October 2, 2013

Structural Distortion

“When I talk about this stuff with clients, they’re only half-listening until this phrase appears.”

Thus spake my learned friend Jim MacGregor, at Abernathy MacGregor in New York City, whose views I hold in high esteem.

“What stuff? What phrase?” I said.

“Market Structure. ‘How market structure can distort your price.’ You write about that,” Jim said, “betcha your readers forward that column to their bosses as much as the previous half-dozen combined.”

I’m not sure what that says about my earlier writ but Jim had my attention. He was saying that explaining how share-prices are affected by market behavior carries more substance than intoning “you need to understand market structure.”

“Market structure” is the behavior of money behind price and volume. Could certain behaviors be distorting fair value for shares?

Exchanges say no. Regulators claim there’s no proof. Surveillance providers tell you to ignore noise.

The biggest money manager today is Blackrock, with $3.9 trillion under management. Blackrock is a quantitative investor known for the $850 billion in its iShares ETFs. It allocates resources top-down. ETFs rebalance every day. Is that noise?

Of 4.5 billion shares trading daily in the US stock market, 1.8 billion, about 40%, are borrowed every day (some amount from Blackrock). That’s not owning, it’s renting.

There are 3,600 national-market-system companies in the US when you remove ETFs, investment companies and multiple classes of stock (I bet Blackrock owns every one). There are two million global indexes. Thousands in US equities are calculated every second. There are more ways to slice stocks than there are underlying corporations.

I was explaining market structure last week to the head of a major public brand, who asked why he should care about market structure if price reverts to a rational level over time. After my explanation, he became a client. I’ll come to what I said.

In Paris in June, Karen and I wanted to visit the top of the Eiffel Tower. The line at the north footing stretched dimly into the gloaming. We’d heard access was quicker at the south entrance. We went there. About 25 were waiting. We were elated. Except there are no elevators at the south footing. You climb. Market structure affected our behavior.

ModernIR monitors bottom-up investment behavior as a share of overall market volume (about 16% the past 12 mos.) and as a price-setter over various time-periods.

Some say it can’t be done. High-frequency traders measure behaviors to game price-movements. Goldman Sachs monitors behavior to modulate value-at-risk, as does every major broker-dealer. Why then can’t somebody else meter Goldman Sachs and high-frequency traders? They have no lease on programmers and mathematicians.

Had we loitered in the north line at the Eiffel Tower, we’d never been atop when the lights came on, nor seen the expanse of Paris at dusk. But we’re humans, not machines. With our machines at ModernIR, we routinely see market prices that separate from fair value by 15-20%. Do you ever get that back? It’s a statistical market today, subject to the Butterfly Effect, a mathematical term. Look it up.

What’s fair value? I ran a discounted-cash-flow model for my own edification in the IR chair long ago. It was valuable to the degree buyers and sellers were considering cash flows. Asset allocators don’t. Fast money doesn’t. Today, these forces are more than 70% of market volume, with another 14% tied up in hedges to manage risk or leverage returns.

Rational investment behavior sets price just once every month on average in typical shares. Could you pick the day from a lineup?

I replied to the IRO for that brand-name US firm: “Do your revenues and profits revert to a mean over time, so you can ignore what happens between? No, you have a baseline expectation of routinely understanding revenues, expenses, profits, so you can measure performance and what drives it. Why not a baseline expectation of understanding the composition of volume? What if it showed something other than your assumptions?”

The top price-setting authority in the US equity market in September was asset-allocation – indexes and ETFs. In the past 12 months by a wide margin, it was hedging – trading leveraged with puts, calls and margined accounts. Way bigger than rational investment. The market isn’t reverting to a rational level.

That meets the smell test. Indexes and ETFs dominate investment behavior, with Blackrock as proof. And in the past 12 months, if the economy grew just 2%, what explains 18% S&P 500 gains? Why, leverage, because borrowing is cheap.

For assumptions to translate to facts, the data must match both. Equity data are indisputable. Market structure distorts prices. Perception isn’t reality. And you can know the truth – which is the root of all coolness in the IR chair.

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