Tagged: Earnings

Shell Game

The earnings-versus-expectations construct that fixates Wall Street and business journalism as companies report results fuels bets on which shell hides the pea.

In fact, the stock market is built now on hiding the pea and moving the shells, apparent in the Fee Pilot debate we’ve written about recently.

You know the shell game, right?  This cat is pretty good at it.

As to picking the shell that hides the pea, I’m surprised the investor-relations profession isn’t up in arms over claims like Google parent Alphabet’s good numbers reputedly “boosting earnings optimism,” as one headline read.

What stock picker following GOOG trends and drivers and listening to its IR team and executives providing color and guidance didn’t know the quarter would be good? Keen observers didn’t wake up shouting, “Shazzam! I’m shocked at the numbers!”

But yesterday was Counterparty Tuesday, the one day every month when banks backing directional bets – most very short term – square derivatives books. Every third month it falls amidst earnings. If your bets are right, you get paid. Wrong, you pay up.

Banks shuffle assets accordingly. Yesterday, blue chips were up (GOOG is one now), risky stocks were down.

Take the new Communications Services ETF, XLC (see here in sector ETFs), which presages a reshuffling of Consumer Discretionary and Technology stocks into a re-imagined and amalgamated General Industry Classification System (GICS) for everything from Twitter, to Disney, to Facebook, to Electronic Arts that officially hits markets Sep 21, 2018.

Just four companies accounted for XLC gains yesterday if you view Alphabet’s two stock classes as a single company. Alphabet is 24% of the ETF’s weighting. With Facebook, two stocks are 45% of purported assets (read our ETF White Paper for more on “assets”).

The others with gains were VZ and T, two of the spare coterie comprising the old Telecom GICS that’s going away.  Combined the five green elements of XLC yesterday are 54% of its weighting. The other 21 were all in the red.

If you bet on GOOG and you pile in regardless of numbers, your bet pays because GOOG is so massive that as counterparties cover, it drives the entire market up. No wonder betting abounds.

But it’s not fundamentals. It’s betting on the law of large numbers.

Coming back to the Fee Pilot proposed by the SEC to study whether trading incentives distort how orders are handled, we support it because Fast Traders turn the market into a shell game.

Take HRT Financial, a top high-speed trader. We’ve got nothing against the smart folks behind it. But look up its 13F reports. It trades many billions of shares of stocks every month yet owns almost nothing – a measly few hundred million dollars.

Public companies are led to believe that having a bunch of prices set by high-speed firms that don’t want to own anything is good. Well, where do they get shares to sell to investors?  They borrow most of them – from owners! If they didn’t, it would show up as ownership. Or they buy them elsewhere in the market, in tiny pieces, in fractions of seconds, and immediately sell them. They are moving the shells, not fostering a market with deep supply.

It all fits together.  The earnings-versus-expectations model shifts focus from long-term prospects to how something fluctuates.  What is betting on fluctuations? Arbitrage.

Next piece of the puzzle:  How are prices set in the stock market?  By the fastest order bidding to buy or offering to sell. Fast machines like those run by HRT Financial set prices in tiny increments.  Exchanges offer incentives to high-speed traders to set prices in tiny increments – to keep moving the shells, keep that pea in motion, keep fooling people about where the best price is.

And exchanges sell the data from this shell game because rules require everybody in pursuit of the pea to buy it to prove they’re not gaming their customers. It would be laughable if it weren’t true, and describing the stock market.

Three big lessons, investors and public companies. Number one, you’ve got to have better data than the operators of the shell game if you want to keep track of the pea.  And we’ve got it.  Number two, don’t trust a shell game to give you an accurate portrayal of either business fundamentals or future outcomes.

And number three, the best defense against any form of shell game is knowledge. Education. Knowing how the game works. I refer you to the cat above. If the cat can figure it out, so can we!  Market Structure knowledge is now essential for both investors and public companies.

The Matrix

FactSet says quarterly earnings are up 23% from a year ago. Why have stocks declined?

There’s an inclination to grasp at fundamental explanations. Yet stock pickers generally don’t reactively sell because most times they must be fully invested (meaning to sell, they must buy).

Blackrock, Vanguard and State Street claim for Exchange-Traded Funds tracking the S&P 500 or Russell 1000 that turnover is 3-5%. (Editorial note: Those figures exclude creations and redemptions of ETF shares totaling trillions annually – a story we’ve told exclusively in the Market Structure Map.)

If investors are not responsible, who or what is?  Machines. By market rule all trades wanting to set the best bid to buy or offer to sell are automated – running on an algorithm. Why? Because the best price can be anyplace at anytime in the market system, and trades must move fluidly to it.

Thus, machines have become hugely influential in determining how prices are calculated. An amalgam of broker algorithms, smart routers and exchange order types are continually calculating the probability of higher or lower prices and completing a trade.

By our measures, back on Apr 19 the probability of calculating higher prices dropped. Why? Perhaps risk calculations for asset managers ordered rotation from overweighted equities or a need to slough off capital gains from ETFs (stuff mathematical models routinely do).

We have a mathematical representation for it: The market was Overbought. It doesn’t mean people are overpaying for fundamentals. It says machines will lack data to arrive at higher prices.  What follows this condition is nearly always a flat or lower market.

We know then that math arising from market rules is more powerful than a 23% increase in earnings. That should disturb stock pickers and public companies. If the market is The Matrix (if you’re younger than the movie, watch it to understand the reference), what are we all doing straining so hard to be outliers?

And why do machines possess the capacity to trump value-creation?

Good question.

By the way, the math is now changing. It’s resolving toward a mean.  We measure these price-setting propensities with a 10-point scale, the ModernIR Behavioral Index. Most of the time the stock market trades between 4.0 and 6.0, mean-reverting to 5.0 or thereabouts.

It returns to the middle because rules propel it there. Stocks must trade between the best bid or offer. What lies there? The average price. What do indexes and ETFs hew to? Averages.  We’ve explained this before.

When the market slops beyond 6.0, a mean-reversion is coming.  When it drops below 4.0, it signals upward mean-reversion. The market has descended from about 6.5 a week ago to 5.2 yesterday. The market will soon level off or rise as it did microcosmically yesterday, a day of extremes that ended back near midway (but it’s not down to 4.0, notice).

If math is a more reliable indicator of the future than earnings, why is everybody fixated on earnings versus expectations? What if that model is obsolete? And is that a bad thing?

I don’t think so. The earnings-versus-expectations convention promotes arbitrage. Shouldn’t capital-formation power the market?

Big Movers

You can’t expect the stock market to reflect earnings. I’ll explain.

By week’s end, 20% of the S&P 500 will have reported, and earnings are up 17% over the same period last year so far (normalized to about 7% sans federal corporate tax reform legislation).

Yardeni Research, Inc. reports that price-to-earnings ratios in various categories of the market are not misaligned with history.  The S&P 500 trades just over 16 times forward expected earnings, about where it did in 2015, and in 2007 before the financial crisis, and well below levels before Sep 11, 2001.

Sure, by some measures valuations are extreme. Viewed via normative metrics, however, the market is as it’s been. From 1982-2000, PE ratios were generally rising.  From there to 2012, they were generally falling. Yet between we had multiple major market corrections.

Which returns us to my incendiary opening assertion that earnings today don’t drive stocks. What does? The money setting prices. Let me explain.

Buy-and-hold money tends to buy, and hold. Most conventional “long” equity funds must be fully invested, which means to buy something they must sell something else.  Buying and selling introduces tax, trading-commission, and volatility costs, which can cause stock-picking investors to underperform broad indexes.

The Investment Company Institute reported that 2016 turnover rates among equity funds averaged 34%, or about a third of positions annually. Passive index and exchange-traded funds tout low turnover. State Street, sponsor for the world’s largest ETF, SPY, claimed 2017 turnover was 3%.

We’ll come to the fallacy of low turnover in ETFs.

First, Big Reason #1 for the movement of stocks is arbitrage. Follow the money. Using our proprietary statistical measures of behavior in stock trades, nearly 46% of market volume (20-day ave.) in the Russell 1000 (which is over 90% of market cap) came from high-speed traders.

They are not investors. These machines trade tick data in baskets, aiming most times to own nothing at day’s end. The objective is to profit on intraday price-moves.  For instance, 52% of Facebook’s daily trading volume is high-speed machines. Less then 9% is Active investment by stock-pickers.

Viewed another way, there’s a 46% chance that the price of stocks reflects machines trading the tick. Since less than 12% of Russell 1000 volume was fundamental, there is but a one-in-eight chance that earnings set prices. High-speed trading is arbitrage – profiting on price-differences.

Don’t fundamentals price the market long-term? Again, that would be true if the majority of the money setting prices in the market was motivated by fundamentals. That hasn’t been true this century.

How about fund flows?  Assembling data from EPFR, Lipper and others and accounting for big outflows in February, about $40 billion has come into US stocks this year.

Using Investment Company Institute data and estimates for Mar and Apr this year, ETFs have by comparison created and redeemed some $1.5 TRILLION of shares. Fund flows are less than 3% of that figure.

These “in-kind” exchanges between ETF creators and big brokers that form the machinery of the ETF market are excluded from portfolio turnover. If they were counted, turnover rates in ETFs would dwarf those for conventional funds. And the objective behind creations and redemptions is not investment.

ETF creators make money by charging brokers fees for these transactions (which are tax-free to them) and investing the collateral. Brokers then trade ETFs and components and indexes to profit on the creations (new ETF shares sold to investors) and redemptions (returning ETF shares to ETF creators in exchange for collateral to sell and short).

Neither of these parties is trying to produce an investment return per se. They are profiting on how prices change – which is arbitrage (and if ETF creations are greater than redemptions, they permit more money to chase the same goods, lifting markets).

Summarizing: The biggest sources of movement of money and prices are machines trading the tick, and ETF creators and brokers shuttling tax-free collateral and shares back and forth by the hundreds of billions. If pundits describe the market in fundamental terms, they are not doing the math or following the money.

And when the market surges or plunges, it’s statistically probable that imbalances in these two behaviors are responsible.

Earning the Answers

It’s 8am Eastern Time and you’re in a conference room. Earnings season.

Executives around the table. The serious ones in suits and ties like usual. Others in shorts or jeans. Everybody reading the call script one more time. 

“You think we’ll get that question about inventory levels?” the COO says. 

“What’s the stock gonna do today?” says your CEO. 

All of us who’ve been in the investor-relations chair understand the quarterly grind. We practice, prepare, canvass probable questions, rehearse answers.  Try to get the execs to read the script aloud. We listen to competitors’ calls, seeking key queries.

Yet 85% of the volume in the market is driven by money paying no attention to calls.

“Not during earnings,” you say. “Active money is the lead then.” 

If it is, that’s a victory. It’s an anecdotal observation rather than hard statistical fact, but my experience with the data suggests less than 20% of public companies have Active money leading as price-setter on earnings days. 

I’m reminded of a classic example. One of our clients had screaming Sentiment – 10/10 on our index, slamming into the ceiling – and 68% short volume ahead of results. We warned that without the proverbial walk-off grand slam, nothing would stop a drop. 

Active money led, setting a new Rational Price, our measure of fair value, though shares closed down. In proceeding days the stock lost 8%. It wasn’t the story. It was the sector. Tech tanked. And shorting. And Sentiment.

Which leads us back to the carefully crafted earnings call. We’ve got a variety of clients with Activist investors, and I’ll give you two sharply contrasting outcomes that illustrate the importance of the answer to both your COO’s and CEO’s questions. 

One has been slashing and burning expenses (it’s what you do when somebody horns in with money and personality).  Still, heading into the call shorting was 69% and investors were wary. The company has a history of sharp pullbacks on results.

The only bull bets were from machines that leveraged hard into shares. No thought, just a calculated outcome.

Did you see the Wall Street Journal article yesterday on a massive VIX bet?  Some anonymous trader has wagered about $265 million that the VIX will be over 25 in October.  The trader could win big or lose big.

It’s the same thing. Traders, both humans and machines, bet on volatility, exacerbated by results.  Fast Traders wagered our client would jump about 8% (we could forecast it).  They were right. The buying that drove initial response came from quantitative money. Machines read the data and bought, and shorting dropped 20% in a day.

Rational investors have since been profit-takers.  Price moved so much on bets that buy-and-hold money turned seller.

In the other instance, price fell 15%. Risk Management was 15% of market capitalization ahead of the call because Activism tends to boost the value of the future – reflected in derivatives. But Activists have short attention spans. If you’re two quarters in without any meaningful catalyst, you’re asking for trouble.

Well, that was apparent in the data. They were 60% short every day for 50 days ahead of results, the equivalent of a tapping foot and a rolling eye. If you don’t give that audience a catalyst they’re going to take their futures and forwards and go home. 

Results missed and management guided down, and ALL of that 15% came out of market cap. Investors didn’t sell? No. How does it help long money to sell and slaughter price? They’d wreck months or years of commitment in a minute.

But the future was marked to zero because event-driven money dropped its rights to shares. And 15% of market cap held that way vanished.

The degree of uncertainty in all prices, not just ones at earnings season, are increasing because machines are betting on volatility, long and short, price-spreads.

It’s not rational. It’s gambling. Moral of the story? Prepare well, yes.  But prepare proportionally.  Keep it simple. A minority of the money listens now and cannot overcome the power of arbitrage (we need a better market. Another story.).

You might recoil at the idea. But if the market has changed, shouldn’t we too? Correlate outcomes to effort. Learn market structure. Measure the money. Set expectations. Prepare. But prepare wisely. Efficiently. Don’t confuse busy with productive.  

For your COO, the answer is yes, we’ll get that question, and for your CEO, the answer probably has no bearing on how shares will behave. Keep the answer short. (And yes, we can forecast how shares will behave and what will set price. Ask us.)

Expectations vs Outcomes

“Earnings beat expectations but revenues missed.”

Variations on this theme pervade the business airwaves here during earnings, currently at fever pitch.  Stocks bounce around in response. Soaring heights, crushing depths, and instances where stocks moved opposite of what the company expected.

Why?

Well, everyone is doing it – betting on expectations versus outcomes.  The Federal Reserve Open Market Committee meeting wraps today and much musing and a lot of financial betting swirls around what Chair Yellen is expected to offer as outcome.

Then Friday the world stops at 8:30am ET, holding its breath to see if the expectation for April US jobs matches the outcome.

And by the way, I will join Rick Santelli in Chicago Thursday morning, in between, on Squawk on the Street to pontificate fleetingly and I hope meaningfully.

Obsession with expectations versus outcomes in equity markets and across the planar vastness of economic and monetary data blots out long-term vision and fixes attention on directional bets.

It’s not investment. And it’s no way to plan the future, this mass financial pirouette around a data point.  But it’s the market we’ve got. We must understand it, like it or not.

Back to your stock. The reason that after you beat and raise your stock falls is what occurred ahead of your call.

It may have nothing to do with how you performed versus consensus. For proof, droves from the sellside are looking for IR jobs because trillions of dollars migrating from active portfolios into indexes and ETFs aren’t using sellside research. Or listening to calls.

It reminds me of the Roadrunner cartoons, Wile E. Coyote running off the cliff. Remember? Parts of Wile E. drop in order, the last thing remaining, his blinking eyes.

That’s to me like results versus consensus.  The eyes of Wile E. Coyote, last vestige of something fallen off the cliff of colossal change to investment and trading behavior. The sellside still has everybody thinking outcomes versus expectations matter to investors.

No, they matter to the hordes with directional bets – over 40% of the market.

They bet long or short, or on the spread between high and low prices. They may have fixed for floating swaps that pay if you beat, leading counterparties to sell your shares – and the bettors are short your stock too, so they make a fee on the bet and more covering as your stock falls.

And the CEO says to you, “What the heck?”

If your stock is 50% short (we measure it) and slamming the ceiling of Sentiment due to a marketwide derivatives surge after expirations – which happened Apr 24-25 – it doesn’t matter if you crush consensus. Structure trumps Story. Price will fall because bets have already paid thanks to the broad market.

The market makes sense when you understand what sets price.

Active investment leads less than 20% of the time. The juggernaut of indexes and ETFs rumbles through at about 34%, and it’s now distorting share-borrowing and Risk Management. The latter is 13-16% of your market cap – hopes for the future that can sour or surge on any little data point.

Let’s bring it back to the Fed and jobs and the economy. I said your stock will move based on what happened beforehand.  That can be a day or two, or a week or two.

The economy is massive. It will move on what happened beforehand too but the arc is years. No matter what may be occurring now, which in turn will manifest in the future.

The threat to the US economy and stocks is a lack of appreciation that tomorrow is a consequence of yesterday, not of tomorrow.  For the better part of a decade, furious fiscal and monetary effort promoted borrowing and spending so people would consume more.

But the consequence of borrowing and spending is debt and a lack of money. Which causes the economy to contract in the future. Stocks are pumped on past steroids. If the economy beats and raises, everything can still fall because of what happened yesterday.

We must first navigate consequences of yesterday before reaching the fruits from today.

Same for you. The stock market is awash in bets on divergences, even more when financial results mean opportunity blooms. Your active money clangs around in there, often as confused as you.

Your challenge and opportunity, IR professionals? Helping management develop an expectation of market form that matches the outcome of its function now.

Volatility Insurance

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Stein’s Law

Why are stocks rising if earnings and revenues are falling?

FactSet’s latest Earnings Insight with 70% of the S&P 500 reporting says earnings are down 2.2% versus the third quarter last year, revenues off 2.9%.  Yardeni Reseach Inc. shows a massive stock-disconnect with global growth. Yet since the swale in August marked a correction (10% decline), stocks have recouped that and more.

We’re not market prognosticators. But the core differentiation in our worldview from an analytical standpoint is that we see the stock market the way Google views you:  possessing discrete and measurable demographics. When you search for something online you see what you sought served up via ads at Google, Facebook, Twitter, etc. Advertising algorithms can track your movement and respond to it. They don’t consider you just another human doing exactly the same things as everybody else.

If your stock rises because your peer reports good results, your conclusion shouldn’t stop at “we’re up thanks to them,” but should continue on to “what behavior reacted to their results and what does it say about expectations for us?” Assuming that investors are responsible for the move requires supposing all market behavior is equal, which it is not.

I saw a Market Expectation yesterday for one of our clients reporting today before the open predicting a higher price but not on investor-enthusiasm. Fast traders were 45% of their volume, active and passive investors a combined 40%. So bull bets by speculators trumped weak expectations from investors.  Bets thus will drive outcomes today.

Which leads back to the market. We separate monetary behaviors into distinct groups with different measurable motivation. By correlating behavioral changes we can see what sets prices. For instance, high correlation between what we call Risk Management – the use of derivatives including options and futures – and Active Investment is a hallmark of hedge-fund behavior. The combination dominated October markets. And before the rebound swung into high gear, we saw colossal Risk Management – rights to stocks.

What led markets higher in October are the very things that led it lower Aug-Sep. The top three sectors in October: Basic Materials, Technology, Energy.  Look at three representative ETFs for these groups and graph them over six months: XLB, XLK, XLE.

We might define arbitrage as a buy low, sell high strategy involving two or more securities. The data imply arbitrage involving derivatives and equities. Sell the derivatives, buy the stocks, buy the derivatives, exercise the derivatives.

That chain of events will magnify recovery because it forces counterparties like Deutsche Bank (cutting 35,000 jobs, exiting ten countries), Credit Suisse (raising capital), Morgan Stanley (weak trading results), Goldman Sachs (underperformance in trading) and JP Morgan (underperformance in trading) among others to cover derivatives.

And since the market is interconnected today through indexes and ETFs, an isolated rising tide lifts all boats.  A stock that’s in technology ETFs may also be in broad-market baskets including Russell, midcap, growth, S&P 500, MSCI and other indices.  As these stocks, rise, broad measures do.

At October 22, the ModernIR 10-point Behavioral Index (we call it MIRBI) was topped, signaling impending retreat. That day, the European Central Bank de facto devalued the Euro. The next day, the Chinese Central Bank did the same.  The Federal Reserve followed suit October 28 by holding rates steady. Stocks suddenly accelerated and haven’t slowed. The MIRBI never fell to neutral and is now nearing a back-to-back top.

You’ll recall that Herb Stein, father of famous Ben, coined Stein’s Law: “If something cannot last forever, it will stop.” The rally in stocks has been led by things that cannot last. In fact, the conditions fueling equity gains – everywhere, not just in the US – are comprised of what tends to have a short shelf life (options expire the week after next). Bear markets historically are typified by a steep retreat, followed by a sharp recovery, followed by a long decline.

Whatever the state of the market, what’s occurring won’t last because we can see that arbitrage disconnected from fundamental facts drove it. Understanding what behavior sets prices is the most important aspect of market structure. And it’s the beginning point for great IR.

Your Voice

I debated high-frequency trader Remco Lenterman on market structure for two hours.

Legendary financial writer Kate Welling (longtime Barron’s managing editor) moderated.  Your executives should be reading Kate so propose to your CFO or CEO that you get a subscription to wellingonwallstreet.com. The blow-by-blow with Remco is called Mano-a-Mano but the reason to read is Kate’s timely financial reporting.

Speaking of market structure, yesterday the SEC’s Equity Market Structure Advisory Committee (EMSAC…makes one think of a giant room-sized flashing and whirring machine) met on matters like high-frequency trading and exchange-traded funds.

Public companies have a friend or two there (IEX’s Brad Katsuyama, folks from Invesco and T Rowe Price) but no emissaries. Suppose we were starting a country to be of, for, and by the people but the cadre creating it weren’t letting the people vote?

It makes one think the party convening the committee (the SEC) can’t handle the truth.  After all, it was the person heading that body, Mary Jo White, who proclaimed in May that the equity market exists for investors and issuers and their interests must be paramount.  It’s a funny way to show it.

And now the NYSE and the Nasdaq, left off too, are protesting. BATS is on while listing only ETFs. The Nasdaq generates most of its revenue from data and technology services, not listings.  Intercontinental Exchange, parent of the NYSE, yesterday bought Interactive Data Corp, a giant data vendor, for $5.6 billion.

How long have we been saying the exchanges are in the data and technology businesses? They’re shareholder-owned entities that understand market structure and how to make money under its rules. That’s not bad but it means they’re not your advocates (yet you get the majority of your IR tools through them, which should give you pause).

On CNBC yesterday morning the Squawk Box crew was talking about one of our clients whose revenues near $2 billion were a million dollars – to the third decimal point in effect – shy of estimates. Droves of sellsiders have shifted to the IR chair, suggesting diminishing impact from equity research and yet that stock moved 8% intraday between high and low prices.

What long-term investor cares if a company’s revenues are $2.983 billion or $2.984 billion (numbers massaged for anonymity)? So how can it be rational?

I hear it now:  “It’s not the number but the trend.”  “It’s the color.”  “Revenues weren’t the issue but the guidance was.”

You’re making the point for me. IR professionals have vast and detailed knowledge of our fundamentals as public companies, as we should.  We know each nuance in the numbers, as we should.  We understand the particulate minutia of variances in flux analysis. As we should.

But we don’t get the mechanics of how shares are bought and sold, or by whom. We don’t know how many can be consumed without moving price.  We trust somehow the stock market works and it’s somebody else’s responsibility to ensure that it does.

Ask yourselves:  Would we trust our sales and revenues to a black box? Then why do we trust our balance sheets – underpinned by equity – to one?

Read my debate with Remco Lenterman about what constitutes liquidity and what sets price today (throw in with the c-suite on a subscription to wellingonwallstreet.com).

We picked two of scores of reporting clients this week and checked tick data at the open. Prices for both were set by one traded share.  Suppose you’re the CEO with a stake worth $300 million. We’ve got one of those reporting tomorrow.  What if the first trade is for one share, valued at say $80, and it shaves 8% off market-cap? That’s $24 million lost in that moment, on paper, for your CEO on a trade for $80.

Now you can say, “You’re caught up in the microsecond, Quast. You need to think long-term.”

Or you could wonder, “Why is that possible?  And is it good for long-term money?”

It’s easier for a camel to pass through the eye of a needle than for rational investors to price a stock at the open in today’s market structure.  But we have the power to change that condition by demanding to be part of the conversation. It starts with caring about market structure – because you don’t want the CEO coming back to you later asking, “Why didn’t you tell me?”

Somebody from among us must be on that SEC committee, whirring lights and all.

Turnover

Earnings season.

Late nights for IR professionals crafting corporate messages for press releases and call scripts. Early mornings on CNBC’s Squawk Box, the company CEO explaining what the beat or miss means.

One thing still goes lacking in the equation forming market expectations for 21st century stocks: How money behaves. Yesterday for instance the health care sector was down nearly 2%. Some members were off 10%. It must be poor earnings, right?

FactSet in its most recent Earnings Insight with 10% of the S&P out (that’ll jump this week) says 100% of the health care sector is above estimates. That makes no sense, you say. Buy the rumor, sell the news?

There are a lot of market aphorisms that don’t match facts.  One of our longtime clients, a tech member of the S&P 500, pre-announced Oct 15 and shares are down 20%.  “The moral of the story,” lamented the IR officer, an expert on market structure (who still doesn’t always win the timing argument), “is you don’t report during options-expirations.”

She’s right, and she knew what would happen. The old rule is you do the same thing every time so investors see consistency. The new rule is know your audience. According to the Investment Company Institute (ICI), weighted turnover in institutional investments – frequency of selling – is about 42%.  Less than half of held assets move during the year.

That matches the objectives of investor-targeting, which is to attract money that buys and holds. It does.  In mutual funds, which still have the most money, turnover is near 29% according to the ICI.

So if you’re focused on long-term investors, why do you report results during options-expirations when everybody leveraging derivatives is resetting positions?  That’s like commencing a vital political speech as a freight train roars by.  Everybody would look around and wonder what the heck you said.

I found a 2011 Vanguard document that in the fine print on page one says turnover in its mutual funds averages 35% versus 1,800% in its ETFs.

Do you understand? ETFs churn assets 34 more times than your long-term holders. Since 1997 when there were just $7 billion of assets in ETFs, these instruments have grown 41% annually for 18 straight years!  Mutual funds?  Just 5% and in fact for ten straight years money has moved out of active funds to passive ones.  All the growth in mutual funds is in indexes – which don’t follow fundamentals.

Here’s another tidbit: 43% of all US investment assets are now controlled by five firms says the ICI. That’s up 34% since 2000.  The top 25 investment firms control 74% of assets. Uniformity reigns.

Back to healthcare. That sector has been the colossus for years. Our best-performing clients by the metrics we use were in health care. In late August the sector came apart.  Imagine years of accumulation in ETFs and indexes, active investments, and quantitative schemes. Now what will they do?

Run a graph comparing growth in derivatives trading – options, futures and options on futures in multiple asset classes – and overlay US equity trading. The graphs are inversed, with derivatives up 50% since 2009, equity trading down nearly 40%. Translation: What’s growing is derivatives, in step with ETFs. Are you seeing a pattern?

I traded notes with a variety of IR officers yesterday and more than one said the S&P 500 neared a technical inflection point.  They’re reporting what they hear. But who’s following technicals? Not active investors. We should question things more.

Indexes have a statutory responsibility to do what their prospectuses say. They’re not paid to take risk but to manage capital in comportment with a model. They’re not following technicals. ETFs? Unless they’re synthetic, leveraging derivatives, they track indexes, not technicals.

That means the principal followers of technical signals are intermediaries – the money arbitraging price-spreads between indexes, ETFs, individual stocks and sectors. And any asymmetry fostered by news.

Monday Oct 19 the new series of options and futures began trading marketwide. Today VIX measures offering volatility as an asset class expire.  Healthcare between the two collapsed. It’s not fundamental but tied to derivatives. A right to buy at a future price is only valuable if prices rise. Healthcare collapsed at Aug expirations. It folded at Sept expirations. It’s down again with Oct expirations. These investments depended on derivatives rendered worthless.

The point isn’t that so much money is temporary. Plenty buys your fundamentals. But it’s not trading you.  So stop giving traders an advantage by reporting results during options-expirations. You could as well write them a check!

When you play to derivatives timetables, you hurt your holders.  Don’t expect your execs to ask you. They don’t know.  It’s up to you, investor-relations professionals, to help management get it.

Patterns

Happy Tax Day!  Don’t you wish you could be somewhere else?

Sit at Saba Rock looking north where beyond the earth’s curvature lies Anegada and you know why Richard Branson embraced the British Virgin Islands.

We did too, abandoning electronics including in my case a shaver. From the Soggy Dollar on Jost Van Dyke (named for a Dutch privateer) to Sandy Spit and Sandy Cay and into the azure chop around The Indians off Norman, we let time run a delightful course.

Norman Island is among the reputed inspirations for Robert Louis Stevenson’s “Treasure Island” (which gripped my young imagination), ostensibly eponymous for the pirate Captain Norman, a Briton caught and hung by Puerto Ricans.

Today Norman Island is owned by billionaire Henry Jarecki who in his youth fled anti-Semitic Nazi Germany and later pioneered commodity-futures investing in the USA. His son Andrew recently made film headlines with HBO’s The Jinx on accused killer Robert Durst, the black sheep of the New York real-estate family managing Freedom Tower.

Dr. Jarecki, for years a practicing psychiatrist (still a Yale medical school faculty member) before switching to quantitative futures-trading at his firm Gresham Investment Management LLC, told Wall Street Journal reporter Cynthia Cui in a 2010 interview that both trading and psychiatry are about recognizing patterns. So armed, Jarecki said, you can “transform a modest effort into a grand result.”

How you announce your earnings-date is a recognizable pattern for traders.  One of our clients wrote while I was out, “I know you’re still floating among the virgins but when you reconnect thought you might like to see this exchange I had recently with the quant shop (name removed for privacy but we know and track them)…”

Our client had gotten inquiry from these traders asking when the company would report results. Our client said you’re quants so why do you ask? An analyst there with a Ph.D. thoughtfully responded:

“We are indeed a quantitative firm, focusing in options market making…. Options are typically priced based on the current stock price, a volatility component which characterizes the typical stock price movements possible, and a time component which characterizes how much time the volatility component has to act on the stock. The wrinkle in the problem of option pricing is that volatility doesn’t act uniformly in time; after earnings the stock prices tends to move more than on a typical day. Therefore it is important that we have the correct earnings date in our trading system as soon as it’s publicly available…”

This trading group is profiting in options-volatility, which depends on eliminating price uncertainties including questions about the timing of your earnings. What your company does, your financial results, are irrelevant to the grand opportunity. What matters is the volatility pattern.

This is why we track patterns everywhere in your trading.  We know a great deal about the patterns and we’ve been telling you for ten years now that if you move differently from your peers it’s not about your results but standard deviation, arbitrage, spreads. (more…)