandy Patinkin) in that film pursuing the six-fingered man.

Mr. Fraser-Jenkins, erstwhile head of quantitative strategy at Nomura, thinks the six-fingered threat from passive investment is its lack of judgment for committing capital.

Brilliant point. The equity capital market formed so people with money could take risks on businesses that might improve the human lot.  The brokers pooling capital then supported these endeavors with research so investors could make informed decisions.

Enter Blackrock and Vanguard. No, they’re not Trotsky and Lenin papered in currency. But they’re massive through efficiency, market rules, monetary policy (a system, not good judgment, makes it work), not prowess or wisdom.

Mr. Zweig says Vanguard reported owning 6% of all US shares. Assume Blackrock is about 7%. Combined, they’re 10-15% holders of everything. Dictators.

“What happens when everybody indexes?” John Bogle, Vanguard founder, said to Mr. Zweig.  “Chaos, chaos without limit. You can’t buy or sell, there is no liquidity, there is no market.”

Mr. Bogle adds that we’re a long way from there.  Indexes would have to grow to 90% of the market from between 5-10% now. Oh? We’ll come back to this point to conclude.

When money is directed by a model to equities, there’s a shift in purpose from giving to taking.  How? Models take a piece. Investors commit.

The market first formed so entrepreneurs needing risk-taking capital could find it. A market priced around the willingness of investors to accept risks combined with the capacity of businesses to deliver results is the heartbeat of efficient capital-allocation.

Models don’t care about that relationship. They take, then leave. So invention happens on private equity, which removes from the American capital model its defining egalitarianism for the masses and instead concentrates it in ever fewer hands.

Your job just took on added importance, IR pros. You alone can track the impact and evolution of asset-allocation. Move beyond telling the story to measuring quantitative investment. It’s the job of IR to apprise executives and boards of important facts about the equity market.  It’s our market. No index will tell you something is amiss.

So The Elephant slouches toward serfdom.

In that shadow, any company considering itself a yield investment has Big Data looming tomorrow after the close. Most REITS will separate into a new industry classification from Financials.  That’s like a massive index-rebalance playing out over coming weeks.

Concluding, Mr. Bogle is wrong about how much bigger indexing can get before markets are paralyzed.  We’re now pushing limits. Indexes and ETFS are currently 32-33% of daily volume, combined (our measures). At 40% there will be no room for anything but machines. Stocks are needed to satisfy stock-pickers, fast traders, counterparties for derivatives and trading leverage. It’s already so finely balanced that most stocks don’t trade more than 200 shares at once.

You’re the frontline, IR. This is your fight. Report on it (we can help). Solution? Remove rules making averages the goal. Stock-picking would soar anew.  Else? Serfdom.

A Year Ago

In Luckenbach, Texas, ain’t nobody feeling no pain. We were just there and I think the reason is the bar out the back of the post office.

A country song by that name about this place released in 1977 by Waylon Jennings begins by asserting that only two things make life worth living, one of which is strumming guitars.

In equities, what makes life worth living is certainty.  TABB Forum, the traders’ community, had a piece out yesterday on the big decline in listed options volume, off 19% from last July to a 14-month low. TABB attributed the drop to falling demand for hedges since the Brexit, the June event wherein the UK voted to leave the European Union and exactly nothing happened.

The folks at Hedgeye, responding to a question about whether volume matters anymore since it’s dried up as stocks have risen to records said, paraphrasing, big volume on the way down, low volume on the way up, is as valid as it ever was for investors wary of uncertain markets and means what you think it does. You should be selling on the way up so you don’t have to join those people distress-dumping on the way down.

I got a kick out of that. Sure enough, checking I found that SPY, the world’s most active stock (an ETF) traditionally trading $25 billion daily is down to $11 billion.  Whether it’s August is less relevant than volume.

On August 24 a year ago, the market nearly disintegrated on a wildly delirious day.  August options-trading set a near-period record.

Now what’s that mean to investor-relations folks trying to understand stock-valuation and trading? We’ve long said that behavioral volatility precedes price-volatility. You can apply it anything. As an example, if housing starts plunge, that’s behavioral volatility.  If a movie starts strong and viewership implodes the second week, that’s behavioral volatility.  Both point to future outcomes.

We track market behaviors. They tend to turbulence anyway around options-expirations, which occurred in the past week, and August 2016 was no exception.  On Aug 19, triple-witching, Asset Allocation (investment tracking a model such as indexes and ETFs) surged nearly 11%, Risk Management – counterparties for derivatives – by 3%.

It’s the double-digit move that got our attention.  Double-digit behavioral change is a key indicator of event-driven activity, or trading and investing following a catalyst such as Activism or deal-arbitrage.  It’s very rare in the whole market.

We also tracked a whopping jump since Aug 15 in Rational Prices, or buying by fundamental money.  When it’s coupled with hedging, it implies hedge-fund behavior.  In effect, the entire market was event-driven under the skin yet not by news. Nor did it manifest in prices or volume (Activism also routinely does not).

We’ve got one more data point for this puzzle. Volatility halts in energy, metals and emerging-markets securities have returned after vanishing in June and July.  Remember, market operators have implemented “limit-up, limit-down” controls to stop prices from moving too much in a short period.

So though the VIX is dead calm other things are moving.  Short volume marketwide is nearly identical (44%) to where it was in latter November preceding December volatility and the January swoon.

We conclude that currency volatility may surge, explaining volatility halts in commodities.  Hedge funds are shifting tactics. The dearth of options trading may rather than mean a lack of hedging instead signal the absence of certainty.

Pricing options accurately requires knowing prices of the underlying securities, plus volatility, plus time.  Volatility isn’t the faulty variable. It’s got to be either the prices of the underlying or the uncertainty of time.

Now it may be nothing. But our job here is to help you understand the market’s contemporary form and function. If behavioral volatility precedes change, then we best be ready for some.  We may all want to pull on the boots and faded jeans and go away.

But hang onto your diamond rings (and that’s all the obscure country-music humor I’ve got for today!).

Low Spreads

What keeps stocks going is low volatility.

By seeking only to earn the spread on each transaction and not bet on the direction of markets, you can make money close to 50 percent of the time.

This one sentence from a profile of high-speed firm Virtu by Bloomberg’s Matt Leising to me summarizes the US stock market and its durability.

Computers focus on the difference in cost to buy or sell a very small thing – a handful of shares. They don’t weigh the viability of the entity reflected in the shares or any measure humans use to determine fair value. Thus, what difference does it make whether so-called fundamentals support the price? We’re asking the wrong question.

In the world apart from stocks, European growth is abysmal. Emerging economies are sputtering. The US economy is growing about 1% and juxtaposed with a long slide in productivity, falling revenues in the S&P 500 and five quarters of earnings contraction.

Since 1954, according to Financial Advisor magazine, twelve earnings recessions have met ten actual ones, and stocks have always fallen, the least, 7%, in 1967, and the most, 57%, in 2008-9.  In this one, the stocks of businesses making what drives consumption and employing the consumers and earning the profits that fund the investments core to economic growth are thus far up.

Why is it different this time? One could say “central banks.” Yes, today’s foremost Enron-like off-balance-sheet entities, central banks, have conspired to force people to overpay for most things in the name of helping us all. But they’re a supporting cast.

The main actors are nearer. This era in stocks, thanks to regulations implemented in 2007, is the first to depend almost entirely in the very short-term for prices from computerized systems tracking spreads in prices.

What motivates machines are small spreads. Virtu, with but one losing day from 2009-2014 often pockets peanuts. In one instance from the story, Virtu traded gold ETFs and futures 26 times and earned $36.

But Virtu trades securities from Africa to London sometimes five million times in a day. Its software sits in more financial markets (Bloomberg says 230 globally) than its employee headcount (148 as of Dec 2015).

I hear good things about Virtu from people I respect.  The point here isn’t to judge Virtu or fast trading but to explain why the market cannot, for now, be measured fundamentally. Last week, silver ETFs were top performers and gold and steel ETFs lagged most. It was excruciating hearing analysts trying to explain it rationally.

How stocks behave fits the low-spread phenomenon. The market is a daily life cycle from highs to lows and recoveries and vice versa. It’s a product of tiny spreads and small changes. Narrow gaps mean limited risk as automated trading systems search for ways to set prices between buyers and sellers.

Of course there must be buyers and sellers. The epic symbiosis of our era is high-speed trading and Asset Allocation. This is investing via apportionment such as indexes, exchange-traded funds and quantitative models. This money doesn’t assess prices but follows the map, bread crumbs dropped in enticing meager increments by machines.

Watching the steady march, stock-pickers then reach a nexus of fear and greed, taking the baton and carrying on even as the most ebullient bulls put pensive scratching fingers to noggins. Yesterday we tallied new Rational Prices indicating buying by Active money in nearly 20% of our client base. Fund managers are paid to invest and do, despite wariness.

Low volatility means not the absence of risk but that machines are in charge. Shares falter only when spreads become unmanageable as on May 6, 2010, August 24, 2015, and other manic gap episodes. Big gaps form on distortion among traded asset classes such as stocks, bonds, currencies, commodities and derivatives.

What causes unexpected distortions? If we knew, I’d be writing to you from Monaco. Here outside Austin as we visit family this week, I can only theorize from a decade modeling market behavior.  Distortions today form when the value assigned to any asset class in the future is wrong.  Derivatives are the weak link.

Options expirations for August start tomorrow. Sentiment is positive and stocks are rising, which means they’ll probably fall afterward. But there’s little risk. The machines are in charge. Volatility is low.

Now if you’ll excuse me, I want to get off the bridge over these placid waters.

Light Speed

Alert reader Raj Mehan at Steelcase forwarded a piece from the Wall Street Journal about traders now aiming with machines to execute stock-market transactions near light-speed.

Why the rush?  Companies take flak for “short-termism” that’s a quarter long and yet regulators and traders and academics extol the virtues of fast trading, claiming it makes markets liquid and efficient.

Just this week I was speaking with a CFO for a public company who yawned at the idea he should care about what priced his stock. “It’s interesting but what difference does it make?”  I’m paraphrasing a longer exchange. It’s a vital point of contention, right?

We’ll come to that in a moment. Watching the Olympics this week – exhilarating as ever – the race for speed in the water is stupefying.  Seeing Katie Ledecky crush the field by five seconds for a gold metal gives you goose bumps no matter your country. And the objective of swimming-speed is winning.

It is for traders too. In the WSJ article by Vera Sprothen, folks from high-speed trader DRW Holdings LLC (stands for Donald R Wilson) said competition in financial markets is accelerating the race. A nanosecond is a billionth of a second. Routers can send and receive stock-exchange data in 85 nanoseconds, which is how much time elapses when a bullet fired from a gun travels a half-inch.

Imagine. You fire at a shooting-range target and before the bullet gets there somebody trades your stock several hundred times.

If I’m making a big-ticket purchase the last thing I want is – snap! – to do it faster. Many of you are investor-relations professionals. Do some investors study your business for a year or two before deciding to buy your shares? When I was an IRO, that was common.

Weighty decisions are not made for light speed.  Therefore, traders are not making weighty decisions. Committing capital over time is a risky gambit. Capital deployed the amount of time needed for a bullet to travel a few feet isn’t so fraught.

It’s also not investment. Understand: The stock market in the USA and ever more around the world too is one in which the first trade to arrive prices the stock for everyone. Many stock-trades are paired with other things such as options or currencies or commodities.  Price one superfast, and race over faster than a speeding bullet to something else, and you can make money by taking advantage of price-differences. That is by definition arbitrage.

The efficiency of markets is best assessed by determining how much arbitrage occurs. There’s a lot of arbitrage in booking a hotel room on line. There’s no arbitrage in buying a cup of coffee at Starbucks (unless somebody at the Univ of Chicago wants to study that question and prove me wrong).

In the stock market, almost half of all volume is arbitrage. It may be the most colossally inefficient capital market ever created by human beings. Back up 20 years and it wasn’t. Just 15% of trading could be attributed to arbitrage, and 85% to investment.  Speed and price-differences now consume it.

Which brings us back to our apathetic CFO. If you don’t care about the market for the backbone of your balance sheet enough to understand it, you should be a private company where there’s less arbitrage.

For IR pros in the 21st century, it’s a huge opportunity. Not only is there confidence in knowing how the market works, but somewhere today there’s an IRO who will, having learned, help change the market tomorrow.

Problems are solved after we first understand them.  Most prices for stocks should not be set at the speed of light. Yet that’s happening.

Trivago and Traders

I was high-frequency traded by a travel site.

Had that happen? You web-search a place and pricing and there’s no availability for the date you want so you check elsewhere and suddenly there’s vacancy – but now it costs more so you better act fast!  It’s like the stock market’s recent performance.

It’s not the first time I’ve been played by algorithms but it happened trying to book rooms in Crested Butte this week as we toured my visiting mother around the continental divide. Having spoken with hotel staff and knowing there wasn’t peak demand, I waited. At the hotel we got the best bargain of all. If you want a good deal, cut out the middle man.

And when you’re shopping online for a hotel deal, realize it’s a cabal. Expedia owns hotwire, hotels.com, Orbitz, Travelocity, and trivago to name the biggest brands. Priceline owns booking.com and Kayak among others.

When you start searching for a travel deal, the machines know almost instantly. It’s an integrated network where much of the pricing and supply are controlled by a handful of players.  Start looking for rooms, and rates rise not due to supply outstripping demand but because middle men change the prices.

Let’s think about the stock market. Expedia and Priceline have an advantage through being many places simultaneously. They’re in effect trading all the stocks – all the places you go unless you cut them out and go straight to the hotel.

Who in the market trades everything?  No, not Goldman Sachs. None of the big brokers trade anywhere near all the securities in the market. That’s not the business they’re in.

But high-frequency traders do. All our clients down to the very smallest ones under $50m in market cap are traded daily by high-frequency firms.

High-speed firms trade thousands of securities everywhere simultaneously, generally exchange-traded products where setting the prices everyone sees is the aim: stocks, commodities, derivatives and currencies.

But these firms don’t want to own anything. Wrap your head around this idea, because it’s a lot like getting travel-deal HFT’d.  The travel sites keep changing prices in order to prompt a reaction.  You’ll get teased: “Four left at this price!”

It’s the same in the stock market.  High-speed traders with vastly powerful networked machines connected to all the trading venues know every time there are ripples of supply or demand in any security.  Instantly, the price for that stock changes. If you’ve read the book Flash Boys, you get what I’m saying.

But let’s go one step further.  In the last 17 weeks through July 29 this year, there was not a single one in which Active Investors – buy-and-hold stock pickers – led as price-setters (through both the Brexit Swoon and Brexit Bounce).  In nine of those weeks Fast Traders did.  That’s over half the time (otherwise it’s been Asset Allocation – indexes and ETFs – or Risk Management, counterparties to derivatives like options and futures).

This is why the market is defying fundamentals. It’s exactly how pricing and supply defied fundamentals when we were trying to book a hotel in Crested Butte. Elevation Hotel & Spa was not remotely out. But the fast-trading hotel algorithms sure wanted everyone to think so.

The same thing happens repeatedly through each trading day. Stocks soar, and then falter and fall…and someone tries to book some shares…and all of the sudden prices race back up and the Dow Jones rises 80 points.  Better act fast!  These prices won’t last!

The truth is that the equivalent of booking.com is making it impossible for anyone to know the real supply and demand of stocks.  Since investors can only guess the same as we do hunting for hotel deals, they scratch their heads and try to buy.

You might say, “But we get good hotel deals.” As in the stock market, electronic trading ended laziness at big brokers and exchanges. But now the middle men have taken over. They’re now worse than what we had before. They’re fostering dangerous illusions.

Illusions cause markets to become mispriced because it’s impossible to separate the middle men from the actual supply of product.  How to solve it? First, understand how much of your daily volume is being driven by middle men. Then you can begin to measure what’s real.

Ultimately, investors and public companies should confederate to create a market that bars high-speed traders. Until then don’t be fooled by either HFT or booking.com.

Gilding the Trend

Is index-investing the death knell for investor relations?

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

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

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

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

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

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

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

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

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

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

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

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

Rational Signals

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

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

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

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

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

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

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

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

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

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

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

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

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

ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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