August 15, 2012

Mean Reversion

If our stock reverts to the mean, I don’t see that high-frequency trading matters.

I’m paraphrasing what many CEOs and CFOs believe. The market is complicated. There’s volatility. Trading is global. ETFs and derivatives probably affect volume. But I’m trading at a reasonable multiple of forward earnings, so who cares?

I hear that question sometimes. More often, reporters tell me they hear it from CEOs and CFOs. What difference does it make that 60% of my volume is the same shares trading over and over? So we had 7,800 public companies in the Wilshire 5000 in 1997 and now there are 3,600 in it. My stock trades at 16 times earnings. That’s about right.

So long as my house goes up in value, what do I care that people are getting these really ridiculous variable-rate, no-money-down mortgages for 125% of the home’s value, which means they’re financing the furniture over 30 years? What difference does it make to me? My house is still up 15% in value.

According to the ETF Industry Association, at July 2012 there were 1,486 exchange-traded products (ETPs), up from zero about 15 years ago, give or take, and fast approaching one ETP for every two stocks. The industry had net July inflows of $17.1 billion, mostly to equity ETFs.

Yet for fourteen consecutive months through June 2012, investors have been net redeemers from equity mutual funds. Last Friday, the Securities Technology Monitor reported that equity volumes reached four-year lows. Despite declines, some 62% of trades are “intraday intermediation” – moving shares for profit (getting paid to dig and fill in ditches). High-frequency trading.

Trades match through order types offered by exchanges that must first pass muster with the SEC. Yesterday, BATS filed to offer a “retail liquidity program” like the one approved last month that permits sub-penny pricing on retail orders at the NYSE. The SEC Monday approved a Nasdaq “routable order” that will simultaneously match trades at the Nasdaq and route them to other markets for execution.

One popular order type today is what’s variously called the Midpoint Passive Liquidity Order. It’s an “undisplayed limit order” – dark-pool volume at an exchange — priced at the midpoint of the Protected Best Bid and Offer (PBBO), which means set between the best two automated quotes to buy and sell shares. It’ll do this: MPL orders will generally interact with all order types including contra MPLs excluding: cross or directed orders. MPL orders will be entered as a limit order but are executable only at the midpoint of the NBBO. MPLs will not execute if the market is locked/crossed. MPLs have a minimum entry and execution size of 100 shares.

If you said, “Huh?” that’s the point. Complex, convoluted. Back to our question: What difference does all this make if my stock price reverts to the mean?

Vast flows to derivatives products, but outflows from conventional investment products. Falling volumes, a shrinking set of underlying assets. Complicated methodologies for buying and selling.

Remind you of mortgage-backed securities? It should. The reason your executives should care about the market for your shares more than whether they revert to a mean – for now – is the same reason prudent people always care. If the way business is done is convoluted and dependent on derivatives and intermediation, it is a disaster waiting to happen.

It’s also a clarion call for IROs to have a firm grasp on market structure and what behavior sets the price in your shares. If it’s intermediation, you should know that.

As for structure, we can wait for disaster. That’s always exciting – nothing like a daily shot of adrenaline. But it may take a generation afterward to revert to the mean, as it did from the high in 1929 for equities and the return there in 1954.

Or we could be prudent instead and fix it first. It won’t be scrapped and reconstituted by its participants or regulators. They all depend on it. That’ll be up to public companies and their investors. The SEC is gathering September 14 for a technology summit. Maybe a bunch of us should be there.

Hope to see you in New Orleans Friday!

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