March 9, 2010

How Can 70% and 50% Equal 100%?

Ever since I started ModernIR in early 2005 we’ve been hindered by one thing: me. That’s why I’m delighted to announce a dramatic expansion of the brain trust with the arrival of my brilliant bride, Karen Quast, later this month to head operations.

A CPA by way of Texas A&M and PriceWaterhouseCoopers, Karen moved on to finance at Duke Energy. At DCP Midstream, the joint venture between Duke successor Spectra and ConocoPhillips, Karen took the IR chair to spin off a limited partnership by way of a December 2005 IPO on the NYSE, and she’s been there since. Having her here at ModernIR is like winning the lottery. We’ll finally have superior leadership. Karen is a doer (and she’s super good-looking to boot).

Two other notes: I’m speaking on market structure at the Conference Board’s IR Council in New York Thursday March 11. I’ll be in Silicon Valley March 24-25. If you’d like to meet while I’m out west, I’ve got four spots left on the docket. Drop me a note.

Let’s turn to trading. Something may have changed in March. Program trading – that equity river of life comprised of the crowd’s money – is down. Yet markets are up. How can that be? If programs decline, there’s less selling along with less buying. Trading models continued apace and a supply/demand imbalance formed. It’s like a tug of war where one party lets go of the rope. By our measures in March so far, rational buying is around 6% of volume, while forms of risk-management and speculative trading make up the other 94%.

That may not be true for your stock. Traders aggressively seek anomalies. But whatever the behavior setting your price, it’s evident in market structure. Sometimes it’s a yawn. Other times, it’s eye-popping. Knowing is always cool.

Skeptics say you can’t know what’s behind trading because volume is anonymous. So is the wind. But you can tell which way it’s blowing and what affect it’s likely to have. We take all the breezes and put them together and see if the crowd is setting wind speed, or something else.

You hear all kinds of things about trading. Fifty percent is in programs. Seventy percent is high-frequency. Half the volume is ninety percent algorithmic, to take Yogi Berra’s witticism about baseball and twist it.

So what exactly is it? We can guarantee you that more than 90% of volume is affected by market-structure risk management factors. If you take 100% of your volume, there is a very good chance that 70% of it, give or take, is “high frequency trading,” or forms of arbitrage, market-making and programmed volume designed only to profit from small moves or market inefficiencies and to manage portfolio trading risk or costs. In other words, it’s not there to invest in your stock.

How does that make sense?  Some program trading is churn trading.  Some risk-management volume is, too.  But altogether, it’s mostly fast-moving and almost entirely mathematical.

Exchanges and specialists focus on your biggest market makers. Many look at block trades.  That activity matters less than you think to your price.  It’s the crowd and it’s following the trend. But who’s setting the trend?

All order flow behavior must meet the same market rules, regardless of purpose or time horizon. That alone enables us to see differences. Most activity follows the crowd – which is why most fund managers don’t outperform the market. Some volume speculates on the movement of the crowd, and other volume hedges against the possibility that the crowd is wrong. We don’t have to know who’s doing what; all we have to do is observe the interaction of all the diverse parties. Behavior, in context of rules, materializes.

And if you know the behavior behind your price and volume, you will feel a lot better about the IR chair under your behind, even if you don’t like what you see.

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