February 20, 2013

Maker-Taker’s Mark

Is it diluted?

That’s what everybody wants to know about the market. Are gains for broad equity measures, seemingly epic like my skiing Saturday at Copper Mountain, real or watered down?

That’s actually not our story this week. But we’re so fascinated by what market structure shows that if you huddle in here we’ll share observations. The dollar declined when Japanese Prime Minister Abe said Monday that either the Bank of Japan creates inflation or the government will rewrite its charter. That means more currency devaluations for everyone (if your money buys less tomorrow than it did today, that’s a devaluation whether called one or not).

So stocks rose yesterday. Also helping stocks, money was hedging at options-expirations Feb 15. When investors hedge they tend to invest more funds. Sentiment is okay, too, finishing last week at 5.38 (on a 10-pt scale), up from 5.05 to start the week. Yesterday it was down to 4.71, by far the lowest level all year.

All over, short volumes are down compared to long volumes. That’s a loaded message. Higher short volumes mean more competitive markets. But lower short volumes also mean demand for wholesale short positions is down and shorts are covering. Which is good.

Talk about mixed messages! Investors want stocks to rise but are wary. Lower overall short-interest (bullish) and some short-covering (bullish) also means money is less prepared for the unexpected, and that markets aren’t as competitive as they should be when prices are rising. Pray for no surprises or we’ll have a monumental down day.

Which brings us to our story. Beam, Inc., distiller of Maker’s Mark, said last week that to stretch its oak-aged bourbon it would cut the alcohol content. Drinkers recoiled in horror and disgust. They’d rather do without than do with less for the same price. Beam backed down.

It got me thinking about the “maker-taker model.” For new readers, I’m talking about how exchanges generally charge traders to buy, or take, shares, but often incentivize selling, or making, with payments called rebates. The idea? Exchanges attract buyers with shares for sale. The money is less in matching trades than selling exchange data and earning tape revenue when traders look up quotes for stocks.

What’s in effect happening is that real liquidity – the booze of the market – gets watered down because the same shares get moved over and over to earn trading credits, making it look like there’s more going on than there really is. Volume.

Public companies can get caught up too, thinking that volume is essential. They hear it from investors – “You don’t have enough liquidity.” What about Berkshire Hathaway Class A shares, where volume is never, ever confused with liquidity?

All I’m saying is that substantive markets beat watery ones trying to pass for high-quality. Worry less about your volume and more about what’s underneath it, in your market structure.

Twice yesterday we saw client shares with lighter volumes – but lower short volume. If long money wants in, competing with fewer borrowed shares is a plus. And real owners will be willing to put up with occasional shortages for the sake of quality.

Just ask drinkers of Maker’s Mark.

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