Tagged: Stocks

Pricing Everything

As the colors of political persuasion in the USA ripple today, what matters in the equity market is what the money is doing.

We measure Sentiment by company and sector and across the whole market daily. It’s not mass psychology. Rational thought sets a small minority of prices (your board and execs should know, investor-relations professionals, or they will expect you to move mountains when the power at IR fingertips now is demographics – just as in politics).

We’re measuring ebbs and flows of money and the propensity of the machines executing the mass of trades now to lift or lower prices.

When the market is Oversold by our measures, it means Passive money is likely to be underweight relative to its models and benchmarks, and probability increases that machines will lift prices for stocks because relative value – the price now versus sometime in the past 20 days – is attractive. We call it Market Structure Sentiment.

In Oct 2016, before the Presidential election, Market Structure Sentiment saw its worst stretch since Sep-Oct 2014 when the Federal Reserve stopped buying debt, sending the dollar soaring and the energy industry into a bear market.

We at ModernIR thought then that after pervasive monetary intervention the next bear market would be two years out. On the eve of the Presidential election two years ago, and two years out, the Dow 30 traded at Dec 2014 levels.

We figured we’d called it.

We were wrong (the market makes fools of most who propose to prophesy).  Donald Trump won, and stocks surged until October this year.

As I write Nov 6, Market Structure Sentiment has bottomed at 3.5/10.0 on our 10-point scale. In 2016 it bottomed Nov 9, the day of the election (and stocks surged thereafter).

Conclusions?  Maybe rational thought means little.

Consider: The SEC has approved Rule 606(b)(3) (if rules need parentheses it means there are too many – but I digress) for brokers, requiring that they disclose (thank you, alert and longtime reader Walt Schuplak) when they’re paid by venues for trades and trade for their own accounts.

Public companies and investors, why do we need rules requiring brokers to tell us if they’re getting paid for orders or trading ahead? Because they’re doing it. And it’s legal.

If we want to suppress both things, why not outlaw them?

Because the market now depends on both to price everything.

Let me explain. When the SEC exempted Exchange Traded Funds from the Investment Company Act’s requirement that fund-shares be redeemable for underlying assets, they did so because ETFs had an “arbitrage mechanism,” a built-in way for brokers to profit if ETFs deviated from its underpinning index.  (NOTE: If you don’t know how ETFs work, catch the panel at NIRI Chicago next week.)

Those exemptions preceded Regulation National Market System, which capped trading fees – but left open what could be PAID for trades. I bet the SEC never saw this coming.

Rule 606(b)(3) forces brokers to tell customers when they get paid for trades and if they are trading for themselves at the same time.

In ETFs, the two dovetail. Brokers can earn trading incentives legitimately because they’re fueling the SEC-sanctioned arbitrage mechanism, which requires changing prices. Rules let you get paid for it!

Second, since ETFs are created and redeemed by brokers (not Blackrock), much ETF market-making is principal trading – for a broker’s own account.

So ETFs create opportunity for brokers to get paid for setting price, and to put their own trades ahead of customer orders – the things 606(b)(3) wants to highlight.

Now ETFs are the largest investment vehicle in markets, and Fast Trading prices stocks more often than anything else. Suppose you’re the SEC. What would you do?

Let’s put it in mathematical terms. Our analytics show 88% of trading volume is something besides rational investment. We blame rules that focus on price. Whatever the cause, there’s a 12% chance rational thinking is why Sentiment is bottomed at midterms.

I think the SEC knows. Can they fix it? Well, the SEC created it to begin.

For now, public companies, every time you look at stock-price, there’s a 12% chance it’s rational. Does your board know? If not, why not? Boards have fiduciary responsibility.

And investors, are you factoring market structure into your decisions? You’d best do so. Odds favor it.

Blocking Volatility

Boo!

As the market raged high and low, so did Karen and I this week, from high in the Rockies where we saw John Denver’s fire in the sky over the Gore Range, down to Scottsdale and the Arizona desert’s 80-degree Oct 30 sunset over the Phoenician (a respite as my birthday is…wait for it…Oct 31).

Markets rise and fall.  We’re overdue for setbacks.  It doesn’t mean we’ll have them, but it’s vital that we understand market mechanics behind gyrations. Sure, there’s human nature. Fear and greed. But whose fear or greed?

Regulators and exchanges are tussling over fees on data and trades.  There’s a proposed SEC study that’ll examine transaction fees, costs imposed by exchanges for trading. Regulation National Market System caps them at $0.30/100 shares, or a third of a penny per share, which traders call “30 mils.”

The NYSE has proposed lowering the cap to $0.10/100, or a tenth of a penny per share, or 10 mils. Did you know there’s a booming market where brokers routinely pay eight cents per share or $8.00/100 shares?

What market? Exchange-Traded Funds (ETFs).

We’re told that one day the market is plunging on trade fears, poor earnings, geopolitics, whatever. And the next, it surges 430 points on…the reversal of fears. If you find these explanations irrational, you’re not alone, and you have reason for skepticism.

There’s a better explanation.

Let’s tie fees and market volatility together. At right is an image from the iShares Core MSCI EAFE ETF (CBOE:IEFA) prospectus showing the size of a standard creation Unit and the cost to brokers for creating one.  Divide the standard Unit of 200,000 shares by the usual cost to create one Unit, $15,000, and it’s $0.08/share (rounded up). Mathematically, that’s 2,600% higher than the Reg NMS fee cap.

Understand: brokers provide collateral – in this case $12.5 million of stocks, cash, or a combination – for the right to create 200,000 ETF shares to sell to the public.

Why are brokers willing to pay $8.00/100 to create ETF shares when they rail at paying $0.30/100 – or a lot less – in the stock market?

Because ETF shares are created in massive blocks off-market without competition. Picture buying a giant roll of paper privately, turning it into confetti via a shredder, and selling each scrap for a proportionate penny more than you paid for the whole roll.

The average trade-size for brokers creating IEFA shares is 200,000 shares.  The average trade-size in the stock market where you and I buy IEFA or any other stock is 167 shares (50-day average, ModernIR data).  Do the math on that ratio.

ETF market-makers are pursuing a realtime, high-speed version of the corporate-raider model. Buy something big and split it into pieces worth more than the sum of the parts.

In a rising market, it’s awesome.  These creations in 200,000-share blocks I’ve just described are running at nearly $400 billion every MONTH. Create in blocks, shred, mark up. ETF demand drives up all stocks. Everybody wins.

What happens in a DOWN market?

Big brokers are exchanging your stocks, public companies, as collateral for the right to create and sell ETF shares.  Suppose nobody shows up to buy ETF shares.  What brokers swapped to create ETF shares is suddenly worth less, not more, than the shredded value of the sum of the parts. So to speak.

Without ETF flows to drive up it up, the collateral – shares of stocks – plunges in value.

The market devolves into desperate tactical trading warfare to offset losses. Brokers dump other securities, short stocks, buy hedges. Stocks gyrate, and the blame goes to trade, Trump, earnings, pick your poison.

How do I know what I’ve described is correct?  Follow the money. The leviathan in the US equity market today is creating and redeeming ETF shares. It’s hundreds of billions of dollars monthly, versus smatterings of actual fund-flows. You don’t see it because it’s not counted as fund turnover.

But it fits once you grasp the weird way the market’s last big block market is fostering volatility.

What’s ahead? If losses have been sorted, we’ll settle down in this transition from Halloween to November. Our data are still scary.  We may have more ghouls to flush out.

Counterparty Tuesday

Anybody hear yesterday’s volatility blamed on Counterparty Tuesday?

Most pointed to earnings fears for why blue chips fell 500 points before clawing back.  Yet last week the Dow Jones Industrial Average zoomed 540 points on earnings, we were told.  We wrote about it.

Counterparty Tuesday is the day each month following expiration of the previous month’s derivatives contracts like puts, calls, swaps, forwards (usually the preceding Friday), and the start of new marketwide derivatives contracts the following Monday.

When grocery stores overstock the shelves, things go on sale.  When counterparties expect a volume of business that doesn’t materialize, they shed the inventory held to back contracts, which can be equities.

Counterparty Tuesday is a gauge indicating whether the massive derivatives market – the Bank for International Settlements tracks over $530 trillion, ten times the global economy – is overstocked or understocked. It’s much larger than the underlying volume of Active Investment behavior in the US stock market.

Let me use a sports analogy. Suppose your favorite NFL team is beating everyone (like the LA Rams are).  “They are killing everybody through the air,” crow the pundits.

You look at the data. The quarterback is averaging five passes per game and zero touchdowns.  But on the ground, the team is carrying 40 times per game and averaging four rushing touchdowns.

These statistics to my knowledge are fake and apply to no NFL team right now. The point is the data don’t support the proffered explanation. The team is winning on the ground, not through the air.

In the same vein, what if market volatility in October ties back to causes having no direct link to corporate earnings?

What difference does it make if the stock market is down on earnings fears or something else?  Because investor-relations professionals message in support of fundamental performance, including earnings.  Boards and management teams are incentivized via performance. Active stock-picking investors key off financial performance.

If the market isn’t swooning over performance, that’s important to know!

Returning to our football analogy, what data would help us understand what’s hurting markets?  Follow the money.

We wrote last week about the colossal shift from active to passive funds in equities the past decade.  That trend has pushed Exchange-Traded Funds toward 50% of market volume. When passive money rebalanced all over the market to end September, the impact tipped equities over.

Now step forward to options expirations, which occurred last week, new ones trading Monday, and Counterparty Tuesday for truing up books yesterday. Money leveraged into equities had to mark derivatives to market. Counterparties sold associated inventory.

Collateral has likely devalued, so the swaps market gets hit. Counterparties were shedding collateral. The cost of insuring portfolios has likely risen because counterparties may have taken blows to their own balance sheets. As costs rise, demand falters.

Because Counterparty Tuesday in October falls during quarterly reporting, it’s convenient to blame earnings. But it doesn’t match measurable statistics, including the size of the derivatives market, the size and movement of collateral for ETFs (a topic we will return to until it makes sense), or the way prices are set in stocks today.

The good news?  Counterparty Tuesday is a one-day event. Once it’s done, it’s done. And our Market Structure Sentiment index bottomed Oct 22. We won’t be surprised if the market surges – on earnings enthusiasm? – for a few days.

The capital markets have yet to broadly adapt to the age of machines, derivatives and substitutes for stocks, like ETFs, where earnings may pale next to Counterparty Tuesday, which can rock the globe.

Borrowed Time

“If a stock trades 500,000 shares daily,” said panelist Mark Flannery from hedge fund Point72 last Thursday on my market-structure panel, “and you’ve got 200,000 to buy or sell, you’d think ‘well that should work.’ It won’t. Those 500,000 shares aren’t all real.”

If you weren’t in Austin last week, you missed a great NIRI Southwest conference.  Mr. Flannery and IEX’s John Longobardi were talking about how the market works today.  Because a stock trades 500,000 shares doesn’t mean 500,000 shares of real buying and selling occur.  Some of it – probably 43% – is borrowed.

Borrowing leads to inflation in stocks as it does in economies.  When consumers borrow money to buy everything, economies reflect unrealistic economic wherewithal. Supply and demand are supposed to set prices but when demand is powered by borrowing, prices inevitably rise to unsustainable levels.  It’s an economic fact.

All borrowing is not bad. Borrowing money against assets permits one to spend and invest simultaneously.  But borrowing is the root of crises so watching it is wise.

Short interest – stock borrowed and sold and not yet covered and returned to owners as a percentage of total shares outstanding – isn’t unseemly. But it’s not a predictive indicator, nor does it describe risk. The great majority of shares don’t trade, yet what sets price is whoever buys or sells.

It’s far better to track shares borrowed as a percentage of total traded shares, as we described last week. It’s currently 43%, down one percentage point, or about 2.3%, as stocks have zoomed in latter August.

But almost 30% of stocks (excluding ETFs, routinely higher and by math on a handful of big ones averaging close to 60%) have short volume of 50% or more, meaning half of what appears to be buying and selling is coming from something that’s been borrowed and sold.

In an up market, that’s not a problem. A high degree of short-term borrowing, much of it from high-speed firms fostering that illusory 500,000 shares we discussed on the panel, means lots of intraday price-movement but a way in which short-term borrowing, and covering, and borrowing, and covering (wash, rinse, repeat), may propel a bull market.

In the Wall Street Journal Aug 25, Alex Osipovich wrote about how Goldman Sachs and other banks are trying to get a piece of the trading day’s biggest event: The closing auction (the article quotes one of the great market-structure experts, Mehmet Kinak from T Rowe Price). Let’s dovetail it with pervasive short-term borrowing.

We’ve mapped sector shorting versus sector ETF shorting, and the figures inversely correlate, suggesting stocks are borrowed as collateral to create ETFs, and ETFs are borrowed and returned to ETF sponsors for stocks.

A handful of big banks like Goldman Sachs are primary market-makers, called Authorized Participants (as opposed to secondary market-makers trading ETFs), which create and redeem ETF shares by moving stock collateral back and forth.

The banks give those using their versions of closing auctions the guaranteed closing price from the exchanges.  But it’s probably a great time to cover short-term ETF-related borrowings because trades will occur at an average price in effect.

The confluence of offsetting economic incentives (selling, covering borrowings) contribute to a stable, rising market. In the past week average intraday volatility dropped to 1.9% from a 200-day average of 2.5% at the same time shorting declined – anecdotal proof of the point.

What’s the flip side?  As with all borrowing, the bill hurts when growth stalls. When the market tips over at some future inevitable point, shorting will meet shorting. It happened in January 2016 when shorting reached 52% of total volume. In February this year during the correction it was 46%. Before the November election, short volume was 49%.

The point for both investors and public companies is that you can’t look at trading volume for a given stock and conclude that it’s equal and offsetting buying and selling. I guarantee you it’s not.

You don’t have to worry about it, but imbalances, however they may occur, become a much bigger deal in markets dependent on largescale short-term borrowing. It’s another market-structure lesson.

August Currents

“Treasury yields rise as Turkey worries fade,” declaimed a headline at Dow Jones Marketwatch yesterday.

This one day after the New York Times bleated, “Plunge in Lira, Turkey’s Currency, Fuels Fears of Financial Contagion.”

Why are stocks, ostensibly propelled by fundamentals (earnings and revenue growth this reporting cycle were strong), instead wracked by the machinations of a minor monetary unit for an economy that ranks 19th, behind the Netherlands and Indonesia and just ahead of Saudi Arabia?

They’re not.  It’s the dollar. Every investor and investor-relations professional should understand currency valuation, just as we all must grasp how the market works and what the money is doing (we wrote about that last week).

(To Turkey, for a prescient economic perspective, read this piece by Jim Rickards – whose gold views fuel skepticism but who always writes thoughtfully.)

The dollar is the world’s reserve currency. Simplistically, instead of holding gold, countries own dollars, and sell or buy them to adjust the value of their own currencies.

The USA by contrast only mints the buck and the Federal Reserve uses interest rates to regulate its value. In effect, higher interest rates mean a stronger dollar, lower interest rates a weaker buck, all other things being equal. (In fact, some economics ingenue somewhere should write a thesis establishing that the definition of inflation is low rates.)

Anyway, stocks are risk assets that reflect fluctuations in currencies every bit as much as they are supposed to offer a barometer of economic activity.

Take Turkish stocks.  The lira has been falling in value for years while Istanbul’s stocks shined, especially last year. Yet the economy has slipped a couple notches in global rankings.

The US economy is booming, and yet markets have stalled in 2018. The dollar is at a 52-wk high, spiking lately. In 2017, the dollar devalued 12% and stocks soared. There’s consistent inverse correlation between broad US equity measures and the dollar’s value.

We’ve described Teeter Totter Monetary Theory before. The nexus of the Teeter of supply meeting the Totter of demand should determine prices.

But under the modern floating-rate currency construct, central bankers move the fulcrum, which is money, to balance out the teeter totter. To encourage investment (supply) increase the value of the dollar (also lifting productivity, something few in orthodox economics recognize). To fuel consumption, depress interest rates so people borrow more and save less.

The problem is these policies over time erode the veracity of stock prices – and the value of everything from debt to art to homes to money.

Yes, many economists will disagree. But the evidence is stark, as is the math. Goods are the numerator, dollars, the denominator. If the dollar depreciates, things like stocks and beer cost more. Increase its value – more purchasing power – and prices fall.

August has had a recent history of currency volatility.  August 2010 and August 2011 were rocked by the euro, which nearly failed. August 2015 brought a sudden Chinese currency devaluation and on the 24th a thousand Exchange Traded Funds were volatility halted. Stocks didn’t recover until October.

As August 2018 fades like summer grass, there are currents.  The dollar is strong and market-structure Sentiment is sluggish, positive now but without a vital mean-reversion. Options expire the 16th-17th and 22nd, a split cycle for derivatives. (NOTE: Speaking of August, don’t miss NIRI SWRC next week — I’ll be there.)

If stocks top into expirations with a rising dollar, we could have a hard mean-reversion to finish the summer. It’s no prediction, just a higher probability. And it’s not fundamental – yet another reminder that the stock market cannot be seen merely as an economic gauge.

 

Rules and Money

There are two pillars to market intelligence: The Rules, and The Money.

By market intelligence, I mean information about what’s pricing a stock. So, translating, information about what’s pricing a stock must derive from the rules that govern stock-trading, and how money conforms to those rules.

Wouldn’t that be supply and demand?  Would that it were! There are instead four big rules for stocks now, tenets of Regulation National Market System about which every investor and investor-relations officer should have a basic grasp.

“Quast,” you say. “This sounds about as exciting as cleaning a tennis court with a tooth brush. In Houston. In the summer.”

It can be very exciting, but the point isn’t excitement.  If you don’t know the rules (always expect your market intelligence provider to know the rules for stocks), your conclusions will be wrong.  You’ll be guessing.

For instance, if you report strong results and your stock jumps on a series of rapid trades, can a human being do that?  Refer to the rules. What do they require?  That all marketable trades – an order to buy or sell stock – be automated.

No manual stock order can be marketable. Manual orders are nonmarketable, meaning prices for the stock must come to them instead. Picture a block of cheese and a grater passing by it and shaving some off.

The rule creating this reality in stocks is the Order Protection Rule, or the Trade-Through Rule. Same thing. It says traders cannot trade at $21.00 if the same stock is available for $20.99 somewhere else. To ensure compliance, regulators have mandated that orders wanting to be the best bid to buy or offer to sell must be automated.

And the bid to buy will always be lower than the offer to sell. Stocks may only trade at them, or between them.  There can only be one best price (though it may exist in several places).

Now start thinking about what money will do in response.  Orders will be broken into pieces. Sure enough, trade size has come down by factors, and block trades (we wrote about it) are a tiny part of the market.

Big Commandment #2 for stocks is the Access Rule. It goes hand-in-glove with the first rule because it’s really what turned the stock market into a data network.

The Access Rule says all market centers including stock markets like the five platforms operated by the NYSE, the three owned by the Nasdaq, the four owned by CBOE, the newest entrant IEX, and the 32 broker markets that match stock trades must be connected so they can fluidly share prices and customers.

It also capped what exchanges could charge for trades at $0.30/100 shares – paid by brokers trading in the stock market for themselves or customers (the SEC Fee Pilot Program aims to examine if these fees, and their inverse, incentive payments, cause brokers to execute trades in ways they would not otherwise choose).

The third big rule outlaws Sub-Penny Pricing, or quoting in increments so small they add no economic value.  You may still see your stock trading at $21.9999 because of certain exceptions for matching at midpoints of quotes.

Reg NMS lastly imposed new Market Data Rules. Since everyone is sharing prices and customers on this network called the stock market, plans had to be refined for pooling data-revenue (prohibiting sub-penny trading was meant to prevent a proliferation of tiny meaningless prices).

Yet, data is a byproduct of prices. There are hundreds of millions of dollars of revenue governed by the Consolidated Tape Association, which divides proceeds according to how various platforms and brokers quote and trade in accordance with best prices. Outside the CTA, there may be billions of dollars now in proprietary data feeds.

These rules drive how money behaves. The fastest machines will price your stock to start the day no matter where you trade, because they have the quickest bids and offers. But their purpose is to profit on changing prices, not to own stocks.

Passive investment dominating the market is aided by rules. What lies between the bid and the offer? The average price. Those tracking benchmarks like index mutual and exchanged-traded funds get a boost toward their objective.  Prices become uniform (our data show very tight Poisson distribution in the stock market – which helps securities tracking benchmarks).

And because stock prices are highly unstable – average intraday spread in the Russell 1000 the past five trading days is 2.6%, and the typical stock trades over 16,000 times daily in 167-share increments – investors turn to substitutes like derivatives. Even Warren Buffett who once famously skewered them as instruments of mass financial destruction has large derivatives positions.

Let’s finish where we started. Why doesn’t supply and demand drive stock prices? Because rules governing trades don’t let supply and demand manifest naturally. The greatest proportion of trades are now driven by machines wanting to own nothing, the opposite of a market animated by supply and demand.

When you look at your stock or stocks in your portfolio, remind yourself: What’s driving them up and down are rules, and money racing around a course in compliance with those rules.  Some part is rational. A bunch of it isn’t.  We all – investors and public companies – can and should know what’s going on. The first rule, after all, is to be informed.

Welcome to the 21st century stock market.

Lab Knowledge

We are finally watching Breaking Bad five years after the most successful basic cable series in television history ended.

It’s symbolic of the era that we’re viewing it via Netflix. And NFLX Market Structure Sentiment is bottomed, and shorts have covered. We’ll come to market structure in a moment because it intersects with Breaking Bad.

Launched in 2008, Breaking Bad is about high school chemistry teacher Walter White, who turns to cooking methamphetamine to cover medical bills. He becomes Heisenberg, king of blue meth.

I won’t give the story away but what sets Walter White apart from the rest of the meth manufacturers is his knowledge of molecular structure. Let’s call it Lab Knowledge.  With lab knowledge, Walter White concocts a narcotic compound that stuns competitors and the Drug Enforcement Agency alike. He produces it in a vastly superior lab.

In the stock market there’s widespread belief that the recipe for a superior investment compound is the right set of ingredients comprised of financial and operating metrics of businesses.

Same goes for the investor-relations profession, liaison to Wall Street. We’re taught that the key to success is building buyside and sellside relationships around those very same financial and operating metrics.

There’s a recipe. You follow it, and you succeed.

Is anyone paying attention to the laboratory?

The stock market is the lab. Thanks to a total rewriting of the rules of its chemistry, the laboratory has utterly transformed, and the ingredients that underpin the product it churns out now are not the same ones from before.

I don’t mean to toot the ModernIR horn, but we did the one thing nobody else bothered to do.  We inspected the lab.  We studied the compounds it was using to manufacture the products circulating in the market (ETFs, high-speed trading, etc.).

And we saw that stock pickers were failing because they didn’t understand what the lab was producing. It was not that they’d stopped finding the historically correct chemical elements –financial and operating metrics defining great companies of the past.

It’s that these ingredients by themselves can no longer be counted on to create the expected chemical reaction because the laboratory is compounding differently.

And the difference is massive. The lab determines the outcomes. Write that down somewhere. The lab determines the outcomes. Not the ingredients that exist outside it.

So investors and public companies have two choices.  Start a lab that works in the old way.  Or learn how the current lab works. The latter is far easier – especially since ModernIR has done the work. We can spit out every manner of scientific report on the ingredients.

Back to market structure, before NFLX reported results it was 10/10 Overbought, over 60% short and Passive money – the primary chemical compound for investments now – was selling.  The concoction was destined to blow up.

Everyone blamed ingredients like weaker growth and selling by stock pickers, when those components were not part of the recipe creating the explosion in NFLX. Now, NFLX will be a core ETF manufacturing ingredient, and it will rise.

Investors, what’s in your portfolio?  Have you considered the simmering presence of the laboratory in how your holdings are priced?  And public companies, do you have any idea what the recipe is behind your price and volume?

If you want to be in the capital markets, you need lab knowledge. Every day, remind yourself that the ingredients you’re focused on may not be the ones the lab is using – and the lab determines the outcome. The lab manufactures what the market consumes.

One of the things we’ll be talking about at the NIRI Southwest Regional Conference is the laboratory, so sign up and join us Aug 22-24 in Austin.  Hope to see you there!

 

 

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.

Piloting Fees

What do these pension funds below have in common?

All (over $1.3 trillion of assets), according to Pensions & Investments, periodical for retirement plans, endorse the SEC’s Fee Pilot program on stock-trading in US equities.

The California State Teachers’ Retirement System
The California Public Employees Retirement System (CalPERS)
The Ontario Teachers Pension Plan (Canada)
The New York City Retirement Systems
The State of Wisconsin Investment Board
The Alberta Investment Management Corp. (Canada)
The Healthcare of Ontario Pension Plan (Canada)
The Alaska Permanent Fund Corp.
The Arizona State Retirement System
The San Francisco City & County Employees’ Retirement System
The Wyoming Retirement System
The San Diego City Employees’ Retirement System

In case you missed the news, we’ll explain the study in a moment. It will affect how stocks trade and could reverse what we believe are flaws in the structure of the US stock market impeding capital formation. But first, we perused comment letters from other supportive investors and found:

Capital Group (parent of American Funds) $1.7 trillion
Wellington Management, $1 trillion
State Street Global Advisors, $2.7 trillion (but State Street wants Exchange Traded Products, ETPs, its primary business, excluded)
Invesco, $970 billion
Fidelity Investments, $2.4 trillion
Vanguard, $5.1 trillion
Blackrock, $6.3 trillion (with the proviso that equal ETPs be clustered in the same test groups)
Assorted smaller investment advisors

By contrast, big exchange operators and a collection of trading intermediaries are either opposed to the study or to eliminating trading incentives called rebates.  We’ll explain “rebates” in a bit.

That the views of investors and exchanges contrast starkly speaks volumes about how the market works today.  None of us wants to pick a fight with the NYSE or the Nasdaq. They’re pillars of the capital markets where we’re friends, colleagues and fellow constituents. And to be fair, it’s not their fault. They’re trying to compete under rules created by the SEC. But once upon a time exchanges matched investors and issuers.

Let’s survey the study. The program aims to assess the impact of trading fees, costs for buying and selling shares, and rebates, or payments for buying or selling, on how trading in stocks behaves.  There’s widespread belief fees distort how stock orders are handled.

The market today is an interconnected data network of 13 stock exchanges (four and soon five by the NYSE, three from the Nasdaq, and four from CBOE, plus new entrant IEX, the only one paying no trading rebates), and 32 Alternative Trading Systems (says Finra).

The bedrock of Regulation National Market System governing this market is that all trades in any individual stock must occur at a single best price:  The National Best Bid to buy, or Offer to sell – the NBBO.  Since exchanges cannot give preference and must share prices and customers, how to attract orders to a market?  Pay traders.

All three big exchange groups pay traders to set the best Bid to buy at one platform and the best Offer to sell at another, so trades will flow to them (between the NBBO).  Then they sell feeds with this price-setting data to brokers, which must by rule buy it to prove to customers they’re giving “best execution.” High-volume traders buy it too, to inform smart order routers.  Exchanges also sell technology services to speed interaction.

It’s a huge business, this data and services segment.  Under Reg NMS, the number of public companies has fallen by 50% while the exchanges have become massive multibillion-dollar organizations.  No wonder they like the status quo.

The vast majority of letters favoring the study point to how incentive payments from exchanges that attract order flow to a market may mean investors overpay.

One example: Linda Giordano and Jeff Alexander at BabelFish Analytics are two of the smartest market structure people I know. They deal in “execution quality,” the overall cost to investors to buy and sell stocks. Read their letter. It explains how trading incentives increase costs.

Our concern is that incentives foster false prices. When exchanges pay traders not wanting to own shares to set prices, the prices do not reflect supply and demand. What’s more, the continuous changing of prices to profit on differences is arbitrage. The stock market is riven with it thanks to incentives and rules.

The more arbitrage, the harder to buy and sell for big investors. Arbitrage is the exact opposite motivation from investment. Why would we want a market full of it?

The three constituents opposing eliminating trading payments are the parties selling data, and the two principal arbitrage forces in the market:  High-frequency traders, and ETFs.

What should matter to public companies is if the stock market is a good place for the kind of money you spend your time targeting and informing. Look at the list above. We’ve written for 12 years now about how the market has evolved from a place for risk-taking capital to find innovative companies, to one best suited to fast machines with short horizons and the intermediaries selling data and services for navigating it.

Today, less than 13% of trading volume comes from money that commits for years to your investment thesis and strategy. All the rest is something else ranging from machines speculating on ticks, to passive money tracking benchmarks, to pairing tactics involving derivatives.

So public companies, if your exchange urges you for the sake of market integrity to oppose the study, ask them why $22 trillion of investment assets favor it? When will public companies and investors take back their own market? The SEC is offering that opportunity via this study.

Are there risks? Yes. The market has become utterly dependent for prices on arbitrage. But to persist with a hollow market where supply and demand are distorted because we fear the consequences of change is the coward’s path.

Substitutes

Substitutes were responsible for yesterday’s market selloff.

Remember back in school when you had substitute teachers? They were standing in for the real deal, no offense to substitutes.  But did you maybe take them a little less seriously than the home room teacher?

The market is saturated with substitutes. The difference between stocks and the home room back in grammar school is nobody knows the difference.

If shares are borrowed they look the same to the market as shares that are not borrowed.  If you use a credit card, the money is the same to the merchant from whom you just bought dinner or a summer outfit. But it’s a substitute for cash you may or may not have (a key statistic on consumption trends).

Apply to borrowed stock. The average Russell 1000 stock trades $235 million of stock daily, and in the past 50 trading days 46%, or $108 million, came from borrowed shares. The Russell 1000 represents over 90% of market capitalization and volume. Almost half of it is a substitute.

Why does it matter?  Suppose half the fans in the stands at an athletic event were proxies, cardboard cutouts that bought an option to attend a game but were there only in the form of a Fathead, a simulacrum.

The stadium would appear to be full but think of the distortions in player salaries, costs of advertisement, ticket prices.  If all the stand-ins vanished and we saw the bleachers were half-empty, what effect would it have on market behavior?

Shorting is the biggest substitute in the stock market but hardly the only one.  Options – rights to buy shares – are substitutes. When you buy call options you pay a fee for the right to become future demand for shares of stock.  Your demand becomes part of the audience, part of the way the market is priced.

But your demand is a Fathead, a representation that may not take on greater dimension. Picture this:  Suppose you were able to buy a chit – a coupon – that would increase in value if kitchen remodels were on the rise.

Your Kitchen Chit would appreciate if people were buying stoves, fridges, countertops, custom cabinets.  Now imagine that so many people wanted to invest in the growth of kitchen remodels that Kitchen Chits were created in exchange for other things, such as cash or stocks.

What’s the problem here?  People believe Kitchen Chits reflect growth in kitchen remodels. If they’re backed instead by something else, there’s distortion.  And buying and selling Kitchen Chits becomes an end unto itself as investors lose sight of what’s real and focus on the substitute.

It happens with stocks. Every month options expire that reflect substitutes. This kitchen-chit business is so big that by our measures it was over 19% of market volume in the Russell 1000 the past five days during April options-expirations.

It distorts the market.  Take CAT.  Caterpillar had big earnings. The stock was way up pre-market, the whole market too, trading up on futures – SUBSTITUTES – 150 points as measured by the Dow Jones Industrial Average.

But yesterday was Counterparty Tuesday, the day each month when those underwriting substitutes like options, futures, swaps, balance their books.  Suppose they had CAT shares to back new options on CAT, and they bid up rights in the premarket in anticipation of strong demand.

The market opened and nobody showed up at the cash register. All the parties expecting to square books in CAT by selling future rights to shares at a profit instead cut prices on substitutes and then dumped what real product they had.  CAT plunged.

Extrapolate across stocks. It’s the problem with a market stuffed full of substitutes. Yesterday the substitutes didn’t show up to teach the class. The market discovered on a single day that when substitutes are backed out, there’s not nearly so much real demand as substitutes imply.

Substitution distorts realistic expectations about risk and reward. It’s too late to change the calculus. The next best thing is measuring substitutes so as not to confuse the fans of stocks with the Fatheads.