Tagged: Disclosure

Big Blanket

The US stock market trades about $500 billion of stock daily, the great majority of it driven by machines turning it into trading aerosol, a fine mist sprayed everywhere. So tracking ownership-changes is hard. And unless we speak up it’s about to get a lot harder.

In 1975 when the government was reeling like a balloon in the wind after cutting the dollar loose from its anchoring gold, Congress decided to grant itself a bunch of authority over the free stock market, turning into the system that it now is.

How?  Congress added Section 11A to the Securities Act, which in 2005 became Regulation National Market System governing stock-trading today – the reason why Market Structure Analytics, which we offer to both public companies and investors, are accurately predictive about short-term price-changes.

And Congress decided to create a disclosure standard for investors, amending the Securities Act with section 13F. That’s what gave rise to the quarterly reports, 13Fs, that both investors and public companies rely on to know who owns shares.

I use the phrase “rely on” loosely as the reports are filed 45 days after the end of each quarter, which means the positions could be totally different by the time data is released. It’s a standard fit for the post office. Mail was the means of mass communication in 1975.

Currently, the standard applies to funds with $100 million or more in assets. Many managers divide assets into sub-funds to stay below that threshold.  So most companies have shareholders that show up in no reports. But at least they have some idea.

Well, out of the blue the Securities and Exchange Commission (SEC) has decided to lift the threshold to $3.5 billion to reflect, I guess, the collapse of dollar purchasing power.

But nothing else changes!  What would possess a regulatory body ostensibly responsible for promoting fairness and transparency to blanket the market in opacity while keeping in place time periods for reporting that have existed since 1975?

I’m reminded of a great line from the most quotable movie in modern history, Thank You For Smoking: I cannot imagine a way in which you could have $#!!@ up more.

Public companies have been asking the SEC for decades to modernize 13F reporting. Dodd Frank legislation passed in 2010 included a mandate for monthly short-position reporting. It’s not happened because the law put no timeframe on implementation.

But how stupid would it be to require monthly short-position reporting while letting long positions remain undisclosed till 45 days after the end of each quarter?

Much of the world has stricter standards of shareholder disclosure.  Australian markets empower companies and stock exchanges to require of investors full disclosure of their economic interest, on demand.

Our regulators appear to be going the opposite direction.

Australia offers an idea, SEC. If you’re going darken the capital markets with a new (non) disclosure standard, then how about empowering companies to demand from holders at any time a full picture of what they own and how they own it?

Investors, I get it. You don’t want anyone knowing what you have.  Well, it seems to work just fine in Australia, home to a vibrant capital market.

And let’s bring it around to market structure.  There is a woefully tilted playing field around ETFs.  A big investor, let’s say Vanguard, could give a billion-dollar basket of stocks to an Authorized Participant like Morgan Stanley off-market with no trading commissions and no taxes, in exchange for a billion dollars of ETF shares.

None of that counts as fund-turnover.

It could happen by 4p ET and be done the next day.  No trading volume. And then Vanguard could come right back with the ETF shares – again, off-market, doesn’t count as fund-turnover – and receive the stocks back.

Why would investors do that? To wash out capital gains. To profit on the changing prices of stocks and ETFs. This is a massive market – over $500 billion every month in US stocks alone.  It’s already over $3 TRILLION in total this year.

What’s wrong with it?  All other investors have to actually buy and sell securities, and compete with other forces, and with volatility, and pay commissions, pay taxes, alter outcomes by tromping through supply and demand.  Oh, and every single trade is handled by an intermediary (even if it’s a direct-access machine).

So how is that fair?

Well, couldn’t all investors do what Vanguard did?  No. Retail investors cannot.  Yes, big investors could take their stock-holdings to Morgan Stanley and do the same thing. But trading stocks and ETF shares back and forth to profit on price-changes while avoiding taxes and commissions isn’t long-term investment.

That the ETF market enjoys such a radical advantage over everything else is a massive disservice to public companies and stock-pickers.

And after approving the ETF market, you now, SEC, want to yank a blanket over shareholdings to boot?  Really?  Leave us in 1975 but 35 times worse?

Market Structure Analytics will show you what’s happening anyway. And nearly in real time. But that’s not the point. The point is fairness and transparency. Every one of us should comment on this rule.

Reality Disconnect

In 1975, there were no electronic exchanges in the United States.  Now the average S&P 500 component trades electronically 17,000 times daily in 134-share increments totaling a mean of $500 million of stock.

Yet public companies still have a 1975 standard of shareholder disclosure from the SEC, called 13F filings, referencing the section of the Securities Act with instructions for investment advisors of specified size to report positions 45 days after each quarter-end.

It’s a reality disconnect. Retaining this standard says to executive teams and boards for public companies that “regulators and legislators want you to believe this is what’s driving your share-value.”

You can’t believe what the market is telling you on a given day, let alone over a quarter. We’ll come to that.

In 1975, there were no Exchange Traded Funds, no Fast Traders.  The first index fund open to the public launched Dec 31, 1975, from Vanguard, with $11 million of assets.

Today, index investing has surpassed active stock-picking in the US for assets under management. ETFs are the phenomenon of the era, with growth surpassing anything modern markets have ever seen. There is one ETF for each Russell 1000 stock now.

Total US market capitalization is more than $30 trillion, and 1% of it trades every day – over $300 billion of stock. By our measures, ETFs are responsible for roughly 60% directly or indirectly. ETFs are priced by arbitrage. Arbitrage blurs delineation between Fast Traders and ETF “market-makers.” Both make trade decisions in 10 nanoseconds.

None of this money we’ve just highlighted pays attention to earnings calls or reads 10-Ks and 10-Qs or press releases.  It’s rules-based investing. Asset allocation. Trading.

As money has shifted tectonically from Active to Passive, regulatory and disclosure costs for public companies – to serve Active investors – have gone the opposite direction.

We estimate costs related to quarterly and annual reporting, associated public reviews and audits, and Sarbanes-Oxley and Dodd-Frank and other regulations total $5-6 billion annually. For the roughly 3,400 companies traded nationally, investor-relations budgets consumed by communications tools, travel, reports and services are $3-4 billion.

Unless the point of regulation is busywork, the rules are confusing busy with productive. As the money ceases to listen – there’s been a diaspora of sellside analysts from Wall Street to the IR chair because the buyside has gone passive – the chatter from companies has exponentiated.

The Securities Act says no constituency of the national market system including issuers is to be discriminated against. Failing to modernize data to reflect reality is a disconnect.

Summing up, public companies, beset by a leviathan load of regulatory costs for investors, which are moving in math-driven waves and microseconds, wait to see what funds file 13F records of shareholdings 45 days after the end of each quarter.

There’s more.  The average stock has four distinct trading patterns per month, meaning traders unwind and return, funds rebalance, derivatives bets wax and wane, in 20 trading days. Not over a quarter.

About 45% of all trading volume is borrowed. Another 45% comes from Fast Trading machines (with heavy overlap as machines are automated borrowers) that close out 99% of positions before the trading day ends.

All told, 87% of market volume comes from something other than stock-picking. The disclosure standard supposes – because it dates to 1975 – that all volume is rational.

The reality disconnect is so bad now that machines look like humans. As we wrote last week, the whole of financial punditry has been caught up in a vast reputed momentum-to-value shift.

Except it didn’t happen.

Sure, momentum stocks plunged while value stocks surged.  Yet as this story from Marketwatch yesterday notes (I’m a source here too), AAPL is a core component of flying value indices.  Isn’t AAPL a growth stock?

Here’s the kicker.  The principal reason for swooning momentum and soaring value was a rush by Fast Trading machines that spread through markets, and a corresponding short-squeeze for ETF market-makers, which routinely borrow everything but were caught out in ripping spreads between ETFs and component stocks.

What if today’s Federal Reserve monetary policy decisions reflect belief money has shifted to value?  What if investment decisions are incorrectly recalibrated?  What if observers falsely suppose growth is slowing and crow anew about impending recession?

The market is disconnected from 13Fs. How about modernizing them, regulators? I’ll be going to Capitol Hill and the SEC with the NIRI delegation next week to make this case.

Meanwhile, be wary of markets. The Fed was intervening yesterday and likely cuts rates today by 25-50 basis points, just as volatility expirations hit now, and before a raft of stock, index, ETF, currency, Treasury and interest-rate derivatives expire through Friday. And Market Sentiment is topped.

Maybe it’s nothing. But if the market rolls, there are data-driven reasons.  And it’s about time disclosures took a leap forward past the reality disconnect for public companies.

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…)