Tagged: Investing

The Winners

There was a country hit 30 years ago called Nobody Wins.

Why drag out a 1993 song by Radney Foster?  Well, it popped into my head reading the SEC’s proposed new regulations for the US stock market.

Oh, but somebody wins here.

Photo 126390367 / Sec © Grey82 | Dreamstime.com

If you missed last week’s first chapter, Origins, read it.  I promised this week to describe who wins in the 1,650 pages of new regulations the SEC thinks the stock market needs.

At Amazon is a book called “How to Play Chess: A Beginner’s Guide to Learning the Chess Game, Pieces, Board, Rules, & Strategies.” It says you’ll master chess. It’s got 498 reviews and gets 4.5 stars. It’s 49 pages.

If you can master chess in 49 pages, you’d think the stock market, which the SEC has opened to 100 million Main Street folks by permitting free trading (no commissions!), must be simple. After all, the SEC wouldn’t just let beginners in. Right?

Regulation National Market System, which regulates the stock market’s quotes, prices data and access (to all three) is 520 pages.  Probably a good idea to know what it says.

After all, the US stock market is home to about $45 trillion of invested assets, over 3,500 public companies, over 2,000 Exchange Traded Funds, hundreds of closed-end funds, scads of preferred and other classes. A combined 10,000 securities.

It’s roughly 70% of total global market-capitalization.  If you’re an investor, this market supports your retirement plans.

But wait, there’s more.

The SEC’s Market Data Infrastructure Plan is 900 pages.  You should probably know what’s in that too. With it, the Clayton SEC regime aimed to end the exchange data monopoly. Exchanges sued and blocked parts of it (not the definitions, though).

The stock market and the exchange business are all about data.

The NYSE is a tiny part of Intercontinental Exchange (NYSE: ICE), which is in the data business.  ICE had $9.2 billion of revenue in 2021, $4.1 billion of income, a 44% margin.

According to ICE’s 2021 10K, 71% of its revenue is data, analytics and network services.  Listings are 13%.

The Nasdaq had 2021 revenue of $3.4 billion after deducting $2.2 billion of rebates paid to traders to set prices, and earned $1.2 billion, a 35% margin.

Here’s the irony. The whole of SEC market regulation is about narrow margins. LOW SPREADS. Remember those two words. 

Nasdaq segment-reporting shows 2021 revenue of $1.1 billion from market data, index-licensing and analytics. 

Do the math. Without that byproduct from operating markets and paying traders to set prices, the Nasdaq made $100 million.

That’s still a lot of money. But it’s a 3% margin, not much different than running a grocery store. Grocery stores are low-margin stock markets matching producers of goods with consumers of them.

The stock market is a grocery store for public companies trying to find investors for their shares.  And this grocery store has margins of 35-44%. 

At whose expense?

The intermediaries using the platform such as Citadel, Virtu (30% margin in 2021), Hudson River Trading, Quantlab, Two Sigma, Infinium, GTS, SIG, Tower Research, IMC, Flow Traders, Optiver, make billions of dollars as middlemen.

Jane Street traded $17 trillion of stock in 2020 and made $8 billion, give or take. It’s got 2,000 employees. Bank of America just reported net income of $7.1 billion. It’s got 220,000 employees.

Anybody seeing a trend? 

The SEC has now proposed 1,650 more pages, bringing the total near 3,000, not counting the thousands more pages of rule-filings emanating from the exchanges every year.

And they’re principally focused on shrinking spreads. A penny is too wide. We need tenths of pennies in quotes now, or the little guy is getting screwed.

We’re told.

By the way, you’ll hear a term over and over and over from regulators and exchanges:  Execution Quality.  It’s supposedly what defines the stock market as “good.”

No, it’s what makes money for intermediaries and ensures what the SEC wants: That somebody keeps posting quotes and trades in this absurdly complicated environment.

When you see the term, know it’s obfuscation.

Let me cut out the intermediating verbiage. The SEC sees that we have a bifurcated market where half the trades, roughly, are occurring off-exchange in dark pools, but the exchanges provide the prices, quotes and small spreads. And the exchanges make scads selling resulting DATA.

The SEC also sees that the data advantage held by the exchanges is unfair, but the exchanges sue when the SEC tries to fix it.  And meanwhile as trading OFF exchange nears 50%, the VALUE of the data the exchanges sell is threatened, and so is the necessary tense alliance between the SEC and exchanges.

So the SEC has, with 1,650 pages, struck a deal. We’ll push more trading and quotes and prices back to you, exchanges, so you get more of the spread. But charge less for trades and ensure that the continuous auction market doesn’t break down.

Execution quality.

The winners are the SEC and the exchanges. 

I can promise you this, investors, traders and public companies, parties for which the stock market exists: Trading in tenths of pennies at stock exchanges is bad.

The smaller the spread, the shorter the investment horizon.

And that’s what these latest 1,650 pages promote. Smaller spreads, tinier trades, more data.  Bigger margins for intermediaries. For the purposes I described.

It’ll be called Execution Quality. It means the middlemen are merchandising you.

And you lose.

Do you care? Does anyone anymore?  You issuers, you are the biggest losers. You’ve lost your audience, your capital-formation mechanism.

And if you let the parties running your market make 40 cents of every dollar, you probably deserve it.

Market Palio

Maybe we should have a horse race to decide our elections. 

In Siena, the whole region gathers July 2 and August 16 annually, thronging the Piazza del Campo (the city square you see behind our beverages in the photo here, shot Sep 26) for The Palio, pounding equine competitions involving the city’s contrade, the 17 districts of Siena.

View of the Piazza del Campo from the best bar seat in the square (photo Tim Quast Sep 26, 2022).

After Siena succumbed in a 150-year war with Florence (talk about endurance), competition turned inward. The city’s uniquely designated districts redirected their energies to competitive horsemanship instead of Florentine raids.

Each year, horsemen from ten of the contrade race each other, three furious laps around the square. The other seven automatically qualify for the next race, with three others added by lottery.

I’ll skip the finer details but it’s full of intrigue, chicanery, sordid deals, massive sums spent on jockeys, who may conspire and cheat, and tears and cheers and meals and wine.

In short, it’s just like politics. 

But in The Palio, while victory is everything, it really means nothing. It’s just Sienese culture.  That seems like a much better outcome than modern politics.

The stock market lately too has felt like The Palio.  A drumming, entertaining, heartbreaking, chaotic mess pelting around turns and slamming into walls, with little logic or purpose.

Can we make sense of it?  Of course. But not logically.  It’s the Palio of Siena.  It only makes sense if you understand the underlying story and purpose.

Public companies and investors, your best friend amid the churning dirt of the market’s Palio is market structure. It’ll help you make sense of what seems to be random disorder.

The best-performing S&P 500 stock year-to-date is OXY, up about 88%.  Ranked second is ENPH, up about 55%.  Both are energy stocks, one the old-fashioned kind with a D rating for planet-friendliness, whatever that means.  The other is a clean-energy stock.

Active money is 9% of OXY’s daily volume, 10% of ENPH’s. Both perform well financially but not more so than other Energy stocks. But both are darlings of Passive money, receiving outsized allocations. Over 40% of trading volume in both traces to Exchange Traded Funds.

It’s like the two stocks were the winning horses in The Palio (where the horse wins, even without a rider).

It’s a lesson about the stock market. There’s still a lot of clinging to the notion that you own “good companies.”  As defined by what?  OXY and ENPH are good companies as defined by the amount of volume from ETFs.

If that’s the money driving the stock market, then they’re both good companies.

And it illustrates the importance of understanding what kind of money creates good companies.  And it may not be revenue and profits.  It may be Demand vs Supply.

OXY has spent 130 of 183 days since Jan 4 at 5.0 or higher Demand on the ten-point scale we use to measure buying and selling by investors and traders, called Market Structure Sentiment.  ENPH has spent 118 days at or over 5.0. 

The more time stocks spend over 5.0, the better they do. There’s no direct connection to financial results.  It’s about whether there’s greater Demand for the stock from any purpose or time-horizon.

Did anyone pick OXY and ENPH as the 1-2 ranked S&P 500 stocks for 2022 when the year began?  I don’t know.  Not based on financial performance. Those winners would have come from the Tech sector. Which has been brutalized.

The math is clear.  Winners in the stock market are not determined by financial performance but by Supply/Demand balances. Strong demand, constrained Supply, prices rise.  It’s a much better predictor of winners than is the bottom line.

For better or worse.

In that sense, the stock market is The Palio. It’ a horse race built around culture, where “culture” is market structure.

We tell users of Market Structure EDGE to always know the Supply/Demand balance of stocks they like, and to buy divergences.

And for public companies, the Supply/Demand balance is critical to predicting what stocks will do at any time, but especially into earnings.  After all, Supply and Demand are measuring every input – fundamental, quantitative, long/short, global macro, hedged, high-frequency, leveraged, you name it.

So how do you win the stock market’s Palio?  It’s a lottery.  You can improve your chances of a shot at victory by first being BIG.  Get into the Russell 1000 and do it with M&A if you must. You’ll be where 95% of the money and the market cap is.

And then it depends on your contrada, your segment of the stock market.  Then you hang on till the three laps are done. The good news is we can measure your odds of winning.

Inflation

Well, that answers that question. 

The question?

If over 50% of volume in the S&P 500 is short for the first time ever and investment declines 3% despite a 5% rise for stocks the week ended Sep 9 driven by trading machines, could the market implode?

By the way, the ModernIR team is hosting a webinar for clients Monday Sep 19 at noon ET (copy this link to your calendar at that time) titled Incorporating Market Structure Into Daily IR Activities. It features two IROs in panel format. We’re opening it to the public.

I don’t think it would have mattered if Consumer Price Index data had been better rather than worse.  The market would have tanked and the pundits would have said, “Investors fear the Fed will kill the economy.”

As it was, they said, “Inflation is killing the economy.”

Illustration 135950410 © VectorMine | Dreamstime.com

The economy and the stock market are not the same things.  In fact, the fundamentals of investing and how the stock market works are not the same thing. 

The stock market is 100% electronic, about 97% algorithmic and dominated by computerized models. Over half of all trading has an investment horizon of a day or less – and that behavior drove stocks up but shorted them too.

Investors with horizons of about 400 milliseconds were prepared for the market to tip over.  Everybody else was not.

Supply/Demand imbalances have the same effect in the stock market that they do in any market.  Weak demand, high supply, prices fall. They go on sale, like when a store overstocks goods and brays that “everything must go!”

Inflation reflects one thing: Overstocked dollars. Inflation means your money buys less. Inflation causes consumption to decline. It’s a mathematical fact.

So, it’s fatuous twaddle for Federal Reserve officials to claim they need to “slow the economy down” to stop inflation.  No, inflation slows an economy down. 

The Fed does not need to stop people from buying houses and cars and fuel and groceries. That won’t solve inflation.

Inflation will fall when dollars are removed from circulation.

That’s what higher interest rates do.  Paul Volcker in the 1970s lifted rates near 20% to induce people like my grandparents to buy laddered certificates of deposit paying 15-18% from banks.

Consumers sucked the supply of dollars out of the market. Prices came down.  Savers had something to show for it.

The trouble now is that businesses have been induced to pay sharply more for labor at the same time that the Fed needs to sharply increase the cost of capital.

What happens if the cost of people and the cost of money rise at the same time?  Businesses either go broke or have to suddenly slash output or employment, or both.

Businesses first cut output, hoping higher prices will offset higher costs.

And that slams headlong into the very thing the Fed claims to be trying to tamp down by discouraging consumption, which inflation is already doing.

The Hebrew words for “without form” and “void” in the biblical book of Genesis chapter 1 verse 2 are “tohu” and “bohu.”

I would describe Fed policy as tohu and bohu. I’m for higher rates. But not lower rates in the first place. That was the disaster. It’s too late to fix it without big pain.

Surprisingly, the stock market is not without form or void.  It’s got behaviors and rules, which combine to produce prices.  The behaviors are measurable, the rules are knowable.

And thus, so are prices.  If we measure prices according to the time-horizons setting them, in context of rules, the market’s behavior makes sense.

But listening to CNBC pundits trying to describe how stocks trading at 17 times earnings are fairly valued and ones trading at 30 times are not reflects no comprehension of how the stock market works.

That would be true if most of the money was motivated by multiples of earnings.  Statistically, there’s a one-in-ten chance that your stock, public companies, is priced by that motivation.

And no, it’s not true over time. Prices are set by whoever buys and sells.

(EDITORIAL NOTE: I’m speaking to the AGA IR Workshop in New York Sep 19 on what really prices stocks – hope to see you there.)

I mentioned in the August 24 blog that a study (by BNY Mellon and Accenture covering 9,000 respondents) found that people think cryptocurrencies are less complicated than stocks and bonds.

Flabbergasting. Whose fault do you suppose that is?

I’d be utterly confused too if my understanding of the stock market – and I have about 85,000 professional hours dedicated to it, 60,000 of those aimed at market structure – derived from the view of pundits.

We need a basic grasp of economics, so we’re not fooled by inflation (or economists).  Money is the foundation of commerce.

And investors and public companies should understand the stock market. That does NOT mean how businesses are valued – cash flows, sum of the parts, comparables.  That works in PRIVATE equity.

Those don’t determine the preponderance of prices in the stock market. If anything, relative value does.  It’s what made Ken Griffin and Jeff Yass rich, among a host of other fast-trading folks. And they invest in PRIVATE equity.

If you want to know more about the stock market, put this link in the noon ET block on your calendar Sep 19.

Objectivity

The marvel is that people keep buying it. 

Buying what?

That the stock market goes up and down for rational reasons.

The market plunged in the first half of 2022, worst start in 50 years.  Yet jobs numbers remain strong, the dollar is strong, blah blah.

Then the stock market soared. While we didn’t get back to all-time highs, the breadth and depth of the rebound rocked.  AAPL stormed from $130 to $175, back near where it was in March.

Now, maybe there’s justification.  We humans, and especially stock analysts, come up with reasons why something is worth X or Y times forward earnings.  As if it’s the answer.

You know it’s trading at 11 times 2023 earnings. That’s way undervalued.

Really?  What about the cost of everything? The value of the currency? The relative value of everything, the amount of debt, interest rates, on it goes?

Do you know turtles come out of the surf at Ho’okipa Beach in Maui to sleep?

Tim and Karen at Fleming Beach, Maui, north of Kapalua at sunset, Sep 6, 2022. Photo courtesy Tim Quast.

There are people saying it’s because the temperature of the ocean is rising. They’re driven out of the water to cool off, we’re led to believe.

You can come up with a reason and hold it with religious fervor, for anything. But that doesn’t make it so.

There are people who say the turtles have been doing it since one particularly wise one told the others, “You know you can go onto the sand and get an uninterrupted eight hours of sleep and then haul off into the ocean again?”

Animals aren’t stupid.  I offered George the Miniature Horse some hand-pulled grass down near the black lava rocks at Keanae on the road to Hana in Maui.

George looked at what I was offering and at the pile of fresh-cut better grass in front of him and said, “Naw, I’m good man, thanks.”

He didn’t say it out loud but I got it.

Animals and nature make you question your assumptions, if you’re willing.

And humans make a lot of wrong assumptions. Books have been written, Nobels awarded, about the human tendency toward “confirmation bias,” the ceaseless pursuit of things that reinforce what we believe is true.

Like the stock market plunged because people feared a recession and soared because they stopped fearing it.

I’m guilty of confirmation bias, too.  There are no doubt times when the data may say something different than I think. But unless we change the way the data are measured – which requires subjectivity – the data are what they are.

There’s a passage in the bible about how God makes the sun rise and the rain fall on the good and the evil alike.  Maybe it’s the basis for Hemingway’s title, The Sun Also Rises.

Causal relationships are hard. So often they carry confirmation bias, subjectivity.  This happened because of that.

I saw a headline yesterday after stocks continued down that the reason was energy concerns in Europe, interest rate concerns in the USA.

Says who? A reporter?

I can tell you definitively in the data that stocks in the S&P 500 fell 3% last week because Exchange Traded Funds sold off about 3% of holdings, and Short Volume – the market’s supply chain – topped 50% of all trading volume for the first time ever.

The sun rises and sets, because of math.  Stocks rise and fall because of math.  Rain falls or doesn’t fall because of math. 

Humans make subjective decisions because of emotion. 

So do animals in the sense that they see this and the see that and they make a choice.  The turtles realized they didn’t have to jack with sharks, breathing, drift, etc., if they hauled out of the water overnight.

And this is why math matters in investor-relations and investing as it does in every other aspect of life. It’s the only way to sort objectivity and subjectivity.

Neither thing is fully right. Math isn’t motivated. It just…is.  But you need it to understand motivation. 

We have the math for public companies and investors, while everybody else obsesses all day long about emotion.

Humans including those in the c-suite are emotional. We need a gauge. Ask us, and we’ll show you what actions should depend on math. The rest is up to you.

What Matters

Happy New Year!

I hope you enjoyed our gift:  A two-week break from my bloviating!  We’d planned to run best-of columns and thought better, because everybody deserves a respite.

We relished the season in the Colorado mountains, as this album shows (see world-class ski-race video too).  If the album eludes you, this is Steamboat Springs 2020, and us on snowshoes, and the view up high where it’s always 3 o’clock (a superb ski run).

I’m thinking about 2020.  And I’m reading “The Man Who Solved the Market,” about quant hedge fund Renaissance Technologies, by Wall Street Journal reporter Greg Zuckerman.  You should read it, too.

About 47% in, my Kindle says, Zuckerman writes, “One day, a data-entry error caused the fund to purchase five times as many wheat-futures contracts as it intended, pushing prices higher.

“Picking up the next day’s Wall Street Journal, sheepish staffers read that analysts were attributing the price surge to fears of a poor wheat harvest.”

There’s so much going on behind stock-prices that’s something other than we think. The point for IR people and investors is why do we do what we do?

In fact, it’s a human question. We do things on the belief they count.

For instance, the quarterly “Q&A bible,” the compendium of earnings-call questions, dominated holiday discussion in NIRI eGroups.

Discourse is great.  But does all that preparatory effort matter?

If we’re spending the same time and effort in 2020 on earnings-call Q&A that we did in 2000, well, why?  In 2000, more than 70% of the money was rational. Today it’s 14%.

Tesla is up 42% the past year, which included an earnings call where CEO Elon Musk trashed an analyst during Q&A.  The Twittersphere blew up.

The stock didn’t.

You should have your executive team prepared for questions, investor-relations professionals. But you don’t need a bible in 2020 because rational behavior is a paltry part of why stocks move.

Equal to preparation for questions should be the time directed to educating your executives and board on what can move price with results, and why, and what historical data indicate are risks, and why risk exists in the first place – and if you can mitigate it by changing WHEN you report and how you notify investors.

And if you’re 10/10 Overbought and 60% short before you report, put your best VALUE foot forward. Data, not Q&A, should driver call-prep.

Human beings do things because they ostensibly matter and produce returns.  If we’re going through motions because it’s tradition, then 2020 should be the year you change tradition.

And investors. What matters to you?  Returns, right?

The average S&P 500 component moves 36% every month, intraday (1.6% each day between highest and lowest prices), change often lost in closing prices.  In a perfectly modulated, utterly quantitative Shangri-La, you’d capture ALL of that by buying low and selling high.  You could make 432% per year.

That’ll never happen. Eugene Fama, legendary University of Chicago economics professor, who’s 80 years old and still teaching, won a Nobel Prize for demonstrating the return-diminishing pugnacity of volatility.

But if there’s so much volatility, why expend immense effort finding great companies when the odds are roughly 1% that doing so will produce market-beating returns?

Wouldn’t it be smarter – wouldn’t it matter more – to surf volatility waves in today’s market?

I find in traveling around the country – we’re headed to Austin Thursday – talking to IR people and investors that they’re depressed by these things.

If what we learned doesn’t matter, should we rend garments, gnash teeth and weep?

No.

That’s like being depressed by passing time.  Time is a fact.  We can make the most of it, or we can rue its passage.  What’s it gonna be?

So what, IR people, if you don’t need a 400-page Q&A document that requires a software package to manage?  A single Word page, stored to the cloud so you can cross-reference in future quarters, is proportionate.  You’ve saved TIME to do things that MATTER.

What matters?  If you want to be in the US equity markets in 2020 as a public company, an investor-relations professional, an investor, what matters is knowing what money is doing.

It’s a law of success.  It’s not what you know about YOU that matters.  It’s what you know about life, the environment you’re in, the job you’re doing, about how to build relationships.

Right?

We should stop spending all our time understanding our businesses, and none understanding the market that assigns value to them.  That’s the flaw of IR.  Nothing more.  Let’s change it in 2020.

And you investors, why all the Sisyphean work finding great businesses without first understanding how the market transforms those businesses into products with fleeting and ever-evolving value?

If you could capture just 10% of the daily volatility of the S&P 500 by buying stuff low and selling it high, you’d win. It’s provable, useful math. That matters.

Resolve to make 2020 the year you learn what the money is doing.  It matters. We at ModernIR figured out the road map. Ask us how to start on the journey.

Age of Discovery

Bom Dia!

We returned Monday from Portugal after two fantastic weeks roaming and pedaling this land famed for its explorers. We stood at Cape St. Vincent, once the end of the known world where Vasco da Gama, Ferdinand Magellan and Christopher Columbus sailed off to what many thought was a ride over the edge.

In a sense, the investor-relations and stock-picking professions are at Cape St. Vincent. The market we’ve known, the one driven by business fundamentals, is a spit of rock projecting into a vast sea of unknown currents.  We are explorers on a forbidding shore.

Henry the Navigator, father of the Age of Discovery, challenged fear, superstition and entrenched beliefs to create the Harvard of sailing schools on the barren shoals of Sagres, a stone’s throw south of Cape St. Vincent. From it went intrepid adventurers who by sailing what proved to be a globe laid the cornerstones of today’s flattened earth that’s interconnected economically and culturally.

Speaking of conquering the unknown, I’m paneling for the NIRI Virtual chapter at noon ET today on the impact of Exchange Traded Funds, then tomorrow addressing the Capital Area NIRI group on how ETFs drive the market.

It’s what the money is doing. If as IR professionals we’re to fulfill our responsibilities to inform our boards about important facets of equity valuation, we have to know these things as explorers knew the sextant.

By the same token, investors, if you know only how stocks should be valued bottom-up but not how the market transforms stocks into products and data priced by arbitrage, then you’ll fail to beat the benchmark.  Market Structure is as essential to navigation as was knowing currents and stars and weather patterns for yesteryear’s seafarers.

How do we at ModernIR know we’ve got the right navigational tools for today’s market?  Vasco da Gama combined knowledge and forecasts learned at the School of Navigation to find a passage by sea to India.

We combine knowledge of market rules and the behavior of money with software and mathematical models that project outcomes – passages.  If our knowledge is correct, our sextant will mark a course.

Our models are roughly 93% accurate in forecasting short-term prices across the entire market – a startling achievement. For comparative purposes, moving averages have no measurable statistical capacity to forecast prices, and variances between them and actual prices are factors larger than that in our models. Why use tools that don’t tell you where you’re going?

Ownership-change is a tiny fraction of trading volume. What does it tell you about how your price is set?  Nothing. By contrast, patterns of behavioral change are as stark as waves in Cascais – or the world’s biggest surfers’ waves off Nazare.  We see waves of sector rotation, short-term turns in the market – just like weather patterns.

We’re in an age of discovery. Some will cling to a barren spit of land, doing what they’ve always done. The rest will set a new course to a future of clarity about how stocks are priced and valued and how money behaves.  Which group will you be in?

Hope to see you at a NIRI chapter meeting soon!  And ask us how we can help you navigate the coming earnings season with better tools.

Lab Knowledge

We are finally watching Breaking Bad five years after the most successful basic cable series in television history ended.

It’s symbolic of the era that we’re viewing it via Netflix. And NFLX Market Structure Sentiment is bottomed, and shorts have covered. We’ll come to market structure in a moment because it intersects with Breaking Bad.

Launched in 2008, Breaking Bad is about high school chemistry teacher Walter White, who turns to cooking methamphetamine to cover medical bills. He becomes Heisenberg, king of blue meth.

I won’t give the story away but what sets Walter White apart from the rest of the meth manufacturers is his knowledge of molecular structure. Let’s call it Lab Knowledge.  With lab knowledge, Walter White concocts a narcotic compound that stuns competitors and the Drug Enforcement Agency alike. He produces it in a vastly superior lab.

In the stock market there’s widespread belief that the recipe for a superior investment compound is the right set of ingredients comprised of financial and operating metrics of businesses.

Same goes for the investor-relations profession, liaison to Wall Street. We’re taught that the key to success is building buyside and sellside relationships around those very same financial and operating metrics.

There’s a recipe. You follow it, and you succeed.

Is anyone paying attention to the laboratory?

The stock market is the lab. Thanks to a total rewriting of the rules of its chemistry, the laboratory has utterly transformed, and the ingredients that underpin the product it churns out now are not the same ones from before.

I don’t mean to toot the ModernIR horn, but we did the one thing nobody else bothered to do.  We inspected the lab.  We studied the compounds it was using to manufacture the products circulating in the market (ETFs, high-speed trading, etc.).

And we saw that stock pickers were failing because they didn’t understand what the lab was producing. It was not that they’d stopped finding the historically correct chemical elements –financial and operating metrics defining great companies of the past.

It’s that these ingredients by themselves can no longer be counted on to create the expected chemical reaction because the laboratory is compounding differently.

And the difference is massive. The lab determines the outcomes. Write that down somewhere. The lab determines the outcomes. Not the ingredients that exist outside it.

So investors and public companies have two choices.  Start a lab that works in the old way.  Or learn how the current lab works. The latter is far easier – especially since ModernIR has done the work. We can spit out every manner of scientific report on the ingredients.

Back to market structure, before NFLX reported results it was 10/10 Overbought, over 60% short and Passive money – the primary chemical compound for investments now – was selling.  The concoction was destined to blow up.

Everyone blamed ingredients like weaker growth and selling by stock pickers, when those components were not part of the recipe creating the explosion in NFLX. Now, NFLX will be a core ETF manufacturing ingredient, and it will rise.

Investors, what’s in your portfolio?  Have you considered the simmering presence of the laboratory in how your holdings are priced?  And public companies, do you have any idea what the recipe is behind your price and volume?

If you want to be in the capital markets, you need lab knowledge. Every day, remind yourself that the ingredients you’re focused on may not be the ones the lab is using – and the lab determines the outcome. The lab manufactures what the market consumes.

One of the things we’ll be talking about at the NIRI Southwest Regional Conference is the laboratory, so sign up and join us Aug 22-24 in Austin.  Hope to see you there!

 

 

Block Monopoly

This year’s rare midweek July 4 prompted a pause for the Market Structure Map to honor our Republic built on limited government and unbounded individual liberty. Long may it live.

Returning to our market narrative: Did you know that 100% of Exchange Traded Fund creations and redemptions occur in block trades?

If you’ve got 48 minutes and a desire to understand ETFs, catch my podcast (you can get our ETF White Paper too) with IR Magazine’s Jeff Cossette.

In stocks, according to publicly reported data, three-tenths of one percent (0.3%) of NYSE trades are blocks (meaning 99.7% are non-block).  The Nasdaq compiles data differently but my back-of-the-envelope math off known data says blocks are about the same there – a rounding error of all trades.

Blocks have shrunk due to market regulation. Rules say stock trades must meet at a single national price between the best bid to buy and offer to sell.  That price relentlessly changes, especially for the biggest thousand stocks comprising 95% of volume and market cap (north of $2.5 billion to make the cut) so the amount of shares available at the best price is most times tiny.

We track the data.  At July 9, the average Russell 1000 stock traded 13,300 times per day in 160-share increments.  If you buy and sell shares 200 at a time like high-speed traders or algorithmic routers that dissolve and spray orders like crop-dusters, it’s great.

But if you buy cheese by the wheel, so to speak, getting a slice at a time means you’re not in the cheese-wheel buying business but instead in the order-hiding business. Get it? You must trick everybody into thinking you want a slice, not a wheel.

The cause? Market structure. Regulation National Market System, the regime governing stock trades, says one exchange must send to another any trade for which a better price exists there (so big exchanges pay traders to set price. IEX, the newest, doesn’t).

Put simply, exchanges are forced by rules to share prices. Exchanges cannot give preference to any customer over another.

ETFs get different rules. Shares are only created in blocks, and only traded between ETF creators and their only customers, called Authorized Participants.

I’m not making this up. When Blackrock wants more ETF shares, they create them in blocks only.  From Blackrock’s IVV S&P 500 ETF prospectus: Only an Authorized Participant may engage in creation or redemption transactions directly with the Fund. The Fund has a limited number of institutions that may act as Authorized Participants on an agency basis (i.e., on behalf of other market participants).

Why can ETFs offer preference when it’s against the law for exchanges? Fair question. There is no stated answer. The unstated one is that nobody would make markets in ETFs if a handful of firms didn’t have an unassailable competitive advantage, a sure chance to make money (why ETF fees are so low).

Again from the IVV prospectus:

Prior to trading in the secondary market, shares of the Fund are “created” at NAV by market makers, large investors and institutions only in block-size Creation Units of 50,000 shares or multiples thereof.

Each “creator” or authorized participant (an “Authorized Participant”) has entered into an agreement with the Fund’s distributor, BlackRock Investments, LLC (the “Distributor”), an affiliate of BFA. A creation transaction, which is subject to acceptance by the Distributor and the Fund, generally takes place when an Authorized Participant deposits into the Fund a designated portfolio of securities (including any portion of such securities for which cash may be substituted) and a specified amount of cash approximating the holdings of the Fund in exchange for a specified number of Creation Units.

And down a bit further (emphasis in all cases mine):

Only an Authorized Participant may create or redeem Creation Units with the Fund. Authorized Participants may create or redeem Creation Units for their own accounts or for customers, including, without limitation, affiliates of the Fund.

Did you catch that last bit? The creator of ETF shares – only in blocks, off the secondary market (which means not in the stock market) – may create units for itself, for its customers, or even for the Fund wanting ETF shares (here, Blackrock).

And the shares are not created at the best national bid to buy or offer to sell but at NAV – Net Asset Value.

Translating to English: ETF shares are created between two cloistered parties with no competition, off the market, in blocks, at a set price – and then sold to somebody else who will have to compete with others and can only trade at the best national price, which continually changes in the stock market, where no one gets preference and prices are incredibly unstable.

It’s a monopoly.

Two questions:  Why do regulators think this is okay? The SEC issued exemptive orders to the 1940 Investment Company Act (can the SEC override Congress?) permitting it.

We wrote about the enormous size of ETF creations and redemptions. Which leads to Question #2: Why wouldn’t this process become an end unto itself, displacing fundamental investment?

Three Ways

Jakob Dylan (he of Pulitzer lineage) claimed on the Red Letter Days album by the Wallflowers that there are three ways out of every box.  Warning: Listen to the song at your own risk. It will get in your head and stay there.

Something else that should get in the heads of every investor, every executive and investor-relations professional for public companies, is that there are three ways to make money in the stock market (which implies three ways to lose it too).

Most of us default to the idea that the way you make money is buying stuff that’s worth more later. Thus, when companies report results that miss by a penny and the stock plunges, everybody concludes investors are selling because expectations for profits were misplaced so the stock is worth less.

Really? Does long-term money care if you’re off a penny? Most of the time when that happens, it’s one of the other two ways to make money at work.

Take Facebook (FB) the past two days.

“It’s this Cambridge Analytica thing. People are reconsidering what it means to share information via social media.”

Maybe it is.  But that conclusion supposes investors want a Tyrion Lannister from Game of Thrones, a mutilated nose that spites the face. Why would investors who’ve risked capital since New Year’s for a 4% return mangle it in two days with a 9% loss?

You can buy stocks that rise in value.  You can short stocks that decline in value. And you can trade the spreads between things. Three ways to make money.

The biggest? We suppose buying things that rise dominates and the other two are sideshows.  But currently, 45% of all market trading volume of about $300 billion daily is borrowed. Short.  In January 2016, shorting hit 52% of trading volume, so selling things that decline in value became bigger than buying things that rise.  That’s mostly Fast Trading betting on price-change over fractions of seconds but the principle applies.

Facebook Monday as the stock plunged was 52% short. Nearly $3 billion of trading volume was making money, not losing it.  FB was 49% short on Friday the 16th before the news, and Overbought and overweight in Passive funds ahead of the Tech selloff.

The headline was a tripwire but the cause wasn’t investors that had bought appreciation.

But wait, there’s a third item. Patterns in FB showed dominating ETF market-making the past four days around quad-witching and quarterly index-rebalances. I say “market-making” loosely because it’s a euphemism for arbitrage – the third way to make money.

Buying the gaps between things is investing in volatility. Trading gaps is arbitrage, or profiting on price-differences (which is volatility).  ETFs foster arbitrage because they are a substitute for something that’s the same: a set of underlying securities.

Profiting on price-differences in the same thing is the most reliable arbitrage scheme. ETF trading is now 50% of market volume, some from big brokers, some from Fast Traders, nearly all of it arbitrage.

FB was hit by ETF redemptions.  Unlike any other investment vehicle, ETFs use an “in-kind exchange” model. Blackrock doesn’t manage your money in ETFs. It manages collateral from the broker who sold you ETF shares.

To create shares for an S&P 500 ETF like IVV, brokers gather a statistical sampling of S&P stocks worth the cost of a creation basket of 50,000 shares, which is about $12 million. That basket need be only a smattering of the S&P 500 or things substantially similar. It could be all FB shares if Blackrock permits it.

FB is widely held so its 4% rise means the collateral brokers provided is worth more than IVV shares exchanged in-kind. Blackrock could in theory make the “redemption basket” of assets that it will trade back for returned IVV shares all FB in order to eliminate the capital gains associated with FB.

So brokers short FB, buy puts on FB, buy a redemption basket of $12 million of IVV, and return it to Blackrock, receive FB shares, and sell them. And FB goes down 9%.  The key is the motivation. It’s not investment but arbitrage profit opportunity. Who benefited? Blackrock by reducing taxes, and brokers profiting on the trade. Who was harmed? Core FB holders.

This is 50% of market volume. And it’s the pattern in FB (which is not a client but we track the Russell 1000 and are building sector reports).

The next time your stock moves, think of Jakob Dylan and ask yourself which of the three ways out of the equity box might be hitting you today. It’s probably not investors (and if you want to talk about it, we’ll be at NIRI Boston Thursday).

Hidden Volatility

Volatility plunged yesterday after spiking last week to a 2017 zenith thus far. But what does it mean?

“Everybody was buying vol into expirations, Tim,” you say. “Now they’re not.”

Buying vol?

“Volatility. You know.”

It’s been a long time since we talked about volatility as an asset class. We all think of stocks as an asset class, fixed income as an asset class, and so on.  But volatility?

The CBOE, Chicago Board Options Exchange, created the VIX to drive investment in volatility, or how prices change. The VIX reflects the implied forward volatility of the S&P 500, extrapolated from prices investors and traders are paying for stock futures. The lower the number the less it implies, and vice versa.

(If you want to know more, Vance Harwood offers an understandable dissection of volatility and the VIX.)

For both investor-relations professionals and investors, there’s a lesson.  Any effort to understand the stock market must consider not just buying or selling of stocks, but buying or selling of the gaps between stocks. That’s volatility.

It to me also points to a flaw in using options and futures to understand forward prices. They are mechanisms for buying volatility, not for pricing assets.

Proof is in the VIX itself. As a predictor it’s deplorable. It can only tell us about current conditions (though it’s a win for driving volatility trading). Suppose local TV news said: “Stay tuned for yesterday’s weather forecast.”

(NOTE: We’ll talk about trading dynamics at the NIRI Southwest Regional Conference here in Austin on Lady Bird Lake Aug 24-25 in breakout sessions. Join us!)

Shorting shares for fleeting periods is also a form of investing in volatility. I can think of a great example in our client base. Earlier this year it was a rock star, posting unrelenting gains. But it’s a company in an industry languishing this summer, and the stock is down.

Naturally one would think, “Investors are selling because fundamentals are weak.”

But the data show nothing of the sort! Short volume has been over 70% of trading volume this summer, and arbitrage is up 12% while investment has fallen.

Isn’t that important for management to understand? Yes, investing declined. But the drop alone prompted quantitative volatility traders to merchandise this company – and everyone is blaming the wrong thing. It’s not investors in stocks. It’s investors in volatility. Holders weren’t selling.

“But Tim,” you say. “There isn’t any volatility. Except for last week the VIX has had all the enthusiasm of a spent balloon.”

The VIX reflects closing prices. At the close, all the money wanting to be average – indexes and ETFs tracking broad measures – takes the midpoint of the bid and offer.

Do you know what’s happening intraday?  Stocks are moving 2.5% from average high to low. If the VIX were calculated using intraday prices, it would be a staggering 75 instead of 11.35, where it closed yesterday.

What’s going on? Prices are relentlessly changing. Suppose the price of everything you bought in the grocery store changed 2.5% by the time you worked your way from produce to dairy products?

Volatility is inefficiency. It increases the cost of capital (replace beta with your intraday volatility and you’ll think differently about what equity costs).  Its risk isn’t linear, manifesting intraday with no apparent consequence for long periods.

Until all at once prices collapse.

There’s more to it, but widespread volatility means prices are unstable. The stock market is a taut wire that up close vibrates chaotically. Last week, sudden slack manifested in that wire, and markets lurched. It snapped back this week as arbitragers slurped volatility.

It’s only when the wire keeps developing more slack that we run into trouble. The source of slack is mispriced assets – a separate discussion for later. For now, learn from the wire rather than the tape.  The VIX is a laconic signal incapable of forecasts.

And your stock, if it’s hewing to the mean, offers volatility traders up to 2.5% returns every day (50% in a month), and your closing price need never change.

When you slip or pop, it might be the volatility wire slapping around.  Keep that in mind.