Tagged: Investor Relations

Light Speed

Alert reader Raj Mehan at Steelcase forwarded a piece from the Wall Street Journal about traders now aiming with machines to execute stock-market transactions near light-speed.

Why the rush?  Companies take flak for “short-termism” that’s a quarter long and yet regulators and traders and academics extol the virtues of fast trading, claiming it makes markets liquid and efficient.

Just this week I was speaking with a CFO for a public company who yawned at the idea he should care about what priced his stock. “It’s interesting but what difference does it make?”  I’m paraphrasing a longer exchange. It’s a vital point of contention, right?

We’ll come to that in a moment. Watching the Olympics this week – exhilarating as ever – the race for speed in the water is stupefying.  Seeing Katie Ledecky crush the field by five seconds for a gold metal gives you goose bumps no matter your country. And the objective of swimming-speed is winning.

It is for traders too. In the WSJ article by Vera Sprothen, folks from high-speed trader DRW Holdings LLC (stands for Donald R Wilson) said competition in financial markets is accelerating the race. A nanosecond is a billionth of a second. Routers can send and receive stock-exchange data in 85 nanoseconds, which is how much time elapses when a bullet fired from a gun travels a half-inch.

Imagine. You fire at a shooting-range target and before the bullet gets there somebody trades your stock several hundred times.

If I’m making a big-ticket purchase the last thing I want is – snap! – to do it faster. Many of you are investor-relations professionals. Do some investors study your business for a year or two before deciding to buy your shares? When I was an IRO, that was common.

Weighty decisions are not made for light speed.  Therefore, traders are not making weighty decisions. Committing capital over time is a risky gambit. Capital deployed the amount of time needed for a bullet to travel a few feet isn’t so fraught.

It’s also not investment. Understand: The stock market in the USA and ever more around the world too is one in which the first trade to arrive prices the stock for everyone. Many stock-trades are paired with other things such as options or currencies or commodities.  Price one superfast, and race over faster than a speeding bullet to something else, and you can make money by taking advantage of price-differences. That is by definition arbitrage.

The efficiency of markets is best assessed by determining how much arbitrage occurs. There’s a lot of arbitrage in booking a hotel room on line. There’s no arbitrage in buying a cup of coffee at Starbucks (unless somebody at the Univ of Chicago wants to study that question and prove me wrong).

In the stock market, almost half of all volume is arbitrage. It may be the most colossally inefficient capital market ever created by human beings. Back up 20 years and it wasn’t. Just 15% of trading could be attributed to arbitrage, and 85% to investment.  Speed and price-differences now consume it.

Which brings us back to our apathetic CFO. If you don’t care about the market for the backbone of your balance sheet enough to understand it, you should be a private company where there’s less arbitrage.

For IR pros in the 21st century, it’s a huge opportunity. Not only is there confidence in knowing how the market works, but somewhere today there’s an IRO who will, having learned, help change the market tomorrow.

Problems are solved after we first understand them.  Most prices for stocks should not be set at the speed of light. Yet that’s happening.

Gilding the Trend

Is index-investing the death knell for investor relations?

According to S&P Dow Jones – which, you REITs, will be breaking out your sector from Financials Aug 31, as will MSCI – over the ten years ended Dec 2015 a staggering 98% of all active investment managers in the USA underperformed the S&P 500.

These outfits are indexers and will make the case for models. But there’s an obvious rub for the profession pitching stories to stock-pickers.  If the folks listening are trailing the benchmarks, investors will move to passive investing.  And they are, in droves. If your team loses all the time, people quit coming to the games.

There’s a tendency in the IR profession to want to shove our heads in the sand about this disturbing condition.  If we can keep quiet, keep doing what we’ve done, maybe the problem will go away or management will remain unaware of it.

That’s no strategy!  Let me gild this trend in gold for the IR profession. Who is our audience?  The money.  Right?  The IR goal is a well-informed market and a fairly valued stock.  So long as you have measures (and we do here at ModernIR!) that will tell you when these conditions exist and how to keep them there, there’s no need for stress at the state of stock-picking.

Make no mistake:  Telling the story will never go away. We need the Active demographic. You have to cultivate a diverse set of styles among stock-pickers. But it can no longer be your sole endeavor. Where 25 years ago the dominant force was bottom-up investing, today’s principal price-setting investment behavior is Asset Allocation – indexes and exchange-traded funds.

Fine! So be it.  The IR profession must adapt.  We’ve seen evolution in the role over the past decade with a swath of public companies giving IR auxiliary duties ranging from communications to financial planning and analysis. Now IR must add data analysis.

Let me explain. If the money is following models, then model the money.  You can’t talk to that sort of investment about what distinguishes you.  Blackrock and Vanguard don’t listen to earnings calls. Who cares? You can track money quantitatively with a great deal more accuracy and a whole lot less work to boot than trooping all over the planet seeing stock-pickers, most of whom will fail to perform as well as SPY, the world’s most actively traded equity – which is a passive investment.

We live in a world where data and technology have converged everywhere from your kitchen to your retirement portfolio. It’s time the IR profession caught up.  Invesco owns PowerSharesJanus owns VelocityShares. The buyside is adapting. We’d better, too.

So what should you do?  The simplest, easiest and most affordable solution is to use Market Structure Analytics, which we invented to demographically profile all the money driving your equity. You can know every day what percentage of your volume is from Asset Allocation (and three other big behaviors).

Not everyone can, I realize! If nothing else, start today educating your management about ETFs.  Go to alletf.com and find out how many are associated with your shares. Explain that investments of this kind are dominating equity inflows, and consider it a badge of honor if they’ve got more than 5% of your equity collectively.

There’s a lot to grasp about ETFs. And if you’re a longtime reader you know my rub with them: They’re derivatives. Set that aside for now.  Our profession must shift from defense to offense.

It begins with leading management into the equity market we’ve got rather than letting them discover it themselves. They’ll wonder why you didn’t explain it.

Up and Down

If money leaves, how is it stocks rise?

After all, most suppose the market is premised on buying leading to higher prices and selling producing lower ones. And humanity has also held through the ages that a thing seeming too good to be true probably is.

In that vein, Lipper US Fund Flows, a Thomson Reuters unit, tracked billions in outflows from US mutual and exchange-traded funds in equities throughout June including about $7 billion from US equities the week of June 29.

As the Brits fled the European Union so did money from stocks, which offered a stomach-curdling free-fall reminiscent of the Summit Plummet at Disney’s Blizzard Beach. Doom loomed.

Instantly, US equities boomeranged back, a weird financial-markets mulligan. Pundits cheered. Most of us prefer to be richer rather than poorer so heralding rising stocks is natural. But shouldn’t we want to understand why they’re up? Particularly if we’re getting contradictory data such as higher prices from less money?

Could it be short-covering? ModernIR tracks daily short volume, and it was 45.7% of all trading for  the week ended June 13, 45.8% at June 27, and by last Friday had risen to 46.7%. Higher, not lower (yes, nearly half the volume is short).

How about fundamentals? A rosier future economic view can cheer current money. Ah, but from the Federal Reserve, to the Organization for Economic Cooperation and Development, to the International Monetary Fund, hoary heads of the dismal science see deepening malaise worsened by the Brexit, creaky European banks, possible copycat flight from the Eurozone – even a slowdown for the USA.

If things that should drive stocks up are down and yet stocks are up anyway, what might we predict ahead?  There’s a saying that it’s better to keep one’s mouth closed and look like a fool than to open it and remove all doubt.  Forecasting the future is a fool’s errand.

But drawing sound conclusions never goes out of style. Economist Herb Stein, father of Ben, coined Stein’s Law:  If something cannot last forever, it will stop.

Stocks by nature reflect things that can’t last. They go up and down.  And the market is not really up. On Dec 29, 2014, the S&P 500 closed at 2090 and on July 5, 2016 finished at 2088. Stocks are now characterized by short-term ebbs and flows.

The pursuit of short-term price-changes is arbitrage, which isn’t additive investment behavior. Can a market characterized by declining money flows, weakening fundamentals and arbitrage, with no material gain in over eighteen months, gather steam?  Anything is possible. But it’s not a sound conclusion.

Plus, stocks are a mirror for something larger. We call it the Great Risk Asset Revaluation.  Starting in 2009, the Federal Reserve bought trillions’ worth of government and mortgage debt with dollars it created. Much of that money found its way via banks into risk assets – things with variable valuation – such as stocks, bonds, real estate and commodities like oil. Prices for these soared.

And then it all stopped.  See Stein’s Law. At Sep 3, 1998, the Fed’s balance sheet was about $500 billion.  At Sep 4, 2008, it was $900 billion.  At Aug 21, 2014, it was $4.5 trillion. And at June 30, 2016, it was $4.5 trillion.  The Fed’s balance sheet stopped expanding in latter 2014.  Since then, the US stock market has not risen and the global economy has been thrown into turmoil.

It’s all about the money.  Not how much is in the stock market but what the value of the US dollar is relative to other currencies. When the Fed ceases expanding its balance sheet, the dollar appreciates. It’s math. The bad news is that prices of risk assets will reset correspondingly lower.  The good news is that it’s the way back to reality.

When?  In the housing crisis, it was two years after home prices stopped rising that the bottom fell out of the mortgage-backed securities market.  In August it’ll be two years since the Fed’s balance sheet stalled.  Oil alone has repriced so far.

Whenever the Stock Reset comes (and much will be done to stop it), we’ll all survive it – and real opportunity will again abound. Besides, who wants a market that seems too good to be true?

The IEX Machete

We humans don’t like change.

We become accustomed to uncomfortable shoes, kinks in the neck each morning, the monotony of sameness. Were we recorded we’d likely be surprised to hear ourselves making excuses for why what we don’t like must continue. The USA’s Declaration of Independence lamented how people are disposed to suffer ills rather than change them.

The rise of IEX, the Investors Exchange, embodies that ethos. Late last Friday the enterprising folks canonized by Michael Lewis in his book Flash Boys won longsuffering reward when the Securities and Exchange Commission granted the alternative trading system status as a US stock exchange able to host listings.

We’ve become disposed to suffer ills. It’s been 45 years since companies wanting to list shares publicly with a US national stock market had more than two choices (OTC Markets Group and NYSE MKT, I’m not slighting either of you here). That’s remarkable in a country that prides itself on entrepreneurialism and innovation, and testament to both the byzantine form the market has taken and the entrenched nature of the competition.

Comments on IEX’s exchange application are supportive save for vitriol from would-be peers reminiscent of the invective and condescension of some activist investors (think Icahn and Ackman).

Contrast with the behavior of golfing professionals at last weekend’s US Open. Dustin Johnson won his first major despite a controversial penalty, and his fellow competitors rallied behind him despite what we could call “losing market-share.”  Contender Bubba Watson on CNBC’s Squawk Box said he was with fans shouting “Dus-tin! Dus-tin!”

That’s mature professionalism. By contrast, IEX joins the green jackets of the stock-exchange business to derogations from peers. They’ve lobbied for every penalty stroke.

We mean no offense to the incumbents. But it’s embarrassing. Our stock market obsessed with speed and crammed with arbitrage and mostly inhospitable to the active “long-only” (few now are purely long) investors companies spend all their time and resources courting is meaningfully a product of legacy exchanges. We’ve been sold a bill of goods.

The Duopoly is loath to admit IEX or share the power they’ve exercised over the listing process. Why? If innovation and choice are byproducts of free markets, incumbent opposition should raise eyebrows (kudos to the SEC for reinforcing the mechanism of a free and open market that exists for issuers and investors). They’ve chosen easy regulatory monopoly instead, and it’s made them arrogant.

Without restraint through competition and transparency, the market has become a tangle of vines smothering differentiation between companies and promoting arbitrage over investment. The proof is in plunging ranks of public companies, confusion everywhere about what’s setting prices (we’ve cured that malady by the way), and a general migration of stock-prices toward means without regard to fundamentals (those who blame regulation I get it, but the market itself is the problem).

We’ve lost sight of original purpose. So welcome to the jungle, IEX.  We could use a sharp machete.

Busily Productive

“We try not to confuse busy with productive.”

Thus spake the head of investor-relations for an Israeli tech company years ago, and as we wrap the 2016 NIRI National Conference here in June-gloomy but ever awesome San Diego, I recall it anew.

IR for those of you who don’t know is the job that sits at the confluence of the inflow of capital to companies with shares trading publicly and the outflow of information to the buyers and sellers of shares. With investing gaining popularity in the 1960s, companies organized the effort of courting the former and formalizing the latter, and IR was born.

Attracting investors and communicating effectively will remain a bedrock of our profession until the second-to-last public company is consumed by the one giant firm owning everything and in turn owned by one exchange-traded fund leviathan (let’s hope that future never arrives!).

Most IR spending goes to telling the story and targeting investors, the historical yin and yang of IR.  But how are your shares priced?  Do you know?  Is our profession confusing busy with productive?

Let’s review. IR targets investors suited to the story.  We track corporate peers to find areas needing improvement and ways in which we outperform.  I did this too as a telecom IRO (investor relations officer). Your investment thesis defines unique exceptionalism.

Yet trades are measured by averages, indexes and ETFs hew to the mean, and high-speed traders setting prices want to own nothing.  While you’re trying to rise above, all the algorithms are bending your price back to the middle. It’s one reason why indexes beats stock-pickers: Market structure punishes outliers while active money seeks them.

The only NIRI session I was able to attend this year (we’re busying seeing customers, colleagues and friends during the conference) was a tense paneled polemic (moderated adroitly by one of our profession’s scions, Prudential’s Theresa Molloy) with IEX, hero of Flash Boys with a June 17 SEC deadline on its exchange application, and incumbents the NYSE and the Nasdaq.

Without offense to our market-structure friends at the exchanges, it’s stunning how the legacy firms lobby to preserve speed. Here’s what I mean. When the NYSE and the Nasdaq savage IEX for suggesting that slowing prices down by 350 microseconds is unfair, they are bleating a truth: Their dominance depends on privileges for fast traders.

I’ll reiterate how the market works:  Exchanges don’t aggregate supply and demand, they fracture buying and selling by running multiple markets rather than one. Suppose Nordstrom at the mall split into three stores located at either end and in the middle, with different products in each.  It would inconvenience shoppers, who would have to buy clothes one place and then troop to the far end for shoes. But if Nordstrom was selling data on customer patterns in the mall, it would be a great strategy.

Exchanges pay fast traders to set prices.  Prices are data.  Exchanges make billions selling data.  When IEX says it won’t influence the movement of money by paying for prices but instead will match buyers and sellers fairly and charge them both the same price – which none of the other exchanges do – the truth should be obvious to everyone.

It’s this:  Exchanges are deliberately spreading buyers and sellers apart to sell data. Fast traders are paid by exchanges to create great clouds of tiny trades reflecting narrowly separated prices – the exact opposite of the efficiency of size.

Exchanges sell that price data back to brokers, which are required to give best prices to customers, which they can only demonstrate by buying price data and making sure they match trades at averages of these prices, which means the prices are going to be average, which means the entire market is defined by fast traders and averages.  No wonder Blackrock is enormous. The structure serves it better than stock-pickers – IR’s audience.

This is a racket.  You IR folks are running your executives around the globe at great cost telling the story, targeting investors, tracking ownership-change. Yet the market is built on artificial prices intended to generate data revenue. Structure trumps story.

Stop confusing busy with productive.  Again, telling the story will never go away. But learn what sets your price.

We’ve solved that problem for you.  We announced our Market Structure Analytics Best Practices Guide last Friday, and our new Tableau-powered Market Structure Report.  Five Best Practices. Six Key Metrics. Do these and you’ll be a better IR practitioner in the 21st century – and maybe we’ll cease to be gamed when CEOs understand the market. Five Best Practices (drop me a note for our Guide):

Knowledge. Make it your mission to know how the stock market works.

Measurement.  Measure the market according to how it works, not using some metric created in the 1980s. We have six metrics. That’s all you need to know what matters.

Communication.  Proactively inform your management team about how the six metrics change over time so they stop believing things about the market that aren’t true.

A Good Offense.  Use metrics to drive relationships on the buyside. More meetings confuses busy with productive; develop a better follow-up plan.

A Good Defense.  Since markets don’t work anymore, Activism – a disruption of market structure – is perhaps the most popular active value thesis now.  Activists have had 35 years to learn how to hide from Surveillance.  They don’t know how starkly Market Structure Analytics capture their movements.

Let’s stop being pawns. Without public companies the market does not exist. That’s serious leverage.  Maybe it’s time to starting using it.

Ring of Fire

Yesterday China’s stock-futures market Flash-Crashed 10% and recovered in the same single minute.

For those new to market structure, the term “Flash Crash” references a hyperbolic rout and recovery in US equities May 6, 2010 in which the Dow 30 erased a thousand points and gained most of that back, all in 20 minutes. It’s vital to understand the cause, whether you’re the investor-relations officer for a public company or an investor.

China blamed a futures trade for prompting Tuesday’s fleeting plunge. A year ago, China’s stock-futures market had exploded into the planet’s busiest. Then as its equity market was imploding last summer, the government cracked down on futures trading. China also moved to devalue its currency in August last year, ahead of a dizzying Aug 24 plunge in US equities that saw trading in hundreds of Exchange Traded Funds (ETFs) halted as share-prices and fund asset-values veered sharply apart.

Trading in 2016 Chinese stock futures is a shadow of its 2015 glory but yet again sharp volatility in derivatives followed a currency move. Monday as the USA marked Memorial Day the People’s Bank of China pegged the yuan, China’s currency, at the lowest relative level versus the dollar since the Euro crisis of 2011, which also brought rocking volatility to US stocks.  A similar move Aug 12 preceded last summer’s global stock-market stammer.

Every time there’s an earthquake in Japan or Indonesia, it seems like another follows in Chile or New Zealand.  What geologists call the “Ring of Fire” runs from Chile and Peru up along the west coast of the United States and out through the Aleutian Islands of Alaska and down past Japan and Southeast Asia to the South Pacific and New Zealand.

The more things interconnect, the greater the risk. Tectonic connections are a fact of life on this planet, and we adapt.  But we’ve turned global securities markets into a sort of ring of fire as well. In geology, we link tectonic events and observable consequences. In global securities markets, we don’t yet give the magma of money its due.

Globalization helped to intertwine the planet, sure. But it’s not the fault line. All the money denominating everything from your house to Chinese futures is linked via the dollar, the globe’s “reserve currency,” meaning it’s the House Money, the one every country’s central bank must have. If for instance a country’s currency is falling, it can sell dollars and other currencies and buy its own to improve the ratio and thus the value.

Two consequences arise that feed directly back to US public companies and investors.  Suppose the world’s markets were all tied together with a single string and each market had a little coil to play out. That’s currency. Money.  If one market is doing well, the others may be tempted to tug on the string in order to be pulled along, or to let out some string to change the balance of investment flows.

The process becomes an end unto itself.  The connecting currency string is tugged and played in an effort to promote global equilibrium in prices of assets and performance of economies. So arbitrage develops, which is investing in the expectations of outcomes rather than the outcomes themselves. Focus shifts from long-term returns to how things may change based on this economic data point or that central-bank policy shift.

The fissures that develop can be minute monetary arbitrage imbalances like China’s futures flash crash yesterday.  Or much larger and harder to see, like trillions of dollars in ETFs focused on a stock market trading 15% over long-term valuations that rest on economic growth half that of historical averages.

Before the May 2010 Flash Crash, the Euro was falling sharply as Greece neared collapse.  Before 2011 market turmoil globally, the Euro was again shuddering and some thought it was in danger of failing as a currency (that risk remains).  In Japan, the stock market is up 80% since the government there embarked in 2012 on a massive currency expansion. Now this year, the government having paused that expansion, it’s down 10%.  Has the market corrected or is it inflated?  Is the problem the economy or the money?

On the globe’s geological Ring of Fire, unless we achieve some monumental technological advance, living on it comes with risk and no amount of adjustment in human behavior will have an iota of impact. It’s tectonic.

In the stock market, fundamentals matter. But beneath lies a larger consideration. Markets are linked by currencies and central banks toying with strings.  The lesson for public companies and investors alike is that a grand unifying theme exists, like the physical fact of a Ring of Fire: Watch the string.

And there was a tremor in China again.

Dollar Ratios

My friend’s dad joked that kids are the most destructive force in the universe.

For stocks, the most powerful (and sometimes destructive) force is the movement of the dollar. The Federal Reserve and the Bank of Japan both meet today so it could soar or swoon. Since the buck holds sway, we should all of us in the capital markets from investors to issuers understand how and why.

Stocks react to the dollar because they’re opposite sides of the ledger. Debits and credits.  If money buys less, a debit, then what preserves value (stocks) increases in price, a credit.  So a “strong dollar” means more value resides in the currency and less in stocks.  A weak dollar is the opposite, and value transfers at higher risk into stocks to offset diminishing purchasing power – the quantity of things money buys.

It’s about ratios.  In the past, countries would scrounge around for a gob of gold. Then they could issue paper currency at a ratio. Played poker?  Chips are an asset-backed currency. Pay money, get chips.  Want more chips? Pay more money. The ratio is always the same so chips have fixed value and supply varies with the number of players.

Not so with money.  If Europe has spent more than it makes, its debts depressing the economy (like credit card debt constrains discretionary income), the European Central Bank can manufacture more money – bump up the chip stack without paying.  Remember our ratios?  Increase the supply of euros and prices of risk assets that preserve value, like stocks and bonds, rise to compensate.

Follow that reasoning. When money declines in value, stuff costs more. When stuff costs more, the revenues of the businesses supplying the stuff increase.  And since consumption – buying stuff – is the core way we count “economic growth” today, economies grow when prices rise.

Get it?  Yeah, it’s balderdash that selling the same unit at a higher price is growth. But that’s how governments now measure it. All central banks including the Federal Reserve thus have inflation targets. They are trying to create growth, without which most governments go broke.

Think I’m making this up?  Follow the math. You can’t print a batch of Benjamins. That’s counterfeiting. So how do central banks create money?  They issue money against the most widely available commodity in the world today:  Debt.

When you buy dinner on a credit card, the bank doesn’t reach into somebody’s savings account to pay the restaurant. It creates money. Pay the balance and that money vanishes.

Remember the ratios? Burn money and there are fewer dollars, which means the dollar rises in value, and prices fall, and economies contract (not really but that’s how we count now), and stocks swoon. Create money and the opposite occurs – everything rises.

Investor-relations people, you know the term “multiple-expansion?” It describes stocks that cost more without any change to underlying fundamentals.  This is a product of money-creation. In effect, central banks are trying to induce us all to pay more for things than they’re worth.  Value investment is the opposite: buying at a discount.

For perspective, JP Morgan is leveraged about 8 to 1.  Citigroup, about 7 to 1.  The Fed? With capital of $40 billion and liabilities of $4.54 trillion, its leverage ratio is 113 to 1.  Where money before depended on assets, like gold, now it’s backed by liabilities – debt.

The European Central Bank is buying eighty billion euros of debt a month to create money. What happens to debt? Its value skyrockets and interest rates plunge. It’s the opposite in the real world. You’re in hock, you pay the vig.  Bigger debts, more cost.

Japan is way beyond that, financing the government by directly trading yen for government debt, and now it’s buying exchange-traded funds, shifting to equities with infinite supply (ETFs can theoretically create as many shares as demand requires – but inevitably leverage increases). Japan is even contemplating paying banks and businesses to borrow. Why? Because debt creates money and more money keeps prices from falling.

The effort fails because consumers buy more when prices fall and less when they rise. So the very attempt to drive economic growth is in fact undermining it. Plus, the soundness of our currencies today depends on the capacity of governments to pay on their debts.

Summarizing, the world is indebted so it needs money. Central banks supply money by exchanging it for debt.  Creating money paradoxically reduces the capacity of consumers to buy things because prices rise. So they have to go into debt.  The cycle repeats like two parties munching opposite ends of a strand of spaghetti.

Back to stocks. When they vary inversely with the dollar it’s contraction or expansion of multiples, not real growth.  And that means consumers are losing purchasing power.  Since consumption drives economies now, it inevitably leads to slower growth.

And that’s what the planet’s got. Circular reasoning obfuscates facts.  The solution is a stable currency so all of us can understand fair value for stocks and everything else. But we’ll start with identifying the destructive force – and it’s not the kids.

Side Deals

Yesterday on what we call Counterparty Tuesday, stocks plunged.

Every month options, futures and swaps expire and these instruments represent trillions of notional-value dollars. Using an analogy, suppose you had to renew your homeowners insurance each month because the value of your house fluctuated continually.  Say there’s a secondary market where you can trade policies till they expire. That’s like the stock market and its relationship to these hedging derivatives.

As with insurance, somebody has to supply the coverage and take the payout risk. These “insurers” are counterparties, jargon meaning “the folks on the other side of the deal.”  They’re banks like Deutsche Bank, HSBC, Morgan Stanley, Citi.

Each month the folks on the other side of the deal offer signals of demand for insurance, a leading indicator of investor-commitment. We can measure counterparty impact on market volume and prices because we have an algorithm for it.  Last week (Feb 17-19) options and futures for February expired and the folks on the other side of the deal dominated price-setting, telling us that trading in insurance, not the assets themselves, was what made the market percolate. That’s profoundly important to understand or you’ll misinterpret what the market is doing.

On Monday Feb 22, a new series of derivatives began trading. Markets jumped again. Yesterday on Counterparty Tuesday, the folks on the other side of the deal told us they overshot demand for options and futures or lost on last week’s trades.  And that’s why stocks declined.

The mechanics can be complicated but here’s a way to understand. Say in early February investors were selling stocks because the market was bearish. They also then cut insurance, for why pay to protect an asset you’re selling (yes, we see that too)?

Around Feb 11, hedge funds calculating declines in markets and the value of insurance and the distance to expirations scooped up call options and bought stocks, especially ones that had gone down, like energy and technology shares and futures.

Markets rose sharply on demand for both stocks and options. When these hedge funds had succeeded in chasing shares and futures up sharply in short order, they turned to the folks on the other side of the deal and said, “Hi. We’d like to cash these in, please.”

Unless banks are holding those stocks, they’re forced to buy in the market, which drives price even higher. Pundits say, “This rally has got legs!” But as soon as the new options and futures for March began trading Monday, hedge funds dumped shares and bought puts – and the next day the folks on the other side of the deal, who were holding the bag (so to speak), told us so. Energy stocks and futures cratered, the market swooned.

It’s a mathematical impossibility for a market to sustainably rise in which bets produce a loser for every winner. If hedge funds are wrong, they lose capacity to invest.  If it’s counterparties – the folks on the other side of the deal – the cost of insurance increases and coverage shrinks, which discourages investment.  In both cases, markets flag.

Derivatives are not side deals anymore but a dominant theme. Weekly options and futures now abound, more short-term betting. Exchange-Traded Funds (ETFs), derivatives of underlying assets, routinely populate lists of most active stocks. Both are proof that the tail is wagging the dog, and yet financial news continues casting about by the moment for rational explanations.

Every day we’re tracking price-setting data (if you don’t know what sets your price the problem is the tools you’re using, because it’s just math and rules).  Right now, it’s the counterparties. Short volume remains extreme versus long-term norms, telling us horizons are short. Active investment is down over $3 billion daily versus the long-term.

You can and should know these things. Stop doing what you’ve always done and start setting your board and your executives apart. Knowledge is power – and investor-relations has it, right at our fingertips.

Bieber in a Bottle

Volumes are big but trades are small as markets pitch and buck.  On this restless sea, is there a message in a bottle?

That would seem poetic, were literature a help to your CFO in a stock market seeming the same hot mess as Justin Bieber’s Grammy performance Monday night. And what exactly was Kendrick Lamar doing?

If you didn’t see the Grammys, never mind. Back to US stocks, volume daily is leviathan, approaching 10 billion shares that as we noted last week must ionize through fewer than 20 firms on the way to sea spray. Markets last broke so furiously upon the shoals in August 2011 when it seemed the Euro might collapse (which begs that question anew and again leaves it unanswered).

Is it sound or just fury? Amid steep losses shifting to sharp gains into February options expiring today through Friday, trade-sizes have shrunk to the smallest on record.  TABB Group, the market structure consultancy, says average shares per trade in equities was of late 202 shares, dipping from the previous all-time low of 203 last October as markets surged like war from the trenches of August.

Conventional wisdom holds that blocks mark bigs. We’re told whales move in schools. But wait. The buyside and sellside have spent billions on trading technologies to make buying look like selling. The purpose of algorithms is deception.

Let me repeat that:  The purpose of algorithms is deception. Looking for blocks or watching the buy/sell balance means missing the technological revolution in trading the past fifteen years. At ModernIR, we preach a behavioral gospel.  All money is not the same. All prices are not equal.  The purpose of algorithms is deception (repetition is the best form of emphasis). Exchanges sell data, not products.

Against that backdrop, one key to understanding why stock-prices shift is recognizing that the market is not comprised of one behavior.  Suppose you were at the Super Bowl. Would you expect every person in the stands to act the same or might you anticipate bifurcation? Some portion of the audience will be rooting for one team and silent when the other excels. The weighting on sides determines the size of the roar and the silence.

Apply that to your stock.  The greatest mistake currently committed by executives of public companies is supposing the money in the market is a Super Bowl full of unilateral fans rooting for The Team. Recently I encountered an IR officer convinced that revamping the call script was the reason shares were up with earnings mid-November after falling with the call mid-August. That’s akin to supposing you caused an earthquake by slamming a door (August was China and expirations, not earnings).

There is one concrete fact you can know from big volume and small trades by taking the market at face value: A bidding war is underway. What’s knowable on the surface ends there. The rest resides lower.

You can measure the behaviors comprising your daily volume (this is what we pioneered – and if you don’t know what’s setting your price, you’re doing IR like a caveman).  Google, Amazon, Facebook, parse internet traffic. In the 21st century, companies should be parsing volume into demographic bands (if you think your exchange should be doing it, you’re right but misunderstanding what business exchanges are in).

Measure the market as it is. Because an approving roar may have the same timbre as derogatory boos. The last thing you want is your CFO before the Board like Justin Bieber on stage convinced the noise is coming from fans.

And that is the note in the bottle.

Eroding Banks

“Other than that, everything’s okay.”

My friend Gary, a smart guy with an MBA from the University of Chicago, uses that line to herald dire situations. It’s from the old UK sitcom starring John Cleese, Fawlty Towers. In one episode, Cleese the restaurateur receives a visit from a health inspector, who excoriates him for a host of violations and threatens to shutter the restaurant. After an uncomfortable silence, Cleese says, “Otherwise everything’s okay?”

Large banks including Morgan Stanley, UBS, Credit Suisse, Deutsche Bank, Citigroup and Bank of America are down about 30% this year.  A great deal has been made of reasons. Sovereign wealth funds, big holders in most, are sellers. Exposure to oil debt. Growth and recession fears crimping expectations for loans. Low or spreading negative rates further restraining interest income.

All perhaps valid.  We’re looking at banks for a different reason. Investor-relations practitioners must understand (really, everyone should) the form and function of the stock market to know what to expect from it. Nine banks are behind 50% of equity-market volume now including the six above plus Goldman Sachs, Barclays and JP Morgan.

Add nine other firms whose principal focus is high-speed trading (I wrote for CNBC last week on the origin of fast markets) and we’ve tallied 90% of market volume, recently averaging 9.7 billion shares daily. Just 25 firms including trading platforms individually handle 0.5% or more of daily volume. Using one anecdote, in 2010 there were about 240 participants executing CSCO trades (different from advertising volume). Today, barely a hundred. There are ever fewer entrances and exits.

Why? Rules require brokers with customers to meet standards of trade-execution or be fined by regulators. Standards reflect averages created by brokers executing trades. Over time, smaller brokers unable to meet them route orders to bigger ones and the market becomes ever more concentrated.

Trillions flowed to stocks through indexes and Exchange Traded Funds (ETFs) after the financial crisis as they rose and rose. Investors supposed diversifying – indexing the market – would reduce risk. But everybody is doing it, so it’s uniformity. ETFs dominate volume ranks (only BAC, a bank, can keep up with the likes of QQQ, SPY, XLF, VXX, GDX, EWJ and other ETFs for daily volume).

Who are the authorized participants, the firms furnishing and removing shares of these ETFs to match inflows and outflows?  The same big banks. Often large investors rely on options or futures to track indexes and hedge risks. The same big banks are major derivatives counterparties.

Speaking of which, add hundreds of trillions of dollars in currency and interest-rate swaps that financial market-participants use to keep pace with ever-changing global money. Counterparties?  The same banks.

The same banks dominate the IPO market, fixed-income underwriting, loan-syndication and equity research. Where the global financial marketplace once was a huge tent with sides furled, today it’s a giant gymnasium with nine exits.

If the money that tracked the market on the way up decided to depart on the descent, and the risk associated with moving was transferred to derivatives and the trades handed off for execution, the weight of the building would poise over each exit, the big banks.

And who buys? Unless active stock pickers show up en masse the parties that must purchase are these big firms providing prime brokerage (trading capital and management services). So they’re executing trades, backing derivatives, redeeming ETF shares, committing capital around imbalances as money departs.

It’s easy to imagine liabilities accumulating. Banks have strict rules for value-at-risk that diminish capacity for after-market support as equity capital sinks. Periodically, capital rules will force shedding of risk – which may have contributed in part to technology carnage Feb 5 as weekly options expired.

Unless we visualize the trusses, plumbing, wiring of the market, we’ll be baffled when the structure creaks.  On June 10, 2015 we warned clients in a note that a down market dependent on derivatives would reveal risk through the failure of one or more big counterparties the same way it did during the mortgage-related financial crisis.  We singled out Deutsche Bank.

Lest you fear, markets are resilient and nothing serves better to correct error than failure.  Besides, other than that everything is okay.