October 12, 2011

Your Earnings Expectations Are the Sum of All Flows

I read this at an Occupy Wall Street site:

“Let me tell you a wonderful old joke from communist times. A guy was sent from East Germany to work in Siberia. He knew his mail would be read by censors. So he told his friends: Let’s establish a code. If the letter you get from me is written in blue ink, it is true what I said. If it is written in red ink, it is false. After a month his friends get a first letter. Everything is in blue. It says, this letter: everything is wonderful here. Stores are full of good food. Movie theaters show good films from the West. Apartments are large and luxurious. The only thing you cannot buy is red ink.”

Great joke. No doubt scrutinizing your trading data to make sense of it is like something written in red, the code for which is blue.

Speaking of which, chances are, your earnings date is approaching. Your intraday volatility (spreads between high and low prices) is perhaps 4%. Across our client base, it’s now over 4% on average. To help you make sense of your stock price, the exchanges and designated market makers and surveillance firms are giving you columns of data on trading by different brokers and sector or economic news. They tell you so-and-so upgraded the sector, causing a strong rally.

You’re not sure. In your gut you think the euro has got a lot to do with it. Maybe the dollar. It would be nice to know. And it would help if you could assess how money will react to the news you announce next week or the week after.

There’s a lot you can know (don’t miss the Nov 3 IR Magazine Think Tank where we’ll discuss it). As much as we rant about the Swiss-cheese state of data for issuers in a gold-bar kind of world for speculators, your trading data in context of market rules is like an electrocardiogram. You can identify what generates the pulse and what’s driving fear and greed in the corpus of your equity market.

It’s a math problem (oh boy). I randomly sampled ten market structure reports for clients. In the past five trading days, Rational share of volume ranged from 10% to 16%, with an average of 12%. Speculative trading averaged 34%; Programs reflecting passive behavior were 29%. Another 24% went to risk-hedging and other things that don’t fit these buckets.

So if you are going to beat your active investors’ expectations on the call, and they consequently value your shares 5% higher, but programs for funds and models – asset managers – set your value 3% lower because of balance-sheet issues, what might happen to your stock?

It’s math. Programs are 29% of your market, so their pricing weight is twice the factor of rational investment. And if speculators have multi-leg straddles that pay off in cash if your shares move down, we can run a calculation that projects what will happen.

We are almost always within 1%. So we must be doing something right. If your stock were trading at $36 ahead of your call, we’d project a close at $34.81, with these expectations applied to outcomes.

How can this be? Markets are a maze of varying purposes and horizons following prescribed rules and order-types to match up as buyers and sellers. This mathematical maze can be sorted through a model.

Since rational investment is about 12% of the market, using data analytics to understand your trading – the same things the folks do who trade it to begin – is a good idea for the IR chair today. You know the 12%. You talk to them all the time. It’s the rest you need to get a grip on, so you can equip management with rational expectations.

We are willing to bet the sum total of wages for a large Wall Street demonstration that no surveillance firm or exchange can equip you with these answers.

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