Taint Natural

In 1884, British comedian Arthur Roberts invented a card game of trickery and nonsense for which he coined the name “Spoof.”  In 2015, spoofing is a decidedly unfunny and ostensibly illegal trading technique in securities markets. But the joke may be on us.

Mr. Roberts made a living on the Briton public-house and music-hall circuit offering bawdy cabaret like “Tain’t Natural,” a vaudeville version of Robinson Crusoe. Today as a result we call satirizing parodies “spoofs.”

Nobody is laughing about spoofing in securities markets.  Wall Street Journal writer Bradley Hope, that paper’s new Robin to the caped-crusader Scott Patterson (IR folks should read Patterson’s “The Quants” and “Dark Pools,” available at Amazon), portrayed as “illegal bluffing” the frenetic keyboard-clicking of a derivatives trader dubbed “The Russian” in a Feb 23 front-page piece. Dodd-Frank, the Roman Coliseum of regulation, banned these fake trades.

Yet stock prices depend on fakery.  Rules mandate trading at the best national price even if you’re moved by something else.  Stock pickers may like the story at a lesser or greater price but can’t so choose. Traders with horizons of milliseconds following rules have the price gun. In order to post best prices, stock exchanges pay high-speed firms for trades (nobody cares more about price than those who exist to set it). Those then price all the rest.  Then exchanges sell the data, perpetuating a market version of robo-signing.

Like a mutating hospital supergene, this price-setting matrix replicated globally. We have two million global index products and options and futures on those and on the ETFs that track them and the components comprising them and the currencies for the countries in which they reside and on the bonds from the debtors and the governments and the commodities driving industry from milk to corn to futures on Norwegian krone – and most of this stuff trades electronically at speed.

Take a breath.

In the WSJ piece on spoofing, the Chicago proprietary-trading firm behind them, 3Red Group LLC (if the firm has three Russian founders they’ve got a sense of humor) says if it clicks fastest, that’s skill not spoofing. Melodramatic?  If only Arthur Roberts could say.

But it’s a point. If we created a marketplace around fakery, is it fraudulent to be a better faker than others?

Blackrock yesterday decried phantom liquidity in currency trading, called “forex” or FX, short for foreign exchange, a $5 trillion daily market dwarfing US equities.  Said Blackrock in a statement reported by Bloomberg: “Our preference in the FX market would be to a view on the liquidity in which we can deal, even if this comes at a higher cost compared to the phantom liquidity.”

We’ll rephrase for the jury.  Real orders are better than fake ones even if they cost more. Like real Twitter followers beat drones, and real restaurant reviews beat paid ones and real interest rates trump manufactured ease.

Jocularity aside, Blackrock proffers a profundity not to be missed by public companies, regulators, central bankers or members of Congress. They’d prefer to pay up for actual trades than down for fake ones.  That ought to be both on a bumper sticker and in handbooks for fresh-faced congresspersons and new central bankers.

The joke here is that spoofing is consequential, not causal.  There’s ad-selling prurience in stories about spoofing but focusing there skips over the root problem. The moment regulators decided to help people figure out the best price (suggesting regular humans are less able than regulatory humans), market gravitas transmogrified into Arthur Roberts slapstick on a collision course with spoofing.

Regulators have long trumpeted the virtue of low spreads and the right of little orders to price the whole market.  Turns out low spreads don’t help real people. A lot of prices doth not liquidity make. And if you want to buy a hundred of something, you don’t get the same price as she who buys a thousand. Tain’t natural – and that’s probably in Hammurabi’s code somewhere.

The next time you check your stock price, consider what’s setting it and why you, your executives or CNBC conclude it’s natural. Until we fix the original mess – which will require collective demand for more real stuff and less fake stuff – the best thing going for the IR chair is that you can measure it all and sort out the trick cards.

And we’re not spoofing you.

Leakage

How often do traders know news before you release it?

I was in the car listening to a business program on satellite radio, and they were talking about crazy moves in shares ahead of news.  The host, a trader and money manager, said, “Even with Reg FD and all the disclosure rules, I swear 85% of the time there’s leakage.”

In this age of mandatory dissertation in television ads of pharmaceutical side-effects, one approaches the term “leakage” with caution.  But in market-structure, the behavior of money behind price and volume today, leakage is a functional fact.  Routinely a day before important news, high-frequency trading jumps, signaling impending change and oftentimes distorting price ahead of material information.

Recently a client had a secondary offering for a big holder. Two weeks before it, the broker who would later underwrite the offering led in what we call influential order flow. Two other brokers had matching increases. Yet the company hadn’t yet determined a manager.

Both examples imply leakage. Maybe the fast traders picked up a nugget of information?  Word worked around to broker trading desks?  Both are possible. But we doubt shenanigans played a role. The tipster in both these instances and in much of what appears predictive in stock-moves is the same: Math.

High-frequency traders, the ones signaling money-moves – the reason ignoring fast trading the way so many do is like yanking the fuel gauge from your car and hucking it in the trash – aren’t people.  It’s not somebody on phone calls or in meetings. No channel-checks have been made or hedge funds plied for leads. They’re machines programmed to respond to data.

Therefore, Watson, the elementary conclusion is that the math changes before news. Now could somebody in the know be the trigger?  Sure. Machines seek central tendencies and departures from standard deviation (as do our algorithms) and a trader unaware could unwittingly tip them to a directional shift with orders that don’t look like the others.

The machines spit feeler orders like tiny drones. For example, a utility with market cap around $2 billion trades 225,000 shares daily.  Over a third of the roughly 2,000 trades yesterday were for less than 100 shares. Ten percent were 10 shares or fewer.  Once we saw six hundred-share trades move CSCO $6 in one second. High-speed trading algorithms feather the markets with the smallest possible commitments seeking directional tips.

Suppose a computer metered human traffic at New York’s Penn Station.  The computer would know that before the 2:07 to Bay Head on a westbound track, people are going to fill the station.  Now imagine the computer can determine how many cars should comprise the train, using algorithms that measure human traffic the half-hour leading into 2:07 pm.  If today the standard deviation in the pattern is up and foot traffic down, the computer will peg demand as exceptionally light and order up a very short train for the long trip down the north shore.  What if people were just late arriving? (more…)

The Reality Discount

If reality were measured like stocks in multiples of earnings, how much should we discount it?

Alert (and good-looking) reader Karen Quast sent a Feb 8 story from The Atlantic by entrepreneur Nick Hanauer, Amazon investor and founder of aQuantive, acquired by Microsoft for $6.4 billion. Called “Stock Buybacks are Killing the American Economy,” Hanauer’s treatise contends companies have shifted from investing in people and stuff to trafficking in earnings-management.

While Hanauer’s real target is sociological, he offers startling statistics compiled at theAIRnet.org. Companies in the S&P 500 have repurchased $6.9 trillion of stock the past decade including $700 billion last year.

The Sept 2014 Harvard Business Review ran a similar story by UMass professor William Lazonick called “Profits Without Prosperity.” Mr. Lazonick says S&P 500 components between 2003-2012 spent 54% of profits, or $2.4 trillion, on buybacks, and another 37% ($1.6 trillion) on dividends, thus sending 91% on to holders.  What strikes me is that companies must’ve borrowed roughly $3 trillion more for buybacks.

Hanauer also nods toward GMO Capital’s ($120 billion AUM) James Montier, whose incendiary white paper “The World’s Dumbest Idea” (drawn from a Jack Welch observation) has been the subject of contention in the investor-relations profession and beyond.  Montier claims a tally of buybacks from the 1980s forward shows firms repurchased more shares than were issued.

If that seems to defy the existence of the stock market (if more shares were bought than offered, how are there any to trade?), it doesn’t. There once were nearly 8,000 companies in the Wilshire 5000 while today it’s 3,750 (you’d think the Wilshire 5000 described the number of companies in it), a 53% freefall. But the big have gotten bigger, with US market capitalization about $2.8 trillion in 1988 and $25 trillion today (rewind to 1950 and total market cap was $92 billion – equaling just, say, Biogen Idec’s market cap now). (more…)

Function Follows Form

Let me go. I don’t want to be your hero.

Those words strung together move me now viscerally after seeing the movie Boyhood, in the running at the Academy Awards, as I write, for best of the year. I’m biased by the video for “Hero” from the band Family of the Year because it highlights rodeo, something bled into the DNA of my youth.  See both. The movie is a cinematic achievement that left us blurry. The song is one I wish I’d had the talent in youth to write.

As ever for the ear that hears and the eye that sees, there’s a lesson for investor-relations. We might have heard MSCI last week refraining those lyrics – let me go, I don’t want to be your hero – to the ValueAct team, activist investors.

Over the past few years as activism has flourished, many companies have longed to be let go but have benefited from the activist grip. Herbalife and Bill Ackman.  Hewlett-Packard and Relational Investors. Dow Chemical and Dan Loeb’s Third Point.  Tessera and Wausau Paper and a raft of others just off Starboard.  On it goes, all around.

A curious condition has laid hold of stocks in the last number of years. It used to be that results differentiated.  Deliver consistent topline and bottom-line performance, do what you say you’ll do, explain it in predictable cadence each quarter – these were a reliable recipe for capital-markets rewards. Form followed function.

Activism by its nature supposes something amiss – that a feature of the form of a company is incorrect or undervalued, or simply operated poorly. By calling attention like the old flashing blue light at Kmart (have I just dated myself?), activists have often outperformed the market.

Meanwhile, the opposite has become more than an exception.  From our own client base we could cull a meaningful percentage of companies following the formula of consistent performance yet missing bigger prizes. (more…)

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. (more…)

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…)