Tagged: rules

For the Birds

Did you know the Caribbean is full of brown boobies? 

The blue-footed brown booby, about the size of a seagull.  We’re just back from sailing St Martin and St Barts, where the critters of both sea and sky delighted.

Unlike the stock market, apparently, which has gone to, um, the birds. 

By the way, best food in the islands?  Grand Case on St Martin. It’s French. Need I say more?  On our boat, we had French food, French wine, French chef.

It’s a wonder we left. I gained five pounds. You can see it in the photo, aboard our catamaran in St Barts (more trip photos if you’re interested).

Tim and Karen Quast aboard Norsegod in St Barts Harbor (courtesy Tim Quast).

Back to stocks, we should have expected cratering markets because fundamentals have deteriorated dramatically.

Oh no, wait. They haven’t. 

Zscaler (ZS), which has been crushing expectations every quarter, is up just 6.7% the past year now after rising over 500% the past five years. It’s down 33% the last six months.

Philip Morris (PM), which is not growing, is down 7% the past five years but up 8% the past six months.

The popular explanations for why these conditions exist have reached such shrieking insanity that I might be forced to return to the sea.  And French food.

First, let’s understand how stocks go up.  Not the “more buyers than sellers” version but the mechanics. 

There is demand.  It can come from investors, traders or counterparties. Active investors buy opportunity, Passive investors buy products – growth, value, etc. Traders chase arbitrage (different prices for the same thing). Counterparties buy or sell to meet or mitigate demand for derivatives like options.

When all converge, prices explode. 

And there are compounding factors. Many investors now prefer Exchange Traded Funds (ETFs), which don’t increase the SUPPLY of stocks, just the DEMAND for them.

And traders buy or sell short-term prices with connection only to previous prices, leading to spiraling short-term gyrations.

And derivatives as both implied demand and supply magnify moves.

Are you with me still? Think this is for the birds?

The Tetris of the stock market, the arranging of these blocks, distorts perceptions of supply and demand and fosters absurd explanations.

And over time, it erodes realized returns.  All the toll-collectors – money managers, ETF sponsors, trading intermediaries, stock exchanges, counterparties – get rich.

As of yesterday, the Nasdaq is up about 6.5% annually since March 2000, before taxes and inflation and without respect to risk premia. Tech stocks move 3.5% intraday daily.

You see? Daily price-moves are more than half the average expected pre-tax returns. That’s because of what happens when all the Tetris blocks start falling.

Here’s how. Active investors stop buying equities. Passive investors slow allocations and see redemptions.  Speculators stop setting prices. ETFs have to redeem shares so compounding demand is suddenly replaced by a vacuum. Implied demand via derivatives vanishes.

And prices implode.

This is how the DJIA drops 800 points in a day.

And we haven’t even talked about short volume.  The SEC permits intermediaries to create stock when no real supply exists to satisfy it. That is, they can short stocks without borrowing.

That works great on the way up as it provides supply to rising prices that would otherwise go unsatisfied. On the way down, we become aware that the implied demand in created stock just doesn’t exist.

So, Tim. What can we do in this market?  

You can’t control it.  We could fix it if we stopped letting shilling Fast Traders set prices and create stock.

If we junked the continuous auction market and returned to periodic auctions of real demand and supply. No real buyers or sellers, no prices.

And stock markets should actually compete by offering separate “stores” that aren’t connected electronically and forced to share prices. As it is, markets are just a system.

Alas, none of this will happen anytime soon.

So.

We can continue as companies, investors and traders fooling ourselves that fundamentals drive markets.  Or we can learn how markets work. The starting point.

Otherwise, we’re like somebody reading the opening line today. “Did he just say ‘boobies’?”

I was talking about birds.

We need to understand the topic. The market (ask us, we’ll help).

Moon Rules

We spent last week in Summit County, famous for Breckenridge and Keystone. With windows open and the sun set, the temperature at 9,000 feet drops fast, great for sleeping.

It’s not great for staying awake reading a Kindle but I worked through some exciting pages of Artemis, the new novel by Andy Weir, who wrote The Martian, made into a Ridley Scott movie starring Matt Damon.

And yes, Artemis got me thinking about market structure. Not because of the profanity, the ripping pace, the clever characters, the exotic settings.  It’s a book set on the moon, where scientific rules matter.

Weir’s genius is the application of science to clever storylines. On the moon, if you want to commit a crime to save the community, you better understand how to blend acetylene and oxygen in zero atmosphere. Fail to follow or understand the rules, you die.

It’s not life and death in the stock market but rules play the same supreme role in dictating outcomes. If as public companies you think your story will determine the outcome for your stock, the rules will humble you.  How much of your trading volume comes from Active Investment? You can and should know – and it’s not what you’d think. But that’s not the point of being public, is it.  So don’t be afraid.

If you’re an investor and you think fundamentals will pace you to superior results, think again. The amount of money choosing company financials has plunged, while funds indexing to markets has mushroomed. Rules helping models will eat your lunch.

What rules? Start with Regulation National Market System. It creates a marketplace that forces revenue-sharing among intermediaries. Professional sports like basketball in the USA also operate with rules that shift focus from playing the sport to managing salary cap (Denver just traded three Nuggets for that reason).

If you don’t know this, you’ll have a false understanding of what drives the sport. The “haves” must distribute funds to the “have nots.” Some owners in money-losing markets might choose to skimp on salary to scrape mandated distributions from teams making bank (I wonder what the NBA Cavaliers will do now?).

Right now, stock market sentiment reflecting not the opinions of humans but the ebb and flow of money and the way machines price stocks (the rules, in other words) is topping again as it did about June 12. Options expire today through Friday.  So, no matter what you expect as earnings commence, the market will have a propensity to decline ahead.

It’s like the rules on the moon.  In one-sixth of earth’s gravity, harsh sun, no atmosphere, success depends on knowing how stuff works. Investors and public companies, welcome to the moon. You can’t treat it like earth. Rules determine outcomes. If your actions don’t account for the rules that govern how markets function, outcomes will reflect it.

But it’s fun on the moon once you know what you’re doing. It’s fun knowing when the market is topped, and bottomed, on rules. It’s fun doing investor-relations when you know what all the money is doing.  So, come on up to zero atmosphere! It’s not scary.

Listing

Why do you need an exchange?

Between the Tiber River and the Piazza del Quirinale in Rome sit the remains of Trajan’s Market, built around 100 AD by that Roman emperor famed for militaristically expanding the empire to its zenith.

Considered the world’s first covered multistory shopping mall, Trajan’s Market, designed by Greek Damascan architect Apollodorus, ingeniously and conveniently clustered vendors and shoppers. Thus that era’s real estate industry saw the importance of location, a timeless lesson.

Taking queue from the ancients, our financial forebears on Broad Street in New York City similarly fashioned a marketplace in 1792, after for some time trading stocks under a buttonwood tree. The bazaar they birthed called the New York Stock Exchange aggregated the investors with cash and the growth enterprises needing it. Investing leapt toward the modern era.

That worked well until exuberance and mushrooming Federal Reserve currency supplies collided in 1929. Then the government said, “All right, everybody, out of the pool.”

With the Securities Act of 1933 and the Securities Exchange Act of 1934, the government sought to introduce safety to markets by eradicating fun and frivolity.  No longer would stock brokers hold court without a king, insouciantly supposing they could match buyers and sellers on merits without a bunch of paperwork with alphanumeric identifiers that governments so prefer.

As a result, some 82 years after Government ordered everybody to stand in lines and fill out forms, public companies in these here United States in 2015 need an exchange to list shares if they want the public to trade them (there are exceptions on the smaller end, the over-the-counter market, which has many thousands more companies than the big National Market System – but that’s a story for another time).

The question now is does it matter where you list your shares? We can prove in less than a blink of an eye that location, location, location is irrelevant (that should be our first clue that something is amiss) today in the equity market.

No, really.  We can show you in a split-second.  If you’ve never seen it, watch these ten milliseconds (the blink of an eye is about 300 milliseconds) of MRK trading compiled by data firm Nanex and posted to Youtube. (more…)

Sizing Ticks

Ticks are blood-sucking insects, about how regulators have viewed spreads between stock prices.

Country singer Brad Paisley sings that he’d like to walk you through a field of wildflowers and check you for ticks. As a kid in tick country on Oregon’s Snake River breaks, I pulled plasma-bloated fatsos off my skin and watched my grandmother touch match-reddened tweezers to protuberant tick buttocks on my grandfather’s scalp.

Now the Securities and Exchange Commission is studying ticks. It’s in regulatory parlance SEC Release No. 73511, File No. 4-657.  You can comment by email at rule-comments@sec.gov, or on the website, here (include “File No. 4-657” in any case).

Fittingly, we’re in New York this week where ticks began, a timely escape from the season’s first deep freeze in Denver.  Your stock trades in penny increments, or ticks, thanks to rules created by the SEC in the 20th century.

The belief then was that brokers were charging too much with wide spreads in securities that jobbed small investors. Shrink ticks to desiccated carcasses and mom and pop would win went the reasoning. Fifteen years after slimming ticks, the SEC has ordered a study on widening them. The SEC didn’t say it made a mistake last century. It just told exchanges, “See if there’s a better way.”

I’ve read File No. 4-657 from introduction to footnotes and definitions.  We’ve summarized before but hitting highlights, the exchanges have proposed three clusters and a control group comprising effectively all the 1,750-ish small-caps in the market. Stocks will quote in five-cent spreads but trade anywhere between, or trade in five-cent spreads, or trade at five-cent spreads with a “trade-at” rule, this latter blasted by brokers because it prohibits undercutting prices at exchanges. (more…)