March 15, 2017

Weathering Change

Everyone complains about the weather but nobody does anything about it.

Mark Twain often gets credit for the clever quip but Twain’s friend Charles Dudley Warner said it.  We’re not here to talk weather though the east coast is wishing someone would do something about it.

Like the weather, there’s a relentlessness to stock-market evolution from fundamentally powered capital-formation to procurement process in which vast sums plug into models that pick, pack and stack stocks in precisely indexed packages.

Blackrock, Vanguard and State Street oversee $11.5 trillion that’s generally blind to sellside research and deaf to the corporate story. It’s a force of nature, more like a weather pattern than investment behavior.

Investor-relations folks say: “What do we do about it?”

Alert reader Karen Quast found a paper from Goldman Sachs advising Boards to respond to the rise of passive investment:

The recent decline in active single-stock investing raises important considerations for corporate boards of directors. The decline has been driven by a shift toward ‘passive investing’ and other forms of rule-based investing, such as index funds, factor-based investing, quantitative investing and exchange-traded funds (ETFs).

The decline of active investing means that, in many cases, stock prices have become more correlated and more closely linked to a company’s ‘characteristics,’ such as its index membership, ETF inclusion or quantitative-factor attributes. As a result, companies’ stock prices have become less correlated to their own fundamental performance.

Goldman Sachs is urging preparation. You can’t change the weather. You can only weather the change. The weather forecast isn’t a call to arms. It’s information we use to adapt to conditions. We prepare for discomfort.  We set realistic expectations.

That’s how investor-relations should view passive investment. We call it Asset Allocation because it’s a behavior that directs dollars to equities according to a model apportioning resources for opportunity and risk.

One way to help the board and the management prepare is to present the idea that there’s not just one behavior buying and selling shares. We ran data for an anonymous company whose share-price is 4% higher today than a year ago, trailing the broad market.

There are four purposes behind buying and selling, one of which is Asset Allocation, and all have equal capacity to set price. After all, market rules today prohibit preference (IR people should understand rules governing how shares are priced and traded and we’ll be discussing it at the Twin Cities NIRI chapter next week – join us!).

There are 50 weeks and in each a behavior led, and bought or sold (one week, Active Investment led and price didn’t change, rotation from growth to value).

It’s eye-opening. The behavior “winning” the most weeks was Fast Trading, short-term machines profiting on price-differences rather than investing.  It led 16 weeks, or 32% of the year, and bought more frequently than it sold.

Active Investment – your stock pickers – and Asset Allocation (indexes, ETFs, quantitative investors) were tied, leading 12 weeks each, but where Asset Allocation bought and sold equally, Active Investment sold more than it bought.

Finally, Risk Mgmt, counterparties to portfolio insurance and trading leverage with derivatives, led 10 weeks, or 20% of the year, but bought 70% of the time.  Put them together and the reason the stock is up a little is because the combined demographics behind price and volume bought 26 times and sold 23 times.

You laugh?  These data are telling! If not for other behaviors, Active Investors would have lowered price. Maybe that’s a message for the board and management team – but show this data to them and it will forever change how they think about the market.

The point isn’t changing the market but understanding how it works, measuring it consistently and adapting to reality.  Fundamentals do not rule now.

But with data analytics, it remains profoundly under the purview of investor-relations. That should bring great comfort to all of us in the profession.  Passive investment isn’t something to fear but to measure.

Market Sentiment:  The Federal Reserve likely hikes rates today, and options expire tomorrow and Friday, the latter the first quad-witching session of 2017. Also, S&P and Nasdaq indexes rebalance. VIX expirations still loom next week.

And our Sentiment is negative for the first time since the election. It’s a weather forecast.  No need for panic, only preparation. We’ll all weather change.

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