Tagged: sellside

Westworld

The smash HBO series Westworld is a lot like the stock market: It has the appearance of reality but is populated by machines (which are trying to take over in both places).

What the market lacks in gratuitous nudity it more than compensates for with a veneer that far exceeds what the Westworld operators call “the narrative.”  Most think the market’s narrative is headlines and fundamentals.  Examine what the money is doing, the rules of the market, the way exchanges match trades today, and it’s the opposite.

Fundamentals are the sideshow. The sellside has imploded. Blackrock, Vanguard and State Street cut costs by cutting them out. Index and exchange-traded funds (ETFs), dominating investment the past decade, don’t follow fundamentals.  We just hired a person from Janus because stock-picking is like the androids in Westworld: subject to repeated obliteration.

JP Morgan and Goldman Sachs both have said publicly that 10% of their trading volumes now are active investment. Sellside analysts in droves are trying to get investor-relations jobs. Why then is IR spending 85% of its effort on the buyside and sellside?

And the earnings-versus-expectations model is misdirection. It’s not for buy-and-hold investors. It’s for arbitragers. It’s an opportunity to bet. Investors don’t change their minds that way.

What’s exploded is the use of derivatives. The same handful of banks from Goldman Sachs to UBS that perpetuate earnings vs. expectations execute 90% of customer equity orders and handle 95% of the derivatives market.  They know the direction of equity flows so they can hedge long or short. Their best customers are hedge funds and high-speed firms profiting on price-changes.

These same big firms are ETF authorized participants, which have created and redeemed some $2 trillion of ETF shares already this year, contributing to whopping market volatility. Actual inflows to equities are 2% of that figure! It’s arbitrage.

We’ve become the hosts – as the androids in Westworld are called. Unwitting contributors to a storyline. What if we suspended all our effort at outreach to the buyside and sellside…and nothing happened?

Berkshire Hathaway doesn’t hold an earnings call. Tesla’s Elon Musk went off over banal analyst questions, but questions don’t buy or sell stocks and TSLA is right where the math signaled (about $301), up on – you guessed it – ETF creations, arbitrage.

You don’t want to hear this? Do you prefer to live in Westworld, hosts for a narrative not of your design? Don’t do that.  IR is the chief intelligence function. You’re supposed to know what’s going on.  We rarely stress it here, but I’m saying it today. Market Structure Analytics, which we invented, can tell you everything you need to escape Westworld:

-What’s setting your price every day

-The demographic composition of your volume by behavior

-The trends of behavioral change

-When Active money buys or sells, and if it’s growth, GARP or value

-If your investors are engaged

-The risk from directional bets and whether they’re long or short

-The presence of deal arbitrage, Activism and short attacks (and likely success)

-Borrowing trends in your shares

-How passive investment affects stock performance

-Visual indications of short-term market cycles including how ETFs work

-Key trends and drivers

-Key metrics for knowing if your equity is healthy or not

-Forecasted prices (with 95% accuracy five days out)

-Earnings expectation models

-Predictive Sentiment for Overbought and Oversold conditions

-Why your shares behave differently than peers or the market

You might say, “So?”

Public companies have a fiduciary responsibility to act in the best interest of shareholders, which includes understanding how the market is using those shares.  If IR was a business division, we’d expect nothing less than a full SWOT disposition. IR is the equity product manager – arguably as vital as any business division. You need data.

Analytics should first enable you to see important trends and drivers – in consumer behavior, in a business, in your equity.  That’s the starting point for actions. IR has fallen into a rut of saying it wants actionability – but without first understanding equity drivers.

Public companies have over the past 20 years let intermediaries make rules that work well for intermediaries like exchanges selling data and technology services but poorly for ourselves and long-term money. The problem is IR behaves still like it’s 20 years ago.

We remedy that deficiency.  If you want to see how, give us 15-30 minutes by web meeting to show you why Market Structure Analytics should be considered a vital part of being public today (and you investors, we’ll soon have a solution for you too!).

Ticking Down

In 2016 to much fanfare, the SEC and the stock exchanges smashed a bottle of champagne on the looming bow of a tick-size study and launched that battleship into the markets.  Two years later the tick study is limping into port in a lifeboat.

For those of you thinking what the heck is a tick-size study, the US stock market is top-heavy.  The weighted average market capitalization of the Wilshire 5000 Total Market Index is $165 billion, yet the median is $1.1 billion.  The market is skewed massively large.  We mentioned these data in our 2014 comment letter on the SEC’s tick study.

Over 90% of the Wilshire 5000’s market cap is concentrated in less than 750 companies – with the bulk of trading volume, inclusion in indexes, Exchange Traded Funds. Seen another way, the Russell 1000 is about 92% of market cap, the Russell 2000, 8%.

The SEC looked across the sea of the market and determined that small caps were marooned in forgotten eddies and byways.  How to remedy it?  Hike the spread.

Historic backdrop is needed to appreciate the irony. Today the market trades in mandated penny spreads, thanks to SEC-led decimalization of markets in 2001.  Why? Back then, many thought intermediary brokers were gouging investors by buying low and selling way too high.

By reducing spreads to a penny, computerized trading systems were able to compete with brokers. The cost to trade plunged.  Regulators cheered their own brilliance.

But sellside research imploded. Without a trading spread to fund cost centers like analysts poring over data and penning reports, the number of firms supporting small stocks with market-making operations tumbled.

The average IPO before decimalization had 66 underwriters, which wrote research on the many thousands of traded stocks. Today’s IPOs have on average six underwriters. Of the 3,500 individual companies comprising the Wilshire 5000 Index, about 2,500 have little or no analyst coverage, and wan trading.

Regulators thought, “Maybe we should widen the spreads?”

When you’re through laughing, I’ll resume the story.

So in 2014, the SEC directed exchanges to run a study grouping stocks – comprising virtually all small caps by our count – in control and variable buckets to see if lifting the spread from one penny to more, such as five cents, would lead to more market-making.  It took two years to hash out details, and the study commenced in October 2016.

The plug will be pulled in October now because the study has produced scant measurable change.  By my reading, market capitalization has become even more concentrated during the study, and the number of public companies continues to shrink.

If wider spreads worked before, why didn’t they work this time?  Four words: Regulation National Market System. Before decimalization, stock markets were not connected to each other electronically and forced to share prices and customers and trade at a single best national price – across all platforms – called the National Best Bid or Offer.

Reg NMS gave us that market. Hike the spread from one penny to five where all trading is still electronic, markets interconnected around the BBO, all you’ve done is widen the step into the same building, and the same behaviors that run up and down the steps – high-speed machines – still set the price.

Nothing has been done to change the economics of brokerage, which still won’t support research.  Plus, rules, not economics, determine spreads.

Suppose you were in the banana business, and you flew back and forth from Belize buying bananas and selling them here. Then the government said you could only make a penny per banana. You cannot predict from time to time if a penny spread on bananas will work for you. And nearer banana growers would put you right out of business.

That is exactly what happened to small caps. They’ve been ticked down to uneconomical. You can’t expect to succeed now as a new public company in US markets unless you land among the thousand largest. The cutoff? About $2.5 billion.

Could we fix this problem? Of course!  But the forces wanting a thousand liquid low-spread stocks to support everybody’s index, ETF, trading, and stock-picking portfolios are powerful.  Until we realize we’ve no longer got a capital formation battleship and it’s instead adrift on a raft, we best love low ticks and big stocks.

Streaming Market

Spotify ditched convention yesterday with its direct listing on the NYSE. It didn’t raise money or ring the opening bell.  It gave shareholders a way out.  It’s a touchstone for the state of the capital markets.

CrunchBase says Spotify has raised $2.6 billion in 22 funding rounds in private markets where you don’t have to file 10-Ks and 10-Qs and fight proxy battles, meet a rising sea of disclosures from the impact of your business on the environment to how much more the CEO makes than the janitor.

No high-frequency traders. No passive investors ignoring your fundamentals but browbeating you over governance. No worrying about meeting expectations that somebody will game by spread-trading you versus the VIX.  No analyst models to tussle over.  No scripts or contentious Q&A over quarterly results. No Activists.

Spotify cut out all the banks save two to help with pricing and a bit of secondary market-making and let holders sell shares through a broker via the NYSE node on the market’s network and now they can trade anywhere.  Welcome to the new age.

It’s more proof of the decline and fall of the sellside, source of brokerage research. In the past 20 years, it’s been buffeted by a series of body blows:

-The Order Handling Rules in the late 1990s commenced a shift from valuable information to speed in trading markets.

Decimalization in 2001 gutted the intermediary margin paying for sellside analysts.

-Elliott Spitzer’s 2003 Global Settlement forcibly separated research from trading and with it went the glory era of the all-star sellside analyst and in its place came the age of trading technology.

-In 2007, Regulation National Market System transformed the stock market into a frenetic, automated blitzkrieg where competing markets are forced to share customers and prices, and market structure overtook story as price-setter, dealing another dire setback to analyst research.

-Over the ensuing decade with now prices made to trade at averages (the mandatory best-bid-and-offer model from Reg NMS imposed midpoints, averages, on the stock market), trillions of dollars dropped the sellside, shifting from information as key to beating benchmarks, to technology for tracking benchmarks, and average became better than superior.

Today Exchange Traded Funds, derivatives of underlying stock assets, drive 50% of market volume and have no connection to differentiating research. Blackrock, Vanguard and State Street have slashed active investment (and brokerage research), and most of their $13 trillion in combined assets follow models tracking benchmarks.

What’s all this got to do with Spotify?  If form follows function, Spotify is the future.  The function of the stock market isn’t capital formation anymore. That happens in private equity. Public markets are an exit strategy, where stocks go to trade. It’s what you do at the end of the beginning, so to speak, to give the first money in a way out.

Private equity is still built on vital information and differentiation, not averages. There is a vibrant and thriving capital market out there, but it’s not the stock market.

The stock market is a place to trade things. It’s what ETFs facilitate – arbitraging everything toward a mean. You don’t need banks and bells and big road trips to make things tradable. You just need a node on the network.  We’ll see more of it, I’m sure.

I wonder why we’re consuming so much time and energy on corporate disclosure if so much of the money ignores it.  ETFs offer Summary Prospectuses because nobody reads the prospectuses.  What about a Summary 10-Q? What about a slimline 10-K?

Let me be blunt: Why are public companies spending billions on disclosure if half the market volume is machines trading things? Isn’t that a waste of money?

These are questions somebody should be answering.

It should affect how we think about the skill set for investor relations in the future. Everything is data today. If you ride a bike, you’ve got data analytics. Post a job via LinkedIn? Data analytics. The IR people of tomorrow should be data analysts, not just storytellers. Quantify, track and trend the money, whether it follows the story or not.

We can’t stay back in the 1990s talking to a failing sellside. Spotify didn’t. And it’s the future, a streaming market.

Core Reality

“Our stock dropped because Citi downgraded us today.”

So said the investor-relations chief for a technology firm last week during options-expirations.

For thirty years, this has been the intonation of IR. “We’re moving on the Goldman upgrade.”  “UBS lifted its target price, and shares are surging.” “We’re down on the sector cut at Credit Suisse.”

But analyst actions don’t buy or sell stocks.  People and machines do. Thirty years ago you could be sure it was people, not machines.  Now, machines read news and make directional bets. And why is a sellside firm changing its rating on your stock smack in the middle of expirations?

We’ll get to that. Think about this. Investors meet with you privately to learn something about your business or prospects somebody else might overlook.  Analyst actions are known to all. You see it on CNBC, in new strings, from any subscription feed.

How could it be uniquely valuable information proffering investment opportunity?

Let me phrase it this way. Why would a sellside firm advertise its views if those are meant to differentiate?  If you’re covered by 50 analysts with the same view, how is that valuable to anyone?

Indexes and exchange-traded funds track benchmarks. Call them averages.  Brokers must give customers prices that meet averages, what’s called “Best Execution.” If most prices are average, how are we supposed to stand out?

Now we get to why banks change ratings during expirations. Citi knows (Citi folks, I’m not picking on you. Bear with me because public companies need to learn stuff you already know.) when options expire. They’re huge counterparties for derivatives like options, swaps, forwards, reverse repurchases.

In fact, yesterday’s market surge came on what we call “Counterparty Tuesday,” the day each month following expirations when the parties on the other side of hedged or leveraged trades involving derivatives buy or sell to balance exposure. They were underweight versus bets (our Sentiment Index bottomed Monday, signaling upside).

Sellside research is a dying industry. Over 40% of assets now are in passive-investment instruments like index and exchange-traded funds that don’t buy research with trading commissions as in the old days.

How to generate business?  Well, all trades must pass through brokers.  What about, say, nudging some price-separation to help trading customers?

How?  One way is right before the options on stocks are set to lapse you change ratings and tell everyone.  No matter who responds, from retail trader, to high-speed firm, to machine-reading algorithm, to counterparty backing calls, it ripples through pricing in multiple classes (derivatives and stocks).  Cha-ching. Brokers profit (like exchanges) when traders chase spreads or bet on outcomes versus expectations.

We’re linear in the IR chair. We think investors buy shares because they might rise, and sell them when they think they’re fully valued. But a part of what drives price and volume is divergences from averages because that’s how money is made.

In this market of small divergences, your shares become less an investment and more an asset to leverage. Say I’m a big holder but your price won’t diverge from the sector. I get a securities-lending broker and make your shares available on the cheap.

I loan shares for trading daily and earn interest. I “write” puts or calls others will buy or trade or sell, and if I can keep the proceeds I boost yield.

I could swap my shares for a fee to the brokers for indexes and ETFs needing to true up assets for a short time.  I could sell the value of my portfolio position through a reverse repurchase agreement to someone needing them to match a model.

Here’s why traders rent. Say shares have intraday volatility – spread between daily highest and lowest prices – of 2%, the same as the broad market. A high-speed algorithm can buy when the price is 20 basis points below intraday average and sell when it’s 20 basis points over (rinse, repeat).

If the stock starts and finishes the month at $30, the buy-and-hold investor made zero but the trader capturing 20% of average intraday price volatility could generate $4.80 over the month, before rental fees of say half that (which the owner and broker share).  That’s an 8% return in a month from owning nothing and incurring no risk!

Let’s bring it back to the IR chair.  We’d like to think these things are on the fringe. Interesting but not vital. Across the market the past twenty days, Asset Allocation was 34% of daily volume. Fast Trading – what I just described – was 37%. Risk Management (driving big moves yesterday) was almost 14% of volume.

That’s 85%. The core reality. Make it part of your job to inform management (consistently) about core realities. They deserve to know! We have metrics to make it easy, but if nothing else, send them an article each week about market-function.

Tray Dat

We’ll be listening in the car to a song on satellite radio’s The Pulse, trying to keep current, and I’ll say to Karen, “Do you understand what he’s saying?”

You may feel the same way about equity-market rules. Take for instance the Trade-At Rule.  No it’s not Tray Dat, but I think I heard that in a song on The Pulse.  We didn’t hear something sounding like Tray Dat during the Little River Band concert Sunday at Denver’s Hudson Gardens, the band touring 39 years with a revolving cast still delivering goose-bump harmonies on Lady, Take It Easy on Me, Cool Change and Reminiscing.

Anyway, the Trade-At Rule matters to IR because it sharply impacts the buyside and sellide – your two core constituencies. And if the CFO stops you in the hallway and says, “What do you think of this Tray Dat thing the SEC is considering?” you don’t want to stammer.

So here’s what’s happening.  The SEC in June directed exchanges and Finra, the regulatory body for brokerages, to develop a plan for testing wider spreads in stocks. The SEC wants three test groups for a year-long pilot program.  All three will include stocks with market caps under $5 billion, volume below one million daily shares, and prices over $2.

One group, the control, will trade as it does now.  The second will have greater tick sizes, or spreads between prices for buying and selling shares, called the best Bid (to buy) and Offer (to sell). The plan is still conceptual – the SEC in June gave market participants 60 days to craft their proposal – but it’s probable we’d see five-cent spreads.

The third group will incorporate along with bigger ticks another idea: The Trade-At Rule. Best way to describe it? If you’ve read the book Flash Boys, there’s a story Brad Katsuyama tells about seeing 25,000 shares for sale on his screen, and readying his own order to buy those 25,000 shares. His finger is poised over the keyboard, counting down, 5-4-3-2-1…click. He presses the button to buy – and the orders disappear and he gets but a small portion of what he could clearly see was available.

The Trade-At Rule would ostensibly remedy this problem by prohibiting somebody from front-running the displayed price. It would seem to force trades out of dark pools where prices can’t be seen, onto exchanges, where they can. There are exemptions for big block dark pools like Liquidnet and Aqua, and for exchanges with the best price right before the new “marketable” order arrives. (more…)