June 26, 2019

In Control

This is what Steamboat Springs looked like June 21, the first day of summer (yes, that’s a snow plow).

Before winter returned, we were hiking Emerald Mountain there and were glad the big fella who left these tracks had headed the other way (yes, those are Karen’s shoes on the upper edge, for a size comparison).

A setup for talking about a bear market?  No.  But there are structural facts you need to know.  Such as why are investor-relations goals for changes to the shareholder base hard to achieve?

We were in Chicago seeing customers and one said, “Some holders complain we’re underperforming our peers because we don’t have the right shareholder mix. We develop a plan to change it.  We execute our outreach. When we compare outcomes to goals after the fact, we’ve not achieved them.”

Why?

The cause isn’t a failure of communication. It’s market structure.  First, many Active funds have had net outflows over the last decade as money shifted from expensive active management to inexpensive passive management.

It’s trillions of dollars.  And it means stock-pickers are often sellers, not buyers.

As the head of equities for a major fund complex told me, “Management teams come to see my analysts and tell the story, but we’ve got redemptions.  We’re not buying stocks. We’re selling them. And getting into ETFs.”

Second, conventional funds are by rule fully invested.  To buy something they must sell something else.  It’s hard business now.  While the average trade size rose the past two weeks from about 155 shares to 174 shares, it’s skewed by mega caps.  MRK is right at the average.  But FDX’s average trade size is 89 shares.  I saw a company yesterday averaging 45 shares per trade.

Moving 250,000 shares 45 at a time is wildly inefficient. It also means investors are continually contending with incorrect prices. Stocks quote in 100-share increments. If they trade in smaller fractions, there’s a good chance it’s not at the best displayed price.

That’s a structural problem that stacks the deck against active stock pickers, who are better off using Exchange Traded Funds (ETFs) that have limitless supply elasticity (ETFs don’t compete in the market for stocks. All stock-movement related to creating and redeeming ETF shares occurs off-market in giant blocks).

Speaking of market-structure (thank you, Joe Saluzzi), the Securities Traders Association had this advice for issuers:  Educate yourself on the market and develop a voice.

Bottom line, IR people, you need to understand how your stock trades and what its characteristics are, so you and your executive team and the board remain grounded in the reality of what’s achievable in a market dominated by ETFs.

Which brings us to current market structure.  Yesterday was “Counterparty Tuesday” when banks true up books related to options expiring last week and new ones that traded Monday.  The market was down because demand for stocks and derivatives from ETFs was off a combined 19% the past week versus 20-day averages.

It should be up, not down.

Last week was quad-witching when stock and index options and futures lapsed. S&P indexes rebalanced for the quarter. There was Phase III of the annual Russell reconstitution, which concludes Friday. Quarterly window-dressing should be happening now, as money tracking any benchmark needs to true up errors by June 28.

Where’d the money go?

If Passive money declines, the market could tip over. We’re not saying it’s bound to happen.  More important than the composition of an index is the amount of money pegged to it – trillions with the Russells (95% of it the Russell 1000), even more for S&P indices.

In that vein, last week leading into quad witching the lead behavior in every sector was Fast Trading.  Machines, not investors, drove the S&P 500 up 2.2%, likely counting on Passive money manifesting (as we did).

If it doesn’t, Fast Traders will vanish.

Summing up, we need to know what’s within our control.  Targeting investors without knowing market structure is like a farmer cutting hay without checking the weather report.  You can’t control the weather. You control when you cut hay – to avoid failure.

The same applies to IR (and investing, for that matter) in modern markets.

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