May 31, 2017

Building Signals

We’re back from the Belizean reef, living like pirates among the stars. Refreshing! When your home is this, and your view is that, and sweet critters are resident below, even I can forget about market structure.

But not for long!  While we sailed with phones in airplane mode and minds in Caribbean mode, the Wall Street Journal launched a journalistic barrage about “the quants,” traders using computers.  I counted 18 items in the series May 21-26.

They missed one big thing. We’ll come to it.

Lead writers Gregory Zuckerman and Bradley Hope with support from a cast describe how algorithms have commandeered Wall Street. It’s not just that computerized instructions are behind the largest slice of stock market activity now – developments we’ve been writing about for more than 12 years.

“Everybody in this industry is suddenly saying: ‘Couldn’t a robot do that?’” said Sean McGould, president of Lighthouse Investment Partners, in a story titled This Old School Hedge Fund is Going Quant by reporter Rob Copeland about Magnetar Capital.

Turns out robots can power a retail day trader’s long-short statistical arbitrage portfolio, trade probabilities in deal arbitrage, market Exchange Traded Funds (ETFs) to investors. And a lot more.

“What if we could take what was in our head and our database and make rules out of it?”

So said Magnetar founder and Citadel alum Alec Litowitz in the same piece. (Aside: This is precisely what we do at ModernIR – take cumulative human market knowledge and experience and translate it into software code that infuses measures of market behavior with objectivity and consistency. Meaning is in patterns, rules-based comparatives.)

Investor relations professionals, if you want to understand the market for the product you manage – your shares – you should read them. We also cover the same subject matter in our Market Structure 101 and 201 classes.

Investors, you should read too. And there’s a convergence for both sets of professionals. The WSJ did a nice job here. They’ve demonstrated the correct role for investigative journalism: To uncover facts and arrange them coherently so readers gain knowledge.

The biggie that’s gone missing I’ll set up by casting far back. Walt Kelly for over 25 years wrote a famous comic strip in newspapers called Pogo. It ended in 1975. Among its vast accumulation of one-liners was this, phrased variously: “We shall meet the enemy, and not only may he be ours, he may be us.”

It’s been translated: “We have met the enemy and he is us.”

From smart-beta ETFs to Blackrock to the vast scope of hedge-fund management, investors are relying on mathematicians and computer scientists and Ph.D. data miners to build the next signal by plumbing troves of economic and business data.

They ARE the signals. It’s like wondering what keeps casting shadows on the wall and finding it’s you.

I’ll give you three building blocks for comprehending modern stock-trading. Number one, all trades must meet between the best bid to buy or offer to sell. Number two, all trades wanting to set the bid or the offer must be automated so they can move fluidly around the National Market System.

And number three, algorithms are designed to deceive. Put those together.  The entire stock market is constructed around a single price for any security, which will be set by machines, which will also be trying to deceive others.

Yet everybody mistakenly thinks they’ll find some signal by threshing data. No, signals are trades. Period. Deceptive ones.

Investors, you’re after differentiating fundamentals.  IR professionals, you’re promoting differentiating fundamentals.

And everybody is building signals. It’s a crossroads in both these professions.  If what you’re doing is at loggerheads with how prices are set, what should you do?

I have a full answer but not enough time for it. A key part is you can’t keep doing what you’ve always done while expecting a different result. You’re then just a buoy on the channel. No more open water.

It’s your market, investors and public companies. Are you ceding it to the signal-chasers?

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