Infected Stocks

Coronaviruses are common throughout the world. So says the US Centers for Disease Control and Prevention.

The market didn’t treat news of spreading cases in China and the first in the USA (from a Chinese visitor) that way though. Airline and gaming stocks convulsed yesterday.

There’s as ever a lesson for investor-relations practitioners and investors about how the stock market works now. News compounds conditions but is infrequently causal. Investors, there are opportunities in divergences. IR pros, you need to know what’s real and what’s ripple-effect, because moves in stocks may not reflect rational sentiment.

Airline and leisure stocks demonstrate it. Active Investment pushed airlines up 2.4% last week, industry data we track (with proprietary analytics) show.

But.

Shorting rose, and demand for derivatives used to protect or leverage airline investments fell 7% into last week’s options-expirations (know the calendar, folks). That’s a signal that with new options trading yesterday, counterparties would shed inventory in those stocks because demand for options was down.

Both facts – Active buying last week, weak demand for leverage – run counter to the narrative of investor-fear. The data say these stocks would have been down anyway and news is simply compounding what preceded it.

No doubt some investors knee-jerked to headlines saying investors were selling, and sold. But it’s not the cause. It’s effect.

We can’t isolate gaming in GICS data but leisure stocks shared behavioral characteristics with airlines. Investment was up last week, led by Passive money rather than Active funds (Active rose 2% too). But Risk Management, the use of leverage, declined 3%. And the pattern of demand changed.

What if the real cause for declines in these industries is the rising cost of leverage?

I’ll make my last plug for the book The Man Who Solved the Market. Near the end, one of Jim Simons’s early collaborators at Renaissance Technologies observes, “I don’t deny that earnings reports and other business news surely move markets. The problem is that so many investors focus so much on these types of news that nearly all of the results cluster very near the average.”

He added that he believed the narratives that most investors latch onto to explain price-moves were quaint, even dangerous, because they breed misplaced confidence that an investment can be adequately understood and its future divined.

I’ll give you two more examples of the hubris of using headlines to understand stocks. The S&P 500, like airline and leisure stocks, experienced a 2% decline in demand for derivatives into expirations last week. Patterns changed. Ten of eleven sectors had net selling Friday even as broad measures finished up.

If the market is down 2% this week – and I’m not saying it will fall – what’ll be blamed? Impeachment? Gloomy views from Davos? The coronavirus?

One more: Utilities. These staid stocks zoomed 4% last week, leading all sectors. They were the sole group to show five straight days of buying. We were told the market galloped on growth prospects from two big trade agreements.

So, people bought Utilities for growth?

No, not the reason. Wrapped around the growth headlines was a chorus of voices about how the market keeps going up for no apparent reason. Caution pushes investors to look for things with low volatility.

Utilities move about 1.4% daily between intraday high and low average prices. Tech stocks comprising about 24% of the S&P 500 are 2.6% volatile – 86% more!

Communication Services, the sector for Alphabet, Facebook, Twitter and Netflix, is 2.8% volatile every day, exactly 100% more volatile than Utilities.

The Healthcare sector, stuffed with biotechnology names, is 4.8% volatile, a staggering 243% greater than Utilities.

These data say low-volatility strategies from quantitative techniques, to portfolio-weightings, to Exchange-Traded Funds are disproportionately – and simultaneously – reliant on Utilities. If volatility spikes, damage will thus magnify.

IR people, you’ve got to get a handle on behaviors behind price and volume (we can show you yours!). Headlines are quaint, even dangerous, said the folks at Renaissance Technologies, who earned 39% after-fee returns every year for more than three decades.

Investors, you must, too (try our Market Structure EDGE platform). None of us will diagnose market maladies by reading headlines. The signs of pathology will be deeper and earlier. In the data.

Proportional Response

Proportional Response is the art of defusing geopolitical conflict.

Proportional Response is also efficient effort. With another earnings season underway in the stock market, efficient effort should animate both investment decisions, and investor-relations for public companies.

I’ve mentioned the book The Man Who Solved the Market, about Jim Simons, founder of Renaissance Technologies. There’s a point where an executive is explaining to potential investors how “RenTec” achieves its phenomenal returns.

The exec says, “We have a signal. Sometimes it tells us to buy Chrysler, sometimes it tells us to sell.”

The investors stare at him.

Chrysler hadn’t been a publicly traded stock for years (they invested anyway – a proportional response).

That executive – a math PhD from IBM – didn’t care about the companies behind stocks. It didn’t bear on returns. There are vast seas of money rifling through stocks with no idea what the companies behind them do.

RenTec is a quant-trading firm. Earnings calls are irrelevant save that its models might find opportunity in fleeting periods – even fractions of seconds – to trade divergences.

Divergences, tracking errors, are the bane of passive money benchmarked to indexes. If your stock veers up or down, it’ll cease for a time to be used in statistical samples for index and exchange-traded funds (ETFs).

And hedge funds obsess on risk-adjusted returns, the Sharpe Ratio (a portfolio’s return, minus the risk-free rate, divided by standard deviation), which means your fundamentals won’t be enough to keep you in a portfolio if your presence deteriorates it.

Before your eyes glaze over, I’m headed straight at a glaring point.  Active stock-pickers are machinating over financial results, answers to questions on earnings calls, corporate strategy, management capability, on it goes.

On the corporate side, IR people as I said last week build vast tomes to help execs answer earnings-call questions.

Both parties are expending immense effort to achieve results (investment returns, stock-returns). Is it proportional to outcomes?

IR people should have their executive teams prepared for Q&A. But let’s not confuse 2020 with the market in 1998 when thousands of people tuned to Yahoo! earnings calls (that was the year I started using a new search engine called Google).

It’s not 2001 when about 75% of equity assets were held by active managers and some 70% of volume was driven by fundamentals.

It’s 2020. JP Morgan claims combined indexed money, ETFs, proprietary trading and quant funds are 80% of assets. We see in our data every day that about 86% of volume comes from a motivation besides rational thought predicated on fundamental factors.

Proportional Response for IR people is a one-page fact sheet for execs with metrics, highlights, and expected Q&A.  The vast preparatory effort of 20 years ago is disproportionate to its impact on stock-performance now.

Proportional response for investors and public companies alike today should, rather than the intensive fundamental work of years past, now incorporate quantitative data science on market structure.

IR people, don’t report during options-expirations. You give traders a chance to drive brief and large changes to options prices. Those moves obscure your message and confuse investors (and cause execs to incorrectly blame IR for blowing the message).

Here’s your data science: Know your daily short-volume trends and what behaviors are corresponding to it, and how those trends compare to previous quarters. Know your market-structure Sentiment, your volatility trends, the percentages of your volume driven by Active and Passive Investment and how these compare to past periods.

Put these data in another fact sheet for your executive team and board.  Provide guidance on how price may move that reflects different motivations besides story (we have a model that does it instantly).

Measure the same data right after results and again a week and a month later. What changed? If you delivered a growth message, did growth money respond? That’s quantitatively measurable. How long before market structure metrics mean-reverted?

Investors, data science on market structure isn’t another way to invest. It’s core to predicting how prices will behave because it reflects the demographics driving supply and demand.

There are just a thousand stocks behind 95% of market cap. You won’t beat the market by owning something somebody else doesn’t. You’ll beat it by selling Overbought stocks and buying Oversold ones.  Not by buying accelerating earnings, or whatever.

The stock market today reflects broad-based mean-reversion interspersed with divergences. RenTec solved the market, we’re led to conclude, by identifying these patterns.  The proportional response for the rest of us is to learn patterns too.

What Matters

Happy New Year!

I hope you enjoyed our gift:  A two-week break from my bloviating!  We’d planned to run best-of columns and thought better, because everybody deserves a respite.

We relished the season in the Colorado mountains, as this album shows (see world-class ski-race video too).  If the album eludes you, this is Steamboat Springs 2020, and us on snowshoes, and the view up high where it’s always 3 o’clock (a superb ski run).

I’m thinking about 2020.  And I’m reading “The Man Who Solved the Market,” about quant hedge fund Renaissance Technologies, by Wall Street Journal reporter Greg Zuckerman.  You should read it, too.

About 47% in, my Kindle says, Zuckerman writes, “One day, a data-entry error caused the fund to purchase five times as many wheat-futures contracts as it intended, pushing prices higher.

“Picking up the next day’s Wall Street Journal, sheepish staffers read that analysts were attributing the price surge to fears of a poor wheat harvest.”

There’s so much going on behind stock-prices that’s something other than we think. The point for IR people and investors is why do we do what we do?

In fact, it’s a human question. We do things on the belief they count.

For instance, the quarterly “Q&A bible,” the compendium of earnings-call questions, dominated holiday discussion in NIRI eGroups.

Discourse is great.  But does all that preparatory effort matter?

If we’re spending the same time and effort in 2020 on earnings-call Q&A that we did in 2000, well, why?  In 2000, more than 70% of the money was rational. Today it’s 14%.

Tesla is up 42% the past year, which included an earnings call where CEO Elon Musk trashed an analyst during Q&A.  The Twittersphere blew up.

The stock didn’t.

You should have your executive team prepared for questions, investor-relations professionals. But you don’t need a bible in 2020 because rational behavior is a paltry part of why stocks move.

Equal to preparation for questions should be the time directed to educating your executives and board on what can move price with results, and why, and what historical data indicate are risks, and why risk exists in the first place – and if you can mitigate it by changing WHEN you report and how you notify investors.

And if you’re 10/10 Overbought and 60% short before you report, put your best VALUE foot forward. Data, not Q&A, should driver call-prep.

Human beings do things because they ostensibly matter and produce returns.  If we’re going through motions because it’s tradition, then 2020 should be the year you change tradition.

And investors. What matters to you?  Returns, right?

The average S&P 500 component moves 36% every month, intraday (1.6% each day between highest and lowest prices), change often lost in closing prices.  In a perfectly modulated, utterly quantitative Shangri-La, you’d capture ALL of that by buying low and selling high.  You could make 432% per year.

That’ll never happen. Eugene Fama, legendary University of Chicago economics professor, who’s 80 years old and still teaching, won a Nobel Prize for demonstrating the return-diminishing pugnacity of volatility.

But if there’s so much volatility, why expend immense effort finding great companies when the odds are roughly 1% that doing so will produce market-beating returns?

Wouldn’t it be smarter – wouldn’t it matter more – to surf volatility waves in today’s market?

I find in traveling around the country – we’re headed to Austin Thursday – talking to IR people and investors that they’re depressed by these things.

If what we learned doesn’t matter, should we rend garments, gnash teeth and weep?

No.

That’s like being depressed by passing time.  Time is a fact.  We can make the most of it, or we can rue its passage.  What’s it gonna be?

So what, IR people, if you don’t need a 400-page Q&A document that requires a software package to manage?  A single Word page, stored to the cloud so you can cross-reference in future quarters, is proportionate.  You’ve saved TIME to do things that MATTER.

What matters?  If you want to be in the US equity markets in 2020 as a public company, an investor-relations professional, an investor, what matters is knowing what money is doing.

It’s a law of success.  It’s not what you know about YOU that matters.  It’s what you know about life, the environment you’re in, the job you’re doing, about how to build relationships.

Right?

We should stop spending all our time understanding our businesses, and none understanding the market that assigns value to them.  That’s the flaw of IR.  Nothing more.  Let’s change it in 2020.

And you investors, why all the Sisyphean work finding great businesses without first understanding how the market transforms those businesses into products with fleeting and ever-evolving value?

If you could capture just 10% of the daily volatility of the S&P 500 by buying stuff low and selling it high, you’d win. It’s provable, useful math. That matters.

Resolve to make 2020 the year you learn what the money is doing.  It matters. We at ModernIR figured out the road map. Ask us how to start on the journey.

Time and Sentiment

Time matters.

We’ve gone 42 trading days with the ten-point Market Structure Sentiment index, our proprietary measure of the propensity of algorithms to lift or lower prices, over 5.0. That’s a growth-at-a-reasonable-price (GARP) market since Oct 17.

It’s by no means the longest. More on that in a moment.

The market seems impervious to fault lines as we move into year-ending options-expirations tomorrow through Friday, and index rebalances, and portfolio window-dressing.

It’s nothing like either 2010, the Year of the Flash Crash, or 2012, the Year of the Glitch. I wrote an editorial for IR Magazine on those, a retrospective ahead of 2020 on the last decade of market structure.

The market’s capacity to relentlessly rise through a corporate earnings recession (we’ve had three quarters of falling comparative profits), trade disputes, Presidential impeachment, on it goes, shows how both the IR profession and investors need different data in the arsenal to understand how stocks are valued.

Two other terrific IR Magazine pieces highlight the value of data to IR. We’re not alone! Reporter Tim Human describes how AI Alpha Labs uses deep-learning to help investors understand how to achieve better returns – something IR must know.

Oliver Schutzmann of Iridium Advisors says future IR will be data science – because that’s how the market works.

Speaking of data, ours for the S&P 500 show Active money the past year was the lead buying behavior 7% of the time. The worst day was Dec 19, 2018, with just one company earning what we call a new “Rational Price” from Active Investment. The best day came a month later on Jan 18, 2019, when 26% of the index had new Rational Prices.

Add selling, and Active money leads the S&P 500 behaviorally about 14% of the time.

Back to Sentiment, over the 42 days where the market has gone up, up, up on positive Sentiment, Active money led buying just 6% of the time. Exchange Traded Funds have led, our data indicate, 67% of the time, directly or indirectly.

Data points like these are requisites of the IR job the next decade. And measuring changing behavioral trends will be essential to understanding stock prices. Case in point, I saw a client’s data yesterday where Fast Traders, automated machines creating price-changes, were responsible for a 40% 2019 decline in equity value.

Machines don’t know what you do. But they can trigger negative and positive chains of events divergent from fundamentals.

In this case, trading machines blistered shares on consecutive earnings reports, which in turn pushed Passive money to leave because volatility created tracking errors, which caused market cap to fall out of the Russell 1000 – which is 95% of market value today.

Active money was incapable of overcoming the overwhelming force of Passive behavior.

Back to Sentiment and Time, before the market tipped over in the fourth quarter of 2018 Sentiment stayed around 5.0 or higher for 66 days. When it finally dipped below 4.0, a Sentiment bottom, the market was cast into tumult.

Part of the trouble was delayed portfolio rebalances. When markets go up, investors put off aligning positions to models. When the turn comes, there’s a scramble that compounds the consequence.

We’re hitting one of those crucial points this week, delayed rebalances colliding with options-expirations, index-rebalances and year-end.

We may see nothing. After all, it’s only been 42 days. Sentiment went 45 days at 5.0 or better this spring on the great January rally. There were 42 positive days from June 11 to Aug 8, too.

My final thought in the final fresh blog for 2019 (we’ll do retrospectives to finish out the year) is a monetary one. Karen reminds me that monetary policy clears a room like a fart – so you can’t talk about it often.

But it’s another data point driving market behavior. As the Federal Reserve has turned accommodative again – that is, it’s shifted from shrinking its balance sheet and raising rates to expanding assets and lowering rates – we’ve seen a corresponding fall in shorting and derivatives-leverage in stock-trading.

In fact, a steep drop for shorting coincided with a sudden spike in what’s called the Fed Funds overnight rate. Remember that? Happened in September. The rate the Fed had set near 1.5% exploded to 10% as the market ran out of cash.

Ever since it’s been troubled, the Fed Funds market. The Fed keeps injecting tens of billions of dollars into it. That market is meant to provide banks with temporary liquidity to process payrolls, taxes, credit-card payments, transaction-settlements and so on.

What if ETFs are using cash to collateralize transactions (rather than actual stocks) at the same time rising consumer debt is beginning to weigh on bank receipts and liquidity?

If that’s at all the case, time matters. We’re not worried about it – just watchful. But with so vast a part of market volume tracing to ETFs, and Sentiment getting long in the tooth, we’re cautiously wary as this fantastic trading year ends.

Hummingbird Wings

I recall reading in high school that the military’s then new jet, the FA-18 Hornet, would fall out of the sky if not for computers.

Could be that’s exaggerated but the jet’s designers pushed the wings forward, creating the probability of continual minute turbulence events too frequent for human responses.  Why do that? Because it made the plane vastly nimbler in supersonic flight.

You just had to keep the computers on or the craft would go cartwheeling to earth.

As we wrap a remarkable year for stocks in a market too fast for humans and full of trading wings whipping fleeting instances of turbulence, we’re in a curious state where the machines are keeping us all airborne.

I don’t mean the market should be lower.  Valuations are stretched but not perverse. The economy is humming and the job market is great guns. And while the industrial sector might be spongy, the winds in the main blow fair on the fruited plain.

So why any unease about stocks, a sense the market is like an FA-18 Hornet, where you hope the computers keep going (ironic, right)?

It’s not just a feeling.  We at ModernIR as you longtime readers know are not touchy-feely about data. We’re quantitative analysts. No emotion, just math.  Data show continual tweaking of ailerons abounds.

You see it in fund flows. The WSJ wrote over the weekend that $135 billion has been pulled from US equities this year. Against overall appreciation, it’s not a big number. But the point is the market rose on outflows.

And corporate earnings peaked in real terms in 2014, according to data compiled by quantitative fund manager Julex Capital. We’ve got standouts crushing it, sure.  But if earnings drive stocks, there’s a disconnect.

I’m reading the new book on Jim Simons, the “man who solved the market,” says author and WSJ reporter Greg Zuckerman. Simons founded Renaissance Technologies, which by Zuckerman’s calculations (there’s no public data) has made more than $100 billion the past three decades investing in stocks. Nobody touches that track record.

It’s a riveting book, and well-written, and rich with mathematical anecdotes and funny reflections on Simons’s intellectually peripatetic life.

Renaissance is not a stock-picking investment firm. It’s a quant shop. Its guys and gals good at solving equations with no acumen at business or income statements proved better at investing than the rest.

It’s then no baseless alchemy to propose that math lies at the heart of the stock market.

And son of a gun.

There’s just one kind of money that increased the past year.  Exchange Traded Funds (ETFs). This currency substituting for stocks is $224 billion higher than a year ago and about a trillion dollars greater the past three years.  As we learned from Milton Friedman and currency markets, more money chasing the same goods lifts prices.

Stocks declined in 2018, yet ETF shares increased by $311 billion, more than this year.  In 2017, ETF shares increased by $471 billion.

Behind those numbers is a phantasmagorical melee of ETF creations and redemptions, the ailerons keeping the market’s flight level through the turbulent minutia flying by.

I’ve explained it numerous times, so apologies to those tiring of redundancy. But ETFs are substitutes for stocks.  Brokers take a pile of stocks and give it to Blackrock, which authorizes the brokers to create and sell to the public a bunch of ETF shares valued the same as the pile of stocks.

If you sell ETF shares, the reverse happens – a broker buys the ETF shares and gives them to Blackrock in trade for some stocks of equal value.

This differential equation of continuous and variable motion doesn’t count as fund-turnover. But it’s massive – $3.2 trillion through October this year and $10.7 trillion, or a third of the market’s total value, the past three years.

Why the heck are there trillions of ETF transactions not counted as fund flows? Because our fly-by-wire stock market is dependent on this continuous thrum for stable harmonics.

That’s the hummingbird wings, the Butterfly Effect, for stocks.

We can see it.  In July a seismic ripple in behavioral patterns said the market could tumble. It did. Dec 3-5, a temblor passed through the movement of money behind prices. The market faltered.

If the ETF hive goes silent, we’ll cartwheel.  It won’t be recession, earnings, fundamentals, tariffs, Trump tweets, blah blah.  It will be whatever causes the computers to shut off for a moment.  It’s an infinitesimal thing.  But it’s why we watch with machines every day.  And one day, like a volcano in New Zealand, it’ll be there in the data.

Jim Simons proved the math is the money. It’s unstable. And that’s why, investor-relations pros and investors, market structure matters.

Boxed Yellow Pencils

“How do you think about ESG?” said my friend Moriah Shilton at a San Francisco NIRI summit some weeks back with hedge fund Citadel.

Silence. The four panelists shifted around.  A couple whispered to each other. Finally, somebody offered with a throat-clearing cough, “It doesn’t factor into our portfolio decisions.”

For those not fluent in Investor Relations (IR) Speak, ESG is “Environmental, Social, Governance.”  NIRI is the National Investor Relations Institute, professional association for the liaison between public companies and Wall Street.

ESG dominates the contemporary IR educational platform. NIRI has made a policy statement on ESG. There are at least two ESG sessions here at the NIRI Senior Round Table meeting (and NIRI national board meeting) this week in Santa Barbara.

The ESG heat isn’t coming from stock-picking investors, the “long-only” audience of public companies spending billions annually on communication through compliance-driven reports like 10Ks, 10Qs, press releases and proxies and via proactive outreach aimed at increasing share-ownership.

Nor is it, apparently, coming from hedge funds like Citadel, the other key audience – and I’d argue now the vital IR constituency because of its capacity to compete with the Great Passive Investment Wave – for public companies.

In fact, the Citadel team later said, “We vote with management on proxy matters, or we vote with our feet by selling shares.”

It’s passive money that’s obsessed with ESG. Passive investment to us is any form of capital allocation for a day or more (by contrast Fast Trading is an investment horizon of a day or less) driven by rules. That’s index investing, Exchange Traded Funds, or any variety of quantitative investment, from global macro to statistical arbitrage.

True, passives may oppose a proxy measure that doesn’t comport with an ESG platform. They will, however, continue owning the stock. Index funds pegged to a benchmark like the S&P 500 are required to own the securities comprising the benchmark.

It’s cognitively dissonant to own things you oppose.

But aren’t they trying to promote practices that make companies better stewards for stakeholders?

From my first exposure to it, good business has been sound financial management, the right people, products, markets, capital structure, the advancement of the best interests of your customers, employees, communities. These are essential strands of business DNA.

In fact, turning those into a checklist promotes the possibility that mediocre firms are treated the same as stellar ones by virtue of filling out a form.  Rules breed uniformity.

Nowhere is that more apparent than in the stock market, where rules push prices toward a mean. Track the midpoint – as Passive money does – and returns become superior by pegging the average.

The investor-relations profession, the pursuit of excellence, Warren-Buffett-style investment strategies, are about unique differentiation.  What makes a company better, superior?

Rules-based investing makes things the same. Passive money has boomed because shares of companies are increasingly products defined by shared criteria, like ESG. The more of that there is, the greater the probability the market will become homogeneous.

Without dismissing its merits, I’m perplexed by why public companies and stock-picking investors would promote shared criteria like ESG (why not differentiate with ESG if you’re so moved?).  We don’t want the stock market to become a bunch of yellow pencils in a box.

I think a form of guilt has gripped the passive-investment colossus like what manifests among the Silicon Valley nouveau riche who ofttimes with minimal effort realize vast wealth, and then feel compelled to browbeat the rest about the “greater good.”

How one favors the greater good should be individually chosen, not directed by rules.

So from atop vast heaps of assets gained through doing nothing more than tracking a benchmark, Massive Passives are compelled to berate the market over purpose.

If that purpose is an ESG checklist, the purpose is a dictated set of rules.  The very thing passive investment promotes.  Ironic, right? By subtly suggesting moral superiority, passive investment advances its own self-interest: rules-based investing.

Rather than mindlessly embracing ESG as good for all, a sentient species capable of staggering creativity and achievement through the individual pursuit of happiness that inures to the benefit of the masses owes itself moments of objective reflection.

And the question to ponder is whether a uniform ESG blanket tossed over the capital markets furthers the pursuit of the excellence the IR profession and stock-pickers seek.

Blurry

As Thanksgiving nears, we’re giving thanks for a rock-star stock market since last December, when it fell 20%. Can it hold?

In the simplest sense, whatever has been driving it must continue. Thanksgiving is to me the best holiday because it’s introspective. So let’s reflect on what’s behind stocks.

Everyone says corporate earnings, the economy, monetary policy.  The US economy is strong.  Earnings though are weaker the past three quarters than comparable earlier periods, so it’s not that. Monetary policy is easy, which helps by fueling leverage.

Buybacks?  Sure, a contributor. Geopolitics, trade deals, tariffs?  You’d think those might be headwinds. So far, no. Remember, news doesn’t buy or sell stocks. People and machines do.

Fund-flows? Research from Ed Yardeni says bonds have benefited while stocks have suffered. Domestic trends are disturbing – steep declines for years (See Figure 5) as money steadily shifts toward bonds and foreign equities.

Along our path of reflection we come to market structure – and why both companies and investors should learn it. Between Jul 1, 2015 and present there are 1,097 trading days. Of those, 589 are between 4.5-6.0 on ModernIR’s 10-point Market Structure Sentiment buy/sell scale.

Do the math. The ratio (589/1097) is 5.4/10.0. Reads over 5.0 mean machines will lift prices.  It’s a GARP market – growth at a reasonable price.

Now let’s add in the time the market has spent in “Overbought” territory, above 6.0. It’s 301 days, or 27% of the time. It’s been Oversold (below 4.5) 207 days, 19%.

There’s our answer. It’s GARP 54% of the time, momentum 27% of the time, value 19% of the time. It’s more growth than value, more buying than selling.  Whether money comes or goes, if what comes is disposed to pay up, stocks rise.

Contrast with Sep-Dec 2018. During that period when stocks fell about 20%, they were Oversold 44% of the time and Overbought just 16% of the time.

Narrow the data to 2019 and stocks are GARP just 44% of the time, Overbought 39% of the time. It’s become momentum almost as much as growth.

Zoom on Aug 1-present. GARP behavior is down to 41% of trading, Overbought, 36% of the time, Oversold 23% of the time.

Shouldn’t we be measuring that? By sector, industry, stock? Well. We do, at ModernIR.

Shifting our lens, in the past three weeks across the eleven market sectors, selling has outpaced buying 61% to 39%.

How does money leave stocks while the market sustains GARP or momentum (more Overbought than Oversold) characteristics?

The money behind prices is increasingly short-term, and leveraged. Add up everything that’s not long-only investing and it’s 86% of trading. The AMOUNT of money chasing stocks can shrink and stocks will still rise because the TIME dedicated to buying or selling is increasingly up-or-down, not buy-and hold.

Lesson? Public companies and investors, you cannot count on fundamentals, macroeconomics, central banks, to predict what the market will do. It moves in response to its temporal behavioral biases.

Or put another way, direction hinges on the short-term propensity of money to plow back into stocks tomorrow or to stop doing that.  It shifts to GARP, to growth, to value, and back. When the bias in the data blurs, money falters.

Data are getting blurry (as rock band Puddle of Mudd would say). It’s not a GARP market anymore.

For that reason, I’ll go out on a limb and say it’s too early to call this a record year (like Eric Church, for you country fans).  What got us here has begun eroding. We’re only 1% above the GARP levels for stocks in Q4 2018.

Wrapping up, it’s a great season, this one of Thanksgiving.  Give thanks!  And be alert to changing behaviors.  When lines blur – in your stock, your peers, your sector, industry – you should know. It’s a weather report on what’s coming. We want to stay clear-eyed.

The Fortress

Happy birthday to Karen Quast! My beloved treasure, the delight of my soul, turns an elegant calendar page today. It’s my greatest privilege to share life with her.

Not only because she tolerates my market-structure screeds.

Speaking of which, I’m discussing market structure today at noon ET with Joe Saluzzi of Themis Trading and Mett Kinak from T Rowe Price. In an hour you’ll mint a goldmine of knowledge.  Don’t miss it.

A citadel by definition is a fortress.  I think of the one in Salzburg, Austria, the Hohensalzburg castle perched on the Salzach, “Salt River” in German, for when salt mined in Austria moved by barge.  We rode bikes there and loved the citadel.

It’s a good name for a hedge fund, is Citadel. We were in San Francisco last week and joined investor-relations colleagues for candid interaction with Citadel. IR pros, hedge funds are stock-picking investors capable of competing in today’s market.

Blasphemy?  Alchemy?  I’ve gone daft?

No, it’s market structure. Exchange Traded Funds (ETFs) have proliferated at the expense of what we call in the IR profession “long-only” investors, conventional Active managers buying stocks but not shorting them.

Since 2007 when Regulation National Market System transformed the stock market into a sea of changing stock-prices around averages, assets have fled Active funds for Passive ones.  ETF assets since 2009 have quadrupled, an unmatched modern asset-class boom.

Underperformance has fueled the flight from the core IR audience of “long-onlys.” Returns minus management fees for pricey stock-pickers trails tracking a benchmark. So funds like SPY, the ETF mirroring the S&P 500 from State Street, win assets.

Why would a mindless model beat smart stock-pickers versed in financial results? As we’ve written, famous long-only manager Ron Baron said if you back out 15 stocks from the 2,500 he’s owned since the early 80s, his returns are pedestrian. Average.

That’s 1%. Smart stock-pickers can still win by finding them.

But. Why are 99% of stocks average? Data show no such uniformity in financial results. We come to why IR must embrace hedge funds in the 21st century.

Long-onlys are “40 Act” pooled investments with custodial assets spent on a thesis meant to beat the market.  Most of these funds must be fully invested. That is, 90% of the money raised from shareholders must be spent.  To buy, they most times must first sell.

Well, these funds have seen TRILLIONS OF DOLLARS the past decade leave for ETFs and indexes (and bonds, and target-date mixed funds). Most are net sellers, not buyers.

Let’s not blindly chase competitively disadvantaged and vanishing assets. That confuses busy with productive. And “action” isn’t getting more of the shrinking stock-picking pie.

First, understand WHY ETFs are winning:

  • ETFs don’t hold custodial assets for shareholders. No customer accounts, no costs associated with caring for customers like stock-pickers support.
  • They don’t pay commissions on trades. ETFs are created and redeemed in large off-market blocks (averaging $26 million a pop, as we explained).
  • They don’t pay taxes.  ETFs are created and redeemed tax-free through in-kind exchanges.
  • ETFs avoid the volatility characterizing the stock market, which averages about 3% daily in the Russell 3000, by creating and redeeming ETFs off-market.
  • And fifth, to me the biggest, stock-market rules force trades toward average prices. All stocks must trade between the best bid to buy and offer to sell. The average.

So.  Stocks are moved by rule toward their average prices. Some few buck it.  Stock-pickers must find that 1%. Money tracking benchmarks picks the 99% that are average. Who’s got the probability advantage?

Now add in the other four factors. Who wins?  ETFs. Boom! Drop the mic.

Except dropping the mic defies market rules prohibiting discrimination against any constituency – such as stock-pickers and issuers.

SEC, are you listening? Unless you want all stocks to become ETF collateral, and all prices to reflect short-term flipping, and all money to own substitutes for stocks, you should stop. What. You. Are. Doing.

Back to Citadel. The Fortress. They admit they’re market neutral – 50% long and short. They use leverage, yes. Real economic reach isn’t $32 billion. It’s $90 billion.

But they’re stock-pickers, with better genes. Every analyst is covering 25-55 stocks, each modeled meticulously by smart people. Whether long or short they meter every business in the portfolio. Even analysts have buy-sell authority (don’t poo-poo the analysts!). And they’re nimble. Dry powder. Agile in shifting market sand.

They can compete with the superiority modern market structure unfairly affords ETFs.

So. Understand market structure. Build relationships with hedge funds. This is the future for our profession. It’s not long-onlys, folks. They’re bleeding on the wall of the fortress. And don’t miss today’s panel.

Time Changes

Public companies, are you still reporting financial results like it’s 1995?

Back then, Tim Koogle and team at Yahoo! made it a mission to be first, showing acuity at closing the books for the quarter faster than the rest. Thousands turned out for the call and – a whiz-bang new thing – webcast.

Ah, yesteryear and its influence.  It’s still setting time for us all.  No, really.  Benjamin Franklin penned a 1784 letter to a Parisian periodical claiming his experiments showed sunlight was available the moment the sun rose and if only Parisians could get out of bed earlier instead of rising late and staying up, they could save immense sums on candles.

Some say his levity gave rise to the notion of Daylight Savings Time. A closer look suggests it was the Canadians.  Sure, scientist George Hudson of the Wellington Philosophical Society presented an 1895 paper saying New Zealand would improve its industry by turning clocks forward two hours in October, back two in March.

But the occupants of Thunder Bay in northern Ontario first shifted time forward in 1908.

What do Canada and New Zealand have in common besides language and erstwhile inclusion in a British empire upon which the sun never set?  They’re at extreme latitudes where light and dark swing mightily.

The push to yank clocks back and forth swept up much of the planet during World War I in an effort to reduce fuel-consumption.

Here in Denver we’re neither at war and hoarding tallow nor gripping a planetary light-bending polar cap in mittened hands.  So why do we cling to an anachronistic practice?

Speaking of which, in 1995 when the internet throngs hung on every analog and digital word from the Yahoo! executive fearsome foursome (at least threesome), most of the money in the market was Active Investment. That was 24 years ago.

Back then, investor-relations pros wanted to be sellside analysts making the big bucks like Mary Meeker and Henry Blodget. Now the sellsiders want to be IR pros because few hang on its words today like it was EF Hutton and the jobs and checks have gone away.

Volume is run by machines. The majority of assets under management are Passive, paying no attention to results. Three firms own nearly 30% of all equities. Thousands of Exchange Traded Funds have turned capital markets into arbitrage foot races that see earnings only as anomalies to exploit. Fast Traders set most of the bids and offers and don’t want to own anything. And derivatives bets are the top way to play earnings.

By the way, I’m moderating a panel on market structure for the NIRI Virtual Chapter Nov 20 with Joe Saluzzi and Mett Kinak. We’ll discuss what every IRO, board member and executive should understand about how the market works.

Today 50% of trades are less than 100 shares.  Over 85% of volume is a form of arbitrage (versus a benchmark, underlying stocks, derivatives, prices elsewhere).

Active Investment is the smallest slice of daily trading. Why would we do what we did in 1995 when it was the largest force?

Here are three 21st century Rules for Reporting:

Rule #1: Don’t report results during options-expirations.  In Feb 2019 Goldman Sachs put out a note saying the top trading strategy during earnings season was buying five-day out of the money calls. That is, buy the rights (it was 1996 when OMC offered that same advice in a song called How Bizarre.). Sell them before earnings. This technique, Goldman said, produced an average 88% return in the two preceding quarters.

How? If calls can be bought for $1.20 and sold for $2.25, that’s an 88% return.  But it’s got nothing to do with your results, or rational views of your price.

The closer to expirations, the cheaper and easier the arbitrage trade. Report AFTER expirations. Stop reporting in the middle of them. And don’t report at the ends of months. Passives are truing up tracking then. Here’s our IR Planning Calendar.

Rule #2: Be unpredictable, not predictable.  Arbitrage schemes depend on three factors: price, volatility, and time. Time equals WHEN you report. If you always publish dates at the same time in advance, you pitch a fastball straight down the middle over the plate, letting speculative sluggers slam it right over the fence.

Stop doing that. Vary it. Better, be vague. You can let your holders and analysts know via email, then put out an advisory the day of earnings pointing to your website.  Comply with the rules – but don’t serve speculators.

Rule #3: Know your market structure and measure it before and after results to shape message beforehand and internal feedback afterward. The bad news about mathematical markets is they’re full of arbitragers.  The good news is math is a perfect grid for us to measure with machines. We can see everything the money is doing.

If we can, you can (use our analytics!).  If you can know every day what sets your price, how it may move with results, whether there are massive synthetic short bets queued up and looming over your press release, well…why wouldn’t you want to know?

Let’s do 21st century IR. No need to burn tallow like cave dwellers. Go Modern. It’s time.

 

Hot Air

Balloons rise on hot air. Data suggest there’s some in stocks.

Lipper says about $25 billion left US equities in October, $15 billion if you weed out inflows to Exchange Traded Funds (ETFs). Bond flows by contrast were up $21 billion. So how did stocks rise 5%?

In September 2019 when the S&P 500 closed roughly unchanged for the month, the Investment Company Institute reported a net increase in ETF shares of over $48 billion, bringing total YTD ETF creations and redemptions to $2.96 trillion.

For what?  More money has gone than come in 2019, so why more ETF shares?

And should we be concerned that stocks are rising on outflows?

Drawing correct conclusions about stocks depends on a narrative buttressed by data.  If we stay “stocks are up on strong earnings,” and earnings are down, it’s incorrect.

With about 80% of S&P 500 components having reported, earnings are down (FactSet says) about 3% year-over-year, the third straight quarterly contraction. Analysts currently expect Q4 2019 earnings to also contract versus 2018.

I’m not bearish. We measure behavioral data to see WHY stocks act as they do, so we’re not surprised by what happens.  It was simpler when one could meter inflows and outflows to explain ups and downs. More buyers than sellers. Remember those good old days?

Some $70 billion has exited US equities in 2019 yet stocks are at records. If holdings are down while stocks are up, the simplest explanation left to us now is it’s hot air – balloons lifted on heated atmosphere.

What’s heating the air? Well, one form of inflow has risen in 2019: The amount of ETF shares circulating. It’s up $200 billion.

The industry will say it’s because more money is choosing ETFs.  Okay, but is a dollar spent on ETFs hotter than one spent on underlying stocks, or mutual funds? There shouldn’t be more ETF shares if there are less invested dollars.

And if ETFs are inflationary for equities, how and why?

The reason investors are withdrawing money from stocks is because the market cannot be trusted to behave according to what we’re told is driving it. Such as people withdraw money and stocks rise.

Now ahead in the fourth quarter, if indeed rational money is forward-looking, we may see rising active investment on an expected 2020 pickup in earnings.

But measuring the rate of behavioral change from Jan-Nov 2019, the biggest force is ETFs. It’s not even close.  That matches ETF-creation data.

The inflationary effect from ETFs is that the market is hitting new highs as earnings decline and money leaves stocks.

The bedrock of fundamental investment is that earnings drive the market. Apparently not now.  What’s changed? ETFs.

How do they create inflation? Arbitraging spreads between stocks and ETFs has become an end unto itself. The prices of both are thus relative, not moored to something other than each other. And with more ETF shares chasing the same goods, the underlying stocks, the goods inflate.

We see it in the data. Big spreads periodically develop between stocks and ETFs, and stocks rise, and spreads wane, and stocks fall. In the last six weeks, correlation between the movement of stocks and ETFs has collapsed to 39% from over 91% YTD.

That’s not happened since we’ve been tracking the data. If ETFs are substitutes, they should move together (with periodic gaps), not apart. That they are indicates a fever-pitch in the focus on profiting on stock-ETF spreads.

That’s hot air.  The chance to trade things that diverge in value.

The problem with inflation is deflation, and the problem with rising on hot air is falling when it cools. We’re not predicting a collapse. But the risk in a market levitating on hot air is real.

Knowing the risks and how they may affect your stock, investor-relations people, or your portfolio, investors, is pretty important. We have the data to demystify hot air.