Tagged: stock market

Fearless

How does the stock market work?

That’s what somebody was asking at the online forum for my professional association, NIRI.

By the way, the NIRI Annual Conference is underway.  I enjoyed yesterday’s sessions and seeing the faces of my colleagues in the virtual happy hour.  We’ve got two more days.  Come on! We’ll never have another 2020 Covid-19 Pandemic Annual Conference.

So, I’m not knocking the question. The discussion forum is a candid venue where we talk about everything but material nonpublic information.

Investors and traders, how do you think the stock market works?

My profession exists because there are companies with stock trading publicly. Otherwise, there’s no reason to have an investor-relations department, the liaison to Wall Street. IR people better know how the stock market works.

So it gets better. The question that followed was:  What is IR?

Is that infrared? No, “IR” is investor relations. Liaison to Wall Street. Chief intelligence officer. The department that understands the stock market.

So, why is my profession asking how the stock market works? And why, since we’ve been a profession for over a half-century, are we asking ourselves what our job is?

I think it’s because we’re uncertain. Fearful. Grasping for purpose.

We shouldn’t be. The IR job is knowing the story, governance, key drivers in the industry and sector, and how stock-market mechanics affect shareholder value. Internal politics. External rules. Communications best practices.  We are communicators, data analysts.

That’s it.

So how does the stock market work? Section 502 of the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018, which became law in May that year, required the SEC to give Congress an answer.

It did, in this 100-page report released in Aug 2020. The government always takes longer to describe things than the private sector.  No profit motive, you know. But still. Do we think the SEC is making stuff up?

They’re not. I’m a market-structure expert. The SEC presents an exceptionally accurate dissection of how the stock market works, the effects of algorithms, the inherent risks in automated markets.

Did you get that, IR people?  The SEC understands the market. Traders do. Investors do. Shouldn’t we?  It’s the whole reason for our jobs.

If you’re offended, apologies. It’s time for our profession to be a little more David, a little less Saul.  A little more huck the stone at Goliath, a little less cower in the tents.  I studied theology, so if my analogy baffles, see the book of I Samuel in the bible, roughly the 17th chapter.

It’s literature for atheists and believers alike. It’s about knowing what you’re doing, fearlessly.

Here’s the stock market in 120 words, boiled down from 100 SEC pages:

There is a bid to buy, an offer to sell. These are set in motion each trading day by computers. The computers reside in New Jersey. Half the daily volume comes from these computers, which want to own nothing and make every trade. The equations computers use are algorithms that buy or sell in response to the availability of shares, and almost half of all volume is short, or borrowed. Stock exchanges pay computerized traders to set prices. About 40% of volume is Passive or model-based investment, and trades tied to derivatives like options. About 10% is buy-and-hold money. The interplay of these behaviors around rules governing stock quotes, trades and data determines shareholder value. And it’s all measurable.  

If you want to see these ideas visually, here they are.  IR people, it’s a mantra.

What do you tell your executives?  They need to hear these 120 words twice per month. Once a week would be better.  Visually. What part of your board report reflects these facts?

“I don’t describe the stock market.”

Oh? Stop fearing. We’ll help. What do those 120 words above look like through the lens of your stock? Ask. We’ll show you.

Let’s stop wondering how the stock market works and what IR is. IR is the gatekeeper between shareholder value and business execution.  Math. Physics. A slung stone. A board slide.

Let’s be IR. Fearless.

Mean Plus

The stock market is high on tryptophan, hitting records.

Right ahead of Thanksgiving, 2020 looks to deliver the best November in 30 years.  We’re grateful!  You don’t expect it in a pandemic

Courtesy shutterstock

.  You’d think amid a plague we’d find bitcoin trading near $20,000.  Oh, sure enough.  Check.

Where is all the money coming from that’s pounding things to heights right along with real estate, speculative Electric Vehicle stocks from China with no revenue (NYSE:LI), and Elon Musk’s net worth (he is, however, putting people on the space station and recovering first-stage rockets for repeated use by landing them on a barge called “Of Course I Still Love You”)?

Here’s where it gets interesting.

Data from Morningstar, which reports monthly on fund flows, show US equity outflows in October near a monthly record of $46 billion, and over the trailing twelve months (TTM) topping $265 billion.

Active stock-pickers in US stocks have seen outflows of about $270 billion the past twelve months, including $35 billion in October.  The spread in Active versus totals reflects a small net TTM gain for Passive equity funds.

Bonds crushed it, adding over $500 billion TTM taxable and municipal assets.  But the biggie is the swing from Active to Passive across stocks and bonds, in total a $600 billion delta, with about $300 billion into Passive funds and out of Active ones.

Morningstar, always most conservative in gauging Active versus Passive assets, showed the latter overtaking the former in 2019.

Stripping data down, we’ve added a couple billion dollars, net, to US stock funds and hundreds of billions to bond funds, and the stock market is setting records.

You can’t say stocks are soaring on a flood of money. The data don’t support it.  Nor can one say it’s “stock-picking.” Those assets are down another $300 billion the past year, a 12-year-long trend.

So what’s doing it?  Clearly, something else.

To mark Thanksgiving last year, we presented Sentiment data in a piece called Blurry.  As we observed then, stocks have spent the majority of the past half-decade above 5.0 on our 10-point Market Structure Sentiment scale, averaging about 5.4.  That’s a GARP – growth at a reasonable price – market.

And son of a gun, Growth has outperformed Value.

In 2020, stocks have spent 62% of the time over 5.1/10.0 (GARP), and about a third of the time above 6.0/10.0, “Overbought” from a market-structure view.

Demand has exceeded supply. Yet we’ve just seen from Morningstar that money is flat in US equities. The inflows near $300 billion rushed not to stocks but bonds.

One thing so far is sure. Passive money will pay more for stocks than Active money. There are more Passive assets than Active ones now. Any net inflows go to Passive funds.  The average price for all stocks in the S&P 500 was about $127 a year ago. Today it’s about $146, up 15%.

Well, it can’t be stock-picking, can it.  And it’s thus circumstantially evident that Passive Investment is the reason why Growth has beaten Value.

It also explains the market’s relentless propensity to remain over 5.0.  That’s the mean.  Passive money tracks the mean. And, Passive assets are growing – so the outcome is Mean Plus, let’s call it.  A little better than the mean.

ModernIR data show two more factors contributing to these outcomes.  Fast Trading, machines pulverizing trade-size as intermediaries, are 54% of volume the past 200 days.

If your aim running algorithms is changing prices all day and finishing flat, and the market is 5.4/10.0, and Passive money is trying to peg the benchmark, what do you get?

A market that relentlessly rises.

It’s Mean Plus till the next time something like a Pandemic or a currency crisis, or something we haven’t thought of yet, rattles that cage.

Look, all of us want rising markets. It’s great for net worth.  But as we’ve been saying to public companies, you can’t continue to make My Story the principal explanation.  Somewhere in your quarterly board deck there’s got to be more than that.  I’ve just given you some good data.

Energy companies, this is what’s happened to you.  Back up 20 years and you were 15% of the market, even as we imported fuel.  Today amid US energy independence you’re 2.5% of the market.  AAPL is worth more than the whole sector. And AAPL is the most loved of all ETF stocks.

Investors, it’s why market structure matters.  It’s a Mean Plus market for now. We’re grateful this Thanksgiving for it.  But we might say a prayer for protection from its consequences too.

Volatile Liquid

There’s a beer in this for you.  A glass of rosé from Provence if you prefer.

What’s the most liquid stock in the US market?

I’m writing this after the virtual happy hour for the NIRI Big I Conference (it’s a strong event, and you can catch Day Two and our wrap-up today that I’ll take part in), which of course makes one think of beverages. Liquid. Virtual drinks are no match for the real thing, nor is false liquidity in stocks.

Let’s lay the groundwork.  Stock exchanges describe market quality as low spreads.  Spreads have never been tighter, they say, and costs for trading were never lower.

Heck, you can trade for free. That’s about as inexpensive as it gets. So, is a low-cost, low-spread stock market a quality and liquid place?

Depends what you mean.  The market doesn’t fail often. Yes, we’ve recorded nearly 13,000 volatility halts since Mar 9.  Remember all the marketwide pauses that month? Still, it didn’t quit operating.

The Nasdaq just corrected – dropped 10% – in three days. And rebounded as fast. It highlights the importance of the definition of “quality.”

Which leads back to liquidity, and by extension, volatility. All three words ending in “y” are related.

Let’s begin with what liquidity is not.  Volume. Liquidity, bluntly, is the amount of a thing that will trade before the price changes. Put an offer on a house.  What’s the spread between the price you’d pay, and the last that somebody else paid?

I’ve just debunked the idea that low spreads reflect quality.  For the seller, a high spread is a reflection of quality.

Low spreads help parties with short horizons.  If my investment horizon is 250 milliseconds, a spread of a penny is wildly attractive. How many pennies can I make, in how many different issues, every quarter-second?

But if my horizon is more than a day, a wider spread reflects higher quality.  How come stock exchanges don’t mention that?

Let’s go one step further. To me, the measures we traditionally look to for guidance about market quality need revamping. For instance, beta, a measure of volatility, has the same flaws as our current economic measures of inflation.  Beta measures how a stock moves from close to close in relation to the market.

Terrible measure of market quality.  WMT, for instance has a beta score of 0.19, 20% of the volatility of the market. Yet its intraday volatility the past 20 days is 2.9%. The S&P 500 is 2.7% volatile over the same time (intraday high and low).

WHEN an investor buys during the day could in theory be nearly 3% different from somebody else’s price.  And WMT, contradicting beta, is not a fifth as volatile as the market but 7% more volatile.

The truth is low spreads PROMOTE frequent price-changes, which is the definition of volatility. The parties driving low trading spreads are ensuring volatility. Creating it.  And telling us it signals market quality.

They mean well. But good intentions pave roads to oblivion.

(Editorial note: Inflation isn’t the rate at which prices increase. It’s whether you can buy things.  All over the economy, people now buy on credit. Debt has exploded. That’s the evidence of inflation. Not the Fed’s equivalent of beta.)

And liquidity isn’t volume. That’s confusing busy with productive. Volume is stuff changing hands. Liquidity is how MUCH of it changes hands.  The most liquid stock in the market is AMZN (not counting BRK.A, a unique equity), at $70,000 per trade.

The mean component of the S&P 500 trades about $17,000 at a time.  But here’s the kicker. Just 50 companies, 10% of the index, trade MORE than $17,000 per trade. That’s the list from AMZN to DPZ. Everybody else trades less.

Including now, AAPL. It used to be in the top ten. Now it’s 146th post-split, trading about $12,000 per transaction on average.  TSLA was top five but post-split is now 49th at $17,600, well behind 32nd-ranked MSFT at $20,100.

Splits don’t foster liquidity. They breed volume. And price-changes. Volatility. We’re not anti-split. We’re anti-volatility, which increases risk for investors and the cost of capital for companies.

Why does the market promote one at the expense of the other? It’s a question owed an answer. All investors, every public company, should know liquidity. We have the data.

Moon Rules

We spent last week in Summit County, famous for Breckenridge and Keystone. With windows open and the sun set, the temperature at 9,000 feet drops fast, great for sleeping.

It’s not great for staying awake reading a Kindle but I worked through some exciting pages of Artemis, the new novel by Andy Weir, who wrote The Martian, made into a Ridley Scott movie starring Matt Damon.

And yes, Artemis got me thinking about market structure. Not because of the profanity, the ripping pace, the clever characters, the exotic settings.  It’s a book set on the moon, where scientific rules matter.

Weir’s genius is the application of science to clever storylines. On the moon, if you want to commit a crime to save the community, you better understand how to blend acetylene and oxygen in zero atmosphere. Fail to follow or understand the rules, you die.

It’s not life and death in the stock market but rules play the same supreme role in dictating outcomes. If as public companies you think your story will determine the outcome for your stock, the rules will humble you.  How much of your trading volume comes from Active Investment? You can and should know – and it’s not what you’d think. But that’s not the point of being public, is it.  So don’t be afraid.

If you’re an investor and you think fundamentals will pace you to superior results, think again. The amount of money choosing company financials has plunged, while funds indexing to markets has mushroomed. Rules helping models will eat your lunch.

What rules? Start with Regulation National Market System. It creates a marketplace that forces revenue-sharing among intermediaries. Professional sports like basketball in the USA also operate with rules that shift focus from playing the sport to managing salary cap (Denver just traded three Nuggets for that reason).

If you don’t know this, you’ll have a false understanding of what drives the sport. The “haves” must distribute funds to the “have nots.” Some owners in money-losing markets might choose to skimp on salary to scrape mandated distributions from teams making bank (I wonder what the NBA Cavaliers will do now?).

Right now, stock market sentiment reflecting not the opinions of humans but the ebb and flow of money and the way machines price stocks (the rules, in other words) is topping again as it did about June 12. Options expire today through Friday.  So, no matter what you expect as earnings commence, the market will have a propensity to decline ahead.

It’s like the rules on the moon.  In one-sixth of earth’s gravity, harsh sun, no atmosphere, success depends on knowing how stuff works. Investors and public companies, welcome to the moon. You can’t treat it like earth. Rules determine outcomes. If your actions don’t account for the rules that govern how markets function, outcomes will reflect it.

But it’s fun on the moon once you know what you’re doing. It’s fun knowing when the market is topped, and bottomed, on rules. It’s fun doing investor-relations when you know what all the money is doing.  So, come on up to zero atmosphere! It’s not scary.

Impassively Up

A picture is worth a thousand words.

See the picture here, sparing you a thousand words (for a larger view click here). It explains our rising stock market.  Look at the line graphs.  Three move up and down, reflecting normal uncertainty and change. Just one is up like the market.  Passive Investment.

Stock market behaviors

At ModernIR, we see the market behaviorally. There are four big reasons investors and traders buy and sell, not one, so we quantify market volume daily using proprietary trade-execution metrics to see the percentages coming from each and trend them.

Were the market only matching risk-taking firms with risk-seeking capital, valuing the market would be simpler. But 39% of volume trades ticks, gambling on fleeting price-moves. About 12% pairs stocks with derivatives, down from over 13% longer term.

Less than 14% of trading volume ties directly to corporate fundamentals. So rational thought isn’t pushing stocks to records. In a sense that’s good news because most stocks don’t have financial performance justifying the 20% rise for the S&P 500 the past year.

Alert reader Alan Weissberger sent data from the St Louis Federal Reserve (click the “1Y” button at top right) showing falling corporate profits the past year. To be sure, profits don’t always connect to markets or the economy. There were rising corporate profits during the 1970, 1991 and 2001 recessions.

And corporate profits were plunging in 2007 when the Dow posted its second-fastest 1,000-point rise in history (the one from 22,000-23,000 just now is the third fastest, and both trail the quickest, in 1999 when profits were likewise falling).

Now, I’ll qualify: This picture reflects a model. Eugene Fama, the father of the Efficient Market Hypothesis, said models aren’t reality.  If they explained everything then you would need to call them reality.

But the market as we’ve modeled it with machines that bring a taciturn objectivity to the process has been driven by the sort of money that views fundamentals impassively.

You might think it surreal that 36% of volume derives from index and exchange-traded funds and other quantitative investment. Yet it makes logical sense. Blackrock and Vanguard have taken in a combined $600 billion this year says the Wall Street Journal and the two now manage nearly $12 trillion that’s largely inured to sellside analysts and your earnings calls, public companies.

And the number of public companies keeps falling, down a third the past decade. I suspect though no one has offered the math – I will buy a case of our best Colorado beer for the person with the data – that total shares of public companies (all the shares of all the companies minus ETFs and closed-end funds) has also fallen on net, 2007-present.

There you have it.  Money that simply buys equities as an asset class sliced in various ways is doing its job.  But it becomes inflation – more money chasing fewer goods. Wall Street calls it “multiple expansion,” paying more for the same thing (current Shiller PE is the highest in modern history save the dot-com bubble).

And because passive money like Gene Fama’s models doesn’t ask whether prices are correct and merely accepts market prices as they are, there’s no governor, no reasoning, that prompts it to assess its collective behavior. So as other behaviors drop off, passive money becomes the dominant force.

In that vein, look at Risk Mgmt. It reflects counterparties to investors and traders using options, futures, forwards, swaps and other derivatives to protect, substitute for or leverage stock positions. The falling percentage suggests the cost of leverage is rising.

It fits. A handful of banks like Goldman Sachs dominate the business. Goldman’s David Kostin publicly expressed concern about market values. Kostin says the stock market is in the 88th percentile of historical valuations. If banks think downside risk is higher, the cost of insuring against it or profiting on rising markets increases.

Where in the past we worried about exuberance, we should be equally wary of the impassive face of passive investment that doesn’t know it’s approaching a precipice.

I don’t think a bear market is near yet but volatility could be imminent. By our measures the market has not mean-reverted since Sept 1. It suggests target-date and other balanced funds are likely overweight in equities. When it tries to rebalance, we could have severe volatility – precisely because this money behaves passively. Or impassively.

The Math

“Making investment decisions by looking solely at the fundamentals of individual companies is no longer a viable investment philosophy.”

So said Steve Eisman, made famous in Michael Lewis’s book The Big Short, upon shutting down his new investment fund in 2014.  Actor Steve Carrell portrayed Eisman as Mark Baum in last year’s hit movie from the book.

Michael Burry, the quirky medical doctor running Scion Capital in the book and the movie (played by Christian Bale), first earned street credibility via posts about stocks on Silicon Investor, the online discussion forum huge before the dot-com bubble burst.

But in the ten years after Regulation National Market System transformed the stock market in 2005 from a vibrant human enterprise into a wide-area data network, 98% of all active stock-pickers failed to beat the S&P 500, proving Mr. Eisman correct.  You can’t pick stocks on merits alone now.

That’s contrary to the legacy objective of the investor-relations profession, which is to stand the company’s story apart from the rest.

As with finding the root of the mortgage-industry rot, today the market is all about data.  Everything is.  Google Analytics examines internet traffic patterns.  ZipRecruiter is analytics for hiring. Betterment is analytics for personal investing.  HomeAdvisor and Angie’s List are analytics for home-repair. Pandora is analytics for music you like.

Pick your poison. Everything is data. So why, ten years after Reg NMS, is the IR profession calling someone to ask, “How come my stock is down today?” All trades pricing the market under Reg NMS must by law be automated.

If you’re calling somebody to ask about your stock, I’m sorry but you’re doing IR like a caveman. And, paraphrasing Steve Eisman, running the IR department solely by telling the story to investors is no longer a viable industry philosophy.

Why? Because it begins with the flawed premise that the money buying and selling your shares is motivated by fundamentals alone.  For the past decade – the span of Reg NMS – trillions have departed active stock-picking portfolios and shifted to indexes and Exchange-Traded Funds, because tracking a benchmark is a better path to returns.

Take yesterday.  All you had to do was buy technology and materials stocks.  Today it might be something else. The most widely traded stock on the planet is SPY, the S&P 500 ETF.  It traded $7 billion of volume yesterday, ten times BAC, the most active stock.

Here’s another. XLU, the Utilities ETF, was among the 25 most actively traded issues yet the sector barely budged, up 0.04%. Why active then? ETFs fuel arbitrage.  Profiting on price-differences. It’s not where prices close but how they change intraday.

Best trade yesterday?  NUGT, the leveraged gold ETF, was up 7.5% even though gold has been a bust the past month.  The S&P 500 took the whole year to gain 10% and then only on the Trump Bump. Between Dec 30 and Oct 31, the S&P 500 eked out 2% appreciation. You could triple that in a day with NUGT so why invest long-term?

“Boy, Quast,” you say. “It’s the holiday season! What are you, The Grinch?”

Not at all! The opposite in fact. I’m on a quest to make IR central to public companies again. We invented Market Structure Analytics, data for the IR profession to address the demise of IR as Storyteller.  The future for our profession isn’t a command of fundamentals but knowledge of market form and function.

Let me be blunt. Anybody can tell the story. Only IR professionals dedicate themselves to knowing how the market works – and that’s job security, a transferrable skill set.

The way IR shifts back from a rotational role to vital standalone profession is through knowledge of the stock market. If you want to be a biologist, study and understand biology. If you want to be a biology reporter, you just need to know some biologists (no offense to biology reporters).

Which will the IR profession be in 2017?

Having threshed trading data for 15 years now through the regulatory and behavioral transformation of the equity market, I feel a tad like those guys in The Big Short who studied mortgage numbers and concluded it was irrefutable: It was going to blow up.

These data are irrefutable: Over 80% of your volume most days is driven by something much shorter-term than your business strategy.  Ergo, if all you tell your Board and management is how your strategy influences the stock, you’ll at some point be in trouble.

This is the lesson of 2016.  Make 2017 the year IR transforms how the people in the boardrooms of America understand the stock market. That is an invigorating challenge that will breathe value into our profession. The math doesn’t lie.

The GRAR

Power changed hands in the USA today.

I don’t know in what way yet because I’m writing before election outcomes are known, and about something for the market that will be bigger than which person sits in the oval office or what party holds congressional sway.

The GRAR is a lousy acronym, I admit. If somebody has got a better name, holler.  We started talking about it in latter 2014.  It’s the Great Risk Asset Revaluation. We had the Great Recession. Then followed the Great Intervention. What awaits the new Congress and President is the GRAR.

I’ll give you three signs of the GRAR’s presence.  Number one, the current quarter is the first since March 2015 for a rise in earnings among the S&P 500, and the first for higher revenues since October 2014. Until now, companies have been generating lower revenues and earning less money as stocks treaded water, and the uptick still leaves us well short of previous levels.

Since 1948, these recessions in corporate financials of two or more quarters have always accompanied actual recessions and stock-retreats. The GRAR has delayed both.

Second, gains off lows this year for the Dow Jones Industrial Average have come on five stocks primarily. One could use various similar examples to make this point, but it’s advances dependent on a concentrated set of stocks.  This five – which isn’t important but you can find them – include four with falling revenues and earnings. Counterintuitive.

Finally, the market is not statistically higher (adding or subtracting marketwide intraday volatility for all prices of nearly 2% daily) than it was in December 2014.

That’s remarkable data.  It says prices are not set by fundamentals but intervention.

We might think that if earnings growth resumes, markets will likewise step off this 2014 treadmill and march upward. And that’s independent of whatever may be occurring today – soaring stocks or falling ones, reflecting electoral expectations versus outcomes.

In that regard, our data showed money before the election positioned much as it was ahead of the Brexit vote:  Active buying, market sentiment bottomed, short volume down – bullish signals.

You’ve heard the term “delayed gratification?” It means exercising self-discipline until you’re able to afford desired indulgences.  Its doppelganger is delayed consequences, which is the mistaken idea that because nothing bad arises from bad decisions that one has escaped them.

The bad decision is the middle one – The Great Intervention.  The Great Recession was a consequence arising from a failure to live within our means. When we all – governments, companies, individuals – spend less than we make, nobody ever needs a bailout.

But you don’t solve a profligacy problem by providing more access to credit.  The breathtaking expansion of global central-bank balance sheets coupled with interest rates near zero is credit-expansion. To save us from our overspending, let’s spend more.

If I held in my palms a gold coin and a paper dollar and I said to you, “Pick one,” which would you take?

If you said “the dollar bill,” I can’t help you and neither can Copernicus, who first described this phenomenon that explains the GRAR 500 years ago. Nearly everybody takes the gold, right? We inherently know it’s more valuable than the paper, even if I tell you they have the exact same value.  This principle is called Gresham’s Law today.

Credit does not have the same value as cash.  But assets in the world today have been driven to heights by credit, the expansion of which diminishes the value of cash.

What happens when the people owning high-priced assets such as stocks, bonds, apartments in New York, farmland in Nebraska and so on want to sell them?  All the cash and credit has already been consumed driving prices up in the first place.

What will follow without fail is the GRAR. Depending on who got elected, it might come sooner or later.  But without respect to the winner, it’s coming.  The correct solution for those now in power is to avoid the temptation to meet it with credit again, and to let prices become valuable and attractive. Painful yes, but healthy long-term.

That’s the path out of the GRAR. I hope our winner has the discipline to delay gratification.