Perspective

It’s not what you think.  Heard that phrase before?

Last Wednesday, Oct 15, apparently everybody trading equities believed the world was dissolving in an apocalyptic stew of Ebola, European recession, unused petroleum, Chinese debt and Mideast terror. The DJIA at one point dropped 460 points.

Son of a gun. By Friday, October 17 we were back to milk and honey and Captain Crunch! The DJIA rose 263 points. Human nature is fickle. But this juxtaposition stretches credulity. It’s also a lesson on market structure.

In 2013, according to the Investment Company Institute, net US inflows to mutual funds were $152 billion, of which $52 billion went to target-date hybrid funds (mixes of bonds and equities based on one’s age), and about $53 billion to index funds, 82% of which track major market measures like the S&P 500. Exchange-traded funds garnered another $180 billion, mostly equity instruments that track funds tied to indices.

If two-thirds of the net new cash followed asset-allocation vehicles and a greater sum still sought ETFs, which post daily market positions, the likelihood that most of your price-movement reflects fundamentals is low unless you have an activist (event-driven money can catalyze bipolarity in market behavior – higher highs and lower lows).

There’s an animation sequence I’ve seen that starts with what appears to be mountains or desert from great height. Then our vantage point pans back and we see with surprise that it’s something else entirely: the brown pupil of a person’s eye.  We sweep back and the person is standing on a shoreline. Then back we scan across forests, mountains, rivers, countries and then continents until we’re in space seeing below us a lovely cobalt sphere, and we pan further, and it’s the blue pupil of a giant being.

Equities are trading about $200 billion daily. But with high-frequency flows in our data routinely ten times the price-setting authority of any other behavior, true dollar flow could be a small fraction of that.

The US Treasury auctions over $100 billion of notes, bond and bills every week on average (about $8 trillion refinanced or issued in fiscal 2014), data we track in your Market Structure Reports on page two under Macro commentary, clients. Currency trading daily averages more than $4 trillion and routinely tops $5 trillion. That daily figure equals all the cash held outside US retirement accounts, about $5.1 trillion.

According to Sifma, the securities industry association, swaps involving interest rates and currencies total more than $800 trillion of notional value globally. And there we are. We’ve panned back to the eye of the giant.

Last Wednesday as the stock market plunged, so did the US dollar, the steepest slide in our currency versus others since it began running up mid-August. Magically, oil prices stopped slipping and by Friday stocks zoomed.

The vast global accumulation of derivatives contracts have dates-certain. Most use monthly expirations set by the Options Clearing Corp. Contracts for options and futures expired Oct 16-17.  A new series began trading Oct 20.

Today, Oct 22, contracts tied to implied volatility in the S&P 500 – there are some 34 ETFs, along with the famous Fear Index, the VIX, and associated options and futures providing exposure to volatility as an asset class – lapse. The period between September and October expirations has offered volatility traders a cornucopia not seen in years.

Perhaps we’ve settled out.  Back to steady-on. But the ModernIR 10-point Behavioral Index (MIRBI) remains dour, worse even than a week ago. With the European Central Bank set to buy corporate bonds as the US economy steadies, a rising dollar is nearly certain. A strong buck weakens oil and stocks. The Fed meets next week.

Never trust an expirations rally.  You don’t know if you’re standing on the shoreline of a gentle sea, or seeing ductile effluvia from a giant set to shed tears.

This same principle applies to your shares. It’s probably not what you think. Far better to measure the data (market structure!), which never laugh or cry. They just…are.

Volatile

There’s no one-word description. The Ides of October arrives serene and tranquil in Denver, the Rockies dusted with recent snow, the sky intensely blue, deciduous trees on the boulevards colored like Jackson Pollock movements on a Wayne Thiebaud landscape.

By contrast, the equity market recalls the scrolling text concluding Clint Eastwood’s Oscar-winning Unforgiven:  “…of notoriously vicious and intemperate disposition.”

One-word summary: “Volatile.”

Why? Ideas abound. Teetering global growth. The threat of an African pandemic. Mideast conflict. Breaking Bad is off the air.  With the Chicago Board Options Exchange’s measure of implied S&P 500 volatility, the VIX, trading over 20 now and up 71% the past month, wringing hands accompany the ringing of opening market bells.

The VIX stood at 12.8 Sept 11, when the ModernIR 10-Point Behavioral Index (MIRBI) dipped below neutral (5.0) for the first time since Aug 4.  Back then, the MIRBI bottomed Aug 8 and turned positive Aug 14. This time, it’s still negative a full month later, marking the longest dour MIRBI attitude we’ve documented since developing the index roughly four years ago.

The MIRBI measures how money moved the past five trading days versus the five before that, in four demographic clusters (Active money, Asset-allocation, Fast Money, Hedging). This continuous sentiment conveyor belt is thus an excellent barometer of the totality of contemporaneous market behavior. It’s neither qualitative nor technical. It’s almost never wrong on market-direction because ups and downs demand the absence or presence of money – which is what it measures (and can change in a blink).

The big question: Why did all the money turn negative? (more…)

Casting About

I remember the day my elementary school friend pierced his ear. By accident.

We were nine-year-olds fishing eastern Oregon’s Burnt River on my dad’s cattle ranch. Young John gave his line a mighty cast. We awaited the expected kerplunk in the water.  Nothing.  Assuming he’d caught a branch in the trees behind us, he yanked the line and let out a yelp. He’d caught himself. The hook had punched right through his earlobe. I admit, I laughed.

The old way for getting answers to moves in your shares also involves a casting process. If your stock moves up or down sharply, you cast about.

Early in the IR chair I did it too. If the CEO rang and said, “Quast, what the heck’s going on?  Why are we down three percent?” I would react by calling others, who would cast about for reasons. The exchange or my market intelligence sources would say variously, “We’re hearing rumors there’s a seven-digit seller,” or “UBS is big on the sellside so we think it’s retail,” or “you broke through your 20-day and 50-day moving averages and the quants are pressuring shares,” or “Smithers on the sellside at Gaujem & Flippitt has got a bearish sector note out today.”

Some or all of it could be causal, and some or all is irrelevant. There’s no statistical link. What if your stock is down today because of something occurring last week?

If it rains today in your city, it’s unlikely that anybody is ringing weatherpersons and saying, “Hey, what’s going on?  What’re you hearing to explain this rain?” Meteorologists have models that while imperfect provide generally accurate predictive views of tomorrow’s weather.  We check forecasts before we travel, right?  Last week Karen and I were glad to know flying into Dallas that the bad weather would hit Thursday and not Friday. (more…)

Peer Review

Autumn the past two weeks splashed brilliantly over the Colorado Front Range. It puts everything into perspective.

I recall as a kid my mother saying in retort to my reason for some dunderheaded act, “You did it because ‘everybody else was doing it?’”

Investor-relations professionals have long tracked what everybody else is doing, comparing the company’s trading with a set of peers. Clustering similar things is a time-tested statistical maxim. We practiced it on the ranch of my youth at the auction yard, sorting groups of our steers on display for potential buyers uniformly by color, weight, shape. One weak link could throw off the average per-pound price.

What makes a peer?  Similar characteristics. Yesterday I sent a screenshot to an IRO (investor relations officer, for you newbies) showing startling comportment between her shares and another stock. One is a home-furnishings retailer, the other a technology high-flyer in cloud architecture.

On the surface, no distinguishing features say these two are peers. But machines calculating probabilities see patterns, not sectors. In human physiology, beneath the skin we’re all the same. We’re peers though we may not look alike. In the stock market, physiology is comprised of rules, prices, supply and demand.

It calls into question comparing how you trade versus peers. Yesterday one of our household-name clients asked, “We’re trailing our peers, so how can the cause be macro?” The data were overwhelming: No movement in rational behavior, massive change for indexes/ETFs and hedging. Our client is the “category killer” in that group, the one every index, every ETF, will own – or sell. Macro selling won’t hit peers the same, and either way, pressure wasn’t fundamental.

That’s no absolute either. Another category-killer in a different industry outperformed its peers because safe-harbor money was buying only the biggest. Plus, algorithms executing the same instructions in an industry group can produce different effects on components. (more…)

Double Standard

Humans are often entertained by illustrations of absurdity through reality.

For instance, Treasury Secretary Jack Lew months ago said he’d like to address tax inversions but lacked authority.  Yesterday, Treasury imposed rules to limit inversions. My reading of Section Two of the U.S. Constitution reveals no lawmaking authority vested in the executive branch.

I could compile a book of examples. I won’t.  Instead, I’ll offer one for the IR chair and the public-company executive suite. In 1975, Congress added Section 13f to the Securities Act to “increase the public availability of information regarding the securities holdings of institutional investors.” I was eight years old then and had no idea I’d spend my adult life working in the capital markets with thus far no update to the provision.

NIRI CEO Jeff Morgan said in his weekly note to members yesterday that the Board had held its annual meeting with the SEC to discuss disclosure. “I am not sure we came to any concrete agreement on how we might traverse down the road to improving disclosure,” Jeff wrote.  He was talking about the burden of it.

In August 2000, the SEC imposed Regulation Fair Disclosure (Reg FD) to “promote the full and fair disclosure of information by publicly traded companies and other issuers.” Following and vastly increasing disclosure-costs was The Sarbanes-Oxley Act of 2002 (SOX as we call it), passed by the U.S. Congress to protect shareholders and the general public from accounting fraud and errors and to improve accuracy in corporate disclosures. I remember that my company spent about $2 million as a small-cap NASDAQ-traded firm with $200 million in revenues complying with Section 404 and other requirements the first year.

I recall an ensuing variety of rules through the Financial Accounting Standards Board and SEC Staff Accounting Bulletins, all adding time, effort, cost and disclosure. (more…)

Risk

We figured if The President goes there it must be nice.

Reality often dashes great expectations but not so with Martha’s Vineyard where we marked our wedding anniversary. From Aquinnah’s white cliffs to windy Katama Beach, through Oak Bluffs (on bikes) to the shingled elegance of Edgartown, the island off Cape Cod is a winsome retreat.

Speaking of retreat, my dad, a Korean Police Action era (the US Congress last declared war in 1943, on Romania. Seriously.) veteran, told me his military commanders never used the word retreat, choosing instead “advance to the rear!”

Is the stock market poised for an advance to the rear? Gains yesterday notwithstanding, our measures of market sentiment reflected in the ten-point ModernIR Behavioral Index dipped to negative this week for the first time since mid-August. Risk is a chrysalis formed in shadows, studied by some with interest but generally underappreciated.

It happened in 2006 in housing, when trader John Paulson recognized it and put on his famous and very big short. Most missed the chrysalis hanging rather elegantly in the mushrooming rafters of the hot residential sector.

It happened in the 17th century Dutch tulip bubble, an archetype for manic markets.  Yet then tulips and buyers didn’t suddenly explode but just the money behind both, as ships from the New World laden with silver and gold flooded Flanders mints with material for coin. Inflation is always and everywhere a monetary phenomenon.

It’s hard to say if mania is here hanging pupa-esque on the cornices of the capital markets. Most say no though wariness abounds. Mergers are brisk and venture capital has again propagated a Silicon Valley awash in money-losing firms with eye-popping values. Corporate buybacks will surpass $1 trillion in total for 2013-2014, capital raking out shares from markets like leaves falling from turning September trees. (more…)

Big Opportunity

Amazed. Dazed. Perhaps needing a drink.

Thus shown the faces of investor-relations practitioners at yesterday’s NIRI Southwest Regional Conference as Rajeev Ranjan from the Chicago Federal Reserve Bank put up his final slide and pronounced it a graphical representation of market microstructure. It appeared to be some sort of complex engineering schematic.

And it reflects how stocks trade today. Many say, “Ignore high-frequency trading because it’s noise from those who don’t care about fundamentals.” If traders oblivious to fundamentals and uninterested in owning your shares routinely price them and all other equities, how can you rely on prices the market displays that underpin the corporate balance sheet?

Proving that even the SEC is antsy now about this structure, a tick-size study to consider wider trading spreads is nearing finalization. Did you get the memo? No?  Exactly. Public companies have been omitted – but the comment period is coming! If ever public companies needed to speak up, this is the opportunity. With that preamble, we’ve reserved today’s Market Structure Map for yesterday’s blog post from our good friends at Themis Trading. Take it away, Joe and Sal:

 

While we in the trading community continue to debate the merits of HFT and the structural defects in our market structure, there continues to be a group of market constituents that remains silent in the debate – the public companies.  The stock market has undergone dramatic structural changes over the past decade but many of these changes were done without the input of the public company.

Public companies are the reason that the stock market exists, they are what research analysts cover and who bankers seek to do deals with. Without listed public companies, there would be no S&P 500 ETF or E-mini futures contract.  There would be no rebate or latency arbitrage that hinges on microwave networks and football-field-sized data centers.

We’re not quite sure why the public company largely remains silent in the market structure debate.  Possibly, it is because market structure has continued to get more complicated and they fear they are not up to date on the changes.  Or possibly, they feel that in return for annual listing fees, the stock exchanges should be representing their views.  Considering that exchanges now get most of their revenues from data-related services, looking out for public companies seems to be on the back of their to-do list.

While our friend Tim Quast from ModernIR continues to speak out on structural issues on behalf of his public-company clients, it is rare that we see any others in that segment speak out.   However, we recently came across an article written in Canada’s Financial Post by David Beatty, which tackles the issue of market structure and public listings. Mr. Beatty is Chairman of the Board of Canada-based Rubicon Minerals and is also on the Board of Directors for First Service Corporation and Canada Steamship Lines. (more…)

Without Your Knowledge

Facebook collaborated with two respected universities to study your emotional responses when shown different kinds of news. Without your knowledge.

We learned in June, you might recall, that Cornell, the University of California at San Francisco and Facebook delved into the doings and feelings of 700,000 of us folks without so much as a by-your-leave. The aim was unalloyed, as aims often begin when people sit in rooms with statistics and contemplate how to study them.  Do users post negative prose if they’re exposed to adverse news?

It seems innocuous, sure. I’m not knocking the social network and that’s not the point of today’s piece. If you’re sharing your innermost feelings with a community of one billion, your expectation for inclusion on the distribution list for the memo about a psychological study should be a number approaching zero.

Speaking of memos you didn’t get, we wrote two weeks ago that the SEC had in June ordered the stock exchanges and Finra, regulator for brokers, to craft a program for larger tick-sizes in small-caps. The plan is out. Without input from public companies. But you can yet weigh in. We’ll come to it.

There are four groups, not three as we’d initially thought. The three test groups will contain about 400 entities each with prices over $2, volume under a million shares, and market-cap of $5 billion or less, and will study trading in five-cent increments.

Lest you suppose this is the backwater of the market, there are only 754 large-cap companies in the Wilshire 5000.  Not enough to constitute two test groups. Most of the stocks trading publicly fit criteria for this proposed program.

That makes this plan more than a test. It’s a functional repudiation of Regulation National Market System. But instead of admitting its errors, the SEC simply ordered the exchanges to propose an alternative, thus permitting regulators to sidestep responsibility for screwing up 80% of the marketplace. (more…)

Beyond Curiosity

Let’s talk about houses.

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

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

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

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

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

Now suppose it was unclear who was buying and selling houses, whether the sales were cash or financed, how much of the volume of new and existing home-sales were simply transactions between brokers trying to pump up volumes (suppose it were half!), whether mortgage applications were real or indications of interest that wouldn’t materialize, and 35% of all home-sales were in the dark with nothing more known about them save the net number. (more…)

Tray Dat

We’ll be listening in the car to a song on satellite radio’s The Pulse, trying to keep current, and I’ll say to Karen, “Do you understand what he’s saying?”

You may feel the same way about equity-market rules. Take for instance the Trade-At Rule.  No it’s not Tray Dat, but I think I heard that in a song on The Pulse.  We didn’t hear something sounding like Tray Dat during the Little River Band concert Sunday at Denver’s Hudson Gardens, the band touring 39 years with a revolving cast still delivering goose-bump harmonies on Lady, Take It Easy on Me, Cool Change and Reminiscing.

Anyway, the Trade-At Rule matters to IR because it sharply impacts the buyside and sellide – your two core constituencies. And if the CFO stops you in the hallway and says, “What do you think of this Tray Dat thing the SEC is considering?” you don’t want to stammer.

So here’s what’s happening.  The SEC in June directed exchanges and Finra, the regulatory body for brokerages, to develop a plan for testing wider spreads in stocks. The SEC wants three test groups for a year-long pilot program.  All three will include stocks with market caps under $5 billion, volume below one million daily shares, and prices over $2.

One group, the control, will trade as it does now.  The second will have greater tick sizes, or spreads between prices for buying and selling shares, called the best Bid (to buy) and Offer (to sell). The plan is still conceptual – the SEC in June gave market participants 60 days to craft their proposal – but it’s probable we’d see five-cent spreads.

The third group will incorporate along with bigger ticks another idea: The Trade-At Rule. Best way to describe it? If you’ve read the book Flash Boys, there’s a story Brad Katsuyama tells about seeing 25,000 shares for sale on his screen, and readying his own order to buy those 25,000 shares. His finger is poised over the keyboard, counting down, 5-4-3-2-1…click. He presses the button to buy – and the orders disappear and he gets but a small portion of what he could clearly see was available.

The Trade-At Rule would ostensibly remedy this problem by prohibiting somebody from front-running the displayed price. It would seem to force trades out of dark pools where prices can’t be seen, onto exchanges, where they can. There are exemptions for big block dark pools like Liquidnet and Aqua, and for exchanges with the best price right before the new “marketable” order arrives. (more…)