Supine Risk

We’re in New York this week while companies gather in Dallas for the annual NAREIT conference, the association for real estate investment trusts.

Real estate is about 3% of the S&P 500. By comparison, Technology is 23%, the largest by a wide margin over healthcare and financials (a combined 27%).  Yet large REIT Exchange Traded Funds hold more assets than big Tech ETFs, with the top ten for each managing $54 billion and $46 billion respectively.

The implication is disproportionate influence in real estate from passive investment. With market sentiment the weakest in more than a year by our measures, I’m prompted to reflect on something we’ve discussed before: Risk in passive investment.

One might suppose that investments following models are less risky than portfolios built by selecting stocks on fundamental factors. Singling out businesses leaves one open to wrong decisions while baskets diffuse risk. Right? Look at Vanguard’s success.

Yes. But missing in these assumptions is what happens when concentrated assets are bought and sold. The biggest real estate funds are mainly at Vanguard, Blackrock, State Street and Schwab. It’s probably true across the whole market.

Behind ETFs, stocks are concentrated too. We’ve described how the top thousand stocks are more than 90% of market volume, capitalization and analyst coverage. Just 8% of assets are in the Russell 2000, the bottom two tiers of the Russell 3000. And there are barely more than 3,300 companies in the Wilshire 5000 now.

Lesson: Everything is big. One reason may be that money buys without selling. Inflows are topping outflows (hint: That has now stopped for the first time in over a year), so indexes aren’t paying out capital gains, skewing returns, as Jason Zweig wrote in the Wall Street Journal Nov 10.

Mr. Zweig highlights the PNC S&P 500 Index Fund, which is distributing 22% of assets as a taxable gain because people have been selling it.  The fund has performed about a third of a percent behind peers. Add in capital gains and the sliver becomes a maw.

Mr. Zweig notes that some big funds including the Vanguard 500 Index and the State Street Institutional S&P 500 Index Fund haven’t paid out capital gains in more than 15 years. If investors aren’t cashing out, assets aren’t sold, capital gains aren’t generated, and results don’t reflect underlying tax liability.

To me there’s a bigger passive risk still. With more money chasing the goods than selling them, things perpetually rise, turning investor-relations professionals and investors alike into winners, but begging the question: What happens when it stops?

I’ve always liked Stein’s Law as a bellwether for reality. If something cannot last forever, said Herb Stein, father of famous son Ben, it will stop. Since it cannot be true that there will always be buyers without sellers, the prudent should size up what happens when giant, concentrated owners shift from buying to selling.

To whom do they sell?

And how can we have buyers without sellers?  Mr. Zweig talks about that too, indirectly. We’ve written directly about it (and I’ve discussed it with Mr. Zweig).  Indexes and ETFs may substitute actual shareholdings with something else, like derivatives. If you can’t find an asset to buy, you buy a right to the asset. This idea torpedoed the mortgage market. You’d think we’d learn.

There’s a rich irony to me in equities now.  During the financial crisis, regulators bemoaned the long and risky shadows cast by giant banks too big to fail because failure would flatten swaths of the global economy.

That was just banks. Lenders.

What we’ve got now is the same thing in the equity market, but risk has transmitted to the assets we all depend on – not just the loans that leverage dependency.

It’s the most profound reason for future policymakers (Jay Powell and Steven Mnuchin) to avoid the mistakes made by the Bernanke Generation of central bankers, who depressed interest rates to zero out of frantic and preternatural fear of failure.

The absence of reasonable interest rates devalues money and pushes it into assets at such a profound rate that for very long stretches the only thing occurring is buying. Result: Everything is giant, and concentrated – the exact opposite of the way one diffuses risk.

When it stops there are no buyers left.

How to get out of a problem of this magnitude?  Quietly. If enough people tiptoe away, there will be buyers when everything is properly priced again.  The hard part is knowing when, because passive risk reposes supine.

Evaluation

We’re in San Francisco at the NIRI meeting, warming up with winter coming to Denver and as summer carries airily on in stocks.

What metrics do you use to evaluate your own shares, investor-relations folks, or ones you own, investors?

I don’t mean fundamentals like cash flow, growth, balance sheet data. Those describe businesses. Stocks are by and large products.

If you bristle at that assertion, it’s just math. JP Morgan and Goldman Sachs have either outright said or intimated that about 10% of their trading volumes come from fundamental investment (our data show 13.5% the past five days). Implication: The other 90% is driven by something else.

This disconnect between how investors and public companies think about stocks and what sets stock prices is to me the root of the struggle for stock pickers and IR professionals alike today.

For instance, the winds are starting to whip around the regulatory regime in Europe called MiFID II, an acronym profusion that considers securities “financial instruments” and will dramatically expand focus on data and prices – two things that power short-term trading.

For proof, one expert discussing MiFID II at TABB Forum said derivatives are “ideally suited” to the regime because they’re statistical. And a high-speed trading firm who will remain anonymous here because we like the folks running it sees MiFID II as a great trading opportunity.

Back to the question: What are your metrics?  It might not be what you’re thinking but it appears to me that the metrics most widely used by investors and companies to evaluate stocks are price and volume. Right?

But price and volume are consequences, not metrics. Think of it this way: What if meteorologists had gone to Puerto Rico and surveyed the damage and reported back that there must’ve been a hurricane?

That’s not very helpful, right? No, meteorologists forecasted the storm’s path. They offered predictive weather metrics. Forecasts didn’t prevent damage but did help people prepare.

The components of the DJIA are trading about 27 times earnings, as I wrote last week. Not adjusted earnings or expected earnings. Plain old net income. It’s a consequence of the underlying behaviors.

By understanding behaviors, we can prepare, both as investors and public companies, for what’s ahead, and gain better understanding of how the market works today.

I can summarize fifteen years of studying the evolution of the US equity market: machines are creating prices, and investors are tracking the averages. That combination creates valuations human beings studying businesses would generally find too rich.

How? Rules. Take MiFID II. It’s a system of regulation that advantages the pursuit of price based on market data, not fundamentals. In the US market, stock regulations require an intermediary for every trade. That also puts the focus on short-term prices.

Then every day by the close, all the money wanting to track some benchmark wants the best average price. So short-term price-setters can keep raising the price, and money tracking averages keeps paying it.  It’s not a choice.  It’s compliance.

In the past five days, data show the average spread between intraday high and low prices is a staggering 3%.  Yet the VIX spent most of that time below 10 and traded down to 9!

How? Machines change prices all day long, and at the close everything rushes to the average, so the VIX says there’s no volatility when volatility is rampant. Since machines are pursuing the same buy low, sell high, strategy that investors hope to execute save they do it in fractions of seconds, the prices most times end higher.

But it’s not rational thought doing the evaluating.

The lesson for IR folks and investors alike is that a market with prices set this way cannot be trusted to render accurate fundamental evaluation of business worth.

What causes it to break? Machines stop setting prices.  What causes that? There’s a topic for a future edition!  Stay tuned.

The Middle

Keep it between the lines, advises an old country song from my youth.

“Quast,” you say. “If it’s from your youth, drop the modifier ‘old.’ That’s a given.”

You’d be right. Yesterday was ghoulish, as my Halloween trick was turning 50. Dead in the middle between zero and a hundred. And so now that I’m an elder I can pontificate with more gravity. Or such is the hope.

The Federal Reserve wraps a quiet meeting today where no doubt much pontification by elders ensued, and the trick for the Fed is to keep it between the lines. I expect the Trump administration, if the next Fed head is current Fed governor Jerome Powell, hopes to hew to the middle. No rocked boats or roiled waters, is the thinking.

The stock market is the same. It migrates to the mean. So successful is the average in 2017 that we’ve not had a single short-term market bottom (I’ll explain shortly).

The Wall Street Journal’s list of international indices shows none in the red the last 52 weeks. Root through Bloomberg and you’ll find a few deep in the ranks. Qatar is down 20%. Pakistan, Montenegro, Botswana and Bosnia in the red. But losers are few.

In the deep green are the Merval in Argentina, up 62%, the S&P 500 in the US, 21%, and the Dow Jones Industrial Average comprised of plodding blue chips, up 29%.  Even economically beleaguered Venezuela (native son Jose Altuve guilds baseball’s Astros) should’ve told citizens to buy local stocks as they’ve rocketed 4,700% in a year.

I tallied data on DJIA components.  The average blue chip is trading at 27 times earnings, with shares up 90% the past five years, 18% per annum on average. Yet a survey of financials the past four years across the thirty shows average revenue DOWN 2%, earnings down 7%.

There are some strong blue chips. But money and market structure have distorted the valuation picture (where markets and the Fed dovetail). While we’re not wary, we know it’s true and there will be blood. We’re just in the middle where everybody forgets about cause and effect.

We use the ModernIR Behavioral Index to predictively meter short-term movement of money on a 10-point scale. Over 5.0, more money is coming than going.  Under it, the opposite.  Historically, over 7.0 was a market top predicting profit-taking the next 30 days, and under 4.0 was a near-term market bottom, a value signal.

The market in 2017 is in the middle. That’s a buy and hold market, yes. But it lacks value signals too. People are overpaying. Stocks in 2012 dipped below 4.0 on 41 trading days out of roughly 260 total.  In 2013, there were 31 market bottoms; in 2014, 22; 2015, 39, and 2016, 31.

In 2017, none. Zero. The ModernIR Behavioral Index was 3.5/10.0 on Nov 8, 2016, the last bottom (those who bought then correctly read sentiment!).

I’m glad the US economy is posting numbers many thought impossible – 3% GDP growth for consecutive quarters. It can deliver even better data.  But right now too much money is chasing too few goods.

There’s one source of blame: The Federal Reserve.  Other central banks influence money supply but there’s still just one reserve currency (all efforts thus far to change it notwithstanding).

Result: Picture a Cape Canaveral launch. The space shuttles now retired would blaze 37 million horsepower fighting off gravity. The Falcon Heavy from SpaceX lifts goods to the space station with power like 18 Boeing 747s strapped on and throttled up.

There is no floating economy in space where gravity doesn’t exist. A great gout of central-bank money cannot as with space travel blast the planetary fisc past the gravitational pull of debt and spending. It can only create a long comet trail of stock prices and real estate prices and bond prices.

We think we’re in the middle. And we are. But not how we suppose. We’re between.

The Shiller PE as we wrote last week is the second steepest outlier in its history. Fundamentals don’t match stock prices. Gravitational pull is coming. We’re nearer the edge than the middle, viewed that way.

Many have decried central banks for opening floodgates, claiming it would produce a monetary Katrina. I supposed it would be two years from when the Fed’s balance sheet stopped expanding in latter 2014. But the Trump Rocket took us to zero market bottoms.

What’s tripped up doomsayers is a misunderstanding of the middle. The space between actions and consequences can be long. What is the Fed getting wrong?  It’s keeping us in the middle. It’s eliminating winners and losers.

We’ve got to get out of the middle before the bottom of it drops out.  Jerome Powell, can you help?

Easy Riders

It’s been so easy making money on stocks around the planet that the actual easy money has been forgotten.

The European Central Bank Thursday is expected to signal intent to curtail long-running mass purchases of corporate debt. Of course the Federal Reserve, the American central bank, sees higher interest rates yet last raised in March, so who do you believe?

And why should you care?

Because there are two giant macro inputs to stocks, investors and public companies:  currencies and interest rates.  Central banks pull the biggest levers affecting both.  Stocks are denominated in currencies that when fluctuating can spawn violent ripples (2008 was a huge spike in the dollar).

With central banks coordinating currency policies to smooth fluctuations, price volatility has appeared to vanish. It’s not gone, however. It’s just stabilized – like the amazing stabilization technology in my Google Pixel phone. Whizzing down the road on a bike I can hold my camera behind me and film followers and the video is dead stock still. Nary a jitter. The central bank of phones.

If I wipe out on the bike, no amount of stabilization will compensate. That’s not an intended analogy but maybe it’s apropos.  We’ve all been easy riders.  Stocks don’t fall, they just rise.  Prices hardly vary save to pop periodically.

Back to the ECB, a Wall Street Journal article yesterday offers perspective. Last year the ECB bought $115 billion of corporate bonds, more than the entire eligible supply of $103 billion.

One result is high-risk companies are getting investment grade financing with a taxpayer guarantee. The thinking is that buying risky corporate borrowings drives more economic output. But the public was outraged about backstops for giant banks in the financial crisis.  One wonders how taxpayers will respond if those bonds fall apart.

The WSJ article notes that a mere 0.2% tick up for bond yields would wipe out a year’s worth of returns (because the value of the bonds would decline, and bond buyers are now chasing rising prices more than yield).

The ECB isn’t buying bank bonds, but it’s bought so much other issuance that a quarter of continental investment grade corporate debt has negative yields. Investors are paying for the privilege of owning them because prices keep rising (it’s a bit like equities where rich multiples mean investors are paying for the privilege of one-way stocks).

Low interest rates remove a clarion call about the value of money and the presence of risk. Investors priced out of high-yield bonds by central banks instead look to other even riskier things for returns. Those traditionally buying investment grade instruments are forced to move to higher risk too, for a desired return.

Everywhere risk increases yet paradoxically it appears to vanish, because interest rates say there is none and all prices rise.

For investor-relations professionals today, it’s a reminder of how important your job is.  So many things besides story now populate your whiteboard, ranging from passive investment, to a shrinking sellside, to macro factors. Keep execs informed.

And investors, never forget that your assets are as good as the stability of the money denominating them, and creating value is hard work. We’ve been easy riders a long time. We may get a hint Thursday from the ECB of hills ahead.

Impassively Up

A picture is worth a thousand words.

See the picture here, sparing you a thousand words (for a larger view click here). It explains our rising stock market.  Look at the line graphs.  Three move up and down, reflecting normal uncertainty and change. Just one is up like the market.  Passive Investment.

Stock market behaviors

At ModernIR, we see the market behaviorally. There are four big reasons investors and traders buy and sell, not one, so we quantify market volume daily using proprietary trade-execution metrics to see the percentages coming from each and trend them.

Were the market only matching risk-taking firms with risk-seeking capital, valuing the market would be simpler. But 39% of volume trades ticks, gambling on fleeting price-moves. About 12% pairs stocks with derivatives, down from over 13% longer term.

Less than 14% of trading volume ties directly to corporate fundamentals. So rational thought isn’t pushing stocks to records. In a sense that’s good news because most stocks don’t have financial performance justifying the 20% rise for the S&P 500 the past year.

Alert reader Alan Weissberger sent data from the St Louis Federal Reserve (click the “1Y” button at top right) showing falling corporate profits the past year. To be sure, profits don’t always connect to markets or the economy. There were rising corporate profits during the 1970, 1991 and 2001 recessions.

And corporate profits were plunging in 2007 when the Dow posted its second-fastest 1,000-point rise in history (the one from 22,000-23,000 just now is the third fastest, and both trail the quickest, in 1999 when profits were likewise falling).

Now, I’ll qualify: This picture reflects a model. Eugene Fama, the father of the Efficient Market Hypothesis, said models aren’t reality.  If they explained everything then you would need to call them reality.

But the market as we’ve modeled it with machines that bring a taciturn objectivity to the process has been driven by the sort of money that views fundamentals impassively.

You might think it surreal that 36% of volume derives from index and exchange-traded funds and other quantitative investment. Yet it makes logical sense. Blackrock and Vanguard have taken in a combined $600 billion this year says the Wall Street Journal and the two now manage nearly $12 trillion that’s largely inured to sellside analysts and your earnings calls, public companies.

And the number of public companies keeps falling, down a third the past decade. I suspect though no one has offered the math – I will buy a case of our best Colorado beer for the person with the data – that total shares of public companies (all the shares of all the companies minus ETFs and closed-end funds) has also fallen on net, 2007-present.

There you have it.  Money that simply buys equities as an asset class sliced in various ways is doing its job.  But it becomes inflation – more money chasing fewer goods. Wall Street calls it “multiple expansion,” paying more for the same thing (current Shiller PE is the highest in modern history save the dot-com bubble).

And because passive money like Gene Fama’s models doesn’t ask whether prices are correct and merely accepts market prices as they are, there’s no governor, no reasoning, that prompts it to assess its collective behavior. So as other behaviors drop off, passive money becomes the dominant force.

In that vein, look at Risk Mgmt. It reflects counterparties to investors and traders using options, futures, forwards, swaps and other derivatives to protect, substitute for or leverage stock positions. The falling percentage suggests the cost of leverage is rising.

It fits. A handful of banks like Goldman Sachs dominate the business. Goldman’s David Kostin publicly expressed concern about market values. Kostin says the stock market is in the 88th percentile of historical valuations. If banks think downside risk is higher, the cost of insuring against it or profiting on rising markets increases.

Where in the past we worried about exuberance, we should be equally wary of the impassive face of passive investment that doesn’t know it’s approaching a precipice.

I don’t think a bear market is near yet but volatility could be imminent. By our measures the market has not mean-reverted since Sept 1. It suggests target-date and other balanced funds are likely overweight in equities. When it tries to rebalance, we could have severe volatility – precisely because this money behaves passively. Or impassively.

Climbing Mountains

You’re welcome.

Had Karen and I not departed Sep 20 for Bavaria to ride bikes along the Alps, who knows what the market might have done?  There’s high statistical correlation between our debouchment abroad and a further surge for US stocks.

Stocks spent all of September above 5.5 on the 10-point ModernIR Sentiment Index. Money never paused, blowing through September expirations and defying statistics saying 80% of the time stocks decline when Sentiment peaks as derivatives lapse.

Were we committed to the interests of stock investors we’d pack our bags with laundered undergarments and return to Germany before the market stalls.

But is the market rational?

Univ. of Chicago professor Richard Thaler, who won the Nobel Prize this week for his work on behavioral economics, is as flummoxed as the rest by its disregard for risk. While Professor Thaler might skewer my certitude to knowledge quotient (you’ll have to read more about him to understand that one), I think I know why.

Machines act like people.  My Google Pixel phone constructed a very human montage of our visit to Rothenberg, a Franconian walled medieval city in the woods east of Mannheim.  I didn’t pick the photos or music. I turned on my phone the next day and it said here’s your movie.  (For awesome views of our trip click here, here, here and here.)

Google also classifies my photos by type – mountains, lakes, waterfalls, boats, cars, churches, flowers, farms, beer.

Don’t you suppose algorithms can do the same with stocks? We have long written about the capacity machines possess to make trading decisions, functionally no different than my Pixel’s facility with photographs.

For companies and investors watching headlines, it appears humans are responding.  If airline stocks are up because of good guidance from United Airlines and American, we suppose humans are doing it. But machines can use data to assemble a stock collage.

The way to sort humans from robots is by behavior. It’s subtle. If I sent around my phone’s Rothenberg Polka, where the only part I played was naming it, recipients would assume I chose photos and set them to music. Karen would look at it and say, “Get rid of that photo. I don’t like it.”

Subtleties are human. Central tendencies like flowers and waterfalls are well within machine purview. Machines don’t like or dislike things. They just mix and match.

Apply to stocks. It explains why the market is impervious to shootings, temblors, volcanic eruptions, hurricanes, geopolitical tension. Those aren’t in the algorithm.

Humans thus far uniquely grapple with fear and greed. A market that is neither greedy nor fearful is not rational. But it can climb mountains of doubt and confound game theorists. What we don’t know is how machines will treat mismatched data. We haven’t had much of it in over nine years.

Times and Seasons

You need examples.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A Big Deal

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Acronym Techniques

The stock market is full of acronyms.

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

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

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

If I missed any vital acronyms, apologies.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And your stock is an acronym.

Harvey Market Structure

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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