Tagged: Trading

Auctioning Profits

What’s the closing auction worth?

A member of the investor-relations profession last week posted a story for community discussion on a CBOE BATS proposal to open day-end auctions to exchanges that don’t have listings.

Right now rules say only the listing venue, largely the Nasdaq and the NYSE, can host end-of-day trades that many investors count on for prices that best track broad measures like the S&P 500 and Dow Jones Industrial Average.  BATS is trying to change it.

First, what’s the closing auction? Near the end of the trading day, exchanges that list stocks start providing data on buy and sell orders that want to get the last and best price.  All three big exchange groups host them – the NYSE, Nasdaq, BATS – and new entrant IEX has gotten tacit approval for its closing auction ahead of listings.

All three big groups have rules around what kinds of orders are included, but generally they are “market on close,” or a trade that takes the best price to buy or sell, or “limit on close” trades that only execute if the specified price matches the market.

BATS is the earliest in providing data and starts sending five-second updates on buy and sell imbalances at 3p ET. The NYSE and the Nasdaq follow at 3:45 and 3:50p ET respectively, also every five seconds.  Have you noticed how prices can change significantly in the last hour and especially last 15 minutes? There’s your reason.

Oversimplifying, right at 4p ET everywhere, buy and sell interest is matched at an average price. The NYSE calls it an auction, BATS uses a Dutch Auction (averaging all prices, excluding outliers) and the Nasdaq calls it the Closing Cross.

Now it gets interesting. This mass closing trade for NYSE stocks happens only at the NYSE and ditto for Nasdaq-listed shares.  BATS has proposed to the SEC that they be able to match trades in NYSE and Nasdaq stocks in the closing auction.

This at root is why exchanges want your stock-listing, public companies. It’s where the money is made.

The listing exchanges are outraged. Who can blame them? All the more when you understand the economics. Save at the open and close, trading at the exchange is a low-margin and often money-losing business.

They pay high-speed firms to set the best bid to buy or offer to sell. They’d flinch at my description but that’s the truth. Rules cap what exchanges can charge for trades at $0.30/100 shares.  But they can pay incentives well beyond that. The big exchanges have incentive tiers and platforms for high-volume customers paying up to $0.45/100 shares. They lose money on these.

Why would they do that? Because all trades in your stocks must match between the NBBO – the national best bid or offer. It’s a central tenet of Reg NMS, which governs markets. Exchanges pay some traders to be honey that attracts the bees.

The exceptions are the opening and closing auctions. Here, all the order flow ends up between the bid and offer by rule at some average price, and exchanges do not pay incentives because they have a monopoly in their listed stocks.

In fact, they charge about $0.09/100 to both the buyer and the seller ($0.18 total), meaning they make more in the auctions than any other time. Easy money.

Nearly 10% of trading occurs in the closing auction because it offers indexes and ETFs trying to “peg the benchmark” the best chance of getting prices nearest the index they’re tracking.

With about 6.5 billion shares trading daily marketwide and roughly 2.6 billion of it at the NYSE and Nasdaq, and 10% of that in the close, you can get to roughly $150 million of potential revenue annually for the big exchanges in these auctions. These are our estimates, mind.

But that’s not the half of it. Literally. Hosting the closing auctions drives two other vital revenue streams for big exchanges. First is a share of revenue from the Consolidated Tape Association.

The Tape Plan, as it’s called, divides revenue from data generated by stock tickers (you look up a ticker, you’re driving exchange revenue). It’s hundreds of millions of dollars yearly for members.  It’s apportioned by quote-share and trade-share in stock symbols. The closing auction gives the NYSE and Nasdaq a disproportionate part.

Second and data-related, prices from the closing auction comprise valuable data, and brokers are required to buy it to prove they matched best prices. The most precious product exchanges sell is data. And it’s vital to profits, since trading is a commodity.

The Nasdaq earned $108 million of net income in fiscal 2016, NYSE parent ICE, which is less reliant on equity trading, about $250 million. Take $250-$300 million (that they split) away – figuring data is double closing-auction trading revenue – by fragmenting the close, and the bottom line for both is hampered.

It’s an estimate. But follow the money and this is where it leads.

I can make the argument both ways. Fragmenting imbalance data by spreading the auctions out could mean mispricing. That to me is the leading argument against the BATS proposal.  Conversely, BATS would argue that it’s using the same pricing data so it merely increases access and removes an unfair advantage from listing exchanges – which could help you pay lower listing fees, issuers.

The bottom line is you need to know how the market works. Otherwise you cede control of it to parties wanting to profit on your prices.  That’s not in the best interest of your shareholders.

Volatility Insurance

In Texas everything is bigger including the dry-aged beef ribs at Hubbell & Hudson in the Woodlands and the lazy river at Houston’s Marriott Marquis, shaped familiarly.

We were visiting clients and friends before quarterly reporting begins again. Speaking of which, ever been surprised by how stocks behave with results?

We see in the data that often the cause isn’t owners of assets – holders of stocks – but providers of insurance. To guard against the chance of surprises, investors and traders use insurance, generally in the form of derivatives, like options. 

Played Monopoly, the board game? A Get Out of Jail Free card is a right but not an obligation to do something in the future that depends on an outcome, in this case landing on the “go to jail” space. It’s only valuable if that event occurs. It’s a derivatives contract.

At earnings, if you shift the focus from growth – topline – to value – managing what’s between the topline and the bottom line – the worth of future growth can evaporate even if investors don’t sell a share.

Investors with portfolio insurance use their Get Out of Jail Free cards, perhaps comprised of S&P 500 index futures. The insurance provider, a bank or fund, delivers futures and offsets its exposure by selling and shorting your shares. It can drop your price 10-20%.

Writers Chris Whittall and Jon Sindreu last Friday in the Wall Street Journal offered the most compelling piece (may require registration — send me a note if you can’t read it) I’ve seen on this concept of insurance in stocks.

Investors of all ilks, not just hedge funds, protect assets against the unknown, as we all do. We buy life, auto, health, home insurance.  We seek a Get Out of Jail Free card for ourselves and our actions.

In stocks, we track this propensity as Risk Management, one of the four key behaviors setting market prices. It’s real and by our measures north of 13% of total market cap.

But the market has been a flat sea.  No volatility.  This despite a new President, geopolitical intrigue, global acts of terror, a Federal Reserve stretching after eight Rumpelstiltskin years, and a chasm between markets and fundamentals.

Whittall and Sindreu theorize that opposing actions between buyers and sellers of insurance explains the strange placidity in markets where the VIX, the so-called Fear Gauge derived from prices of options on stocks, has been near record lows.

The thinking goes that the process of buying and selling insurance is itself the explanation for absence of froth. Because markets seem inured to threats, investors stop buying insurance such as put options against surprise moves, and instead look to sell insurance to generate a fee. They write puts or calls, which generate cash returns.

Banks take the other side of the trade because that’s what banks do. They’re now betting volatility will rise. To offset the risk they’re wrong, they buy the underlying: stocks. If volatility rises the bet pays, but the bank loses on the shares, which fall. 

This combination of events, it’s supposed, is contributing to imperturbable markets. Everything nets to zero except the stock-purchases by banks and cash returns generated by investors selling insurance, so there’s no volatility and markets tend to rise.

Except that’s not investment. It’s trafficking in get-out-of-jail-free cards.

And despite low volatility, there’s a cost. We’ve long said there will be a Lehman moment for a market dominated by Risk Management.

We’ve seen hedge funds struggle. They’re big players in the insurance game. And banks have labored at trading. Maybe it’s due to insurance losses. Think Credit Suisse, Deutsche Bank, HSBC.  Someone else?

From Nov 9-Mar 1 the behavior we call Risk Management led as price-setter marketwide, followed closely by Active Investment. The combination points to what’s been described: One party selling insurance on risk, another buying it, and a continual truing up of wins and losses.  

Now, for perspective, the VIX is a lousy alarm system. It tells us only what’s occurred. And intraday volatility, the spread between daily high and low prices across the market, is 2.2%, far higher than closing prices imply.

We may reach a day where banks stop buying insurance from selling investors, if indeed that’s what’s been occurring.  Stocks will cease rising.  Investors will want to buy insurance but the banks won’t sell it.  Then real assets, not insurance, will be sold.

It’s why we track Risk Management as a market demographic, and you should too.  You can’t prevent risk. But you can see it change.

Outliers

“Since I started Baron Funds in 1982,” said Ron Baron on Squawk Box last week, “we’ve owned 2,500 stocks. Take 15 of them out and we’re average.”

Baron is quintessentially rational. Visit Baron Funds and click on About and the words across the top are Long-term Investors. Research-Driven. No better proof can be found than that the director of research at Baron, Amy Chasen, was the IR head at Avon for years.

There are 36 fund managers and analysts at Baron overseeing about $21 billion of assets and the firm since 1982 has distinguished itself via patience and homework. Pick good companies and hold them for a long time. 

What percentage of the picks would you expect to be outliers – top performers? Maybe 75%?  The firm is looking for outliers after all. They’re not aiming to be average like Blackrock and Vanguard.

Okay, that’s probably a high expectation. Every time we demonstrate Market Structure Analytics to somebody new we expect there’s a 35% chance, based on the numbers we track, that that person will become a client, because we’re also patient and persistent.

So let’s lower our target for Baron.  Seventy-five percent is too high but you’d think stock pickers would be hoping they’re right at least half the time.  No?

You already know the answer: 0.6% of the firm’s stock selections beat the averages. That’s what 15 of 2,500 is.  The other 2,485 choices add up to average.  Now the good news for Baron is they don’t have to be right often to be good.

The bad news for IR is that using Baron Capital as our index of investor-relations outcomes, the likelihood that you’ll stand out from the crowd is less than 1%. 

“Oh come on Quast, what is this? The beatings will continue until moral improves?”

Oh ye pessimists, it’s the opposite.  IR is not just a storyteller.  IR is the product manager of the equity market.  If your management team thinks you have a 90% chance of standing out from the crowd and you lead them to persist in that belief, you’re creating a lot of needless IR stress. 

It doesn’t mean you stop trying of course. According to our illustrious trade association, NIRI, which at long last as a CEO again, 92% of public companies hold earnings calls (you wonder who the 8% are that don’t, and I’d love to know if they trade differently than the 92% — and my bet is there’s only about a 1% chance they do).  We tell the story because we must. 

But it’s high time IR adapts to the market we’ve got and it’s a lot like retail.  By that I mean the money isn’t one demographic, any more than the customers in Nordstrom are all one demographic group (they may share some characteristics sure, but they’re not all the same age or gender or height or weight).

And by that I also mean you all have high-speed pricing. Do you know that Amazon changes the prices of many items every 15 minutes?  They reprice with algorithms in response to online demand.  Well, now all the other retailers have had to adapt.  Walmart, Target, Best Buy and others may change prices 5-6 times a day now. 

I’ve got the Market Structure Report for a large food company here in front of me. It traded over 53,000 times daily the past week. Theoretically it could be a different price every time. The spread each day between highest and lowest prices averaged 2.3%. Add that up over 20 trading days and it’s 46% of the stock’s market cap.

Retailers are continuously engaging in markdowns to rid the shelves of “the dogs,” the stuff that’s not selling. And some hot new thing will come along and demand patterns change and retailers start lifting prices. It’s happened to me with hotels and airlines.  You too?

Juxtapose that with long-term research-driven investment and you see the problem. The dominant investment behavior of the day is Blackrock and Vanguard. They want to peg the averages of these continuously shifting notions of what’s a dog, what’s hot, what’s up, what’s down, or what’s getting continuously repriced in fractions of seconds.

And it appears they’ll be right 2,485 out of 2,500 times, or about 99% of the time. Over the past decade, 98% of active fund managers (and I think Baron was in the 2%) failed to beat the S&P 500, says Morningstar (Dec 2005-Dec 2015 but you get the point).  

The 20th century was all about active investment for IR, and telling the story, and as a result 92% of us hold earnings calls. But we’ve got to catch up to the market. 

Sometime over the next decade, 92% of us should be viewing ALL the money as the audience, messaging to some of it and consistently measuring the rest, like retailers do. We’ve got to be data analysts in IR.

Because we won’t all be outliers.

Open Water

If you want to be creeped out – and who doesn’t? – see the movie “Open Water.” It explains the problem with Board reports in investor-relations too.

American director Chris Kentis based his 2003 film on real events. A couple go scuba-diving and are left behind at sea.  He spent $500,000 making it and earned $55 million at the box office. That’s not the part resembling Board reports, unfortunately.

I don’t want to spoil the movie if you’ve never seen it, but I won’t because it’s a psychological drama depending not on action but implication that takes place in one spot on the sea.  Imagine you went scuba diving miles from shore and surfaced and everyone was gone and the current kept you out?

Now suppose as an investigator later it was your job to measure what happened to the couple. You had at your disposal film of the very spot on the ocean that the couple had occupied. You play back four three-month time-lapse slices of film at high speed.

Nothing. Open water.  It’s all you see. Sky whizzes by, days and nights are nearly indistinguishable, the sea appears as an unmarked surface moving across time.

It’s the wrong measure.  To understand what happened to the scuba divers you’d have to zoom in and watch spare increments.  Then you’d see – wait, there.  Are those specks in the water?  Sure enough, two people.  What are they doing?  Now let’s watch….

And that’s what’s wrong with Board reports.  They don’t measure the stock market the way it works. Executives have long strategic horizons and companies are generally benchmarking progress every quarter and looking at years of stock performance.

But your stock is like scuba divers bobbing on the water and your business is as timeless as the sea by comparison to what sets price. Blink.  Okay, blink again. That’s 350 milliseconds, give or take.  Many stocks trade 500 times in one blink.

No, don’t report to the Board every blink in your trading. But if we’re going to impart understanding – the point of providing information – of how shares change in value over time, the measures must reflect the way the ecosystem for your stock functions.

Your buy-and-hold investors have the same horizons you do.  But that’s not the money setting prices most days. Because it buys, and holds.

About 40% of the volume in your stock aims at horizons of a day or less, and generally just fractions of seconds to catch a penny spread a thousand times. Another 33% moves with the ocean, indexes deploying and removing money metronomically with a model. Another 13% or so pegs opportunity to instruments derived from your shares such as options, futures, forwards and swaps with horizons of days or weeks at most.

So just 14% of your market cap traces directly to your long-term strategy.

You say, “That cannot be true.”

In 2006, half the value of the housing market traced to real estate and the rest reflected rights to homes via mortgage-backed securities, and in some markets it was more than 80%. We know because that’s how much home-values declined.

On May 6, 2010, the Flash Crash, the Dow Jones Industrial Average lost a thousand points, or about 10% of its value, in mere minutes, because the money with tiny horizons disappeared from the market.

On August 24, 2015, some exchange-traded funds diverged by 30% or more from the underlying value of assets because money with horizons far shorter than the business strategy of any of the stocks giving them derivative value left. Briefly.

Those are outliers but lesser manifestations are a thrumming reef of vibrancy every day in your stock. At ModernIR, we measure price-setting in one-day and five-day increments because it’s the only way to see the scuba divers bobbing in the water – or the Activists, the fleeting shift in risk-management behavior reflecting deal-arbitrage, the evaporation of momentum, the abrupt drop in index-investment, the paired behaviors indicative of hedge funds coming or going.

Were we to paint stocks with bold brush strokes, the nuances responsible for price-changes would be as flat and impenetrable as open water. And meaningless to the Board and the management team.

The next time you ready information for the Board, think about the ecosystem, which is frenetic – in stark contrast to business strategy.  If nothing else, make sure they recognize that at any given moment, price depends on the 85% oblivious to strategy.

That might seem frightening, like sharks. Like the sharks it’s but a fact of the stock ecosystem, something to be understood rather than feared (and if you want to learn about the ecosystem, ask us!).

Core Reality

“Our stock dropped because Citi downgraded us today.”

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

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

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

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

How could it be uniquely valuable information proffering investment opportunity?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Selling the Future

Karen and I are in Playa del Carmen, having left the US after the Trump election.

Just kidding! We’re celebrating…Karen’s 50th birthday first here on the lovely beaches of Quintana Roo and next in New York where we go often but never for fun. This time, no work and all play.

Speaking of work, Brian Leite, head of client services, circulated a story to the team about Carl Icahn’s election-night buys. Futures were plunging as Mrs. Clinton’s path to victory narrowed. Mr. Icahn bought.

If you’ve got a billion dollars you can most times make money.  You’d buy the cheapest sector options and futures and aim your billion at a handful of, say, small-cap banks in a giant SEC tick-size study that are likely to move up rapidly. Chase them until your financial-sector futures are in the money.  Cash out.  See, easy.

(Editorial observation: It might be argued the tick study exacerbated volatility – it’s heavily concentrated in Nasdaq stocks and that market has been more volatile. It might also be argued that low spreads rob investors of returns and pay them to traders instead.)

If you’re big you can buy and sell the future anytime. The market last week roared on strength for financials, industrials, defense and other parts of the market thought to benefit from an unshackled Trump economy.

An aside: In Denver, don’t miss my good friend Rich Barry tomorrow at NIRI on the market post-election (Rich, we’ll have a margarita for you in Old Mexico).

We track the four main reasons investors and traders buy or sell, dividing market volume among these central tendencies. Folks buy or sell stocks for their unique features (stock picking), because they’re like other stocks (asset allocation), to profit on price-differences (fast trading) and to protect or leverage trades and portfolios (risk management).

Fast trading led and inversely correlated with risk-management. It was a leveraged, speculative rally. Traders profited by trafficking short-term in people’s long-term expectations (there was a Reagan boom but it followed a tough first eighteen Reagan months that were consequences of things done long before he arrived).

Traders buy the future in the form of rights and sell it long before the future arrives, so that by the time it does the future isn’t what it used to be.

They’re grabbing in days the implied profits from a rebounding future that must unfold over months or even years. Contrast with stock-pickers and public companies. Both pursue long arcs requiring time and patience.

Aside: ModernIR and NIRI will host an incredible but true expose with Joe Saluzzi of Themis Trading and Mett Kinak of T Rowe Price Dec 1 on how big investors buy and sell stocks today. 

Why does the market favor trading the future in the present? It’s “time-priority,” meaning the fastest – the least patient – must by rule set the price of stocks, the underlying assets. We could mount a Trump-size sign over the market: Arbitrage Here.

We’re told low spreads are good for investors. No, wide spreads assign value to time. Low spreads benefit anyone wanting to leave fast. Low spreads encourage profiting on price-differences – which is high-frequency trading.

Long has the Wall Street Journal’s Jason Zweig written that patience is an investing virtue.  Last weekend’s column asked if we have the stamina to be wealthy, the clear implication being that time is our friend.

Yet market structure is the enemy of patience. Options expire today through Friday. The present value of the future lapses. With the future spent, we may give back this surge long before the Trump presidency begins, even by Thanksgiving.

I like to compare markets and monetary policy. Consider interest rates. High rates require commitment. Low borrowing costs encourage leverage for short-term opportunities.  We’ve got things backward in money and the markets alike. Time is not our friend.

Upshot?  The country is in a mood to question assumptions. We could put aside differences and agree to quit selling the future to fast traders. Stop making low spreads and high speed key tenets of a market meant to promote time and patience – the future.

Total Confusion

The Nasdaq will now run Goldman’s dark pool.

Walk up to any random stranger and blurt that phrase and see what happens. Nasdaq?  Goldman? Dark Pool? You’re crazy?

Bloomberg reported on Halloween that banker Goldman Sachs would turn over management of its so-called dark pool Sigma X to exchange operator Nasdaq. If you work in the equity capital markets (like the investor-relations profession) you need to understand what’s going on.

It requires a history lesson. In 1792, brokers meeting under a downtown New York buttonwood tree to do business realized that sharing customers would mean more buyers and sellers – a market.  They created the New York Stock Exchange, a “farmers market” for stocks, where interested consumers could peruse the “booths” for products they liked.

Fast forward to 1971. A national association of securities dealers created a quotation system for stocks that became the Nasdaq.

Enter Congress.

Four years after eliminating intrinsic value from money by disconnecting it from assets such as gold, the USA was in “Stagflation” (inflation without growth, something that again seems to be gaining purchase in the data) and people were borrowing shares like crazy and using derivatives in totally new ways.

Worried its new paper money lacking substance was going to derail the stock market, Congress in 1975 passed the Section 11 amendments to the Exchange Act to form a National Market System that could be better “managed.”

Before Congress intervened, stocks were traded at the markets where those shares were listed, and markets were owned by brokers.  After Congress took over, markets were gradually separated from the brokers who created them and stocks could trade anywhere (suppose regulators forced Whole Foods to carry Safeway’s private-label products).

Government moves at glacial speed but leaves the same plowed troughs as do vast wedges of frozen water.  It’s only looking behind that you see the scored landscape. Brokers wanted to match buyers and sellers, so they created exchanges. Regulators linked all those exchanges together, undermining competition while claiming to enhance it. Then regulators separated the markets created by brokers from the brokers.

That’s like a Farmers Market that bars farmers. How does the produce get there?

So faced, brokers created new private markets that were dubbed rather unceremoniously “dark pools” because they’re private members-only affairs.  Here’s the bizarre part. Goldman Sachs operates Sigma X because its customers – investors and traders – wanted to get away from the stock market!

Think about that.  In 1792, brokers pooled stock-buying to create a market. Today, customers of brokers want to avoid the stock-buying pools brokers first created, now called exchanges but which today are for-profit businesses selling data and technology and bearing little resemblance to the early stock bazaars.

Why would buyers and sellers choose a stock Speakeasy over a stock shopping mall?  Because mall shoppers can’t tell if they’re getting a deal or screwed.

But now there is so much pressure on brokers to do this or that to comply with rules that they’re afraid to operate markets. Every time they move, a regulator fines them.

In some ways, we’ve come full circle.  Brokers created exchanges.  Stocks traded on exchanges.  Regulators decided brokers were hurting customers and so separated exchanges from the brokers who created them. Now an exchange is taking over the market a broker created as a substitute for the exchange brokers originally created.

Confused? You should be! This is crazy stuff.  There are too many rules, too little transparency, free interaction.  For investor-relations professionals it means more work for your investors trying to buy shares. Markets should make it easier, not harder.  Isn’t that the point?

For forty years, public companies have been spending money and time targeting investors while ignoring the market where those investors buy shares. Effort targeting investors is for naught if they can’t buy or sell stocks efficiently. Have we got it backward?

Chasing Gaps

Have you ever set an important goal?

Whatever your objective, you must plan how to arrive at your final destination as though it were a journey and you were constructing a map or set of directions. And then you persevere, letting nothing deter your purpose.

We don’t all achieve our goals and any extended effort carries risk. You can fail. Your directions could be wrong. You may have underestimated the obstacles between aspiration and destination.  Or you stop caring. Right?

What if success instead constituted correctly tabulating the difference between planned and actual progress? Boy that would be a lot less stressful. And you would have an arbitrage formula!

Every week governments the world round disgorge data on employment, the real estate market, manufacturing, exports, imports, budgets, capital spending, commodities, corporate profits, relative values of currencies, economic growth and more.

Yesterday, markets in the US considered the balance of international trade, The Institute for Supply Management’s non-manufacturing index (fairly strong) and the Purchasing Managers Index of services (modest but new orders were abysmal). Today’s data smorgasbord features mortgage applications, oil inventories and the Federal Reserve’s Open Market Committee ledger called the FOMC Minutes about what central bankers said at the March meeting.

Economists and investors troll the data for indications of future economic growth or contraction. They’re looking for progress toward purpose. Arbitragers react to it differently, trading the spread between expectations and outcomes.

Fundamental investment dominates? If only. We measure market behaviors. Active investment is barely more than a third of the daily volume of arbitrage.

We could define arbitrage as the difference between planned and actual progress – how something is faring relative to goal, or expectation.  In practical terms, arbitrage funds seek spreads between the current price of stocks and their forward value reflected in a futures contract.  If a stock is considered undervalued now but likely to rise later (call that a goal), a trader will buy the stock and sell a futures contract for commensurate shares.

The less predictable the future is, the shorter the arbitrage timeframe. Weekly options and futures tied to equities, exchange-traded funds and indexes used to be a rounding error. Today they’re 35% of the options market. Trading in options has a notional value five times that of stock-market dollar-volume daily. Nearly 50% of options trace to one security: SPY, the giant S&P 500 ETF.

If the S&P 500 is the goal, the path, the standard, then options reflect the difference between the goal and the expectations, the progress. You see?

Alas, a marketplace with relentless data minutia and nearly infinite ways to bet money on the difference between goal and progress shifts the purpose of the market from goal-achievement to chasing gaps. Why focus on the long term with its pervasive risk and uncertainty when it’s cheaper and less risky to speculate on whether the PMI Services number will be up or down and how new short-term expectations will affect markets?

Now add this in:  Yesterday the Bank of Japan talked the yen down by suggesting it might take interest rates further negative. The Reserve Bank of Australia warned about currency strength, tantamount, too, to talking money down. The Reserve Bank of India cut rates to a five-year low. Money denominates stocks, bonds, derivatives, commodities. Moving money-values constantly shifts focus from the future to a pairs-trade.

Markets are packed with speculators because we’re obsessed with information that deviates the purpose of capital markets from goals to whether something has departed from a benchmark. It institutionalizes averages and promotes arbitrage – chasing gaps.

We could change it by stilling the tides of data and currencies. Prospects for that goal? Currently a number approaching zero. I believe I’ll take out a short futures position.

Bieber in a Bottle

Volumes are big but trades are small as markets pitch and buck.  On this restless sea, is there a message in a bottle?

That would seem poetic, were literature a help to your CFO in a stock market seeming the same hot mess as Justin Bieber’s Grammy performance Monday night. And what exactly was Kendrick Lamar doing?

If you didn’t see the Grammys, never mind. Back to US stocks, volume daily is leviathan, approaching 10 billion shares that as we noted last week must ionize through fewer than 20 firms on the way to sea spray. Markets last broke so furiously upon the shoals in August 2011 when it seemed the Euro might collapse (which begs that question anew and again leaves it unanswered).

Is it sound or just fury? Amid steep losses shifting to sharp gains into February options expiring today through Friday, trade-sizes have shrunk to the smallest on record.  TABB Group, the market structure consultancy, says average shares per trade in equities was of late 202 shares, dipping from the previous all-time low of 203 last October as markets surged like war from the trenches of August.

Conventional wisdom holds that blocks mark bigs. We’re told whales move in schools. But wait. The buyside and sellside have spent billions on trading technologies to make buying look like selling. The purpose of algorithms is deception.

Let me repeat that:  The purpose of algorithms is deception. Looking for blocks or watching the buy/sell balance means missing the technological revolution in trading the past fifteen years. At ModernIR, we preach a behavioral gospel.  All money is not the same. All prices are not equal.  The purpose of algorithms is deception (repetition is the best form of emphasis). Exchanges sell data, not products.

Against that backdrop, one key to understanding why stock-prices shift is recognizing that the market is not comprised of one behavior.  Suppose you were at the Super Bowl. Would you expect every person in the stands to act the same or might you anticipate bifurcation? Some portion of the audience will be rooting for one team and silent when the other excels. The weighting on sides determines the size of the roar and the silence.

Apply that to your stock.  The greatest mistake currently committed by executives of public companies is supposing the money in the market is a Super Bowl full of unilateral fans rooting for The Team. Recently I encountered an IR officer convinced that revamping the call script was the reason shares were up with earnings mid-November after falling with the call mid-August. That’s akin to supposing you caused an earthquake by slamming a door (August was China and expirations, not earnings).

There is one concrete fact you can know from big volume and small trades by taking the market at face value: A bidding war is underway. What’s knowable on the surface ends there. The rest resides lower.

You can measure the behaviors comprising your daily volume (this is what we pioneered – and if you don’t know what’s setting your price, you’re doing IR like a caveman).  Google, Amazon, Facebook, parse internet traffic. In the 21st century, companies should be parsing volume into demographic bands (if you think your exchange should be doing it, you’re right but misunderstanding what business exchanges are in).

Measure the market as it is. Because an approving roar may have the same timbre as derogatory boos. The last thing you want is your CFO before the Board like Justin Bieber on stage convinced the noise is coming from fans.

And that is the note in the bottle.

Your Voice

I debated high-frequency trader Remco Lenterman on market structure for two hours.

Legendary financial writer Kate Welling (longtime Barron’s managing editor) moderated.  Your executives should be reading Kate so propose to your CFO or CEO that you get a subscription to wellingonwallstreet.com. The blow-by-blow with Remco is called Mano-a-Mano but the reason to read is Kate’s timely financial reporting.

Speaking of market structure, yesterday the SEC’s Equity Market Structure Advisory Committee (EMSAC…makes one think of a giant room-sized flashing and whirring machine) met on matters like high-frequency trading and exchange-traded funds.

Public companies have a friend or two there (IEX’s Brad Katsuyama, folks from Invesco and T Rowe Price) but no emissaries. Suppose we were starting a country to be of, for, and by the people but the cadre creating it weren’t letting the people vote?

It makes one think the party convening the committee (the SEC) can’t handle the truth.  After all, it was the person heading that body, Mary Jo White, who proclaimed in May that the equity market exists for investors and issuers and their interests must be paramount.  It’s a funny way to show it.

And now the NYSE and the Nasdaq, left off too, are protesting. BATS is on while listing only ETFs. The Nasdaq generates most of its revenue from data and technology services, not listings.  Intercontinental Exchange, parent of the NYSE, yesterday bought Interactive Data Corp, a giant data vendor, for $5.6 billion.

How long have we been saying the exchanges are in the data and technology businesses? They’re shareholder-owned entities that understand market structure and how to make money under its rules. That’s not bad but it means they’re not your advocates (yet you get the majority of your IR tools through them, which should give you pause).

On CNBC yesterday morning the Squawk Box crew was talking about one of our clients whose revenues near $2 billion were a million dollars – to the third decimal point in effect – shy of estimates. Droves of sellsiders have shifted to the IR chair, suggesting diminishing impact from equity research and yet that stock moved 8% intraday between high and low prices.

What long-term investor cares if a company’s revenues are $2.983 billion or $2.984 billion (numbers massaged for anonymity)? So how can it be rational?

I hear it now:  “It’s not the number but the trend.”  “It’s the color.”  “Revenues weren’t the issue but the guidance was.”

You’re making the point for me. IR professionals have vast and detailed knowledge of our fundamentals as public companies, as we should.  We know each nuance in the numbers, as we should.  We understand the particulate minutia of variances in flux analysis. As we should.

But we don’t get the mechanics of how shares are bought and sold, or by whom. We don’t know how many can be consumed without moving price.  We trust somehow the stock market works and it’s somebody else’s responsibility to ensure that it does.

Ask yourselves:  Would we trust our sales and revenues to a black box? Then why do we trust our balance sheets – underpinned by equity – to one?

Read my debate with Remco Lenterman about what constitutes liquidity and what sets price today (throw in with the c-suite on a subscription to wellingonwallstreet.com).

We picked two of scores of reporting clients this week and checked tick data at the open. Prices for both were set by one traded share.  Suppose you’re the CEO with a stake worth $300 million. We’ve got one of those reporting tomorrow.  What if the first trade is for one share, valued at say $80, and it shaves 8% off market-cap? That’s $24 million lost in that moment, on paper, for your CEO on a trade for $80.

Now you can say, “You’re caught up in the microsecond, Quast. You need to think long-term.”

Or you could wonder, “Why is that possible?  And is it good for long-term money?”

It’s easier for a camel to pass through the eye of a needle than for rational investors to price a stock at the open in today’s market structure.  But we have the power to change that condition by demanding to be part of the conversation. It starts with caring about market structure – because you don’t want the CEO coming back to you later asking, “Why didn’t you tell me?”

Somebody from among us must be on that SEC committee, whirring lights and all.