Tagged: investor relations

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.)

Realistic Expectation

How do you set realistic expectations about your shares for management?

I’ll give you examples.  One of our clients had a cyberattack and disclosed the impact, a material one degrading expected quarterly results.  What to expect?

Shares are up on strong volume.

That’s great but it makes execs scratch their heads. And the reverse can happen.

“The division heads tell their teams that growth will translate into share-price gains,” the investor-relations director told me. “They deliver, and the stock goes down 7%.”

I was having this conversation in Silicon Valley.  In fact, I had it twice the same day.

It illustrates a market transformation affecting investor-relations and investors. Fundamentals cannot be counted on to drive corresponding shareholder value.  Active stock-pickers and IR professionals have been slow to adapt, harming outcomes for both.

I was at the whiteboard in a conference room with another technology IR head, who was comparing revenue and margin drivers for his company and its key peers.

“How do I get these numbers to translate into the share price?” he said.

“You’re making the job harder than it has to be today,” I said. “And you might create unrealistic expectations from management for IR and for the company.”

There’s one more implication (we’ll answer them all before we wrap). Things like stocks behaving unexpectedly shouldn’t be ignored or glossed over.

For example, we found water dripping from the air-handler housing in the basement for the central air-conditioning system at our house. Great timing. July.

We could say, “Huh. That’s not what we were expecting.” And go on about what we’re doing.  But that’s a poor strategy, leaving us open to bigger troubles ahead.

When your stock doesn’t act as you expect, it’s water dripping from your air-handler, telling you, IR folks and investors, you’re missing something vital about the market.

Admit it.  Most of us know the market has got a drippy coil. But we go on with what we’ve been doing. We’d rather ignore the leak in the basement than address it.

For whom is that bigger trouble?  Your management team, IR. And your returns, investors. We should change what we’re doing, and revise expectations.

“I don’t want expectations for our stock,” you say. Would a board hire a CEO candidate who said, ‘Don’t expect anything from me’?

Back to our examples. In the cyberattack, Active money bought the news (bad clarity trumps okay uncertainty) but passive investment drove subsequent gains. The IR head appropriately differentiated the two and set expectations about trends and drivers. That’s good 21st century IR.

In the second example, don’t let the notion that growth will drive appreciation become an unmet expectation. Growth may boost the stock. But the IR Officer can go on the offensive with internal presentations showing how the market works and what role Story plays in setting price.

It’s up to IR to help management understand. If 80% of the time something besides Story sets price, doesn’t everybody internally have a right to know?  Don’t disillusion the team by letting incorrect expectations survive. That’s bigger trouble.

At the whiteboard with our IRO wanting to get the market to value results better, what about doing the opposite? It’s easier, less stressful, data-driven. Let the market tell YOU what it values. If 20% of the market values your numbers, measure when that 20% sets price. (We do that with Rational Price and Engagement metrics.)

Then measure how the rest of the money behaves that doesn’t pay attention to Story, and show your management team its trends and drivers. Now you’ll know when it’s about you, your management team will have data-driven views of what the money is really doing, and you, there in the IR chair, will have wider internal value.  And less stress.

That’s the right kind of realistic expectation.

What’s the market’s leaky coil? Two things.  Passive investment is asset-management, not results-driven stock-selection. Prices expand or contract with the rate of capital inflows and outflows for indexes and ETFs. You don’t control it. It controls you.

And over 50% of daily volume comes from fleeting effort to profit on price-differences or protect and leverage portfolios and trades (often in combo). It prices your stocks without wanting to own them.

And speaking of expectations, options are expiring today through Friday. It’s rarely about you when that’s happening. Set that realistic internal expectation (and stop reporting results the third week of each new quarter).

Dalhart vs Artifice

Texas is booming. We road-tripped it June 28-July 6, giving y’all a break from market structure.

We rolled the I35 corridor from frenzied Frisco north of Dallas, to Austin, now home to 950,000 people, to San Antonio, the fastest-growing Texas city last year, pushing 1.5 million.

From there on July 5 following fireworks the night before in three directions from Hotel Emma, our favorite in the country, we were up in Amarillo by evening (an oblique musical reference back past George Strait to Chris LeDoux, God rest him), and in Denver the next day.

You’d suppose Texas would be taking it in the nose on low oil prices. Yet bergs like Dalhart on the reaches of the Llano Estacado (yaw-no esta-kahdo), the vast plain staked over north Texas, bustle on Main Street and prosper on the boulevards.  If the world blows up, hunker between Texline and Masterson on Highway 87.

What’s Texas tell us about investor-relations, the stock market, investing, the Federal Reserve, the economy?  The farther you get into the heartland the less the things the people in charge think matter, matter.  Life goes on.

Of course, all of us gathered right here at this moment are rooted deep in the market, the Fed, the economy – even those of you in the heartland. We don’t have the – what’s the way to put it?  Convenience.  Of slipping off into the quiet purple of the fruited plain.

Looking from Dalhart, this strikes me:

The stock market.  Passive Investment depending on average prices is carrying the market beyond fundamentals, producing superior outcomes. Can average breed superior, sustainably? Malcolm Gladwell and reality both say no. So prepare for mean-reversion between fundamentals and prices.

When? Nobody knows.  It’ll come with no VIX signal, maybe as the Fed sells assets and spikes the dollar (The Fed trades bonds for dollars, so fewer dollars means higher dollar-value). It’s not that I’m pessimistic. I’m opposed to artifice in the economy, the market. I don’t think Dalhart would accept it. We don’t like it in people, politicians. Right?

Speaking of artifice, our estimable central bankers at the Federal Reserve have determined that after eight years of mediocre output we are ready to rock – though curiously weak inflation, they call it, vexes.

Say Sammy Hagar contended there were several ways to rock. We’d laugh. If I hear one more time that inflation is good, I’m heading to Dalhart.

Inflation is rising prices, which trims both buying power and productivity, the pillars of prosperity. The Fed might be underwhelmed by the increase but we’re paying more. For the same stuff. And calling it growth.

That’s artifice. A treadmill offering the illusion of forward progress, like confusing volume and liquidity (we’ll return to market structure next week so stay tuned).

The Fed should never have institutionalized economic mediocrity with eight years of training wheels. The Tour de France is underway coincidentally, drama on wheels turned by superlatives. You don’t reach the Tour on training wheels. You don’t become an economic tour de force by moseying.

Yet we can’t have an economic adult riding on training wheels. It just looks bad. So we’ll soon have the financial equivalent of a biker barreling into the shrubbery head over handlebars. Dalhart. Life goes on. We’d be better off without Fed artifice. Period.

Same with the stock market. The pursuit of average has become superior there, thanks to big training wheels (a good name for a rock band) from central bankers. Yet we value companies the same, engage in the same IR work. Why do we accept artifice?

Now pedaling toward the economic sludge, the training wheels are coming off the market. Central bankers believe they need only make a pronouncement that all is well and we’ll skim the muck.

The mistake we make is legitimizing it. But there’s reason for good cheer!  The quicker these things mash in a big dustup (and they will), the sooner we get back to Dalhart, and a prosperous global boulevard free of artifice where what’s real matters.

We’ll have to cross the Llano first. Put’er on cruise control, and keep driving.

BEST OF: IR Power

EDITORIAL NOTE: Whew! It’s 11pm here in Orlando (this view just off the patio at Highball & Harvest, The Ritz, Grand Lakes), and NIRI National, the annual confab for investor-relations professionals, has wrapped. The bars at the JW Marriott and Ritz Carlton Grand Lakes are full of IR folks — wait, let me rephrase. Post-conference relationship-building is occurring. We’re all about guidance and message, you know.

This is IR Power. It doesn’t mean what you think in a market where Blackrock, Vanguard, and State Street alone have $11.5 trillion of assets ignoring corporate message and sellside research. I’ll give you our view of NIRI National 2017 (and our fact-finding junket in Key West) next week. For now, IR pros and investors, read this. It’s among our most important posts. Cheers from sultry central FL!

First run:  May 17, 2017

“What’s eye are?  I haven’t seen that acronym.”

So said a friend unfamiliar with this arcane profession at public companies responsible for Wall Street relationships.  IR, for you investors who don’t know, is the role that coordinates earnings calls and builds the shareholder base behind traded shares.

Investor Relations is a vocation in transition because of the passive tide sweeping investment, money that can’t be actively built into a shareholder base. Money in models is deaf to persuasion. The IR job is Story. The market more and more is Structure.

But IR underestimates its power. There’s a paradox unfolding in the capital markets.  I liken it to shopping malls and Amazon.  Used to be, people flocked to department stores where earnest clerks matched people to products.

We still do it, sure. But nowadays seas of cash slosh onto the web and over to Amazon without a concierge. It’s passive shopping.  It’s moved by what we need or want and not by service, save that Amazon is expert at getting your stuff in your hands well and fast.

“You were saying we underestimate our power,” you reply, IR pro. “How?”

You’ve seen the Choice Hotels ad?  A guy with an authoritative voice declares that the Choice people should use four words: “Badda-book, badda-boom.”

The advertisement is humorously stereotyping the consultants, high-powered and high-paid pros who arrive on corporate premises to, buttressed by credibility and prestige, instruct managers on what they must do.

Whether it’s marketing and communications or management like McKinsey & Co., they command psychological currency because of real and perceived credibility, and confident assertion.

Might these people be buffaloing us? There’s probably some of that. But the point is they command respect and value with authority and expertise.

All right, apply that to IR.  Especially now, with the profession in a sort of identity crisis. It’s become the ampersand role.  You’re head of IR &…fill in the blank.  Strategy.  Corporate Development.  Treasury.  Financial Planning & Analysis.  Communications.

The ampersand isn’t causing the crisis. It’s the money.  Bloomberg reporters following the passive craze say indexes and Exchange Traded Funds (ETFs) may surpass active stock funds soon for assets under management.

They already crush stock-pickers as price-setters.  Passive investment is nearly twice as likely to set your price every day as your story.  Buy and hold money buys and holds. Your story isn’t changing daily.  But prices are. Sentiment is. Macro factors are. Risk is.  These and more breed relentless shifting in passive behavior, especially ETFs.

And here’s the IR powerplay.  You are the authoritative voice, the badda-book badda-boom on capital markets internally. With the behavior of money changing, you’re in the best position to be the expert on its evolution. To lead.

If you were the management consultant, you would lay out a plan and benchmarks for organizational transformation. If you were the widget product manager, you’d be providing executives regular data on the widget market and its drivers. You wouldn’t wait for the CEO to say, “Can you pull data together on what’s happening with widgets?”

Sometimes IR people pride themselves on how management never asks about the stock.  If you’re the expert, silence is not your friend. Get out in front of this transformation and lead it.  Don’t let them watch the stock, but help them consistently measure it.

What set of vital facts about passive investment should your management team understand? If you don’t have answers, insist on the resources needed to get them.

Don’t be timid. Don’t wait for management to say, “We want you to study and report back.” It’s too late then. You’ve moved from the expert to the analyst.

Instead, set the pace. See it as a chance to learn to use analytics to describe the market.  Make it a mission to wield your IR power as this passive theme changes our profession.

And we’ll catch you in two weeks!  We’re off to ride the tides on the Belizean reef, a weeklong Corona commercial catamaraning the islands.  We’ll report back.

As we leave, Market Sentiment has again bottomed so stocks rose with Monday’s MSCI rebalances and probably rise through expirations Wed-Fri before mean-reverting again. How many mean-reversions can a bull market handle?

IR Power

“What’s eye are?  I haven’t seen that acronym.”

So said a friend unfamiliar with this arcane profession at public companies responsible for Wall Street relationships.  IR, for you investors who don’t know, is the role that coordinates earnings calls and builds the shareholder base behind traded shares.

Investor Relations is a vocation in transition because of the passive tide sweeping investment, money that can’t be actively built into a shareholder base. Money in models is deaf to persuasion. The IR job is Story. The market more and more is Structure.

But IR underestimates its power. There’s a paradox unfolding in the capital markets.  I liken it to shopping malls and Amazon.  Used to be, people flocked to department stores where earnest clerks matched people to products.

We still do it, sure. But nowadays seas of cash slosh onto the web and over to Amazon without a concierge. It’s passive shopping.  It’s moved by what we need or want and not by service, save that Amazon is expert at getting your stuff in your hands well and fast.

“You were saying we underestimate our power,” you reply, IR pro. “How?”

You’ve seen the Choice Hotels ad?  A guy with an authoritative voice declares that the Choice people should use four words: “Badda-book, badda-boom.”

The advertisement is humorously stereotyping the consultants, high-powered and high-paid pros who arrive on corporate premises to, buttressed by credibility and prestige, instruct managers on what they must do.

Whether it’s marketing and communications or management like McKinsey & Co., they command psychological currency because of real and perceived credibility, and confident assertion.

Might these people be buffaloing us? There’s probably some of that. But the point is they command respect and value with authority and expertise.

All right, apply that to IR.  Especially now, with the profession in a sort of identity crisis. It’s become the ampersand role.  You’re head of IR &…fill in the blank.  Strategy.  Corporate Development.  Treasury.  Financial Planning & Analysis.  Communications.

The ampersand isn’t causing the crisis. It’s the money.  Bloomberg reporters following the passive craze say indexes and Exchange Traded Funds (ETFs) may surpass active stock funds soon for assets under management.

They already crush stock-pickers as price-setters.  Passive investment is nearly twice as likely to set your price every day as your story.  Buy and hold money buys and holds. Your story isn’t changing daily.  But prices are. Sentiment is. Macro factors are. Risk is.  These and more breed relentless shifting in passive behavior, especially ETFs.

And here’s the IR powerplay.  You are the authoritative voice, the badda-book badda-boom on capital markets internally. With the behavior of money changing, you’re in the best position to be the expert on its evolution. To lead.

If you were the management consultant, you would lay out a plan and benchmarks for organizational transformation. If you were the widget product manager, you’d be providing executives regular data on the widget market and its drivers. You wouldn’t wait for the CEO to say, “Can you pull data together on what’s happening with widgets?”

Sometimes IR people pride themselves on how management never asks about the stock.  If you’re the expert, silence is not your friend. Get out in front of this transformation and lead it.  Don’t let them watch the stock, but help them consistently measure it.

What set of vital facts about passive investment should your management team understand? If you don’t have answers, insist on the resources needed to get them.

Don’t be timid. Don’t wait for management to say, “We want you to study and report back.” It’s too late then. You’ve moved from the expert to the analyst.

Instead, set the pace. See it as a chance to learn to use analytics to describe the market.  Make it a mission to wield your IR power as this passive theme changes our profession.

And we’ll catch you in two weeks!  We’re off to ride the tides on the Belizean reef, a weeklong Corona commercial catamaraning the islands.  We’ll report back.

As we leave, Market Sentiment has again bottomed so stocks rose with Monday’s MSCI rebalances and probably rise through expirations Wed-Fri before mean-reverting again. How many mean-reversions can a bull market handle?

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.

Blackrobotics

The point isn’t that Blackrock picked robots over humans.  The point comes later. 

If you missed the news, last week the Wall Street Journal’s Sarah Krouse reported that Blackrock will revamp its $275 billion business for selecting individual stocks, turning over most decisions to machines (ejecting scores of human managers).

For perspective, that’s about 5% of Blackrock’s $5.1 trillion in assets. The other 95% is quantitative already, relying on models that group stocks around characteristics ranging from market capitalization to volatility.

Spanning 330 Blackrock iShares Exchange-Traded Funds (ETFs) are 14 primary clusters of characteristics that define investments. What Blackrock calls its “core” set are 25 ETFs managing $317 billion, more than the entirety of its active stock-picking business. Core investment describes what Blackrock sees as essentials for a diversified portfolio.

Blackrock views investing as a mixture of ingredients, a recipe of stocks.  The world’s largest asset manager thinks it’s better at crafting recipes than picking this or that flavor, like Fidelity has done for decades. 

But who is most affected by the rise of Blackrobotics?  We come to the point.  Two major market constituencies are either marginalized or reshaped: Public companies and sellside stock researchers.

“Sellside” means it’s the part of the market selling securities rather than buying them. Blackrock is on the buyside – investors who put money into stocks. The sellside has always helped investors by keeping stocks on hand like Merrill Lynch and Morgan Stanley used to do, and processing stock trades.

The sellside since brokers first fashioned the New York Stock Exchange also armed investors with valuable information through stock analysis. Analysts were once the big stars wielding power via savvy perspectives on businesses and industries. Everybody wanted to be Henry Blodget talking up internet stocks on CNBC.

Following the implosion of the dot-com boom of the 90s, regulators blamed stock analysts and enforced a ban on the use of valuable research preferentially, a mainstay for brokers back two centuries. So the sellside shifted to investing in technology rather than people, and the use of trading algorithms exploded.

Brokers – Raymond James to Credit Suisse, Stifel to JP Morgan – have long had a symbiotic relationship with public companies. Brokers underwrite stock offerings, placing them with their clients, the big investors.  After initial public offerings, analysts track the evolution of these businesses by writing research and issuing stock ratings. 

That’s Wall Street.  It reflects the best symbiosis of creative energy and capital the world has ever seen. Analysts issue ratings on stocks, and companies craft earnings calls and press releases every quarter, and money buys this combination. The energy of it hisses through the pipes and plumbing of the stock market. 

Blackrock uses none of it. It’s not tuning to calls or consuming bank research. Neither does Vanguard. Or State Street. Together these firms command some $11.5 trillion of assets eschewing the orthodoxy of Wall Street.

Public companies spend hundreds of millions annually on a vast array of efforts aimed at informing stock analysts and the investors who follow what they say and write. Earnings calls and webcasts, websites for investors, news via wire services, continuous travel to visit investors and analysts.

It’s the heart of what we call investor relations.

What Blackrobotics – Blackrock’s machines – mean to public companies is that some effort and spending are misaligned with the form and function of the market. It’s time to adapt. The job changed the moment Vanguard launched the first index fund in 1975.  You just didn’t know it until now. 

How do I change it, you ask? You can’t. Public companies should expend effort proportionate with the behavior of money. The trillions not tuning to calls or reading brokerage research deserve attention but not a message.

If money is using a recipe, track the ingredients and how they affect valuation, and report on it regularly to management. Get ahead of it before management asks.

It’s neither hard nor scary. What made index investing a great idea, to paraphrase Vanguard founder Jack Bogle, was that it was difficult for investors to be disappointed in it.  Same applies to IR and passive investing. What makes data analysis alluring is that it’s a management function and it’s hard to be disappointed in it.

(Note: If you want help, ask us. We use machines to measure machines and it’s simple and powerful and puts IR in charge of a market run by them. I talked about it yesterday at the NIRI Capital Area chapter).  

I’m not sure how capital forms in this environment. Wall Street lacks plumbing. Thus, companies grow privately and become index investments via IPOs, exiting as giants that are instantly part of the thousand biggest in which all the money concentrates.  

It’s not the end of the world, this rise of the machines.  But Blackrobotics come at a cost.  We all must adapt. It’s far less stressful embracing the future than missing the past.

Race Condition

You might think today’s title is about physical fitness.

No, ModernIR is an equity data analytics firm, not a personal trainer. I first heard the term “race conditions” used to describe stock-trading at TABB Forum, the traders’ community, in comments around an October 2012 article there by HFT expert Haim Bodek on why high-frequency traders have an advantage.

Reader Dave Cummings said, responding to it, “When Reg NMS was debated, several people very knowledgeable about market structure (including myself) argued against locked, crossed, and trade-through rules because of the side-effects caused by race conditions between fragmented markets.”

Emphasis mine.  You say who is Dave Cummings and what is this jargon that has me wanting to bludgeon my noggin on a wall?

I hope Mr. Cummings won’t mind my resurrecting his point. He started both BATS Global Inc., the stock exchange the CBOE is buying that by market-share the last five trading days nosed out the NYSE with 20.7% of US volume versus the venerated Buttonwood bourse’s 19.9% (the Nasdaq had 17.7%, IEX 2.2%, and nearly 40% was in broker pools), and speedy proprietary (no customers, trades its own capital) firm TradeBot.

He knows market structure.

We come to the jargon. Don’t tune out, investor-relations people and investors, because you need to understand the market to function well in it. Right?

Most people don’t know what Dave knows (that could go on a T-shirt). Mr. Cummings was explaining that trading rules prohibit the bid to buy and the offer to sell from being the same. A locked market. Crossed markets are out too, by law. You can’t make a bid to buy that is higher than the offer to sell.

And this “trade through” thing means brokers can’t continue buying stock at $20 one place if it’s now available for $19.99 another place.

I’ve said before that there’s no such thing as a “fragmented market.” A market by definition is aggregation. The stock market today is a series of interconnected conclaves all forced to do the same thing with the same products and prices. You understand? You can buy Nasdaq stocks at the NYSE and vice versa and only at the best price everywhere.

ModernIR builds software and runs lots of data-warehousing functions so we know race conditions. It’s when something doesn’t happen in proper sequence, you might say.

For instance, a data warehouse must be updated on schedule before an algorithm processes a routine. Some hiccup in the network slows the population of the data warehouse, so the algorithm fails because data haven’t shown up. Race condition.

The stock market is similarly a series of dependent processes, some of which will inescapably fail. Why would we create a stock market with a known propensity for process errors? Exactly. But let’s focus on what this means to investors and public companies.

It means the market is barred from behaving rationally in some circumstances. What if I want to pay more for something? Or say I don’t mind getting an inferior price for the convenience of staying in one place.

Plus, can we trust prices? What if yesterday’s big gains were a product of a race condition? I’m not saying they were. But we measure discrete market behaviors setting prices. Counterparties for derivatives were heavy buyers Monday when the stock market swooned sharply and then recovered most of its losses by the close.

These big banks or insurers bought because investors had portfolio insurance to guard against losses. That’s not investment behavior.

What then if equity trades tied to derivatives didn’t populate someplace and the market zoomed yesterday on a process error? Again, I’m not saying it did.  But the things Mr. Cummings warned would create errors in markets are cornerstones of the regulations behind the National Market System.

And why can’t a bid and offer be the same? Forcing them to be different means an intermediary is part of every trade. That’s why 40% of trading is in dark pools – to escape shill bids by trading intermediaries.

Why would Congress – which created the National Market System – mandate a middle man for stocks, when to get a good deal you cut the middle man out? Think about that with health care (or with government itself, which is the ultimate middle man).

But I digress.

We have a stock market the requires an intermediary, prohibits buying and selling at the same price (unless at the midpoint between them, which is the average, which is why index-investing is crushing stock-picking), and stops investors from paying the price they want and forces them instead to take a different price.

In Denver real estate, the bid to buy is often higher than the offer to sell because there aren’t enough houses. Don’t you want people paying more for your shares rather than less? So why do rules require the opposite?

I want us all thinking about whether the stock market serves our best interests in current form where passive investment is taking over everything.

I’ll be talking about that to the NIRI Capital Area chapter Apr 4, so come say hi. And we’ll be at NIRI Boston tonight self-congratulating with the rest of the sponsoring vendors in Sponsorpalooza.  You all in Minneapolis, good seeing you last week!

I just hope there are no race conditions in our travel plans from Denver today.

Weathering Change

Everyone complains about the weather but nobody does anything about it.

Mark Twain often gets credit for the clever quip but Twain’s friend Charles Dudley Warner said it.  We’re not here to talk weather though the east coast is wishing someone would do something about it.

Like the weather, there’s a relentlessness to stock-market evolution from fundamentally powered capital-formation to procurement process in which vast sums plug into models that pick, pack and stack stocks in precisely indexed packages.

Blackrock, Vanguard and State Street oversee $11.5 trillion that’s generally blind to sellside research and deaf to the corporate story. It’s a force of nature, more like a weather pattern than investment behavior.

Investor-relations folks say: “What do we do about it?”

Alert reader Karen Quast found a paper from Goldman Sachs advising Boards to respond to the rise of passive investment:

The recent decline in active single-stock investing raises important considerations for corporate boards of directors. The decline has been driven by a shift toward ‘passive investing’ and other forms of rule-based investing, such as index funds, factor-based investing, quantitative investing and exchange-traded funds (ETFs).

The decline of active investing means that, in many cases, stock prices have become more correlated and more closely linked to a company’s ‘characteristics,’ such as its index membership, ETF inclusion or quantitative-factor attributes. As a result, companies’ stock prices have become less correlated to their own fundamental performance.

Goldman Sachs is urging preparation. You can’t change the weather. You can only weather the change. The weather forecast isn’t a call to arms. It’s information we use to adapt to conditions. We prepare for discomfort.  We set realistic expectations.

That’s how investor-relations should view passive investment. We call it Asset Allocation because it’s a behavior that directs dollars to equities according to a model apportioning resources for opportunity and risk.

One way to help the board and the management prepare is to present the idea that there’s not just one behavior buying and selling shares. We ran data for an anonymous company whose share-price is 4% higher today than a year ago, trailing the broad market.

There are four purposes behind buying and selling, one of which is Asset Allocation, and all have equal capacity to set price. After all, market rules today prohibit preference (IR people should understand rules governing how shares are priced and traded and we’ll be discussing it at the Twin Cities NIRI chapter next week – join us!).

There are 50 weeks and in each a behavior led, and bought or sold (one week, Active Investment led and price didn’t change, rotation from growth to value).

It’s eye-opening. The behavior “winning” the most weeks was Fast Trading, short-term machines profiting on price-differences rather than investing.  It led 16 weeks, or 32% of the year, and bought more frequently than it sold.

Active Investment – your stock pickers – and Asset Allocation (indexes, ETFs, quantitative investors) were tied, leading 12 weeks each, but where Asset Allocation bought and sold equally, Active Investment sold more than it bought.

Finally, Risk Mgmt, counterparties to portfolio insurance and trading leverage with derivatives, led 10 weeks, or 20% of the year, but bought 70% of the time.  Put them together and the reason the stock is up a little is because the combined demographics behind price and volume bought 26 times and sold 23 times.

You laugh?  These data are telling! If not for other behaviors, Active Investors would have lowered price. Maybe that’s a message for the board and management team – but show this data to them and it will forever change how they think about the market.

The point isn’t changing the market but understanding how it works, measuring it consistently and adapting to reality.  Fundamentals do not rule now.

But with data analytics, it remains profoundly under the purview of investor-relations. That should bring great comfort to all of us in the profession.  Passive investment isn’t something to fear but to measure.

Market Sentiment:  The Federal Reserve likely hikes rates today, and options expire tomorrow and Friday, the latter the first quad-witching session of 2017. Also, S&P and Nasdaq indexes rebalance. VIX expirations still loom next week.

And our Sentiment is negative for the first time since the election. It’s a weather forecast.  No need for panic, only preparation. We’ll all weather change.