July 26, 2011

The Difference Between Market and Consensus Expectations

We were in San Francisco Sunday escaping the heat parching most of the country. Cool heads are better than hot heads, we thought. It was nice to need a sweater.

Speaking of needing things, there’s a flaw in consensus estimates. Consensus by definition means it’s the general view. But the general view reflected by estimates of earnings, revenues or cash flows comprises less than 15% of total market volume.

Across the market, we find that about 12.5% of substantive volume is what we’d call rational – driven by thoughtful investment derived from fundamentals. How can this be? Great swaths of trading today are driven by relative value – the current value of this basket of things versus that basket of things.

Somewhere around 30% of volume is this kind of trading that we consider program trading. It’s driven by market factors and relative value. After all, currencies that denominate securities have only relative and not intrinsic value. Should we not expect trading instruments to behave the same?

What’s more, some 65% of total market volume on average is just air created by the maker/taker model prevailing across global exchanges, in which we’ve all been fed this line of hooey that a massively mediated market is better for buyers and sellers than one with few intermediaries. When in the history of human commerce has it been more efficient to cut the middle man in rather than out?

So the first thing you should do with your volume is multiply it by 35% – the remainder when you factor out automated high-frequency order-matching. So if you trade five million shares daily, the volume to examine is really 1.75 million shares. What’s 12.5% of that – the rational portion? About 200,000 shares.

About 30% of your 1.75 million substantive shares is speculation. Consider it a collection of diverse ways to trade volatility – the exact opposite of relative value driven by programs, because it’s seeking gaps between things rather than correlation among them.

And the remaining 25% or so ranges from hedging institutional positions to wholesale counterparty volume tied to swapping economic interest in things. Bottom line, if you size up what your stock might do on the basis of fundamentals, you’re likely to be wrong. Why? Because 85% of your volume is driven by behaviors for which fundamentals are secondary to volatility or correlation.

And what if you just had a big increase in program trading last week, and now you announce a change in business strategy? This “risk management” volume that just helped your price may depart because of greater uncertainty, eliminating you from sector baskets, funds, ETFs and trading models. That’s not fundamental disappointment, however. It’s managing perceived risk.

When we tell companies what to expect with earnings, we factor in how ALL the behaviors may react to information that is good, bad or about as expected. The result may be much different than consensus. We think of it as the “Market Expectation.”

We pin big blame for these confusing realities on trading markets that aren’t remotely free. See my guest blog for the Securities Technology Monitor last Friday on that topic.

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