Tagged: Stocks

Growth vs Value

Are you Value or Growth?  

Depends what we mean, I know. S&P Dow Jones says it distinguishes Value with “ratios of book value, earnings and sales to price.”

It matters because Growth is terrorizing Value.  According to data from the investment arm of AllianceBernstein, Growth stocks outperformed Value stocks by 92% between 2015-2020.  Morningstar says it’s the biggest maw on record, topping the 1999 chasm.

If you’re in the Growth group, you’re loving it.  But realize.  By S&P Dow Jones’s measures, anybody could be a Value or Growth stock at any time.  It’s all in the metrics.

The larger question is why the difference?  AllianceBernstein notes that the traditional explanation is earnings growth plus dividends paid.  That is, if your stock is up 50% more than a peer’s, it should be because your earnings and dividends are 50% better.

If that were the case, everybody would be a great stock-picker. All you’d need do is buy stocks with the best earnings growth. 

Well, turns out fundamentals accounted for just ten percentage points of the difference.  The remaining 82% of the spread, as the image here from AllianceBernstein shows, was multiple-expansion.  Paying more for the same thing.

Courtesy AllianceBernstein LP. https://www.alliancebernstein.com/corporate/en/insights/investment-insights/whats-behind-the-value-growth-performance-gap.html

Put differently, 90% of the time Growth stocks outperform Value stocks for no known reason. No wonder stock-picking is hard.

Take Vertex (VRTX) and Fortinet (FTNT), among the two very best and worst stocks of the past year.  I don’t know fundamentally what separates them. One is Tech, the other Healthcare.

I do know that running supply/demand math on the two, there’s a staggering behavioral difference.  FTNT spent 61 days the past year at 10.0 on our ten-point scale measuring demand called Market Structure Sentiment.  It pegged the speedometer 24% of the time.

VRTX spent five days at 10.0.  Two percent of the time.  You need momentum in today’s stock market or you become a Value stock.

We recently shared data with a client who wondered why there was a 20-point spread to the price of a top peer.  We ran the data.  Engagement scores were about the same – 85% to 83%, advantage to our client. Can’t say it’s story then.

But the peer had a 20% advantage in time spent at 10.0.  The behavioral patterns were momentum-style. Our client’s, GARP/Value style.

Okay, Quast.  Suppose I stipulate to the validity of your measure of supply and demand, whatever it is.  Doesn’t answer the question. Why do some stocks become momentum, propelling Growth to a giant advantage over Value?

I think it’s three things. I can offer at least some data, empirical or circumstantial, to support each.

Let’s call the first Herd Behavior.  The explosion of Exchange Traded Funds concentrates herd behavior by using stocks as continuously stepped-up collateral for ETF shares.  I’ll translate.  ETFs don’t invest in stocks, per se.  ETFs trade baskets of ETF shares for baskets of stocks (cash too but let’s keep it simple here). As the stocks go up in value, ETF sponsors can trade them out for ETF shares. Say those ETF shares are value funds.

The supply of Value ETF shares shrinks because there’s less interest in Value.  Then the ETF sponsor asks for the same stocks back to create more Growth ETF shares.

But the taxes are washed out via this process. And more ETF shares are created.  And ETFs pay no commissions on these transactions. They sidestep taxes and commissions and keep gains.  It’s wholly up to traders and market-makers to see that ETF shares track the benchmark or basket.

The point? It leads to herd behavior. The process repeats. Demand for the same stuff is unremitting.  We see it in creation/redemption data for ETFs from the Investment Company Institute. ETF creations and redemptions average over $500 billion monthly. Same stuff, over and over. Herd behavior.

Second, there’s Amplification.  Fast Traders, firms like Infinium, GTS, Tower Research, Hudson River Trading, Quantlab, Jane Street, Two Sigma, Citadel Securities and others amplify price-moves.  Momentum derives from faster price-changes, and Fast Traders feed it.

Third is Leverage with derivatives or borrowing.  Almost 19% of trading volume in the S&P 500 ties to puts, calls and other forms of taking or managing risk with derivatives. Or it can be borrowed money. Or 2-3x levered ETFs. The greater the pool of money using leverage, the larger the probability of outsized moves.

Summarizing, Growth beats Value because of herd behavior, amplification of price-changes, and leverage.

By the way, we can measure these factors behind your price and volume – anybody in the US national market system.

Does that mean the Growth advantage is permanent?  Well, until it isn’t. Economist Herb Stein (Ben’s dad) famously said, “If something cannot last forever, it will stop.”

And it will. I don’t know when. I do know that the turn will prompt the collapse of leverage and the vanishing of amplification. Then Growth stocks will become Value stocks.

And we’ll start again.

Where’s It Going?

Where’s what going?

Time? Hm.

Money?  Well. Yes.

It abounds and yet it doesn’t go far.  Why that’s the case is another story (I can explain if you like but it usually clears a room at a cocktail party).

First, if you were spammed last week with the MSM, apologies! It was inadvertently set on full-auto.  And one other note, our sister company Market Structure EDGE  is up for several Benzinga Fintech Awards.  As in American politics, you may vote early and often (just kidding!). No, you can vote daily though till about Oct 22, 2021.  We hope you’ll help! Click here, and turn it into a daily calendar reminder.

Today we’re asking where the money gushing at US stocks and bonds like a ruptured fire hydrant is going. Morningstar says it’s $800 billion into US securities the last twelve months through July.

That’s minus a $300 billion drop in actively managed equity assets. Stock-pickers are getting pounded like a beach in a hurricane. Public companies, you realize it?

That’s not the point of this piece. But investor-relations professionals, realize the money you talk to isn’t buying. It’s selling.  There are exceptions and you should know them.  But don’t build your IR program around “targeting more investors.” Build it on the inflows (your characteristics), not the outflows.  If you want to know more, ask us.

So where did the $800 billion go? 

About $300 billion went to taxable bond funds.  Not for income. Appreciation. Bonds keep going up (yields down, prices up). They’re behaving like equities – buy appreciation, not income.

The rest, about $500 billion, went to US equities.  We’re going to look at that. 

$500 billion seems like a lot.  Ross Perot thought a billion here, billion there, pretty soon you’re talking real money. For you who are too young to know it, Google that.

But today $500 billion ain’t what it was. And frankly, five hundred billion deutschemarks wasn’t much in the Weimar Republic either.  The problem wasn’t inflation. The problem was what causes inflation: too much money.

Ah, but Weimar didn’t have derivatives. Silly fools.

For perspective, more than $500 billion of Exchange Traded Funds (ETF) are created and redeemed in US equities every month.  Stocks trade more than $500 billion daily in the US stock market.

And the money supply as measured by the Federal Reserve’s “M2” metric reflecting the total volume of money held by the public, increased by $5 trillion from Feb 2020 to July 2021.  That’s a 32% increase. About like stocks (SPY up 33% TTM).

Wait. The stock market is up the same as the money supply? 

Yup.

Did everybody sell stocks at higher prices?

No. Everybody bought stocks at higher prices.

Okay, so where did the stock come from to buy, if nobody sold?

Maybe enough holders sold stocks to people paying 33% more to account for the difference. Good luck with that math. You can root it out if you want.

But it’s not necessary.  We already know the answer. The money went into derivatives. 

The word “derivative” sounds fancy and opaque and mysterious. It’s not.  It’s a substitute for an asset.  You can buy a Renoir painting. You can buy a Renoir print for a lot less. You can buy a stock. You can buy an option on that stock for a lot less.

Suppose you want to buy the stocks in the S&P 500 but you don’t want the trouble and expense of buying 500 of them (a Renoir). You can buy a swap (a print, No. 347 of 3,900), pay a bank to give you the returns on the index (minus the fee).

Or you can buy SPY, the S&P 500 ETF.  You think you’re getting a Renoir.  All those stocks. No, you’re getting a print somebody ran on an inkjet printer.  It looks the same but it’s not, and it’s not worth the stocks beneath it.

Image courtesy ModernIR, Aug 25, 2021.

See this image?  There is demand.  There is supply. The former greatly exceeds the latter like we’ve seen the last year during a Covid Pandemic (chew on that one for a bit), so excess demand shunts off to a SUBSTITUTE. Derivatives. ETFs, options, futures.

That’s what’s going on. That’s where the money went. Look at GME and AMC yesterday. Explosive gains on no news. Why? Banks squared derivatives books yesterday after the August expirations period. Demand for prints (options), not paintings (stock), vastly exceeded supply.

So banks bought the underlying paintings called GME and AMC – and sold traders ten times as many prints. Options. Derivatives. It’s implied demand. The stocks shot up.

Bad? Well, not good. The point isn’t doom. The point is understanding where the money is going. Every trader, investor, public company, should understand it. 

It’s all measurable if you stop thinking about the market like it’s 1995. It’s just math. About 18% of the market is in derivatives.  But about 75% of prices are transient things with no substance.  Prints, not paintings.

Public companies, know what part of your market is Renoir, what part is just a print.  Traders, do the same.

We have that data.  Everybody should always know where the money is going.

Suddenly

Things are getting worrisome. 

It’s not just our spectacular collapse in Afghanistan less than a month before the 20-year anniversary of Nine Eleven.  That’s bad, yes.  Inexcusable.

Illustration 179312099 / Ernest Hemingway © Lukaves | Dreamstime.com

It’s not the spasmodic gaps in supply chains everywhere – including in the stock market. 

It’s not bond yields diving as inflation spikes, which makes sense like accelerating toward a stop sign.

It’s not the cavalier treatment of the people’s money (do you know we spent $750 million of US taxpayer dollars on the Kabul embassy, the world’s largest, then left the keys on the desk?).

It’s all of it.  Stuff’s jacked up, and it should bother us.

Karen and I went to a concert at Strings, the performing arts venue in Steamboat Springs.  If you want to feel better about yourself, go to the state fair.  Or an Asleep at the Wheel concert in Steamboat.

People are showing up with walkers, oxygen tanks, doddering uncertainly up the walkway.  I’m joking!  Mostly.  You get the point. (Lord, I apologize for my poor taste.)

And Asleep at the Wheel is awesome. I grew up on Hotrod Lincoln and The House of Blue Lights.

Anyway, covid mania continues so the hall serves no food or drink inside.  We’re dependent on food trucks outside for snacks.

None showed up.

There was a big bike ride this past weekend, three thousand gravel riders.  The food trucks were there. But there’s not enough staff working to cover more than one base. We and the oldsters were out of luck for tacos and cheesesteak.

But we were told they’d be there, and they weren’t. That kind of thing happened in Sri Lanka when I lived there for a year in college. But not in the World’s Superpower.

It gets worse.

The bartenders were shaking their heads. They couldn’t restock beforehand because the supplier was closed.  No staff.  A major liquor store – the biggest in the region with normally 3-4 registers running simultaneously – had to close because they had no staff to run the shop.

If you can’t stock your bar, you’re in trouble of collapsing as an empire. I say that in the barest jest only.

Back to the stock market.  The supply chain for stocks is borrowed shares. I’ve explained it before.  Dodd Frank basically booted big brokers from the warehouse business for equities.

Used to be, if you were Fidelity you called Credit Suisse and said, “I need a million shares of PFE.”

Credit Suisse would say, “We’ve got 500,000. We’ll call Merrill.”

And the wholesale desk there, the erstwhile Herzog Heine Geduld, would round the other half up.

Not so in 2021.  The banks now are laden to creaking with “Tier One Capital” comprised mostly of US Treasuries.  You’re the government and you need a market for debt, you just change the rules and require banks to own them, and slash interest rates so fixed income funds need ten times more than before.

Elementary, Watson.

What’s more, the stock market is a continuous auction. Everything is constantly for sale in 100-share increments. 

Except there aren’t 100 shares of everything always available. Certainly not 100,000 shares. So the SEC requires – they mandate it – brokers to short stock, create it in effect, to keep the whole continuous auction working.

Well, it’s getting wobbly.  There are sudden surges and swales in short volume now.  And the average trade size in the S&P 500 is 104 shares. Lowest on record.  Almost half that – 44% currently – is borrowed. In effect, the supply chain in the stock market is about 60 shares.

Depending on that tenuous thread is about 75% of three MILLION global index products.  Thousands of ETFs.  And $50 TRILLION of market cap.

The 1926 Ernest Hemingway book The Sun Also Rises has an exchange between two characters.  One asks the other how he went broke.

“Gradually,” he said. “Then suddenly.”

Afghanistan’s sudden collapse was 20 years in the making.  The same thing is happening around us in a variety of ways, products of crises fomenting in our midst that we ignore or excuse.

So what do we do about it?

The societal question is tough.  The market question is simple: Understand the problem, engage on a solution.

Public companies, it’s you and your shareholders sitting at the head of this welling risk.  We owe it to them to understand what’s going on. Know the risk of fragility in your shares’ supply chain. That’s a start. We have that data.

Solving the whole problem will require a well-informed, prepared constituency that cares.  Or all at once it’s going to implode. Not hyperbole. A basic observation.

Optional Chaos

So which is it?  

Monday, doom loomed over stocks. In Punditry were wringing hands, hushed tones. The virus was back. Growth was slowing. Inflation. The sky was falling!

Then came Tuesday. 

Jekyll and Hyde? Options expirations.  Only CNBC’s Brian Sullivan mentioned it. As ModernIR head of client services Brian Leite said, there wasn’t otherwise much effort to explain where the doom went. One headline said, “Stocks reverse Monday’s losses.”

WC Fields said horse sense is the thing a horse has which keeps it from betting on people. We could have used some horse sense.  I Tweeted this video.

Anyway. What must you know, investors and public companies, about why options cause chaos in stocks? (I’m explaining it to the Benzinga Boot Camp Sat July 24, 30 minutes at 1220p ET.  Come join.)

It’s not just that options-expirations may unsettle equity markets. The question is WHY?

Let me lay a foundation for you. Global Gross Domestic Product (GDP) is about $85 trillion. The notional value – exposure to underlying assets – of exchange-traded options and futures is about the same, $85 trillion give or take, says the Bank for International Settlements. The BIS pegs over-the-counter derivatives notional value at $582 trillion.

So call it $670 trillion. All output is leverage 8-9 times, in effect.

Now, only a fraction of these derivatives tie to US equities. But stocks are priced in dollars. Currency and interest-rate instruments make up 90% of derivatives.

All that stuff lies beneath stocks. Here, let’s use an analogy. Think about the stock market as a town built on a fault line.  The town would seem the stolid thing, planted on the ground. Then a tectonic plate shifts.

Suddenly what you thought was immovable is at risk.

Remember mortgage-backed securities?  These derivatives expanded access to US residential real estate, causing demand to exceed supply and driving up real estate prices.  When supply and demand reached nexus, the value of derivatives vanished.

Suddenly the market had far more supply than demand.  Down went prices, catastrophically. Financial crisis.

Every month, what happened to mortgage-backed securities occurs in stocks. It’s not seismic most times. Stocks are assets in tight supply.  Most stocks are owned fully by investors.  Just three – Blackrock, Vanguard, State Street – own a quarter of all stocks.

So just as real estate was securitized, so are stocks, into options, futures, swaps.  While these instruments have a continuous stream of expiration and renewal dates, the large portion ties to a monthly calendar from the Options Clearing Corp (our version is here).

Every month there’s a reset to notional value. Suppose just 1% of the $50 trillion options market doesn’t renew contracts and instead shorts stocks, lifting short volume 1%.

Well, that’s a potential 2% swing in the supply/demand balance (by the way, that is precisely last week’s math).  It can send the Dow Jones Industrials down a thousand points.  Hands wring.  People cry Covid.

And because the dollar and interest rates are far and away the largest categories, money could leave derivatives and shift to the assets underpinning those – BONDS.

Interest rates fall. Bonds soar. Stocks swoon.  People shriek.

Marketstructureedge.com – Broad Market Sentiment 1YR Jul 21, 2021

Options chaos.  We could see it. The image here shows Broad Market Sentiment – DEMAND – for the stocks represented by SPY, the State Street S&P 500 Exchange Traded Fund (ETF).  Demand waxes and wanes.  It was waning right into expirations.

In fact, it’s been steadily waning since Apr 2021.  In May into options-expirations, Sentiment peaked at the weakest level since Sep 2020. Stocks trembled. In June at quad-witching, stocks took a one-day swan dive.

Here in July, they cratered and then surged.  All these are signals of trouble in derivatives. Not in the assets.  It’s not rational. It’s excessive substitution.

We can measure it at all times in your stock. Into earnings. With deals. When your stock soars or plunges.

In 1971, the USA left the gold standard because the supply of dollars was rising but gold was running out. The derivative couldn’t be converted into the asset anymore. The consequence nearly destroyed the dollar and might have if 20% interest rates hadn’t sucked dollars out of circulation.

High interest rates are what we need again. During the pandemic the Federal Reserve flooded the planet with dollars. Money rushed into risk assets as Gresham’s Law predicts. And derivatives.

When the supply/demand nexus comes, the assets will reprice but won’t vanish. The representative demand in derivatives COULD vanish.  That’s not here yet.

The point: Derivatives price your stock, your sector, your industry, the stock market. Adjustments to those balances occur every month.  We can see it, measure it. It breeds chaos. Pundits don’t understand it.

It’s supply and demand you can’t see without Market Structure goggles. We’ve got ‘em.

Supply and Demand

Happy Bastille Day!  Also, Goldman Sachs made $15 per share, 50% over expectations. The stock declined.

JP Morgan earned $12 billion on revenue of $31 billion, doubling views. Shares fell.

Why are banks making 36% margins when you can’t earn a dime of interest?

I digress.

Illustration 98288171 / Goldman Sachs © Alexey Novikov | Dreamstime.com

I told the Benzinga Premarket Prep show July 12 on Market Structure Monday (which we sponsor) that falling demand and rising supply in the shares of JPM and GS predicted the stocks would probably perform poorly despite widespread views both would batter consensus like Shohei Ohtani on both sides of the plate (baseball humor for you).

Sure, you could say everybody already knew so they sold the news. This is the kind of copout we get from people who want to tell us stocks are always expectations of future outcomes while simultaneously telling us “they were down because growth wasn’t quite good enough to get past the whisper number.”

That is BS.  Plain and simple. 

ModernIR can measure supply and demand in JPM and GS and observe that demand is falling and supply is rising.  Even amid the farcical characteristics of the modern stock market, that means prices will fall.

We can meter these conditions in your stock too, by the way.

The best thing about the stock market today is how well it reflects supply and demand.  Currency markets don’t. The Federal Reserve continuously jacks with currency supplies in such manipulative ways that almost no economic measure, from growth to inflation, can be believed.

But in the stock market, the math is so sacrosanct that it’s impervious to the ubiquitous interference by Congress and regulators with the mechanisms of a free, fair and open market. No matter how bureaucrats assail the battlements, nothing disguises the stark supply/demand fluctuations apparent in the data.

Wow, mouthful there, Quast.

I know it. I’m not kidding.

Look, regulators REQUIRE brokers to buy and sell stocks even when there are no buyers and sellers.  That’s called a “continuous auction market.”  That’s what the US stock market is.

Contrast that with an art auction.

Stay with me. I have a point.

The first requirement of an art auction is actual ART.  Even if its pedigree is suspicious, like Nonfungible Tokens (NFT).  There’s still art for sale, and an audience of bidders pre-qualified to buy it.  No shill bidders allowed.

Nothing so provincial impairs the stock market. While you can make stuff up such as always having 100 shares of everything to buy or sell, even if it doesn’t actually exist, you STILL HAVE TO REPORT THE MATH.

Think I’m joking about shares that don’t exist?  Educate yourself on the market-maker exemption to Reg SHO Rule 203(b)(2). Or just ask me. 

Anyway, everything is measurable. Thanks to rules dictating how trades must be executed. In GS trading the day before results, Short Volume (supply) was rising, Market Structure Sentiment (demand) was falling.

Unless stock-pickers become 300% greater as a price-setter than they’ve been in the trailing 200 days – a probability approaching zero – the stock will decline.

I don’t care how good your story is.  Story doesn’t change supply or demand. Only ACTIONS – to buy or sell or short or leverage – do.

This math should be the principal consideration for every public company. Were we all in the widget business, selling widgets, we wouldn’t say, “I hope the CEO’s speech will juice widget sales.”

Now maybe it will!  But that’s not how you run a widget business.  You look at the demand for widgets and your capacity to supply widgets to meet demand. That determines financial performance. Period.

The stock market is the same.  There is demand. There is supply. Both are measurable. Both change constantly because the motivation of consumers differs. Some want to own it for years, some want to own it for 2 milliseconds, or roughly 0.05% of the time it takes to blink your eyes.

Both forms of demand set price, but one is there a whole lot more than the other. If the only behavior you consider is the one wanting to own for years, you’re not only a buffoon in the midst of courtiers. You’re wrong.  And ill-informed.

Thankfully, we can solve that social foible. And sort the data for you.

The stock market is about supply and demand. Earnings season is upon us again.  The market will once more tell us not about the economy or earnings, but supply and demand.

Ask us, and we’ll show you what your data say comes next.

Rustling Data

The Russell Reconstitution is so big everybody talks about it.  And yet it’s not. 

The Nasdaq touted its role facilitating this year’s Russell reset, saying, “A record 2.37 billion shares representing $80,898,531,612 were executed in the Closing Cross in 1.97 seconds across Nasdaq-listed securities.”

Impressive, no question.  That’s a lot of stuff to happen in the equivalent of the proper following distance when driving 65 mph (a rule often ignored, I’ve observed).

I’d also note that the Closing Cross is not the “continuous auction market” required by SEC rules but a real auction where buyers meet sellers. Regulators permit these to open and close markets.

The Nasdaq said, “Russell reconstitution day is one of the year’s most highly anticipated and heaviest trading days in the U.S. equity market, as asset managers seek to reconfigure their portfolios to reflect the composition of Russell’s newly-reconstituted U.S. indexes.”

The press release said it was completed successfully and the newly reconstituted index would take effect “Monday, June 29, 2020.”

Somebody forgot to update the template.

But that’s not the point.  What the Nasdaq said is untrue.  The Russell rebalance June 25, 2021 was not “one of the heaviest trading days in the US equity market.”

It was 159th out of 252 trading days over the trailing year, using the S&P 500 ETF SPY as a proxy (we cross-checked the data with our internal volume averages for composite S&P 500 stocks, and against other major-measure ETF proxies).

SPY traded 58 million shares June 25 this year but has averaged over 72 million shares daily the trailing twelve months.

Whoa.

Right?

This is market structure. If a stock exchange doesn’t know, who are you counting on for facts about the stock market?

CNBC June 29, 2021

I snapped the photo here hurriedly of the conference-room TV at ModernIR yesterday with CNBC’s Sara Eisen and former TD Ameritrade Chair Joe Moglia. But look at what they call in video production the lower third, the caption.

That’s what hedge-fund legend Lee Cooperman said in the preceding segment. “Market Structure is totally broken.”  Eisen and Moglia were talking about it.

When I vice-chaired the NIRI Annual Conference in 2019, I moderated the opening plenary session with Lee Cooperman, Joe Saluzzi, co-author of the book “Broken Markets” (you should read it), and Brett Redfearn, head of the SEC’s division of Trading and Markets (now head of capital markets for Coinbase).

The market may not appear broken to you. But you should know that market-structure events occur about 70 times per year. And the Nasdaq ought to know if the Russell Reconstitution is really a heavy trading day. It’s their business.

Just as it’s your business, investor-relations professionals, to know your market. The equity market.

Just the preceding week, June quad-witching owned the Russell Reconstitution like Mark Cavendish sprinting at the Tour de France.  Worse, actually, though few cycling moments match seeing The Manx Missile win his 31st stage after having left the sport.

It was a beatdown.  SPY volume June 16-18 averaged 97 million shares, 67% higher than the Russell rebalance, peaking the 18th at 119 million shares. 

And June 30, 2020, the final trading day of the second calendar quarter last year, SPY traded more than 113 million shares, nearly twice this year’s Russell volumes June 25.

June 30 is today. 

In fact, the last trading day of each month in the trailing twelve averaged 99 million shares of SPY traded.

What do those dates and June 16-18 have in common?  Derivatives.  Each month, there are six big expirations days: The VIX, morning index options, triple- or quad-witching, new options, the true-up day for banks afterward, and last-day futures.

This final one is the ultimate trading day each month featuring the lapsing of a futures contract used to true up index-tracking. The CBOE created it in 2014 for that purpose. Russell resets may be using it instead.

What’s it say that derivatives expirations are 67% more meaningful to volume than an annual index reconstitution for $10 trillion pegged dollars, or that average daily volume in SPY, the world’s largest exchange-traded derivative – all ETFs are derivatives, substitutes for underlying assets – exceeds volume on a rebalance day?

That your executive teams and boards better know. They deserve to know. If you give them anachronistic data unreflective of facts, it’s no help. Imagine if Lee Cooperman is right, and our profession fails our boards and executive teams.

No practice has a higher duty to understand the equity market than the investor-relations profession.  If you’re not certain, ask us for help. We’ll arm you so you need never worry again about fulfilling it.

Fab Problem

The world relies on one semiconductor company. 

How did an economic ecosystem let itself get boxed in like that?  About the same way it happened in the stock market.  There’s a lesson for public companies and investors.

Yang Jie and colleagues at The Wall Street Journal June 19 wrote a thorough treatise (subscription required) on the extraordinary rise of TSMC, as it’s known, under founder and Texas Instruments veteran Morris Chang.

Courtesy Dreamstime.com

And how 92% of the world’s most sophisticated chips depend on it. And nearly 60% of all chips, including all the ones for iPhones, the chips for cars, for PCs, for a vast array of devices operating on microcircuitry.

The company is a juggernaut and Morris Chang, 89 and now retired, is a genius.  But a different term comes to mind for participants in the semiconductor industry who let themselves become so perilously dependent.

And what about the consumers of the products?  Was no one aware that the boulevard ferrying technological essentials had a sign on it saying “not a through road?”

There was a failure of hindsight and foresight, a fixation on discrete objectives at the expense of broad comprehension of its mechanics and structure. Seems to me, anyway.

What’s this got to do with the stock market?

There’s a similar lack of imagination over the past 15 years among public companies participating in it.  Finra says it regulates about 3,400 brokers.  But 30 of them execute nearly all trading volume, data we’ve observed ourselves as the leader in Market Structure Analytics for public companies.

If you want to know how the stock market works, join ModernIR June 24 to learn how the Great Meme Stock Craze of 2021 happened – and can happen to you. 

Back to the point, it’s far worse than 30. About ten firms handle nearly all customer orders, and another ten set most of the prices but have no clients and aim to own nothing.

And $500 billion daily dances delicately through that machinery.

It happened the way it did for TSMC.  Once, there were many designers and fabricators.  Then designers discovered they could cut costs and burdens by leaving the fab business, outsourcing it to TSMC.

It made sense operationally. It’s a lot cheaper not building and running factories.  The WSJ article says a single fab may cost $20 billion to build.

And by the time you finish, maybe the technology has moved on, and now what?  TSMC will spend $100 billion the next three years staying current.  Hard to compete with that.

The same thing happened in the stock market, though for somewhat different reasons.  Among the thousands of broker-dealers buying and selling securities for investors, the great majority got out of the fab business, so to speak.

They don’t clear their own trades. They don’t even execute their own trades. They’re introducing brokers.  They sell to customers but outsource trading and account services.

It’s an operational decision. You can’t make money owning the infrastructure.  But the reason is market rules created by Congress and regulators.  First, stocks were decimalized. Brokers counted on the spread between buying and selling for profits.  Poof, gone. There went the fabs.

Then regulators in 2007 implemented the 1975 Congressional vision of a “national market system” connecting all markets electronically and setting in motion a rigorous rules matrix on handling trades. It forced most firms to send their trades to a handful capable of making the equivalent of a $20 billion investment in chip fabrication.

And intermediary profits didn’t vanish. Oh no, they’re larger than ever. But where big spreads between stocks in the past supported sellside research and deep arrays of stock-trading by firms with customers, now tiny spreads accrue colossally to a handful of firms you’ve barely heard of.

Read the Front Month Newsletter piece called Jane Street and the Arbitrage Royal Family.  Sounds like a vocal group from the 1960s. If Gladys Knight ran a market-making firm, she’d call it PipTrading LLC.

Jane Street is killing it. Arbitragers. Should that not raise eyebrows?

The Stock Market has the very same supply-chain issue that besets chips.  We only learned about Chip Trouble through the 2020 Pandemic. We shut down the global supply chain.  Now it can’t get back to level.

Supply-chain flaws will show in the stock market when a fab fails, the supply chain stalls. I’m not worried about it. You should be!  Public companies. Investors.  You’ve let parties with no vested interest in the market – regulators – hang it on a fragile wire.  Like the kind etched by Extreme Ultraviolet Lithography.

Look that one up.

Will we ask for a report on the stock-market supply chain before it’s our undoing?  Or is it TSMC all over again?

Characteristic Opportunity

I don’t think Harvard Business Review understands 21st century investor relations.

No offense to the smart folks there.  Authors Dennis Carey, Ram Charan and Bill McNabb are world-renowned and wrote for HBR on the Changing Role of the Investor Relations Officer.  It’s excerpted from a new book by the three.

They argue IR people need to be better communicators with Activists and index funds.

Okay.

They also say the IR job is often seen internally as a dead end. Hm. Never seen that or heard it. I’ve been in this profession for 26 years.

They say, “We know one private company in India, where the CEO has made his son the IRO in preparation for the top job.”

Well, Henry Ford III has been in IR for Ford under the expert tutelage of Lynn Tyson, and he’s on the board of directors. IR is the best gig in the company for developing comprehensive strategic understanding of the business, and it’s no dead end.

But that’s not what I mean. There’s opportunity like springtime (like this photo Monday in Steamboat at the Botanic Park).

These seasoned advisors suppose IR remains about strategic communication, now filtered through governance, Activism, and so on.

I was looking over the educational offerings from IR chapters across the fruited plain.  Where are the programs on advising executives and boards on strategic capital allocation in a market dominated by passive money?

How about improving buyback accountability and capital-allocation efficiency with data?  The effect of spinoffs on capital-formation?  Maximizing your characteristics for passive money? The role of derivatives in the US equity market?

What of raising equity when you can rather than when you need it?  Efficiently matching secondary offerings for controlling holders to market trends? What is liquidity and can we improve ours?  What motivates ETF market-makers?  How does retail order flow affect our stock? Can we be Gamestopped?

These topics are every bit as relevant as managing your IR career, running an investor day, targeting investors, ESG, or pick your thing pervading the program docket.

Maybe more so.  I’ll give you three examples.

Mark Bendza at Honeywell (market cap $155 billion) is a sterling example of your contemporary investor-relations officer.  He realized that by shifting his stock-listing to the Nasdaq, HON would be in the Big Three indices – S&P 500 (SPX), Dow Jones Industrials (DJIA), Nasdaq 100 (QQQ).

He expertly pitched the Board of Directors (we armed him with data and facts) and they agreed.  That’s positioning your company in front of the money.  No amount of telling the story could come close to so canny a move to maximize HON’s characteristics.

That’s a word that should be right in the heart of the IR lexicon.  Characteristics.

Another example.  A homebuilder decided to begin paying a dividend.  That’s a mad GROWTH industry in Post-pandemic America. Pretty soon you’ll need gold bullion to buy lumber. We had to table a remodel project ourselves because the cost of things has become tulip-bulb crazy.

And straight into those teeth, this homebuilder decides to make its strategic capital allocation plan a dividend.  Genius. Accidental or not!  Why? Because it opens access to hundreds of billions of potential passive dollars that want YIELD.

Without telling the story at all.

That’s massively efficient. And anyone can do it.

Finally, a small-cap growth company recognized that growth could not come on story alone.  About 95% of US market capitalization is in the top thousand stocks, and the entry bar is about $5 billion.  How do you get over that bar and in front of all that money?

IR has an opportunity to shape that plan.  This is a great company. They could file a shelf registration for several billion dollars of stock and commit to an aggressive M&A plan – and place that stock as needed with the very investors they now have.

And it’s entirely possible to go from $500 million to $5 billion in a couple years.  Money wants SIZE.

And traders, returns using market structure are better with size too, because size leads to predictable Sentiment.

This is where IR should be playing in the 21st century, without neglecting the traditional things. But you cannot rely on tradition in modern markets where characteristics are more significant and impactful than telling the story.

It’s an opportunity.

Your Umbrella

Leaving South Carolina is hard.

It’s captivating. We had not a bad meal from Savannah to Pawleys Beach. Perfect weather (the surprising part). But always know where your umbrella is.

And thanks to Steve Hufford at Blackbaud for the tip about the Angel Oak Tree south of Charleston.  It’s hundreds of years old and growing majestically still (see photo).

It’s rather like the stock market. Time marches on.  Look, there will be a day when the cavalier treatment of money punctuating modern finance will have consequences. Money isn’t a tree and doesn’t grow on them.

There is, though, an opportunity for a lesson here.  Is “sell in May and go away” a thing? How could it be, if the largest managers of investments in US markets now are diversified passive funds?

“Sell in May” is a tradition. Stock-pickers would cash out of equities and leave the city for the cape. Maybe to Coastal Carolina. I’m envious. You?

But it’s a figure of speech, a trope, an anachronism.  Passive models don’t cash out of equities. Index funds track the basket. Diversified target-date money follows the plan.

All the time.

We humans often hew to tradition long past its due-by date.  It’s a feature of our nature that has marked historical epochs, sometimes ignominiously.

We’re doing it in investor-relations. Do we really know what drives shareholder value, or do we do the things we traditionally have because it’s what’s always been done?

What if we didn’t hold earnings calls?  Would it make any difference?  Berkshire Hathaway doesn’t. The company reports results on Saturdays by press release. BRK.A has materially outperformed the SPX the past decade.  The SPX has materially outperformed most stock-picking funds the past decade.

It’s why ModernIR argues that IR should be a data analytics and management function. If the money in the main now follows models, why do we still do all the stuff we did when most of it picked stocks?  I’d argue it’s tradition. It’s certainly not data.

Back to our theme, significant moves in markets in May then are likely to be coincidental.  We had them last week, attributed for one day to inflation fears, until the next day and the day after that stocks soared hundreds of points.

What happened to inflation fears?  Pundits were conspicuously silent those two days. And I get it.  If you’ve just declared that inflation has spooked equities, and the spookiness evaporates, you’re not sure what to say next.

Conventional wisdom, another way to say tradition, argues inflation harms equities. That’s wrong.  Equities absorb inflation. Only one thing – higher interest rates – would alter that calculus, and higher rates are a RESPONSE to inflation, not a consequence of it. And people wrongly mistake inflation to mean higher rates.

Rising rates would bankrupt the United States government.  Not likely to happen.  Yet, anyway.

What WILL arrive at some point is the actual consequence of inflation: deflation.  When prices rise in response to excess supplies of money, they will at some point stop rising (when the excess money is absorbed by risk assets like stocks) and fall.

Did you know that from 1791 to 1913, pay for members of Congress didn’t much change?  Thanks to a sound currency and improving output, money went further as purchasing power rose, giving them 50% more money over the course of a century — without a raise.

It’s why I argue that monetary policy should promote purchasing power – not growth, price-stability (an utter disaster), full employment (not the domain of the central bank) or any other thing.  If our money goes farther, we need less of it. That should be the aim.

We’re doing the opposite. So unless and until money stops flowing to stocks, the equity tree will grow. 

The flow is slowing though. Broad Market Sentiment, our ten-point index of waxing and waning demand for equities, has been stuck around 6.0 for a month. It means supply and demand are equalizing.  A normal market moves down to 4.0, and back over 6.0. Over and over. Because more money flows to equities than leaves them.

It’s as simple as the math of tides. What comes in goes out.  And starts over.  Sentiment cannot stay at 6.0 without reverting to 5.0 or lower.

So.

We MAY be approaching the first period where outflows exceed inflows since the Pandemic. We’re not there yet. Data say stocks could be up modestly into expirations to finish the week.  

But there’s a scent in the air, wetness on the breeze, the first feel of rain like you’re walking down Oglethorpe past square on square in Savannah, this one burying Nathaniel Green, that one with the Mercer House on the north end, and you feel it.  A raindrop.

No need for worry. But know where your umbrella is.

Roped Together

This Cinco de Mayo we’re grateful for tequila.

Especially if you’re a Tech investor. Why are companies crushing earnings and revenue being pulverized by an imperious market?

It’s easiest to say expectations for the future have diminished and so market capitalization will too.  That doesn’t reflect how the market works.

In fact, there’s inherent contradiction between that orthodox view of equities and the way money now behaves.  Morningstar shows that more than a third of all institutional assets are in large-cap blend Passive funds.  Total domestic ETF assets have increased by $1.5 trillion in the past year, says the Investment Company Institute.

Well, what’s that money do?  We all understand the idea of following the money.  That is, if you want to understand what’s driving behavior, track where the money goes.

For instance, prices of things consumers buy for both daily and discretionary reasons have risen.  Personal income is up 21%.  That’s following the money. The more there is, the more stuff costs.

Until everything resets.

See the image here.  The Tech sector dwarfs other parts of the S&P 500 at 28%.  Data we track show Passive and Active Investment – combined indexes and ETFs and stock-picking flows – were up about 5% in the sector last week as stocks fell 5%.

That means investors were selling Tech.

No mystery there, you might think. But stocks can fall on the absence of buying as much as the presence of selling. And Tech has come down further since, though the pattern of selling by investment behaviors is receding.

Here’s the point.  The stock market’s value nears $50 trillion.  Tech is about $15 trillion. And it’s even more when you consider that the largest companies – Google, Apple, Amazon, Facebook, Tesla, Microsoft – are spread over three sectors, not one, the big green box on the left of the image.

If 5% of that money leaves during month-end window-dressing it’s destabilizing not just to a handful of stocks but to the sector, the whole market.  The big green box is about $24 trillion.  All of that can oscillate if money shifts to say, Financials (up 2% last week) or Energy (up 5%).

I’ll give you another observation from the data.  This one requires understanding something. ETFs – Exchange Trade Funds – are not fiduciaries. They don’t manage your money.  If you buy Blackrock ETFs, you don’t have an account at Blackrock.

And Blackrock can do what you can’t.  Blackrock can dump its Tech stocks all at once via the “redemption basket” – the garbage to take out – while simultaneously asking for only appreciating stocks in the “creation basket,” the grocery cart from brokers.

So Blackrock could shed its falling Tech stocks for ETF shares and then trade the ETF shares for Financials, Homebuilders, Energy stocks, Real Estate stocks.  It thus avoids the falling stocks and rides the rising ones. 

But that’s a very short-term trade.  There’s not enough stock in those sectors and industries to remotely account for the 52% in the giant swaths of the market populated by Big Tech.

So either the whole market tips over. Or suddenly Tech will look good again. There’s no way to meet the demands of large-cap Passive target-date funds with heavy weightings in equities without Tech.

We told clients this in the Friday Market Desk note out Apr 23:

You recall when those two Bear Stearns mortgage-backed securities funds went under in 2007?  We all went, “Huh. Wonder what happened there.”  Then we followed the Dave Barry Car Mechanic Manual:  When your car starts knocking, turn up the radio.

We didn’t understand that those funds and Bear Stearns and Lehman and the whole housing industry were roped together and pulling each other off El Capitan. I’m not saying we’re roped here.  But it’s possible.  

We’re all roped to Tech.  Tied to its weight.

I also trotted out an old theology term from my college days studying that discipline: Laodicea. I said the market was neither cold nor hot, and it was the kind that could spew us out.  You can look it up in the last book of the bible, Revelation, chapter 3.

I think there’s too much commitment to equities by large-cap diversified Passive target-date (that’s a mouthful) funds for us to fall from El Capitan.  Yet.  There will be a day when the flows stop, and Blackrock can’t trade anything for Tech shares.

That’s when, as the head of campus security back in my collegiate days in tornado country would say, “You go grab little brother Willie off the porch.”