April 17, 2013

Understanding Markets

You’ve heard that bit of cowboy wisdom on how to double your money? Fold it over and put it back in your pocket.

I hear folks wanting cowboy wisdom on market structure. What do I need to grasp? In that sense, this could be the most important Market Structure Map I’ve ever written.

If you’re at home, get a glass of wine. We won’t belabor the story, but it’s not a simple one. In the beginning, in 1792, when 24 brokers clustered under a New York buttonwood tree and agreed to give each other preference and charge a minimum commission, trading securities was simple. That became the New York Stock Exchange. Most trades were for investing, some few for speculating. People have been gambling since the Garden of Eden, obviously.

Step forward. In the 1860s ticker tape by Morse code sped markets up but didn’t change structure. In the 1930s, the Securities Act formed the SEC and imposed a regulatory framework. Structure remained similar, if more process-driven.

Take another step. When Benjamin Graham wrote “The Intelligent Investor” in 1949 (Warren Buffett called it the best book about investing ever written), he said to first distinguish investing from speculating. Seek safety for principal and an adequate return, through research in business-like fashion to find good businesses at a discount to intrinsic value. Own them for the long term. Graham separated this “active” investment from cautious and generalized passive investment.

The active approach dominates now only in private equity, or the way Warren Buffett does it – by buying businesses. Passive investment now dwarfs active investment in the stock market. S&P/Dow Jones offers 850,000 index products, MSCI and Russell another 150,000. Less than 16% of Goldman Sachs’ $854 billion of managed assets are in equities – little actively run.

Why? Market structure has fundamentally transformed. First, Congress decided in 1975 that US securities markets were a public asset and moved to create a national market system. That’s Section 11A of the Securities Act. Next regulators on a congressional mission crimped intermediaries, principally the NYSE and the Nasdaq, then broker-owned non-profit securities bazaars. Regulators broke up the marriage by forcing all securities intermediaries to be regulated as either broker-dealers or exchanges.

Then they defined the spreads between stock prices in pennies. They separated research from trading, two inextricable functions forming brokerage-value since maybe the Garden of Eden. They defined how trades would match (between the best prices to buy and sell). They created one giant marketplace that functions like an Ethernet network by making only automated quotes capable of setting the best national price.

They commandeered market data, heretofore the private property of separate marketplaces, dividing it among market participants by market-share in quoting prices and matching trades. And finally, regulators made all brokers behave the same way by defining “best execution” and requiring that all report how orders were routed around the national market system.

It sounds like we’re castigating regulators. No, the intentions had merit. But the vastness of reconstruction can only be attributed one place. If you want uniformity, give everyone a uniform and teach them to march. Few appreciate the magnitude of transformation that’s occurred. Even fewer recognize that if you change the rules, you change the behavior too.

That brings us to 2013. Form has displaced function. The intrinsic value of a business is lost in the marketplace because it rarely determines market price. Automated quotes set prices. Since trade-executions are uniform, both brokers and exchanges pay traders for volume, turning your share-price oftentimes into the pursuit of trading incentives called rebates. That’s arbitrage — which is not investment behavior but speculative behavior.

And 85% of market volume today is moving things around – which in a sense is speculation because it doesn’t depend on intrinsic value. Thus, the opportunity to earn returns from value-investing through patience and diligence has been greatly diminished.

And that’s why passive, short-term investment dominates. Of the nearly 4,300 brokers regulated by FINRA, we see less than 200 of them active in any given month for the largest equities in US markets (the rest send orders to these). The average stock price today moves 40% every month – and most don’t know because it’s intraday. Nearly 70% of volume flows through perhaps 20 firms complying beautifully with best-execution standards.

There are reasons for optimism! IR is more important than ever because the audience you’re trying to reach is smaller, and nothing changes algorithmic behavior better than effective IR messaging to the right active money at the right time.

And IR can and should see the market holistically. Do you think the $7.9 trillion benchmarked to the S&P 500 is noise? Of course not. And you can and must know the effects of passive investment on your price.

Finally, education is power. When IROs understand this structure and quantify its effects, they will lead the way, well-informed management teams alongside, into tomorrow’s better marketplace where value investing again thrives.

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