Tagged: Investor Relations

Volatility

You’ve heard the saying that’s it all in your perspective. It applies to volatility.

Volatility is up 150% since the post-financial-crisis nadir of 10.32 for VIX Volatility in mid-2014. The “Fear Index” closed yesterday over 26, the highest since August 2015 when it topped 28 (way below 43 in 2011 and nearly 80 in 2008). VIX expirations are hitting today.

I’ve been seeing Mohamed El-Erian, whom I admire, chief economic advisor to Allianz and former right hand to Bill Gross at PIMCO, also now gone from the bond giant, on the business TV circuit saying central banks are ending programs designed to dampen financial volatility.

I think he’s got a point, and he means they’re starting to broaden trading ranges in everything from interest rates to currencies (as if we want them setting prices). But volatility is price-uncertainty reflecting evolving valuation.  Conventional measures often fail to reveal change because behaviors in markets morph while the metrics used to understand them don’t.

Figure 1

Figure 1

I can prove it.  In the first chart here (Figure 1), a small-capitalization technology stock on the Nasdaq hasn’t moved much in the year ended Dec 16, 2015 (I’ll explain that date shortly) but the stock rose from a 200-day average price of $20.67 to a five-day mean of $21.05, up 1.8%.  Not too great – but the Russell 2000 Index was off 1.3% in the year ended Dec 16, 2015. Perspective matters.

Now notice:  Daily volatility, or the difference between highest and lowest prices each day, is greater than the change in average price in all four periods.  Think about that. The price changes more every day than it does in moving averages for months and quarters.

Now see Figure 2 showing short volume Dec 1, 2015-Jan 15, 2016 for the same stock. The upper half is long volume (owned shares), the bottom short volume, or rented stock. The blue line is closing price. The data further back show short volume over the trailing 200 days averaged 60.2% daily.

Figure 2

Figure 2

Combine the charts. The stock moved less than 2% on average over the entire period but 60% of the shares trading every day were borrowed, and the spread between high and low prices was nearly 3% every single day.

Do you understand? On the surface this stock is not volatile. But up close it’s torrid – on rented shares. For a solid year, traders have kept this stock in stasis by borrowing and trading, borrowing and trading, because the cost of borrowing was substantially lower than daily price-movement. That’s market-neutral arbitrage.

Everything changed recently. Short volume in Figure 2 plunged Dec 22, 2015.  On Dec 16 (here’s that date now) the Federal Reserve bumped short-term rates to 0.25-0.50%. On Dec 17-18 vast swaths of interest-rate swaps tied to options-expirations lapsed. On Dec 21, the new series of options and futures (and interest-rate swaps) began trading. And on Dec 22, our small-cap’s short volume imploded, finally landing at 33% Jan 11, down from 71% Dec 10, a decline of 54%.

We’ve slung numbers here, I know. But the conclusion is simple. Whatever traders were doing in this small-cap, the Fed’s rate-hike ended it.  We think that’s good. But markets have been addicted for years to cheap credit, which includes borrowing shares for next to nothing, which shifts attention from long-term owning to short-term renting. That changed when the Fed bumped rates. And equites corrected.

There’s another lesson by extension.  What sets your stock’s price may be radically different than you think.  We’ve offered one example that shows short-term borrowing fueled persistent volatility trading masked by apparent long-term placidity. When interest rates crept up minutely, the strategy stopped working.

What’s your stock show?  Price-performance isn’t story alone, perhaps even over the long run, as we’ve just shown. There’s so much to see when measurements reflect current behavior (as ours do). Volatility is price-uncertainty that thanks to policies promoting short-term behavior is now concentrated intraday.  Sorting this out will take time. We won’t change seven fat years with a lean month. The good news is it’s all measurable.

Swimming

Happy New Year!  There comes a time in life when, to quote a friend most adept at wordsmithing, “One hallmark of a great vacation is lying face-down in salt water, with snorkel and face mask, watching the peaceful, sparkling life of the reef.”

We love it any time and December took us to St Martin and a catamaran and a pleasant journey around Anguilla and down to St Barts, the sea waves a solace for body and soul.  If you’ve not yet been where the tradewinds are constant friends, go. It’ll remind you to appreciate life, and time.

As the Chambers Brothers would say, the time has come today (taking eleven minutes to make that musical argument in 1968, the year after my birth) to think about what’s ahead. I wrote a CNBC oped yesterday describing the risk in ETFs that your executives should understand as 2016 unfolds. A goodly portion of the nearly $600 billion of 2015 inflows to passive investment giants Vanguard and Blackrock went to these instruments, portions of which are likely laying claim to the same assets owned by active investors and the indexes ETFs track.

That’s no threat when more money is arriving than leaving, but as Warren Buffett once observed, you only find out who’s been swimming naked when the tide goes out (or something near that).

I don’t know if 2016 will be the Year of Swimming Naked.  Looking back, in Dec 2014 we wrote you readers who are clients: “There is risk that a strong dollar could unexpectedly reduce corporate earnings in Q414 or Q115, stunning equities.  The dollar too is behaving as it did in 2010 when a major currency was in crisis (the Euro, with Greece failing).  Is the Japanese yen next?  The globalization era means no nation is an island, including the USA.”

Money kept flowing but 2015 wobbled the orbits of multiple currencies. Switzerland dropped its euro peg, the euro dropped to decade lows versus the dollar (which hit 2001 highs), the yen became Japan’s last desperate infantryman for growth, and the Chinese yuan repeatedly rocked markets, most recently Monday.

These factors matter to the investor-relations profession.  Picture a teeter-totter.  Once, money was a stationary fulcrum upon which commercial supply and demand around the globe moved up and down.  Today, central banks continuously slide the fulcrum to keep the teeter-totter level. Into the markets denominating the shares of the companies behind commerce pours money following models: indexes and ETFs.

This is our world, IR folks. Fundamentals cannot trump passive investment or the perpetual motion of the money fulcrum. So we must adapt.  Our most important job is to deliver value to management in the market as it is, not as it was. Running a close second is to achieve the IR goal: To the degree we can influence the outcome, aim to maintain a fairly valued stock and a well-informed market – which decidedly doesn’t mean a rising stock.

Both what you can control and whether your stock is fairly valued in a dynamic market where price-setting is more quantitative than qualitative are measurable. But not with valuation models from when the preponderance of money setting prices was taking 10Ks home at night to find the best stocks.  IR must be data-driven in the 21st century.

As 2016 begins, are tides in or out? Our sentiment measures suggest a harsh January. The cost of transferring risk through derivatives is rising. The appreciation of stock-prices necessary to sustain the value of derivatives dependent on them is stalling. And currencies – the fulcrum for prices – show worrisome seismological instability.

Now maybe both January and the year will be awesome, and let’s hope so!  Whatever comes, great IR professionals stand out against a changing backdrop by providing management data points about the stock and the market that deliver calm confidence.

Reflection

Most of you are out this week, but you’ve got phones.

Unless you’re disconnected from them like we were (by choice) a couple weeks back in the Caribbean, you’ll see this post. Send it to your CEO and CFO.

Whatever the theme for the year – “it ended flat,” “The Fed led,” “August Correction,” “Flash Boys,” “The Year of the ETF” – we’ll wrap it by pointing you to our friends at Themis Trading for a final lesson on market structure.  Read “Yale Investment Chief: America’s Equity Markets are Broken,” (if you’re not reading the Themis blog you should be) and reflect:

-The $25 billion Yale endowment fund favors private investments where horizons are longer and less liquid. Think about how often you’ve heard you need “more liquidity.”

-“Market fragmentation allows high-frequency traders and exchanges to profit at the expense of long-term investors.”

-“Market depth is an illusion that fades in the face of real buying and selling.”

-“Exchanges advance the interests of traders by sponsoring esoteric order types, which for hard-to-understand reasons receive the approval of the SEC.”

-And if you’ve not yet done so, read Flash Boys

Then read this editorial in the New York Times.

On January 6, we’ll talk about 2016.  Happy New Year!

Best Of: The Vacuum

Editorial Note: Happy Holidays! We’re back from travels but will share our findings in the first Market Structure Map of the new year. Ahead of Christmas, we’re re-running the most-read MSM of 2015. Market structure should rank among your top priorities, IR professionals. You can target investors and tell your story till your fingers are worked to bone and it won’t matter if the structure of the market sets your price. Seek first to understand. Read on (first published Dec 9): 

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how it’s really priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

The Vacuum

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how it’s really priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

Dollars and Sense

I looked back at what we wrote Dec 2, 2008. It was two weeks before Madoff (pronounced “made off” we’d observed bemusedly) became synonymous with fraud. Markets were approaching ramming speed into the Mar 2009 financial-crisis nadir.

In that environment on this date then, we introduced you to Ronin Capital, a Chicago proprietary trader. It had exploded through the equity data we were tracking. Today it’s a top-twenty proprietary trader in equities but not the runway model.

Yet it’s thriving. It has 350 employees. Its regulatory filings show $9.5 billion of assets including financial instruments valued at $6.4 billion, with government securities comprising $4.5 billion, derivatives about $1.1 billion, and equities about $700 million.

As the Federal Reserve contemplates a rate-increase in two weeks, Ronin Capital is a microcosm for the whole market. Its asset-mix describes what we see behaviorally in your trading, clients: Leveraged assets, dollars shifting from equity trading to derivatives, producing declining volumes and paradoxically rising prices. In a word, arbitrage.

The Fed Funds rate is the daily cost at which banks with reserves at the Fed loan them to each other.  The Fed last raised it June 29, 2006 to 5.25%, marking a pre-crisis zenith. As the housing market trembled, the Fed backpedaled to 4.25% by December 2007. On Dec 16, 2008 the Fed cut to 0.00%-0.25%, where it remains.

Since the Fed began tracking these rates following departure from the gold standard in 1971, the previous low was 1% in June 2003 as the economy was trudging up from the 9/11 swale. The high was 20% (overnight!) in May 1981.  It’s averaged about 5%.

Now for almost ten years – the life of the benchmark US Treasury – there has been no rate-increase. Since 2008, it’s been close to free for big banks to loan each other money. Backing up to Nov 30, 2006, the Fed’s balance sheet showed bank reserves at $8.9 billion, lower than (but statistically similar to) $11.2 billion at Nov 29, 1996. But at Nov 27, 2015, the Fed held $2.6 trillion of bank reserves, an increase of 29,000%.

Lest you seethe, this money was manufactured by the Fed and paid to banks that bought government debt and our mortgages.  It didn’t exist outside the Fed.

The construction of the financial instruments held by Ronin Capital describes how these polices have affected market activity.  First, the pillar of the asset base is government debt, the most abundant security in the world (a commodity – something available everywhere – cannot be the safest asset, by the way).  Governments need buyers for debt so rules manufacture a market. All the big banks hold gobs of government debt.

Second, Ronin holds equity swaps, equity options, options on futures, and currency forward contracts which collectively are 34% greater than underlying equity assets. We infer that Ronin makes money by leveraging into short-term directional trades in options and currencies. It’s worked well. It did in real estate too ten years ago, until mortgage-backed derivatives devalued as appreciation in the underlying asset, houses, stalled.

Ronin Capital, big banks, derivatives, currencies, equities and interest rates are interlaced. When money lacks inherent worth, speculation increases. Government debt is today’s real estate market underpinning massive leverage in today’s mortgage-backed securities, the sea of derivatives delivering short-term arbitrage profits.

To see the potential Fed rate increase Dec 16 as but a step toward normalization is to misunderstand the foundation of capital today. Raising rates to 0.25%-0.50% is good. But it’s at least 29,005% different from raising rates to 5.25% in 2006.

You don’t have to grasp all the mechanics, IR professionals. You do have to understand that if fundamentals have been marginalized by arbitrage the past seven years, wait till the calculus in arbitrage changes.  It’s happening already. We saw a steep drop in shorting the past two weeks. Sounds good, right? But it means borrowing is tightening.

Don’t blame Ronin Capital for adapting.  In fact, forget blame, though it’s apparent where it lies. Let’s instead think about the implication for our task in the equity market. It’s about to get a lot more interesting, and not because of fundamentals.

The good news is that it’s never been more vital to measure your market structure and report facts to management. This is when IR careers are made.

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.

The Replicator

In the television and cinematic series Star Trek, the Replicator creates stuff.  Captain Jean-Luc Picard would instruct it to dispense “tea. Earl Grey. Hot.” This YouTube montage is homage.

Speaking of creating stuff, stocks lately saw the longest 2015 rally in step with the weakest jobs report. It came on derivatives, our data show. The OMC song “How Bizarre” says if you want to know the rest, hey, buy the rights. In stocks, the rights to things rather than the things themselves is what drove them. Traders bought rights.

That means somebody else must buy the stocks.  Exercise the right to buy with a call option and the counterparty – we track counterparties – must fulfill it with shares. One risk for markets is that dealers don’t hold supplies of shares, what’s called inventory.

Why? Rules now discourage banks from carrying risk assets like stocks and require instead owning Tier One capital like sovereign debt (how the product of overspending is safer than the rights to profits is unclear) and so banks have stopped making markets in a majority of stocks. Thus, when derivatives are used they must buy, and stocks soar.

The mortgage crisis I hope taught us to watch how markets work. Mortgages were replicated through derivatives as demand for returns on purchased and appreciating homes outstripped underlying supply. When mortgages stopped increasing and houses started to fall in value, mortgage derivatives imploded.

That risk resides now in exchange-traded funds. ETFs often sample rather than replicate indexes. For instance, yesterday a swath of American Depositary Receipts (ADRs) surged because money rushed into an ETF tracking an MSCI global index that excludes US stocks. The index has nearly 1,850 components but the ETF just over 400, or about 21% of the index’s holdings.

What, you say? The ETF doesn’t own all the stocks? Right. There are two kinds of ETFs:  Physical and synthetic.  The former either own shares or sample them, and the latter rely on derivatives to represent the value of stocks. ETFs track indexes four ways:

Full replication. The ETF buys all the stocks in the underlying index, matching comparative weighting. But it may substitute cash for some or all of the stocks.

Sampling. When the tracking index is large (as in our example above) or if the stocks are not available in sufficient quantity, an ETF may construct a representative sample of the index and own only those stocks.

Optimization. Where sampling focuses on picking stocks reflecting the index’s purpose, optimization is a quantitative approach that uses mathematical models to construct correlation in a set of securities that trade like the index whether they reflect industry characteristics or not.

Swap-replication. ETFs pay counterparties for rights to the economic value of underlying indices. No assets actually trade hands.  This is what synthetic ETFs like Direxion and Proshares use (along with futures and options).

It’s worth noting that the great majority of bond ETFs use sampling because fixed-income issues are so vast and illiquid that full replication is a physical impossibility.

Back to equities, as with all derivatives from collateralized debt obligations to floating-rate currencies, problems don’t manifest until the underlying assets stop increasing in value. Those are your shares. The broad market has generally ceased rising and we’ve had a raft of problems in ETFs.

We don’t need to panic. But ETFs are the modern-era mortgage-backed securities. They were designed to make it convenient for everyone to infinitely own a finite asset class: Stocks. That is impossible, and so, sure enough, ETFs are substituting rights for assets.

It didn’t impact us in the IR profession so long as stocks were up. Whether your shares were in an ETF or not, you benefited from the implied demand in the explosion of ETF assets. When ETFs substitute cash, the resulting rise in your share-price isn’t real.

Do you understand? The dollars didn’t buy shares.  And if ETFs are sampling indexes rather than buying them in full, radical volatility can develop between issues held and excluded.

But there’s a bigger risk. As with mortgage-backed securities, ETFs are a multiplier for underlying assets. ETFs that hold stocks don’t trade them per se. Shares of ETFs trade as a promise against its assets. And ETFs lend securities.

ETFs primarily track indexes. You can’t have one without the other. If ETFs investors leave and index investors leave and both stop lending shares to brokers for intermediaries like high-frequency traders, the structure of the market will fundamentally change.

The Fed’s view notwithstanding, markets can and must both rise and fall, and markets dependent on derivatives fall harder. It’s a lesson of history. If we in the IR profession were responsible for the widget market, we’d continually study widget-market form, function, risk and opportunity.

Investor-relations is the equity product manager. We’d better watch the equity-market replicator (and clients, we do, every day).

ETF Bubble

“We’re 90% in natural gas and natural-gas liquids,” said the investor-relations officer for a NYSE-listed master-limited partnership at yesterday’s NIRI luncheon in Houston, where I spoke on ETFs. “Yet we’re tracking oil.”

In Michael Lewis’s brilliant The Big Short, a small group of people come to believe mortgages are a bubble because they’ve been extended into derivatives treated as though of equal value and composition to the homes and loans backing the mortgages. No distinction then was being made between good mortgages and bad ones, the same woe afflicting our MLP above through models like ETFs. Thus began the big short – bets that a reckoning was coming.

In the stock market the core asset is stocks of public companies. There is a finite supply, which due to widespread corporate consolidation and share-repurchases isn’t increasing. But indexes that cluster stocks into convenient risk-diffusing groups have proliferated.

At the same time, brokers once carrying shares to mark up and sell to big institutional customers have been forced out by rules, and the intermediaries now, fast traders, often have but 100 shares at a time. Without ready stock, it’s gotten very hard for institutions to buy and sell big positions.

Enter exchange-traded funds. Through ETFs, institutions transfer the risk of finding mass quantities of shares to an arcane behind-the-scenes group of custodian brokers called in ETF lingo “authorized participants.” Think of firms playing this role as running the warehouses.

Here’s how it works. Blackrock creates an ETF tracking an index. The ETF must be comprised of percentages of each of its stocks. Blackrock turns to the warehouse, the Authorized Participant (AP), who gets the components off the shelves and packages vast amounts into what are called creation units. You can’t sell ETF shares back to Blackrock. Only the AP can. For investors, ETFs must be bought or sold on the “secondary market.” That is, just like stocks.

If money buys the ETF instead of the index, wouldn’t it rise faster? Thanks to special ETF rules, no. If investors want the ETF, Blackrock has its AP manufacture more ETF units to meet demand – so supply is theoretically infinite.

ETFs in effect cut out the middle man, the stock market. How? For one, ETFs can substitute cash or securities like options and futures for stocks (and they can hold but a statistical sample of the index).

Suppose investors are buying an underlying stock like XOM, and indexes containing XOM, and ETFs tracking energy and including XOM. The sponsor asks the AP for a lot of XOM and the other components so it can whip up more ETF shares. The AP checks the warehouse, and there is no more XOM. So it substitutes cash and futures of equal value.

Second, this “warehouse” concept reflects how APs, we’re led to believe, seem to have infinite access to shares of stock (which we know is impossible). You can’t find a list of APs but experts say they’re big banks getting special permission from ETF sponsors to act for them.

I have a theory. Often in 13F regulatory filings required by the SEC, holdings for the biggest investors like Blackrock and Vanguard barely change. Positions in 13Fs usually roll up to the parent. Maybe the parent’s subunits buy and sell from each other for indexes and ETFs through the APs. It’s an explanation.

Whatever the truth, ETFs are the biggest success in modern financial history because they make it easy for investors to do something that in reality isn’t: get big exposure without altering the market. Thus, ETFs are a form of credit-extension because they offer investors access to something they otherwise couldn’t buy.

Collateralized debt-obligations did the same for mortgages – turned them into something every investor could own regardless of the number or quality of underlying mortgages.

Bubbles manifest not through valuations but when values stop rising. Let’s theorize that the market stalls for an extended period.  Investors get nervous and sell XOM and the index and the ETF. The futures held in place of XOM are now worthless. To prevent panic, the AP sells assets to cover the loss.

Markets deteriorate further. Panic starts.  The AP is tangled up in swaths of valueless derivatives (just like the CDO market). Then it defaults because its balance-sheet no longer qualifies it to serve as an AP. Bear Stearns and Lehman Brothers were big counterparties that failed. A domino effect ensued as balance sheets laden with empty paper imploded.

Public companies, know what ETFs hold your shares and whether they’re big names (we can help you). Your management teams and Boards should understand ETFs and your company’s exposure to them (and the volume multiplier). Even better, you should be tracking every day what sets price (we can do that for you).

The risk I propose here probably won’t manifest. But in the May 6, 2010 Flash Crash, 70% of halted securities were ETFs. On Aug 24, 2015 when markets nearly imploded, there were 1,000 ETF volatility halts.

We might have an ETF bubble.

Showing Up

Investor-relations professionals are traveling salespeople.

Now, we’re not paid commissions and I can see some of you recoiling at the imagery of rumpled suits and satchels stuffed with brushes, a voice saying, “Excuse me, ma’am, do you have a couple minutes?  I’d like to tell you about our brand new…”

Woody Allen said 80% of life is showing up when you’d prefer to stay in bed. Ads play on satellite radio claiming 80% of sales follow the fifth to twelfth contact.  Whether those figures are real, my own sales experience boils down to a single word: Effort.

There’s an article today in the Wall Street Journal about venerable stock-picker Mario Gabelli whom many of us know because of the ponderous way Gamco Investors approaches investment-selection. You can’t quit after the first meeting.

When I was sitting in the IR chair years ago, the sales guy from CCBN – later bought by Thomson Financial and today part of Nasdaq Corporate Services – sold me more stuff than everybody else combined because he was always solving problems for me. He’d observe a need and say, “We could help you do that better.”

I’ve said before that Nordstrom has the best salespeople in retail because they’re concierges. They’re expert at assessing their consumers and matching them with the right products. They’re the unflagging herald helping you pursue sartorial superiority.

This too is the soul of modern investor-relations in a world where our core audience of active stock-pickers shrinks steadily, money like desert sand before the wind blowing to indexes and ETFs. Mario Gabelli despite good performance has seen $2 billion flow from Gamco this year.

IR is about matching product to consumer. We can speak in magisterial terms of the Liaison to Wall Street but at root IR is corporate concierge. We’re Nordstrom for Fidelity or T. Rowe Price, helping them dress well.  And everybody is looking for a garment because that’s what Wall Street does. Fund managers spend other people’s money.

Let’s get right down to handing out Fuller brushes. Say you’ve positioned your company as a growth story.  You craft a growth message, pinpoint growth drivers.  Every quarter you’re delivering financial and performance metrics highlighting sequential and yearly change, percentages metering growth.

But your stock is declining for whatever reason (and we’d know in market-structure data by measuring period-over-period change in behavioral flows no differently than you do with your metrics). Maybe it’s China, the sector is out of favor, the dollar is killing you.

The fact is you’re a value product.  Target growth money when your shares are declining and you won’t sell because the product doesn’t match the consumer. Growth money buys appreciation. Value money buys opportunity. Repeat that.  And there are shades of both. Momentum is aggressive growth money, deep-value high-turnover is aggressive value money. GARP (growth at a reasonable price) is your consistency constituency (say that fast three times).

Every IRO should be cultivating a deep palette of investor-relationships across this money spectrum. These are your consumers. You follow up – knock on doors because 80% of sales take a lot of persistence and if the stats are bogus effort isn’t – with the consumers currently matched to your product.

We produce data for prioritizing this relationship-management effort.  Our action items focus on relationship-management. For instance, you have a tough earnings call and your stock declines. Afterward, you ring top holders and reassure them. It’s protocol.

But wait with the salvo to well-informed prospects you’ve cultivated strategically. Watch the data. When your Sentiment is negative – all the tides of money are out and your short volumes are low – the likelihood your price will rise is high because the first buyer will lift price.

That’s the time to call just your deep-value relationships, the 4-5 you’ve built the past couple years. You have a product to offer these consumers. Highlight value drivers – not growth details. Tell a value story.

If they act, they’ll get an immediate return (call them next only when your product is right for them, and this relationship will become symbiotic).

And now you’re a growth product and story again. Call GARP and growth relationships because your shares will be rising. That’s what you can control. Turn it into an art.  You’ll be the best IRO on the Street because the goal is a well-informed and fairly valued stock (we have metrics for that too).

Remember, 80% of success is showing up. Over and over.