“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.
