Predictive Knowledge

Why don’t I trade like my peers?

The CEO is sure it’s because investors don’t understand something – how you manage inventory, your internal rate of return targets. Pick something.

Investors ask the same question. Why does that stock lag the group? For answers, they root through financials, technology, leadership, position in the market, to find the reason for the discount (or opportunity).

What if these assumptions are wrong?

At prompting from friend and colleague Karla Kimrey in the Rocky Mountain NIRI chapter (which we sponsor) who knows I’m a data geek, I’m reading Michael Lewis’s The Undoing Project, his latest. It’s a sort of sequel to Moneyball, about how baseball’s Oakland A’s changed professional sports with data analytics (read both and you’ll see that ModernIR is Moneyball for IR).

The Undoing Project focuses on why incorrect assumptions prevail.  I don’t have the punch line yet because I’m still reading. But I get the point already and it’s apropos for both investor-relations professionals and investors in markets that often seem to defy what we assume is the rationale behind stocks and the whole market.

Perception overwhelms reality.

The CEO, the IR professionals, investors, are all focused on the same thing. The collective assumption is that any outcome varying from expectations is a deficiency in story.  Personal perceptions have shaped our interpretation of the market’s behavior.

Yet statistically, rational thought is a minority in market volume – about 14% of it, give or take. When markets surged Monday, the Dow Jones Industrials up 183 points, we were told it was enthusiasm about earnings.

The data showed the opposite – Asset Allocation. Money that pays no attention to earnings. It’s 33% of market volume.

Why would it buy now? Because options are expiring today through Friday (and derivatives directly influence 13% of trading volume marketwide).  Asset Allocation uses options and futures to nimbly track benchmarks, and with markets down it’s probable that derivative positions were converted to the actual stocks.

But then it’s over.  Mission accomplished.  Yesterday the market gave back 114 points to go with 138 points last Thursday. The qualitative assumption – the gut instinct – that earnings enthusiasm lifted stocks Monday was not supported by subsequent data.

Daryl Morey, general manager of the Houston Rockets, gives The Undoing Project a literary push in the early pages. An MIT man and not a basketball player, Morey came into the job because team owner Leslie Alexander wanted “a Moneyball type of guy.”

He sought data-driven results.  And it worked.  Houston is in the top ranks for success with draft picks and getting to the playoffs, and other teams have copied them.

Morey says knowledge is prediction. We learn things to understand what may happen. It’s a great way to think about it. Suppose it works in IR and investing too.

It starts with questioning assumptions.  What gut instincts do you hold about your stock that you can’t support with data?  How do they compare to the data on market volume?

I know there’s a swath of people in every walk including IR and investing who think data is BS. Who cares? they’d say.  I go with my instincts. Besides, what difference does it make if we know or don’t?

Knowledge is prediction. Data align perception and reality. In Undoing, Lewis uses the Muller-Lyer illusion. Your mind perceives one line longer. Nay. Measurements prove it.

I’ll leave you with this data on the market. I wrote last week about volatility insurance.  Now we’ve got volatility.  Insurance policies are expiring right now, with the VIX today kicking off April expirations through Friday. Our Sentiment Index trend is like mid-2014.

We don’t know what may come. But we’re thinking ahead. Assumptions are necessary but should be the smallest part of expectation.

That’s a good rule of thumb in life, investing and IR (and if you want help thinking about what IR assumptions may be wrong, ask us. We may not have the answer. But we’ve got great data analytics to help sort reality from perception).

Volatility Insurance

In Texas everything is bigger including the dry-aged beef ribs at Hubbell & Hudson in the Woodlands and the lazy river at Houston’s Marriott Marquis, shaped familiarly.

We were visiting clients and friends before quarterly reporting begins again. Speaking of which, ever been surprised by how stocks behave with results?

We see in the data that often the cause isn’t owners of assets – holders of stocks – but providers of insurance. To guard against the chance of surprises, investors and traders use insurance, generally in the form of derivatives, like options. 

Played Monopoly, the board game? A Get Out of Jail Free card is a right but not an obligation to do something in the future that depends on an outcome, in this case landing on the “go to jail” space. It’s only valuable if that event occurs. It’s a derivatives contract.

At earnings, if you shift the focus from growth – topline – to value – managing what’s between the topline and the bottom line – the worth of future growth can evaporate even if investors don’t sell a share.

Investors with portfolio insurance use their Get Out of Jail Free cards, perhaps comprised of S&P 500 index futures. The insurance provider, a bank or fund, delivers futures and offsets its exposure by selling and shorting your shares. It can drop your price 10-20%.

Writers Chris Whittall and Jon Sindreu last Friday in the Wall Street Journal offered the most compelling piece (may require registration — send me a note if you can’t read it) I’ve seen on this concept of insurance in stocks.

Investors of all ilks, not just hedge funds, protect assets against the unknown, as we all do. We buy life, auto, health, home insurance.  We seek a Get Out of Jail Free card for ourselves and our actions.

In stocks, we track this propensity as Risk Management, one of the four key behaviors setting market prices. It’s real and by our measures north of 13% of total market cap.

But the market has been a flat sea.  No volatility.  This despite a new President, geopolitical intrigue, global acts of terror, a Federal Reserve stretching after eight Rumpelstiltskin years, and a chasm between markets and fundamentals.

Whittall and Sindreu theorize that opposing actions between buyers and sellers of insurance explains the strange placidity in markets where the VIX, the so-called Fear Gauge derived from prices of options on stocks, has been near record lows.

The thinking goes that the process of buying and selling insurance is itself the explanation for absence of froth. Because markets seem inured to threats, investors stop buying insurance such as put options against surprise moves, and instead look to sell insurance to generate a fee. They write puts or calls, which generate cash returns.

Banks take the other side of the trade because that’s what banks do. They’re now betting volatility will rise. To offset the risk they’re wrong, they buy the underlying: stocks. If volatility rises the bet pays, but the bank loses on the shares, which fall. 

This combination of events, it’s supposed, is contributing to imperturbable markets. Everything nets to zero except the stock-purchases by banks and cash returns generated by investors selling insurance, so there’s no volatility and markets tend to rise.

Except that’s not investment. It’s trafficking in get-out-of-jail-free cards.

And despite low volatility, there’s a cost. We’ve long said there will be a Lehman moment for a market dominated by Risk Management.

We’ve seen hedge funds struggle. They’re big players in the insurance game. And banks have labored at trading. Maybe it’s due to insurance losses. Think Credit Suisse, Deutsche Bank, HSBC.  Someone else?

From Nov 9-Mar 1 the behavior we call Risk Management led as price-setter marketwide, followed closely by Active Investment. The combination points to what’s been described: One party selling insurance on risk, another buying it, and a continual truing up of wins and losses.  

Now, for perspective, the VIX is a lousy alarm system. It tells us only what’s occurred. And intraday volatility, the spread between daily high and low prices across the market, is 2.2%, far higher than closing prices imply.

We may reach a day where banks stop buying insurance from selling investors, if indeed that’s what’s been occurring.  Stocks will cease rising.  Investors will want to buy insurance but the banks won’t sell it.  Then real assets, not insurance, will be sold.

It’s why we track Risk Management as a market demographic, and you should too.  You can’t prevent risk. But you can see it change.

Blackrobotics

The point isn’t that Blackrock picked robots over humans.  The point comes later. 

If you missed the news, last week the Wall Street Journal’s Sarah Krouse reported that Blackrock will revamp its $275 billion business for selecting individual stocks, turning over most decisions to machines (ejecting scores of human managers).

For perspective, that’s about 5% of Blackrock’s $5.1 trillion in assets. The other 95% is quantitative already, relying on models that group stocks around characteristics ranging from market capitalization to volatility.

Spanning 330 Blackrock iShares Exchange-Traded Funds (ETFs) are 14 primary clusters of characteristics that define investments. What Blackrock calls its “core” set are 25 ETFs managing $317 billion, more than the entirety of its active stock-picking business. Core investment describes what Blackrock sees as essentials for a diversified portfolio.

Blackrock views investing as a mixture of ingredients, a recipe of stocks.  The world’s largest asset manager thinks it’s better at crafting recipes than picking this or that flavor, like Fidelity has done for decades. 

But who is most affected by the rise of Blackrobotics?  We come to the point.  Two major market constituencies are either marginalized or reshaped: Public companies and sellside stock researchers.

“Sellside” means it’s the part of the market selling securities rather than buying them. Blackrock is on the buyside – investors who put money into stocks. The sellside has always helped investors by keeping stocks on hand like Merrill Lynch and Morgan Stanley used to do, and processing stock trades.

The sellside since brokers first fashioned the New York Stock Exchange also armed investors with valuable information through stock analysis. Analysts were once the big stars wielding power via savvy perspectives on businesses and industries. Everybody wanted to be Henry Blodget talking up internet stocks on CNBC.

Following the implosion of the dot-com boom of the 90s, regulators blamed stock analysts and enforced a ban on the use of valuable research preferentially, a mainstay for brokers back two centuries. So the sellside shifted to investing in technology rather than people, and the use of trading algorithms exploded.

Brokers – Raymond James to Credit Suisse, Stifel to JP Morgan – have long had a symbiotic relationship with public companies. Brokers underwrite stock offerings, placing them with their clients, the big investors.  After initial public offerings, analysts track the evolution of these businesses by writing research and issuing stock ratings. 

That’s Wall Street.  It reflects the best symbiosis of creative energy and capital the world has ever seen. Analysts issue ratings on stocks, and companies craft earnings calls and press releases every quarter, and money buys this combination. The energy of it hisses through the pipes and plumbing of the stock market. 

Blackrock uses none of it. It’s not tuning to calls or consuming bank research. Neither does Vanguard. Or State Street. Together these firms command some $11.5 trillion of assets eschewing the orthodoxy of Wall Street.

Public companies spend hundreds of millions annually on a vast array of efforts aimed at informing stock analysts and the investors who follow what they say and write. Earnings calls and webcasts, websites for investors, news via wire services, continuous travel to visit investors and analysts.

It’s the heart of what we call investor relations.

What Blackrobotics – Blackrock’s machines – mean to public companies is that some effort and spending are misaligned with the form and function of the market. It’s time to adapt. The job changed the moment Vanguard launched the first index fund in 1975.  You just didn’t know it until now. 

How do I change it, you ask? You can’t. Public companies should expend effort proportionate with the behavior of money. The trillions not tuning to calls or reading brokerage research deserve attention but not a message.

If money is using a recipe, track the ingredients and how they affect valuation, and report on it regularly to management. Get ahead of it before management asks.

It’s neither hard nor scary. What made index investing a great idea, to paraphrase Vanguard founder Jack Bogle, was that it was difficult for investors to be disappointed in it.  Same applies to IR and passive investing. What makes data analysis alluring is that it’s a management function and it’s hard to be disappointed in it.

(Note: If you want help, ask us. We use machines to measure machines and it’s simple and powerful and puts IR in charge of a market run by them. I talked about it yesterday at the NIRI Capital Area chapter).  

I’m not sure how capital forms in this environment. Wall Street lacks plumbing. Thus, companies grow privately and become index investments via IPOs, exiting as giants that are instantly part of the thousand biggest in which all the money concentrates.  

It’s not the end of the world, this rise of the machines.  But Blackrobotics come at a cost.  We all must adapt. It’s far less stressful embracing the future than missing the past.

Race Condition

You might think today’s title is about physical fitness.

No, ModernIR is an equity data analytics firm, not a personal trainer. I first heard the term “race conditions” used to describe stock-trading at TABB Forum, the traders’ community, in comments around an October 2012 article there by HFT expert Haim Bodek on why high-frequency traders have an advantage.

Reader Dave Cummings said, responding to it, “When Reg NMS was debated, several people very knowledgeable about market structure (including myself) argued against locked, crossed, and trade-through rules because of the side-effects caused by race conditions between fragmented markets.”

Emphasis mine.  You say who is Dave Cummings and what is this jargon that has me wanting to bludgeon my noggin on a wall?

I hope Mr. Cummings won’t mind my resurrecting his point. He started both BATS Global Inc., the stock exchange the CBOE is buying that by market-share the last five trading days nosed out the NYSE with 20.7% of US volume versus the venerated Buttonwood bourse’s 19.9% (the Nasdaq had 17.7%, IEX 2.2%, and nearly 40% was in broker pools), and speedy proprietary (no customers, trades its own capital) firm TradeBot.

He knows market structure.

We come to the jargon. Don’t tune out, investor-relations people and investors, because you need to understand the market to function well in it. Right?

Most people don’t know what Dave knows (that could go on a T-shirt). Mr. Cummings was explaining that trading rules prohibit the bid to buy and the offer to sell from being the same. A locked market. Crossed markets are out too, by law. You can’t make a bid to buy that is higher than the offer to sell.

And this “trade through” thing means brokers can’t continue buying stock at $20 one place if it’s now available for $19.99 another place.

I’ve said before that there’s no such thing as a “fragmented market.” A market by definition is aggregation. The stock market today is a series of interconnected conclaves all forced to do the same thing with the same products and prices. You understand? You can buy Nasdaq stocks at the NYSE and vice versa and only at the best price everywhere.

ModernIR builds software and runs lots of data-warehousing functions so we know race conditions. It’s when something doesn’t happen in proper sequence, you might say.

For instance, a data warehouse must be updated on schedule before an algorithm processes a routine. Some hiccup in the network slows the population of the data warehouse, so the algorithm fails because data haven’t shown up. Race condition.

The stock market is similarly a series of dependent processes, some of which will inescapably fail. Why would we create a stock market with a known propensity for process errors? Exactly. But let’s focus on what this means to investors and public companies.

It means the market is barred from behaving rationally in some circumstances. What if I want to pay more for something? Or say I don’t mind getting an inferior price for the convenience of staying in one place.

Plus, can we trust prices? What if yesterday’s big gains were a product of a race condition? I’m not saying they were. But we measure discrete market behaviors setting prices. Counterparties for derivatives were heavy buyers Monday when the stock market swooned sharply and then recovered most of its losses by the close.

These big banks or insurers bought because investors had portfolio insurance to guard against losses. That’s not investment behavior.

What then if equity trades tied to derivatives didn’t populate someplace and the market zoomed yesterday on a process error? Again, I’m not saying it did.  But the things Mr. Cummings warned would create errors in markets are cornerstones of the regulations behind the National Market System.

And why can’t a bid and offer be the same? Forcing them to be different means an intermediary is part of every trade. That’s why 40% of trading is in dark pools – to escape shill bids by trading intermediaries.

Why would Congress – which created the National Market System – mandate a middle man for stocks, when to get a good deal you cut the middle man out? Think about that with health care (or with government itself, which is the ultimate middle man).

But I digress.

We have a stock market the requires an intermediary, prohibits buying and selling at the same price (unless at the midpoint between them, which is the average, which is why index-investing is crushing stock-picking), and stops investors from paying the price they want and forces them instead to take a different price.

In Denver real estate, the bid to buy is often higher than the offer to sell because there aren’t enough houses. Don’t you want people paying more for your shares rather than less? So why do rules require the opposite?

I want us all thinking about whether the stock market serves our best interests in current form where passive investment is taking over everything.

I’ll be talking about that to the NIRI Capital Area chapter Apr 4, so come say hi. And we’ll be at NIRI Boston tonight self-congratulating with the rest of the sponsoring vendors in Sponsorpalooza.  You all in Minneapolis, good seeing you last week!

I just hope there are no race conditions in our travel plans from Denver today.

High Speed Risk

Is the era of high-frequency trading over? 

While you ponder whether “High Speed Risk” might be a good name for your garage rock band, let’s reflect on stocks. We said last week: “Our Sentiment is negative for the first time since the election. It’s a weather forecast.  No need for panic, only preparation.”

We measure the short-term movement of money with a 10-point scale. It was about 5.0 or higher from the election until Mar 9, 80 trading days. Last week it dipped below 4.5.

And weather arrived yesterday before today’s VIX expirations. It’s not news about the Trump administration.  It’s the end of a long, leveraged run. Monthly options and futures expired Friday the 17th.  New options traded Monday, Mar 20.

Yesterday was what we call Counterparty Tuesday. If counterparties have estimated demand Monday for new options incorrectly, they true up on Tuesday. Since markets fell, counterparties overshot demand.  

Derivatives have featured prominently in gains since the election. Investors have been buying both stocks and rights to more of them in the future. That additional implied future demand breeds higher current stock prices.

For the first time since the election, investors didn’t buy more future rights.  Does this mark an end to that pattern?  Certainly for the moment.  And it dovetails with the state of high-frequency trading.

For you new readers, let’s canvass high-frequency trading.  In 2007 after Regulation National Market System, a firm calling itself Octeg splashed through the data. In Intel alone, Octeg was driving 35% of monthly volume, crushing Goldman Sachs.

Who is Octeg, we wondered? The firm defied what we knew about brokers, which always wanted to hang a sign out, advertise that they had products for sale. We couldn’t find even a phone number for Octeg.  It was like stumbling on an unmarked warehouse in the suburbs packed to the ceiling with all the stuff you tried to buy at the mall.

While rooting through regulatory filings we found an address in Chicago and then another firm in the same suite called Global Electronic Trading Co (GETCO). 

And then we got it.  Octeg was GETCO spelled backward. The two were the same firm.

Getco dominated trading through the financial crisis, profiting on two ideas. First, exchanges began paying traders to sell shares on their markets. Think of it like a store coupon: Do business with us and we’ll give you a discount. Getco cashed coupons. In gargantuan manner. Exchanges paid them in coupons for relentless volume.

Second, Getco realized that it could be first to set price. So why not set as many prices as possible, forcing big institutions to chop their trades into smaller pieces?

Volume exploded. 

But it wasn’t investment.  Getco had no customers. It was using computers and mathematical calculations to continuously set prices in the stock market, getting paid to buy and sell stocks while simultaneously changing the price ever faster to force big investors into chopping up stock orders into smaller pieces so Getco and its burgeoning ilk could sit in the middle buying low and selling high in fractions of seconds.

At the pinnacle in 2009, we pegged this behavior, high frequency trading, at 70% of volume. Now high-frequency trading by our measures is less than 40% of volume.

The entire market the past decade is built on it. On the floor of the NYSE, four big high-speed firms price all NYSE stocks at the open. At the Nasdaq, a larger number does the same, trading prices for coupons.

The problem is high-frequency traders don’t have customers. They aren’t “working orders” for investors. They are buying low and selling high in fleeting fashion, for profit. Mistake these prices for ones from investors, and you mentally misprice stocks.   

You read that high-frequency traders are “market makers.” They’re “furnishing liquidity.” Traders with no customers can’t make markets. They can only exploit what others in the market don’t know. In 2007, it was easy. Now it’s not.

That’s because big stock brokers are doing the same thing with Exchange Traded Funds, rapidly repricing them, and index funds, and the stocks comprising them, and the options and futures derived from them. The big brokers are better at it than high-frequency traders because they have customers and can make longer directional plays by reading what customers are doing.

In a market without high-frequency trading, all stocks would trade like Berkshire Hathaway Class A shares.  About 400 shares daily.  It would be better for investors. But all the exchanges would go broke. Ironic, isn’t it?

High-frequency trading isn’t done. But with the market we’ve got, the harder it is for high-speed machines to price stocks, the greater the risk of big moves.

Weathering Change

Everyone complains about the weather but nobody does anything about it.

Mark Twain often gets credit for the clever quip but Twain’s friend Charles Dudley Warner said it.  We’re not here to talk weather though the east coast is wishing someone would do something about it.

Like the weather, there’s a relentlessness to stock-market evolution from fundamentally powered capital-formation to procurement process in which vast sums plug into models that pick, pack and stack stocks in precisely indexed packages.

Blackrock, Vanguard and State Street oversee $11.5 trillion that’s generally blind to sellside research and deaf to the corporate story. It’s a force of nature, more like a weather pattern than investment behavior.

Investor-relations folks say: “What do we do about it?”

Alert reader Karen Quast found a paper from Goldman Sachs advising Boards to respond to the rise of passive investment:

The recent decline in active single-stock investing raises important considerations for corporate boards of directors. The decline has been driven by a shift toward ‘passive investing’ and other forms of rule-based investing, such as index funds, factor-based investing, quantitative investing and exchange-traded funds (ETFs).

The decline of active investing means that, in many cases, stock prices have become more correlated and more closely linked to a company’s ‘characteristics,’ such as its index membership, ETF inclusion or quantitative-factor attributes. As a result, companies’ stock prices have become less correlated to their own fundamental performance.

Goldman Sachs is urging preparation. You can’t change the weather. You can only weather the change. The weather forecast isn’t a call to arms. It’s information we use to adapt to conditions. We prepare for discomfort.  We set realistic expectations.

That’s how investor-relations should view passive investment. We call it Asset Allocation because it’s a behavior that directs dollars to equities according to a model apportioning resources for opportunity and risk.

One way to help the board and the management prepare is to present the idea that there’s not just one behavior buying and selling shares. We ran data for an anonymous company whose share-price is 4% higher today than a year ago, trailing the broad market.

There are four purposes behind buying and selling, one of which is Asset Allocation, and all have equal capacity to set price. After all, market rules today prohibit preference (IR people should understand rules governing how shares are priced and traded and we’ll be discussing it at the Twin Cities NIRI chapter next week – join us!).

There are 50 weeks and in each a behavior led, and bought or sold (one week, Active Investment led and price didn’t change, rotation from growth to value).

It’s eye-opening. The behavior “winning” the most weeks was Fast Trading, short-term machines profiting on price-differences rather than investing.  It led 16 weeks, or 32% of the year, and bought more frequently than it sold.

Active Investment – your stock pickers – and Asset Allocation (indexes, ETFs, quantitative investors) were tied, leading 12 weeks each, but where Asset Allocation bought and sold equally, Active Investment sold more than it bought.

Finally, Risk Mgmt, counterparties to portfolio insurance and trading leverage with derivatives, led 10 weeks, or 20% of the year, but bought 70% of the time.  Put them together and the reason the stock is up a little is because the combined demographics behind price and volume bought 26 times and sold 23 times.

You laugh?  These data are telling! If not for other behaviors, Active Investors would have lowered price. Maybe that’s a message for the board and management team – but show this data to them and it will forever change how they think about the market.

The point isn’t changing the market but understanding how it works, measuring it consistently and adapting to reality.  Fundamentals do not rule now.

But with data analytics, it remains profoundly under the purview of investor-relations. That should bring great comfort to all of us in the profession.  Passive investment isn’t something to fear but to measure.

Market Sentiment:  The Federal Reserve likely hikes rates today, and options expire tomorrow and Friday, the latter the first quad-witching session of 2017. Also, S&P and Nasdaq indexes rebalance. VIX expirations still loom next week.

And our Sentiment is negative for the first time since the election. It’s a weather forecast.  No need for panic, only preparation. We’ll all weather change.

The Rising

Can’t see nothing in front of me. Can’t see nothing coming up behind. 

Those of you who know me know I would never write “can’t see nothing.” But Bruce Springsteen can get away with it.

He and the E Street Band put out the eponymous album on July 30, 2002, and it was appropriate for the stock market as the S&P 500 bottomed October 4, 2002 at 800 and proceeded with The Rising, traveling steadily upward to 1,561 by October 12, 2007. 

We didn’t return until Mar 2013, taking longer to get back than to arrive in the first place.

Now we’ve had variations on a Rising theme for eight years. The market bottomed this week in 2009, on Mar 6, at 683 for the S&P 500, lower than when our troubadour from Long Branch, NJ first commanded in gravel and guitar that we come on up for the rising.   

As with the last lyric in Bruce the Bard’s melody, it’s on wheels of fire that we’ve come rolling down here to 2017 in the stock market, blistering records and burning up the tape. 

We at ModernIR study equity data in our inimitable way, the cross of our calling, Bruce might say.  And that’s all the poetry I can muster.  But I’ve got some facts.

We measure Sentiment on a purely mathematical basis, tracking how the four big reasons people buy and sell interact with market prices and where these wax and wane.

We’re good at capturing short-term asset-price changes. We’ve been doing it for a long time. Our five-day forecasts are roughly 95% correlated to the actual average prices for stocks after the five projected days have elapsed – statistically interchangeable.  

Putting it in English, in short spans we can foretell the future, using math, because the money in the market is using math in ways we can observe with precision. 

Here’s what we know about market Sentiment and short-term prices. For 77 consecutive days now, back to Nov 14, 2016, the stock market has been about 5.0 or higher on our 10-point Sentiment Index.  Since June 2012, some 1,200 trading days, 715 have been 5.0 or higher. It’s been a bull market.  But ten percent are in a row since the election. 

Remarkable. (Aside: If you want to kick this around, catch me Friday at the NIRI Silicon Valley Spring Seminar.)

To our knowledge, the previous record for extended neutral or better Sentiment without a single tip to negative was 53 days, from Feb 22 to May 6 last year.  Back in 2013 when we had a momentum stock market, our Sentiment gauge would carom from below 4.0 to over 9.0 – a rocking Richter event – about every month. 

Here’s the thing:  When last year’s epic Sentiment run concluded in May, we were never able to rise sustainably again – until November. It required an extraordinary catalyst in the form of the Wildly Unexpected Donald Trump. The S&P 500 finished October 2016 lower than it wrapped May 2016. Even with another massive catalyst, the Brexit Boomerang, between. 

This is not scientific. It’s not fundamental. It’s not a factor model. But it IS mathematical, and it does reflect how money behaves today. Here’s my conclusion: Without an extraordinary event, a catalyst, when this long Sentiment run atop 5.0 stops, it will mark the end of this particular bull market. 

What’s a real-world application for investor-relations people? We track Sentiment for you.  When you’re Overbought your price will fall, absent a catalyst. When you’re Oversold, barring a tsunami, your shares will rise. It’s not rational. It’s math.  

You can use this data to your advantage.  When you’re a 10, call a couple of your good value holders to check in, because you’re likely to dip, and if your holder buys (you will be on their minds), you might revert to 5.0 quicker – and 5.0 stocks are the bedrock of solid investment portfolios. 

And vice versa. You’re 1.0?  Pick up the phone. The first investor to buy probably makes money (and will remember to look when next you call) and you’ll return to 5.0. It’s not what you say. It’s that you call that counts. Put yourself on the screen.

Won’t that work for the market? Sure.  At Feb 11 last year, the market was a 1.0/10.0. Great time to buy, turned out.  It was a Rising. 

We don’t know what’s ahead. Don’t know what’s coming up behind. But the math says we’ve had it good for a record stretch. It’s hard to keep setting records. 

Story Versus Store

When you’re in a store, how often do you ask for help finding a product?

Now think about that, investor-relations professionals, and investors.  You former are in the business of telling the story – helping people in the store find a product.  You latter are the shoppers seeking products.

Before I go further, on Mar 10 the IR professionals in Silicon Valley are hosting the annual Spring Seminar with content assembled by crack practitioners Kevin Kessel, Kate Scolnick and friends, and it’s one of the most compelling IR agendas I’ve seen in my 22 years in this profession. We’ll be there (ModernIR sponsors). You should be too.

Back to Story vs. Store.  A hundred years ago farmers came to town and handed a list to the proprietor of the general store, who assembled groceries while buyers were at the livery or the brothel or whatever. 

Today you enter your list at Amazon.com or Jet.com or whatever and a couple days later – we had two shipments yesterday at the office – your stuff shows up (probably not while you’re at the livery or the brothel but follow me here).

Apply to investing. Once long ago, you went to Merrill Lynch and while you were at the livery or the brothel or whatever your financial advisor assembled some stocks for you. Today you go to Wealthfront or Betterment and you enter your criteria and algorithms assemble exchange-traded funds for you. 

The IR profession is founded on effective storytelling. As the impresario for Wall Street, you help it find you.  But the money asking for help finding products is plunging.  Active stock pickers cannot win (a separate story about structure over prowess).  The robots are crushing it. 

The IR profession is at a crossroads. Yes, keep telling your Story. But the STORE is the leviathan today.  Not the Story.  Amazon is massive. Call it The Store. Walmart bought Jet.com for $3.3 billion because people don’t need an impresario, the clerks on the floor.

Blackrock and Vanguard don’t use the impresario of Wall Street: Research from investment banks.  But you can click on the little icon for many Web apps and get customer service, most of it outsourced to somebody outside The Store. 

Do we want to be Amazon, or that little icon? We won’t be the Big Dogs in either IR or investment by being better impresarios. Success in the 21st century is ironically about minding the Store. for IR, that means data analysis is the vital key to the future.

And investors, the secret to success in this market is tracking what’s moving into and out of The Store – Blackrock and Vanguard and ETFs are the amazons of equities. 

I’ll give you a case in point. A big client was a juggernaut for two weeks – nothing but green metrics, hitting the forecasts every day. Then short volume doubled in two days. Investment tumbled.

That’s Store. Not Story. You can say you don’t care about the short-term. Well, the Store does. Management does. Who’s minding the store? IR professionals, that’s you.  Ignore the amazons, the leviathans, the temporal distortions at your own peril.

Let’s not be the “click here for support” icon, IR pros. Let’s be Amazon. How? Your equity is a product used by consumers wanting less help from clerks and impresarios. They’re renting it, sharing it, trading it, leveraging it more than you ever imagined. 

If you’re bewildered, ask us for help. But let’s not become little icons at the bottom of screens. That’s no strategy for Boardroom domination.  Let’s be amazons. Love The Store.

Outliers

“Since I started Baron Funds in 1982,” said Ron Baron on Squawk Box last week, “we’ve owned 2,500 stocks. Take 15 of them out and we’re average.”

Baron is quintessentially rational. Visit Baron Funds and click on About and the words across the top are Long-term Investors. Research-Driven. No better proof can be found than that the director of research at Baron, Amy Chasen, was the IR head at Avon for years.

There are 36 fund managers and analysts at Baron overseeing about $21 billion of assets and the firm since 1982 has distinguished itself via patience and homework. Pick good companies and hold them for a long time. 

What percentage of the picks would you expect to be outliers – top performers? Maybe 75%?  The firm is looking for outliers after all. They’re not aiming to be average like Blackrock and Vanguard.

Okay, that’s probably a high expectation. Every time we demonstrate Market Structure Analytics to somebody new we expect there’s a 35% chance, based on the numbers we track, that that person will become a client, because we’re also patient and persistent.

So let’s lower our target for Baron.  Seventy-five percent is too high but you’d think stock pickers would be hoping they’re right at least half the time.  No?

You already know the answer: 0.6% of the firm’s stock selections beat the averages. That’s what 15 of 2,500 is.  The other 2,485 choices add up to average.  Now the good news for Baron is they don’t have to be right often to be good.

The bad news for IR is that using Baron Capital as our index of investor-relations outcomes, the likelihood that you’ll stand out from the crowd is less than 1%. 

“Oh come on Quast, what is this? The beatings will continue until moral improves?”

Oh ye pessimists, it’s the opposite.  IR is not just a storyteller.  IR is the product manager of the equity market.  If your management team thinks you have a 90% chance of standing out from the crowd and you lead them to persist in that belief, you’re creating a lot of needless IR stress. 

It doesn’t mean you stop trying of course. According to our illustrious trade association, NIRI, which at long last as a CEO again, 92% of public companies hold earnings calls (you wonder who the 8% are that don’t, and I’d love to know if they trade differently than the 92% — and my bet is there’s only about a 1% chance they do).  We tell the story because we must. 

But it’s high time IR adapts to the market we’ve got and it’s a lot like retail.  By that I mean the money isn’t one demographic, any more than the customers in Nordstrom are all one demographic group (they may share some characteristics sure, but they’re not all the same age or gender or height or weight).

And by that I also mean you all have high-speed pricing. Do you know that Amazon changes the prices of many items every 15 minutes?  They reprice with algorithms in response to online demand.  Well, now all the other retailers have had to adapt.  Walmart, Target, Best Buy and others may change prices 5-6 times a day now. 

I’ve got the Market Structure Report for a large food company here in front of me. It traded over 53,000 times daily the past week. Theoretically it could be a different price every time. The spread each day between highest and lowest prices averaged 2.3%. Add that up over 20 trading days and it’s 46% of the stock’s market cap.

Retailers are continuously engaging in markdowns to rid the shelves of “the dogs,” the stuff that’s not selling. And some hot new thing will come along and demand patterns change and retailers start lifting prices. It’s happened to me with hotels and airlines.  You too?

Juxtapose that with long-term research-driven investment and you see the problem. The dominant investment behavior of the day is Blackrock and Vanguard. They want to peg the averages of these continuously shifting notions of what’s a dog, what’s hot, what’s up, what’s down, or what’s getting continuously repriced in fractions of seconds.

And it appears they’ll be right 2,485 out of 2,500 times, or about 99% of the time. Over the past decade, 98% of active fund managers (and I think Baron was in the 2%) failed to beat the S&P 500, says Morningstar (Dec 2005-Dec 2015 but you get the point).  

The 20th century was all about active investment for IR, and telling the story, and as a result 92% of us hold earnings calls. But we’ve got to catch up to the market. 

Sometime over the next decade, 92% of us should be viewing ALL the money as the audience, messaging to some of it and consistently measuring the rest, like retailers do. We’ve got to be data analysts in IR.

Because we won’t all be outliers.

The Clash

On Friday Feb 10, behavioral-change in the stock market rocked the Richter.    

Stocks themselves seem rather to be rocking the Casbah, Clash-style (obligatory Grammy Awards Week musical reference, and showing my age I reached back to 1982).  Plus it’s that time again: Options expire today through Friday.

Naturally, Janet Yellen picked this week to tell the market – I say “tell” loosely since her utterances are so inscrutable that we’re left to construe and guess – a rate-hike is coming.

I find it troubling that the regulator of the world’s most important banking system appears to be ignorant of how markets work. Why hint at momentous monetary matters two days before volatility bets lapse?  Then again, maybe it’s purposeful.    

And far easier than ruminating on Chair Yellen’s comments for signals is checking the Fed’s balance sheet. Want to know if the Fed will raise rates?  Look for big moves in either Reverse Repurchases or Excess Bank Reserves.

Let me interrupt here:  Investor-relations folks and investors, I return to the Fed theme because it remains the linchpin of the market. We’ll make it an intriguing visit!

On the Fed’s balance sheet, sure enough – big changes.  Excess Reserves have risen from about $1.8 trillion in January to $2.2 trillion last week (huge numbers, yes. For the 20 years before the financial crisis, excess reserves averaged about $10 billion). 

That’s a $400 billion push, almost as big as the $500 billion the Fed heaved at the market last January and February when it was collapsing under the weight of the mighty buck following the Fed’s first rate-hike in ten years.

You can hardly remember, right?  Back then, the top price-setter (followed by Fast Trading) was Asset Allocation – selling by indexes and ETFs jammed up at the exits.

It stopped because the buck didn’t. The dollar fell. When the dollar weakens, stocks generally rise because they are denominated, like oil, in dollars. Smaller dollar, bigger price.

And vice versa. The dollar strengthened ahead of the 1987 stock market crash.  Ditto the Internet Bubble. In May 2010, the dollar rose right ahead of the famed Flash Crash. Last January’s swoon? The dollar surged in November and December with the rate-hike.

From Mar 2009 until Aug 2014 the dollar was weak as the Fed trampled it, and stocks, commodities, bonds, housing and so on all rose.  Then abruptly in latter 2014 the Fed stopped beefing up dollar-supplies. Stocks statistically flatlined till Nov 9 last year.  The Dow was 18,000 in Dec 2014 and 17,888 Nov 4, 2016.

Since the Fed is no longer creating new dollars rapidly by buying debt, it instead moves money into or out of the counted supply.  Excess reserves increase the counted supply of money, which decreases dollar-value.  And yup, from early January to last week, the dollar dropped 4% (using the DXY, the dollar-futures contract from The ICE).

Why does that signal a rate-hike? Because increasing interest rates is akin to reducing the supply of money.  The Fed hopes the yin of bigger reserves will mesh with the yang of higher rates and stop the buck in the middle.

But the buck is back up 2% already. We come to the Richter move I mentioned to start.  We track the four big reasons people buy and sell stocks. From Nov 9 to Feb 9 as stocks soared, the leading price-setter was Active Investment. Rational people are bullish on American economic prospects.

But the Number Two price-setter is Risk Management – portfolio leverage with derivatives. And it’s nearly as big as Active Investment.  Investors are buying the present and betting on the future, which means both present and future back current stock-prices.

The problem arises if the future isn’t what it used to be, to paraphrase Yogi Berra.  And one axiom of Market Structure is that behavioral volatility precedes price volatility.  Much like clouds gather before a storm.

On Feb 10 clouds formed. Risk Management marketwide jumped almost 18%. It’s unusual to see a double-digit move in any behavior, and this is among the biggest one-day moves we’ve ever seen for Risk Management. Is money questioning the future?

It came right ahead of the Grammys. And more importantly, before Options Week and Janet Yellen.  Were we monitoring the Ring of Fire for seismic events, we’d be predicting a temblor.

Of course, in the same way that seismic activity doesn’t mean The Big One is coming, it might be nothing.  But stocks are near a statistical top in our 10-point Behavioral Sentiment Index again and the buck is rising toward a March rate-increase. Sooner or later, the present and the future will clash. 

Life will go on.  And we’ll be measuring the data.