March 20, 2019

Five Questions

Is less more?

This is the question anyone looking at the stock market as a barometer for rational thought – from stock-pickers to investor-relations professionals – should be asking.

A Wall Street Journal article yesterday, “Passive Investing Gains Even in Turbulent Times,” notes that $203 billion flowed to Exchange Traded Funds (ETFs) between September and January, while $167 billion went to index funds.

Most thought stock-pickers would win assets during volatility. So let’s ask another question. From where did the money come?  Morningstar, the WSJ says, shows $370 billion – the same figure – left stock-picking funds from Sep 2018-Jan 2019.

Here’s a third question: What sets prices for stocks?

If you move money from savings to checking, total value of your bank accounts doesn’t gyrate. Should we be asking why moving money from stock-pickers to indexers would be so violent?

I’ve got one more question for IR practitioners before we get to answers: If stock-pickers are seeing net redemptions – money leaving – what should we expect from them as price-setters in stocks?

Okay, let’s review and answer:

Is less stock-picking worth more?  What sets stock-prices? Where did the money going to ETFs and indexes come from? Why did the market move violently these last months? And finally, what should we expect from stock-pickers as price-setters?

Less is not more.  I’m reminded of a line from a professional poker-player who taught poker to a group of us.  He said, “People who chase straights and flushes borrow money to go home on buses.”

The point is that hoping something will happen isn’t a strategy. Hoping stock-pickers, which have lost trillions to passive investments over the past decade, will set your price more is chasing a flush.

We teach our clients to cultivate a diverse palette of those shrinking Active Investment relationships so an Active force will be present more frequently. We show them how to use data to better match product to consumer, further improving the odds.

But look, IR people: If stock pickers saw $370 billion of outflows, they were selling stocks, not buying them. Less is not more.

Stock prices are set by the best bid to buy or offer to sell. Not your fundamentals, or news or blah, blah, blah. What MOTIVATES somebody to hit the bid or the offer is most often that the price changed.

The investment category benefiting most from changing prices is ETFs, because they depend on an “arbitrage mechanism,” or different prices for the same thing.

(Editorial Note:  I’ll be speaking to the Pittsburgh NIRI chapter the evening of Mar 26 on how ETFs affect stocks.)

ETFs are not pooled investments. Blackrock does not combine funds from investors to buy stocks and hold them in an ETF.  ETFs don’t manage other people’s money.

ETF sponsors receive stocks from a broker as collateral, and the broker creates and sells ETF shares. Only the broker has customer accounts. The ETF’s motivation is to profit on the collateral by washing out its capital gains, leveraging it, selling it, investing it.

I’m trying to help you see the motivation in the market. The longer we persist in thinking things about the market that aren’t buttressed by the data, the greater the future risk of the unexpected.

The money that motivated ETFs to profit from changing prices September to January came from stock-pickers.

The market was violent because ETFs form a layer of derivatives in markets obscuring the real supply and demand of stocks. As stocks declined, the number of shares of ETFs did not – causing a downward cascade.

Then as money shifted out of stocks to ETFs, the supply again did not increase, so more money chased the same goods – and ETFs were a currency reflating underlying assets.

If no money either came into or left the market, and it was tumultuously up and down, we can conclude that the actual withdrawal of money from equities could be epic straight-chasing, everybody borrowing money to go home on buses.

We should expect stock-pickers to drive the market to the degree that they are price-setters. That’s 10-15% of the time. In this market riven with collateralized derivatives, you must know what sets prices.

Stock-pickers, if you know, you won’t chase straights and flushes. IR professionals, you’ll help your board and executive team understand the core drivers behind equity value. It’s your story only sometimes. They should know when it is – and when it’s not.

Much of the time, it’s just because your price changes (which ETFs feed). Ask us! We’ll show you the data behind price and volume.

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