September 2, 2015


One thing you learn not to say is “well it can’t go any lower.”

So said the investor-relations officer for a big energy company as we talked recently about markets. Last week we were writing after the biggest drubbing for stocks since 2008, and as the strongest rally in oil since war – Gulf One, when Saddam, Kuwait and Stormin’ Norman Schwarzkopf were center stage – commenced a quarter-century ago.

If you’re going to spend money in this market as so many public companies do, it’s best to know the derivation of its vicissitudes. Not China, the Fed, oil supplies, jobs data. Those are inputs. What determines outcomes in markets is structure. Think otherwise? Play a game by your own rules and see how others react. Rules govern behavior.

Morningstar said in July that the S&P 500 in the first quarter of 2015 spent more on buybacks ($238 billion) than it earned in profits ($228 billion), an anomaly last seen in latter 2008 when companies were losing money but still plowed $100 billion into stock. They’re buying what they know – their businesses. Why then if the market summarizes business-value do companies struggle to understand it?

The answer is they’re unclear on the rules governing it.  Take the NYSE’s Rule 48, invoked for extreme volatility, about which there’s been chatter at CNBC and elsewhere. It permits the NYSE to suspend ahead of what may be a turbulent day the usual requirement that Designated Market Makers – KCG Holdings, Barclays, IMC Financial Markets and Virtu – approve and post prices before trading starts. I’d translate invocation of the rule as: “Look, do whatever you need to.”

The DMMs may be permitted to do whatever they need to when among other things foreign markets are volatile or unusual activity afflicts the futures market. It would be the latter that triggered yesterday’s use of Rule 48, we’d guess, the fourth time now in two weeks.  So right away the exchange is telling us factors beyond the summary of business-value here in America impact our stocks. Doesn’t matter where you do business.

Rule 48 was created in December 2007 as the mortgage derivatives debacle was picking up steam and as Bear Stearns labored into its final weeks of life. It’s been amended repeatedly, last on August 13 this year by NYSE rule-filing deleting a requirement for DMMs to get exchange approval before initiating trades more than 10% different in price from the last one.

DMMs are proprietary traders – yes, even Barclays here. They’re paid to make markets and so they’re prohibited from filling customer orders for an exchange rebate. But they can “reach across” the market to buy the NYSE’s best offer or sell to its best bid (how that’s different from proprietary trading in dark pools is unclear).

The Nasdaq doesn’t have DMMs but it pays high-speed traders to set prices too. Before markets open, prices are disseminating via proprietary exchange feeds to help fast traders line up and create stable positions. The NYSE says “DMM units have increased their utilization of technology to reduce risk exposure by using algorithms to adjust prices quickly in response to market dynamics.”

Consider these facts against a volatility backdrop, and here’s what you must know:

  • Prices in US markets at the open and throughout the day are often set by fast traders who aren’t investors in your shares but aiming to profit by setting prices.
  • The biggest fast traders are global like IMC and Virtu, the latter saying it’s “embedded” in 200 global markets.
  • Fast traders connect markets globally by trading everything at once – equities, options, futures, currencies (all the stuff transacting on exchanges).
  • They’re arbitragers at root, profiting on spreads.

Here’s the capstone. The average US equity trade-size (if you don’t know yours, you should) is less than two futures contracts. In a global interconnected market, the capacity of high-speed traders to move equity prices using futures is astronomical. 

It’s ultimately about the root of all prices: Money. Currency-volatility. You saw it again this week.

A closing word on markets: The ModernIR 10-Point Behavioral Index at Aug 28 was 1.8. We’ve never registered an official reading below 2.0. A bottom likely looms though September expirations could be ugly again. And we won’t say it can’t go lower.

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