What’s Going on in Exchanges Today?

With a mini-wave of exchange mergers in the last few days, I want to launch into a brief discussion of the role of public equity markets for corporations and investors.  In August, I did an interview with Justin Fox that covered a broad range of topics, many derivative of issues raised in his outstanding book The Myth of the Rational Market (check out my review here).  That interview was important to me for several reasons, one of which was how it helped frame some of my own thoughts with regard to price and value efficiency in financial markets.  At one point, Justin asked whether I had heard of this site called SecondMarket.com and had the following to say:

…a market where commissions are $30 and people are able to trade pretty much whenever they want is going to be better than a market where commissions are $5,000 and you are only allowed to trade once a year.  But I think there’s this point of diminishing returns.

….SecondMarket on the whole is less efficient and less transparent than our public stock exchanges, but precisely because of that, there are companies willing to have their shares traded on it who don’t feel like they want to be public companies.  So, it’s not just this idea that in some ways it’s better for lots of people in terms of raising capital to have this market that people don’t trade all the time.  In some cases, you can only trade once every two months or whatever.  And that’s actually more useful for certain kinds of assets.

Sure enough I had never heard of SecondMarket up to that point so I decided to do a little digging.  Upon searching some more, and in light of the recent Facebook private market fiasco, it’s become clear that for many young, growing companies, public equity markets are an increasingly less favorable option.  The proof is in the fact that fewer and fewer companies are listed on our equity markets each and every year since the height of the dot.com bubble (hat tip to Felix Salmon for the chart):

What does it all mean?  Well firstly, it’s clear that there is plenty of private capital ready and willing to fund young, growing companies.  That’s just one part of it though.  Secondly, and perhaps most importantly, these young companies fear the volatility associated with our public equity markets and the demands on companies to not only meet, but exceed quarterly earnings reports each and every quarter.

For a young company, management’s goals are generally different than a mature one’s.  They’re not necessarily looking to maximize shareholder value on a quarterly basis, but rather looking to build out a longer-term vision into a successful mature company.  The goal in the early days is to scale a proven business model into a mature business.  In order to do so there will be fits and starts along the way, but that’s only natural.  Yet in our public markets such fits and starts often lead to violent reactions from investors that in the worst of cases could potentially derail a company’s access to capital.  Moreover, one adverse quarterly report and investors quickly run to the exits.

Our private markets, on the other hand, are filled with more patient and disciplined investors who knowingly and willingly are ready to withstand such growing pains.   They know about the risks entailed in early stage investing, but are more than willing to take those risks for the upside.  Certainly there are liquidity constrains in private markets whereby early investors cannot sell willingly as they can on public markets, but at the same time, there are no big institutions looking to short companies whose present prices exceed their intrinsic values.  Such shorting increases the supply of stock and makes  the cost of capital for publicly traded companies in contrast to private ones.

All that being said, I have a big problem with this trend and I think its up to the powers-that-be to find a solution ASAP in order to correct it.  Josh Brown recently put it particularly well in a post entitled “Good News for People Who Love Unfairness”:

…I think it’s great and totally American that we now have two stock markets – one for the venture capitalist bourgeoisie and one for you and I and everyone else.  That way, our stupid securities regulations – which are beneath contempt for the Silicon Set – don’t get in the technocrats’ way.

Our public equity markets are designed not just for companies to tap into capital on the cheap.  That’s just part of it.  They are also supposed to give the common man (by man I mean people, but just trying to speak a little poetically here) an equal opportunity to take part in one of the single greatest wealth creators in world history–our public capital markets.  If more and more young growing companies are tapping into private capital markets, then more and more of the outstanding wealth creation opportunities are going to an elite group of the already super-wealthy.  This is not good.

There are ways for companies to avoid some of the problems cited above.  For example, companies who are open and up front with their long-term growth and vision tend to get rewarded in the long-run.  There certainly is price volatility along the way, but smart management can earn the trust of their longer-term holders in their vision.  While some companies have mastered this style of management, that’s not nearly enough.  Something needs to be done and it needs to be done soon to level the playing field once again.

This Rally is Not Just Smoke and Mirrors

Well the time has come and the inevitable pullback is most likely upon us, or is it?  It appears as though we are due for a drop at this point in time, and such action would very much be welcome.  Whether this dip lasts for a day, week, month or just an afternoon is a different question, but this morning the lack of breadth on the market’s bounce was quite telling.  Some short-term downside would make sense.

All that being said, many remain confused about what we market participants (and observers) have witness over the past few months.  Considering my recent absence from the blogosphere, I had quite a few thoughts to get off of my chest, so let’s get started.

Back in the early days of the rally, on September 21st to be exact, I wrote out the Top 5 reasons to Trust This Rally.  At the top of the list was the fact that “In the long run, the market follows the trajectory of earnings.”  Not only did companies beat handily on the bottom line, a trend that started several quarters ago, but also, more companies have beat on the top line this quarter than at any point since 2006.  The beats are so strong that some now question whether companies are gaming the top line as they do bottom line (i.e. the standard lowball guidance in order to setup the slam-dunk beat).  Bear in mind, these are the very same people who all along have questioned the quality of earnings beats considering the lack of revenue growth.

In reality, companies issued their latest guidance in the face of pervasive “uncertainty” and at a time when many feared a double-dip recession to be imminent.  It should come as no surprise that amidst an acceleration in the rate of recovery, companies would make more money.  This is consistent with the strong PMI and ISM data to hit the tape over the past month.  These strong revenues help fuel further gains in EPS, above and beyond those that had been cynically attributed to cost-cutting.

But let’s get to the real meat of the point–why exactly should this translate into an epic market rally that leaves technicians searching for answers?  Many want to “blame” QE2 and say that the market cannot function normally in the face of a liquidity surge into markets.  Sure QE2 was helpful, but let’s be honest, it is far too soon for QE2 to translate into revenue and earnings gains for corporations.  It only started during the last quarter.  Yet despite this rally, many companies remain rather modestly valued on many valuation metrics (sure there are some outliers, as there will always be).

The real answer lies in three letters, TTM: the market’s trailing twelve month P/E ratio.  See, the fourth quarter of 2009 saw earnings hit their lowest levels seen in the Great Recession, yet that quarter continued to show its face in the form of elevated P/E ratios at just about all corporations.  With this quarter’s earnings report, we can finally remove that albatross of a quarter from the TTM P/E ratio and get a much cleaner picture as to the earnings power of many corporations.  While guidance during the last quarter helped give a clue as to what to expect, the earnings results themselves, and the magnitude of the beats both top and bottom line, give concrete confirmation to that effect.

Add to that the fact that the pervasive uncertainty that ruled the Summer has now given way to the animal spirits of optimism and the picture looks dramatically different.  It’s the speed with which this all happened that’s thrown people off.  Just as we unwound in dramatic fashion following the collapse of Lehman brothers, these days we are quickly climbing out of that crater.

If today does mark the beginning of a short-term pullback, patient investors should welcome the opportunity with open arms.  We have far more clarity about the normalized earnings power of many companies, we also have a much clearer idea as to which industries are best positioned to weather a storm in the financial sector.  This is all important information that fuels confidence in the longer-term equity holders to hang on and innocent bystanders to seek an entry.  In the short-run emotion reigns supreme, but in the long-run patience prevails.