The Fulcrum

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

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

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

“What about the dollar?” we asked.

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

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

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

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

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

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

Oil has now declined faster than it rose in 2009.  The rate of collapse is the only connection to increased supply. The real culprit is the fulcrum.

Thinking about the dollar, by late September last year we began saying that corporate earnings, comprising about 13% of US gross domestic product, would falter in Q414 and especially in Q115.

Some laughed. “A strong dollar is great for the US economy,” people said, adding, “We hope you aren’t in a profession involving math.”

Yesterday stocks declined because, shazam!  The dollar is haircutting multinational profits. Headline from the Wall Street Journal: “Strong Dollar Hangs Over Companies, Rattling Investors.”

Are we tempted to say I told you so?  We also warned that if corporate profits decline, so will jobs. Big companies are now cutting thousands to compensate. The problem is if you sold stuff in Euros at $1.50 and you convert sales back to dollars at $1.12, that’s a big divot.

If jobs go, consumer discretionary spending that’s already palsied may drop more. GDP depends on consumption. What’s more, a strong dollar deflates prices – good for consumers yes, but bad for how the government meters economic output.

So the economy could contract, perhaps by the June quarter.  In the stock market, seas of money impelled there by Fed policy may suddenly realize prices are wrong. If we added government debt and the missing risk-free rate of return to stock valuations, by that crude math stocks are at multiples higher than in 2000.

“Boy,” you say.  “Thanks, Quast.  Now, if you’ll excuse me I need to pop this cyanide pill.”

Part of the job of investor-relations is developing a clear-eyed perspective on economic realities. We have said since September that we’re in a period of risk-asset revaluation. The problem all along has been that reality was unclear – because central banks obscured it by moving the fulcrum.

The fulcrum is coming back to center. So which side of the teeter-totter is too long? I don’t have the answer. But each facet of our thesis has borne out as we anticipated. We also supposed that European QE would prompt regulators to force banks into higher reserves, just as QE did here. Check. We expected cessation of QE in the US to meaningfully blunt fixed-income, commodities and currencies (FICC) trading at the primary dealers. Check.

What concerns us is that the risk associated with an off-kilter fulcrum has been farmed out globally by investors to the tune of $650 trillion in currency and interest-rate swaps that now must revalue no differently than corporate revenues and earnings. The banks behind those are the same ones that were in mortgage-backed securities in 2008.

Our optimistic view is that this decentralized market will sort out exposure by summertime, producing big risk-asset rumblings but no tectonic fracture. Our pessimistic hunch is that one or more major counterparties could collapse and stocks might fall dramatically as the US reverts to recession.

We’d take a split. The fulcrum.

The Committee

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

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

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

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

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

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

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

Crumbling Quotes

Terra firma. In Latin, “solid earth.”

Two thousand years ago people thought Latin would be the lasting language of commerce. History disproved that thesis, but the notion of a firm foundation remains. In stock-trading, however, the ground relentlessly crumbles as prices shift in illusion.

The significance of this condition goes beyond whether investors are getting fair prices. Iconoclastic IEX, the alternative trading system and prospective exchange introduced popularly in Michael Lewis’s book Flash Boys, has a solution. More on that in a moment.

Many don’t think there’s a problem. Costs are low, we’re told. Apparently stocks trade easily. But the success measures themselves are incorrect. Clear supply and demand, identifiable participants, differentiated price, service and products – these are hallmarks of free-market function. The buyers and sellers who benefit from low spreads are those whose minds are always changing.

The stock market today forces competitors to share products and to match each other’s prices. Most observable prices come from parties aiming to own nothing by day’s end. Quotes reflect seismographic instability. Nobody knows real supply or demand because 42% of traded shares are borrowed and by our measures 85% of market activity is routinely motivated by something besides rational thought. Half the volume flows through intermediaries who take great pains to remain anonymous. Imagine walking into a shopping mall full of storefronts without signs. You’d feel like you were frequenting something illegal, chthonian.

The eleven registered exchanges and 40 alternative systems comprising the National Market System are in competition with each other no differently than Nordstrom and Saks, but no law requires Nordstrom to point customers down the concourse because a marquee posting best prices says it must. In free markets, humans compete on merit. If you want a good deal cut out the middle man. (more…)

Adapting

Happy New Year!  We trust you enjoyed last week’s respite from the Market Structure Map.  Now, back to reality!

CNBC is leaving Nielsen for somebody who’ll track viewer data better.  Nielsen says CNBC is off 13% from 2013. CNBC says Nielsen misses people viewing in new ways. Criticize CNBC for seeming to kill a messenger with an unpopular epistle but commend it too for innovating. Maybe Nielsen isn’t metering the right things.

I’m reminded of what we called in my youth “the cow business.” The lament then was the demise of small cattle ranches like the one on which I grew up (20,000 acres is slight by western cow-punching standards). Cowboying was a dying business.

And then ranchers changed. They learned to measure herd data and use new technologies like artificial insemination to boost output. They adapted to the American palate. Today you can’t find a gastropub without a braised short rib or a flatiron steak. On the ranch we ate short ribs when the freezer was about empty.  But you deliver the product the consumer wants.

Speaking of which, a Wall Street Journal article Monday noted the $200 billion of 2014 net inflows Vanguard saw to its passive portfolios, which pushed total assets to $3.1 trillion. By contrast, industry active funds declined $13 billion. That’s a radical swing.  The WSJ yesterday highlighted gravity-defying growth for Exchange-Traded Funds, now with $2 trillion of assets.

The investor-relations profession targets active investors. Yet the investor’s palate wants the flank steak of, say, currency-hedged ETFs (up about $24 billion in 2014) over the filet mignon of big-name stock-pickers. IR is chasing a shrinking herd. (more…)

Future Former

As Christmas Eve arrives in the US, market-structure circles are abuzz on tidings from Intercontinental Exchange (ICE), parent of the NYSE, about bold market reform. Is it the birth of opportunity or a winter fable?

In case you missed it, word broke last week that ICE has proposed in a letter to the SEC a plan for fundamentally reforming the stock market. The missive wasn’t offered publicly but reporters have described the contents.

The plan aims to slash what are called access fees – charges paid by traders to purchase shares at the NYSE – from the current capped regulatory rate of 30 cents per hundred to five cents if brokers agree to send the bulk of orders to the exchanges.

The proposal would also ban the “maker-taker” model under which traders earn credits to offer shares for sale at the exchange. There are other elements too, including exceptions for block transactions and retail orders and ostensibly greater insight into data feeds.

Public companies have yet again been omitted from the planning. Why is there a pathological proclivity on the part of exchange operators and regulators to leave out the businesses paying hundreds of millions of dollars in listing fees and without whom there would be no stocks, indexes, ETFs, options or futures?

Getting past that annoying fact, there’s a lot to like because we’ve seen it before.  We call the proposal “Back to Buttonwood.” The NYSE is a product of a two-sentence compact in 1792 inked under a New York City buttonwood tree by which brokers agreed to give each other preference and to charge a minimum commission. Brokers figured if they pooled orders they’d have more customers, and to make it work they’d agree not to undercut each other on price. (more…)

Market Facts

Volatility derivatives expire today as the Federal Reserve gives monetary guidance. How would you like to be in those shoes? Oh but if you’ve chosen investor-relations as your profession, you’re in them.

Management wants to know why holders are selling when oil – or pick your reason – has no bearing on your shares. Institutional money managers are wary about risking clients’ money in turbulently sliding markets, which condition will subside when institutional investors risk clients’ money. This fulcrum is an inescapable IR fact.

We warned clients Nov 3 that markets had statistically topped and a retreat likely would follow between one and 30 days out. Stocks closed yesterday well off early-Nov levels and the S&P 500 is down 100 points from post-Thanksgiving all-time highs.

The point isn’t being right but how money behaves today. Take oil. The energy boom in the USA has fostered jobs and opportunity, contributing to some capacity in the American economy to separate from sluggish counterparts in Asia and Europe. Yet with oil prices imploding on a sharply higher dollar (bucks price oil, not vice versa), a boon for consumers at the pump becomes a bust for capital investment, and the latter is a key driver in parts of the US that have led job-creation.

Back to the Fed, the US central bank by both its own admission and data compiled at the Mortgage Bankers Association (see this MBA white paper if you’re interested) has consumed most new mortgages coming on the market in recent years, buying them from Fannie Mae and Freddie Mac and primary dealers.

Why? Consumption drives US Gross Domestic Product (GDP), and vital to recovery in still-anemic discretionary spending is stronger home prices, which boost personal balance sheets, instilling confidence and fueling borrowing and spending.

Imagine the consternation behind the big stone walls on Maiden Lane in New York. The Fed has now stopped minting money to buy mortgages (it’ll churn some of the $1.7 trillion of mortgage-backed securities it owns, and hold some). With global asset markets of all kinds in turmoil, especially stocks and commodities, other investors may be reluctant successors to Fed demand. Should mortgages and home-values falter in step with stocks, mortgage rates could spike.

What a conundrum. If the Fed fails to offer 2015 guidance on interest rates and mortgage costs jump, markets will conclude the Fed has lost control. Yet if a fearful Fed meets snowballing pressure on equities and commodities by prolonging low rates, real estate could stall, collapsing the very market supporting better discretionary spending.

Now look around the globe at crashing equity prices, soaring bonds, imploding commodities, vast currency volatility (all of it reminiscent of latter 2008), and guess what?  Derivatives expire Dec 17-19, concluding with quad-witching. Derivatives notional-value in the hundreds of trillions outstrips all else, and nervous counterparties and their twitchy investors will be hoping to find footing.

If you’ve ever seen the movie Princess Bride (not our first Market Structure Map nod to it), what you’re reading seems like a game of wits with a Sicilian – which is on par with the futility of a land war in Asia. Yet, all these things matter to you there in the IR chair, because you must know your audience.  It’s comprised of investors with responsibility to safeguard clients’ assets. (more…)

Ups and Downs

Suppose you were an elevator operator.

In 2013, the conservative Weekly Standard reported that the most senior member of the Senatorial coterie of button-pushers on the Hill pocketed about $210,000 in compensation, on par with investor-relations professionals.

The elevators have been automated in the Capitol since the 1960s, meaning anyone from Chuck Schumer (D-NY) to Senator-elect Bill Cassidy (R-LA) could push his own button and power a ride. When government-shutdown loomed in 2011, elevator operators were classed nonessential. But still they push and ride.

We’re not criticizing the Senate lift staff.  The people’s work has got to get done and our men and women leading the nation cannot be bothered with pushing their own buttons. But Ronald Reagan’s wry observation that the nearest thing to eternal life on earth is a government bureau comes to mind. In some office towers now, elevators are so automated that it’s impossible to disembark save at your predetermined destination. The elevator is alpha and omega.

So clearly, elevator-operation isn’t a growth industry. If that’s what you’ve been doing you’ll have to improve your skills and knowledge.  Jim Ziemer, who started as a warehouse freight elevator-operator retired as CEO of Harley-Davidson in 2009. There’s how you deal with ups and downs.

Looking at performance for active investment managers can make one wonder if IR is in the elevator-operator employment classification. The Wall Street Journal’s Jason Zweig wrote recently that 91% of active managers through September this year had underperformed the broad market (for years active managers have lagged but that’s a separate market-structure discussion).  IR spends most of its time and budget courting owners who can’t hold a candle to indexes and ETFs (in a sense, elevators that don’t need active managers as lift-operators). (more…)

Lava Cools

Euclid could have been a hedge-fund manager.

The Greek mathematician and father of differential geometry defined our understanding of three-dimensional shapes in roughly 280 BC. Thanks to Euclid we know what a cube is, and that right angles are all equal.

In 1982, mathematician James Simon started a money-management firm that would seek superior returns not by studying business strategies and financial statements but instead through adhering to mathematical and statistical methods, especially differential geometry. Today secretive Renaissance Technologies, called RenTech by most, manages $37 billion, mainly for its principals. Jim Simons retired in 2009 with an estimated personal fortune of $12.5 billion. Math works.

In 1999, two years after the SEC passed rules on handling trades and set regulations for alternative trading systems that today we call “dark pools,” Richard Korhammer and his engineering colleagues started a direct-access platform they named Lava Trading, a subtle nod to differential geometry and the construction of surfaces. Everything, including equity markets has a surface, and in stocks it’s the top of the book. But below it, in what’s not displayed, is where the action lies.

In 2003, Lava filed a patent on its technique for aggregating market data and placing some trades while hiding others – the top of the book versus the rest of the orders. Differential geometry. The firm became the market-share leader in direct access, a way to describe how investors could skip the stock exchanges to trade with each other.

In 2004, Citigroup spearheaded a dark-pool invasion by big brokers, buying Lava Trading for some $500 million and making it an independent unit. LavaFlow Inc. became known for its market-participant ID (MPID), a four-letter identifier traders use to see who’s driving orders.  Goldman Sachs’s primary MPID is GSCO.  Morgan Stanley’s, MSCO.

Lava’s was FLOW, and FLOW was everywhere. It’s still big. For the week ended Nov 10, FINRA ranked LavaFlow sixth among dark pools behind Credit Suisse, UBS, Deutsche Bank, and the star of Michael Lewis’s hit market-structure tell-all, Flash Boys, IEX.  Combine FLOW with Citi’s two other dark pools and Citi ranked third.

But Citi is chilling LavaFlow, hardening the surface, shutting it down.  In July this year, the SEC fined LavaFlow a record $5 million for permitting a smart order router, computer code that makes buy/sell decisions with high-speed data, to use confidential customer information in trading decisions.

The SEC said these orders totaled 400 million shares over three years. Citi dark pools match that much every two weeks so the allegations concerned roughly 1% of it, a rounding error.

Pulling out of a market where you’re ranked 3rd of 36 seems extreme. But it reflects facts that you must know in the IR chair. First, the stock market isn’t a “market” anymore, and brokers know it. A market by definition is aggregated buy/sell interest, and the stock market today is the opposite of that.

Number two, rather than admit the rules they made in 1997 birthed dark pools and shattered the stock market, regulators are going to regulate dark pools out of existence, and Citi sees it coming. If you think that’s good, remember how we got here to begin.

Third and perhaps most important, Citi ranks second in another market: Derivatives. Bloomberg reported in September this year that Citi has grown its derivatives business nearly 70% since the nadir of the financial crisis and now serves open derivatives contracts worth $62 trillion, second behind market-leader JP Morgan ($68 trillion). It’s the largest counterparty for interest-rate swaps, the biggest derivatives segment.  In derivatives, Citi IS the aggregator.

It fits what we see in equities. When energy stocks took a breathtaking hit the past few trading days following OPEC’s decision to maintain production levels, the behavioral shift was in hedging. The magnitude of movement in prices says it wasn’t driven by real ownership but notional value.

Notional value can reflect tremendous demand or its utter absence in the space of heartbeats because it’s not actual ownership.  We saw stocks drop 30% or more in two days without any meaningful movement in investment behavior.

This is what institutions are doing. It reflects the uncertainty of everything, everywhere. A great deal more money than most realize is putting and taking interest in stocks through derivatives like swaps. That fact is increasingly setting your share-price.  For Citi, the money is in this aggregation, not in equity fragmentation.

Happy Thanksgiving from Austin, TX!  Many of you are out too, seeing family for the holiday. Looking back at 2014, this Market Structure Map from Aug 27 was one of the year’s most widely read. Curiously, some of the same economic data points including the FHFA house-price index and the Case-Schiller Home Price Index were out this week again. 

If we know how many mortgage applications were filed last week, public companies should know what set their stock prices last week too. Every public company deserves good information about the equity market, and it’s not cooler to “just run the business and ignore the stock.” That would be like “just drive the car and ignore the fuel gauge.” Catch you after Thanksgiving!  -TQ

 

Aug 27: Beyond Curiosity

 

Let’s talk about houses.

Let me explain. Twice yesterday I encountered an issue, not a new one though. We were discussing it on a conference call too, preparing for a market-structure session Sept 9 at the NIRI Southwest Regional Conference here in Denver – which if you care about market structure is not to be missed. A highlight, Rajeev Ranjan, central banker with the Chicago Federal Reserve and former algo trader, will explain why the Fed cares whether high-speed traders are gaming equities and derivatives.

Anyway, what issue am I talking about?  I continue to hear executives and investor-relations officers say, “I don’t see why short-term trading matters when we’re focused on long-term investors.”

I hear some of you groaning.  “Quast,” you moan. “We don’t want to keep hearing the same stuff.”  I get that. If you already know the answer, you can cut out of the Market Structure Map early today.  Catch you next week.

The rest of you, if you’ve got a tickling there in the back of your head like a sneeze forming in the nose that you really don’t want the CFO to ask you why market structure matters, then let’s talk about houses.

Big money tracks residential real estate – houses. Just this week we had or will have reports on new home sales, the Federal Home Financing Administration’s housing index, the Case-Shiller Home Price Index, mortgage applications, and pending home sales. Decisions about construction, banking, credit-extension and more depend on these data.  They’re part of certain GDP components. (more…)

Feedback

You’ve got to know what to measure.

Every time I interact with anybody from an airline to my company’s communications providers, I get a survey. “How’d we do?”

It drives me crazy. It’s like Claymation customer service:  Move something, take a picture.  Move something, take a picture. You’ve seen clay animation?  Wallace & Gromit popularized cartoonish clay caricature (and cheese!). Each picture contributed to forming movement and emotion. Every snapshot is feedback that when viewed together become the story. It works in cartoons but isn’t a good customer-service model.

We’re inundated with market information in the investor-relations profession.  The feedback loop is so intensive that it can somewhere morph from meaningful to white noise. You don’t know what you’re measuring or hearing. The sequence of snapshots doesn’t translate to meaningful film. There’s no narrative in the data.

Back when I was in the IR chair, I’d hear all the time that we’d broken through moving averages.  Initially, I exclaimed, “Oh!” and added, “Thank you!” It was only later that I realized moving averages told me little and certainly weren’t entertaining like Claymation. What should I tell management?  “Unfortunately, there’s been a breakdown in our moving averages, prompting a sharp shift in perception.”

Really?

Here’s another metric that confuses busy with productive. We have clients with high short interest. The measure derives from a 1974 regulation from The Federal Reserve to track borrowing in marginable securities accounts as part of aggregate money supply.

Borrowing is a good measure of risk. To that end, if you’re interested in a riotous three-minute explanation of what’s wrong in Europe, click here (it’s a video clip so be appropriately prepared).

But what if we’re not measuring borrowing correctly? Short volume, or trading with borrowed shares instead of owned shares, is roughly 43% of the total market. This measure wasn’t created by the Fed in 1974. It’s current. It’s Claymation. We’ve studied short interest and short volume and found that the former often is inversely correlated with price-movements, suggesting that it’s a lagging indicator of risk (and thus a lousy one). Not so with short volume.

The ownership measure extant today, 13Fs, was created in 1974 as well. It’s deplorable as feedback on institutional behavior, coming 90 trading days after it might have occurred. Today, over $1.7 trillion of assets are held by Exchange-Traded Funds that post ownership positions daily, yet trades clear “T+3,” or potentially four days out.

Do you think about these things in the IR chair? Perception is, “Our price continuously reflects rational thought.” Reality is something else, demonstrably and statistically.  Speaking of which, I’m hoping to take the NIRI Arizona chapter on a rollicking safari through market structure today. Process is more influential than purpose.

What you don’t want to do with your IR forensics is confuse busy with productive. You can track vast seas of data that neither offer narrative nor animate it.  What’s the right feedback mechanism? Reality! What is money doing right now and what’s the likely impact in the future, and what’s that mean to actions in my IR program and what I communicate to management? (more…)