All the Stocks Are the Same Now

Also insider trading and virtual roadshows.

Correlation

Here’s a statistic for you:

The S&P 500 Index’s three-month realized correlation has steadied around the 0.8 level, its highest in about eight years, even though other gauges of market stress such as the Cboe Volatility Index have retreated toward normal levels. The divergence suggests investors continue to focus on just one main driver -- the global coronavirus pandemic -- making it harder for active fund managers to beat their benchmarks.

From beginning the year with a correlation of 0.19, the gauge of how closely the top stocks in the S&P 500 move in relation to one another spiked to 0.85 in mid-March, toward the peak of the coronavirus sell-off before leveling off around 0.8. A maximum possible correlation of 1.0 would signify all stocks are moving in lockstep.

There have been times in the last decade or so when correlations have been very high and people have complained about them. The correlations, they argued, represented some sort of postmodern glitch in the stock market: The dominance of index funds had led to the end of stock picking, or algorithms that relied on historical relationships ended up blindly reinforcing those correlations, or something. Something was broken in the pricing and capital-allocation functions of the stock market, so that all the different stocks traded like the same stock.

This is … not that story. This is, in February there was an economy, and then in March the economy shut down, and eventually there will either be an economy or there won’t be. If there is an economy then different companies will have different earnings, but if there is not then no companies will have any earnings; every company will be better off if there is an economy than if there isn’t. Your bet on whether there will be an economy, and when, will almost certainly determine whether you think any particular company’s stock is over- or underpriced; particular differences in outlook for particular companies are basically irrelevant.

Obviously this oversimplifies—the S&P correlation is 0.8, not 1.0, and videoconferencing software companies or whatever might do well in a pandemic—but I think it is the correct rough model.

If you are an active equity manager who has spent the last few years arguing “sure, index funds are great in a rising market with high correlations, but in more complicated times investors will need the human intuition of active fund management,” this is not ideal. You were hoping for the market to go back to normal, with some stocks going up and others going down, so that you could pick the ones that go up while index funds were forced to hold the ones that go down. Instead, the bull market broke in a way that increased correlations; instead of investors finally coming to their senses and realizing that some companies were exposed to underappreciated risks, what happened is that all companies were overwhelmed by the same novel risk. 

The correlation number is also a way to quantify something that we talk about a lot around here. Roughly speaking, when correlations are high, investors should spend more time worrying about stuff that affects all stocks, rather than about the differences between particular stocks. Often this is a matter of research and prediction, top-down macro analysis versus individual stock-picking: When correlations are 0.19, doing research to find the best stocks will be valuable; when they are 0.8, having an informed guess on how quickly the economy will reopen will be valuable. 

But it is also, potentially, a matter of actual corporate decisions. When correlations are 0.19, a company should try to be better than its peers, because the good companies will outperform their competitors and enrich their shareholders. When correlations are 0.8, outperforming competitors is harder and less valuable, and shareholders will care more about the overall size of the pie than they do about any company’s piece of it. And if you are an investor, with correlations of 0.19 you should focus on finding ways to help the companies you own perform better, but with correlations of 0.8 you should focus on making the economy better.

Traditionally there are ways to do the former: Activist investors, private equity funds, venture capitalists, etc., are all in the business of buying concentrated stakes in particular companies and helping those companies perform better. The latter sounds weirder: No one invests in all the companies and then tries to make “the economy,” in the abstract, better. But it is, increasingly, a business model. The big diversified institutional asset managers, investing giants like BlackRock Inc., do more or less buy big stakes in all the companies, and they don’t generally have the tools or desire to monitor all those companies closely and try to improve their performance. But their big stakes in every company give them a lot of influence; it is just that they can’t efficiently use that influence to push specific corporate actions that would idiosyncratically improve individual companies. Instead they use it to push very broad ideas that they think will improve long-term results for companies generally.

So BlackRock’s big pre-coronavirus push was for companies to have better environmental policies, on the (ostensible) theory that this would improve long-run results for everyone. If the oceans rise and the cities flood, that will be bad for the economy and all the stocks. No one company can prevent that, but maybe all the companies working together can, and BlackRock’s perspective is that of all the companies. 

The push now is even more obvious: You want all the drug companies to work together to find a Covid cure or vaccine and distribute it as widely as possible. If you find a cure, the economy can reopen and all the stocks will go up, which is vastly more valuable to BlackRock than the particular size or allocation of the profits from selling the cure. And so we have talked about how BlackRock is actually calling drug companies and telling them to cooperate to find a cure without worrying about credit or patents or profits. (While active equity managers in the health care sector are skeptical, because they do care about how big the profits are and who gets them.)

In general you’d expect that the higher the correlations among stocks, the more useful these sorts of interventions will be, while with lower correlations company-specific activism will be more valuable. Right now is a weird time, and finding a cure for the coronavirus could be more important for the stock of, say, American Airlines Group Inc. than anything American Airlines can do. 

Insider trading law is weird

Lots of investment firms—private equity funds, hedge funds, etc.—make big investments in public companies and take seats on those companies’ boards of directors. If you own 20% of a company, and if the company makes up 10% of your fund, you don’t want to find out what the company is up to by reading its press releases. You want a seat at the table when the company makes big decisions; you want advance notice of big events; you want to be able to ask detailed questions about strategy and operations and financial projections and get honest answers from management. So if you’re negotiating a big investment in the company, you might ask for a seat on the board of directors, and the company might say yes. 1  You’ll put one of your employees—typically the person who led the investment for your fund—on the board of the company, and she’ll go to board meetings and represent your fund’s views and report back to the rest of your employees on what the company is up to.

This is obvious normal stuff, this is how investing should work. In private companies, it is completely expected that the biggest investors will sit on the board of directors and get detailed information about the company and have a say in strategic decisions and generally share their wisdom with the company’s managers.

But there is an awkward side effect to having a board seat at a public company, which is: How do you trade the stock? There you are, sitting in the board meetings, getting lots of confidential information before the rest of the market does, seeing all the projections, discussing possible strategic plans, and generally getting much better information than the rest of the market gets. (“Material nonpublic information,” this is traditionally called, or MNPI.) You asked for the board seat so that you’d have better information about your investment than the rest of the public does. But getting material nonpublic information about a company by virtue of being a director of the company, and then trading with that superior information, seems like it would be pretty obviously illegal insider trading?

There are ways to deal with this. One way is to take the board seat and not trade: A long-term private-type investor might sit on a company’s board, never buy any stock, and never sell any stock except (1) in a formal public offering with a prospectus disclosing all material information about the company or (2) after giving up its board seat. Another way is to trade and not take the board seat: Some hedge funds will take large stakes in public companies but decline to take board seats, specifically so they remain free to trade. 

But a common approach is to take the board seat and plan to trade only when other directors are allowed to trade. Other directors are allowed to trade! Even the company’s chief executive officer is allowed to trade! They sit in board meetings, they know the company’s secret plans and projections, and yet they routinely buy and sell stock. You can’t really have a corporate finance system in which directors and officers of a company are never allowed to sell the company’s stock.

So everyone accepts the polite fiction that there are times—at least a couple of weeks or so every three months—when the company’s executives and directors don’t know any more about the company than everyone else. Public companies will typically have an explicit policy about this, often with a trading window for executives that opens a few days after quarterly earnings are filed and closes a few weeks later. 2  The rough idea is that, when a company announces earnings and does an earnings press conference and analysts write up the earnings and the market reacts, the company has disclosed everything it knows, and the market knows everything about the company that its executives and directors know. So the executives and directors don’t have any nonpublic information, and they can buy or sell stock freely. 3  But then as the new quarter goes on, the executives get more and more information about how it’s going, so they once again have too much information. So the company goes back into “blackout” and the executives can’t trade.

None of this is true, of course; the CEO of a public company knows a lot more about the company five days after it announces earnings than the average retail investor does. She knows its five-year financial projections and its plans for new products and what’s going wrong on the assembly line and who has called her about potential mergers. But you cannot be too literal about these things or CEOs would never be able to sell their stocks without going to prison, which would make being a CEO significantly less attractive. So we all agree that there’s a brief period when insiders don’t know too much more than outsiders, and they’re allowed to trade then. Mostly. Obviously if the company is negotiating a huge merger right after earnings the CEO shouldn’t trade then, and “open windows” don’t really have much in the way of formal legal status, but the general rule of thumb is that insiders can trade in open windows and can't trade during blackouts.

You might think that the same basic principles would apply to a hedge fund or private equity fund with a board seat. Ares Management LLC seems to have thought so:

In 2016, Ares invested several hundred million dollars in client funds in the Portfolio Company in the form of debt and equity. Confidentiality provisions in the loan agreement remained in effect between Ares and the Portfolio Company on a going forward basis. Moreover, the equity investment allowed Ares to appoint two directors to the Portfolio Company’s board.

As one of its two representatives on the board, Ares appointed a senior member of the Ares “deal team” involved in the debt and equity investment (“Ares Representative”). From time to time following Ares’ investment, the Ares Representative, along with other members of the deal team, received information from the Portfolio Company that posed a risk that it could be MNPI. This information was sometimes then shared more widely within Ares, as contemplated by the aforementioned confidentiality provisions. The information concerned, among other things, potential changes in senior management, adjustments to the Portfolio Company’s hedging strategy, efforts to sell an interest in an asset, the Portfolio Company’s desire to sell equity and use proceeds to retire certain debt, and the Portfolio Company’s election, as allowed under the terms of the loan agreement, to pay interest “in kind” and not in cash.

While the Ares Representative sat on the Portfolio Company’s board, Ares began to purchase the Portfolio Company’s publicly-traded stock. An Ares investment committee had approved the purchases, as well as a recommended purchase limit price and then several subsequent increases in the recommended limit price. During 2016, Ares purchased more than 1 million shares of the Portfolio Company’s stock on the public market. The stock purchase orders had been approved by Ares’ compliance department and occurred during open “trading windows” at the Portfolio Company. ...

That quote is of course from a U.S. Securities and Exchange Commission enforcement action that Ares settled yesterday by agreeing to pay a million-dollar penalty. The open windows were not sufficient, says the SEC, and Ares’s compliance department should have dug deeper:

Ares did not sufficiently take into account the special circumstances presented by the Ares Representative’s dual role as both a member of the Portfolio Company’s board and an Ares employee who continued to participate in Ares’ trading decisions concerning the company. Although Ares’ compliance staff confirmed with the Portfolio Company that the relevant trading windows were open, Ares’ policies and procedures did not provide specific requirements for compliance staff concerning the identification of relevant parties with whom to inquire regarding possession of potential MNPI and the manner and degree to which the staff should explore MNPI issues with these parties. 

I mean, sure, yes, fine. Being in an open window generally means that you don’t have any material nonpublic information about the company’s quarterly earnings, but it doesn’t necessarily mean that you don’t have other kinds of MNPI. If the company was about to be acquired for a huge premium, and your representative on the board was helping negotiate the deal, it would be a bad look to be buying stock. So compliance has to ask not just “are we in an open window” but also “is the company negotiating a merger or anything?” 

Still it’s hard because the question compliance actually has to ask, of the board representative and everyone else on the deal team, is: “Do we have any material nonpublic information about this company?” That is: “Is there anything that we know about this company that the average investor doesn’t know, and that the average investor would want to know?” And there the answer is obviously, always, yes: That’s why you have the board seat; you specifically got the board seat to know more about the company than the general public, because that would be useful for your investment.

So compliance calls up the board representative and says “do we know anything useful and nonpublic about this company,” and the board representative is like “well obviously yes,” and compliance is like “let me rephrase that, is there a merger or a bankruptcy filing coming,” and the board representative is like “not that I know of,” and compliance is like “okay good enough.” And then the board representative is like “well one thing is, they’ve talked about paying interest in kind instead of in cash,” and compliance is like “hmm, I wish I hadn’t called.”

I don’t know, I sympathize a little with Ares here, not wanting to poke this whole rickety setup too hard. If you ask a board member of a public company to list everything that she knows about the company that the general public doesn't know, it will be a long list, and if you look at it for a while you might think “huh this list looks sort of … material,” and then where will you be? Unable to trade, forever?

By the way, I assume that the SEC also doesn’t want to poke any of this too hard. It’s not like hundreds of corporate executives and directors get arrested every year for insider trading, even though corporate executives and directors routinely trade their companies’ stocks. If you buy or sell your stock in an open trading window, and you don’t then immediately announce a merger or a giant security breach or a big sexual harassment problem, everyone agrees to assume that you didn't know anything too material.

Even in this case, the SEC lists all the maybe-material stuff that Ares knew when it was buying stock—“potential changes in senior management,” “efforts to sell an interest in an asset,” the payment-in-kind thing, etc.—but calls it “potential material nonpublic information,” not actual material nonpublic information. And it fined Ares $1 million for violating compliance-policies requirements, rather than fining it lots more money for violating insider trading rules. The SEC doesn't say that Ares actually traded with MNPI, just that its policies were too lax to guard against that. If the SEC went after Ares for insider trading here, just because it traded a company’s stock during open trading windows while knowing what was discussed in the company’s board meetings, wouldn’t it have to go after every director who ever traded stock?

But is it unconstitutional?

Hahaha sure:

Gene Levoff, previously a senior in-house lawyer specializing in corporate law for Apple, was charged last year with trading on inside information about the company’s revenue and earnings dating back to 2011. He asked U.S. District Judge William Martini in Newark last month to throw out the indictment against him, arguing that the prosecution is unconstitutional because no specific criminal law bars such conduct.

“The definition of insider trading is wholly judge-made: Every element of the crime and the scope of regulated individuals subject to it was divined by judges, not elected legislators,” Levoff’s lawyer Kevin Marino said in an April filing. “This alone renders the criminal prosecution of insider trading unconstitutional.”

Look, I have some sympathy for this as a philosophical matter. You should not go to prison for breaking the law unless the law is passed by the legislature and written down somewhere. The specific contours of insider trading law are vague and shifting, and it is part of a law—securities fraud, wire fraud—that is even vaguer. Essentially the law of securities fraud is that you can go to prison for doing stuff that prosecutors and juries think, in hindsight, looks shady. It is not at all a good body of law.

But in this particular case, come on, he was a lawyer at Apple (allegedly) trading on inside information about upcoming earnings. Under any view of insider trading law, that is pretty straightforwardly illegal, and he surely knew that since he was a lawyer responsible for securities-law compliance at Apple. I agree that the law of securities fraud is too vague, really, but not for him.

(Incidentally if you read the SEC complaint, they note that he got earnings information in advance and traded on that information before it was announced, explicitly during a blackout period. Even for corporate insiders there are ambiguities, but, again, not for him.)

“Road” shows

The normal way to sell stock in a public company is, you go to your computer, you open up a screen from your brokerage, you put in how many shares you want to sell, you click “sell,” and a millisecond or two later you have sold your shares. It is pretty much the fastest, easiest, lowest-touch form of sales imaginable; buying a can of Coke involves vastly more time and effort and human interaction than buying 1,000 shares of Coca-Cola Co.

But when private companies first go public, in their initial public offerings, the normal way that they do this is by having their top executives spend two weeks flying around on private jets visiting a bunch of potential investors in different cities so they can meet face-to-face and explain why their stock is good. It is among the highest-touch forms of sales imaginable; most of these companies would not send their entire executive teams out to meet with their biggest customer to sell their product, but they’ll put them all on a plane to sell their stock. 

This makes sense, sure: Already-public companies have established market prices and are covered by Wall Street research and there’s just a lot of information available, so potential buyers don’t need weeks of one-on-one meetings to buy the stock on the exchange. Not-yet-public companies don’t have those things; to get investors to buy stock for the first time, at a price that may or may not be right, you need to come to their cities to look them in the eye.

Still it just feels like a weird disconnect. “What if we pushed the sell button on the computer to sell stock, instead of spending two weeks doing nothing but flying around talking about our company,” a startup founder might almost-reasonably say. And in fact there has been a small vogue for exactly that: We have talked for a while about “direct listings” that cut down on the one-on-one sales and roadshow aspects of the traditional IPO and look more like just selling stock on the exchange. Clearly part of the reason for their (still small but) growing popularity is that some startup founders have noticed that it is very easy to sell stock on the stock exchange and very annoying to sell it via an IPO, and have asked if there’s a way to do an IPO that feels more like selling stock on the stock exchange.

Anyway also now we are in a pandemic and nobody wants to fly around the country or go to crowded investor lunches or generally look anyone in the eye, so:

A number of initial public offerings during coronavirus lockdowns have done strikingly well despite executives being unable to do what they normally do, and present to roomfuls of investors at big financial centres around the world. This has raised questions about whether the schmoozing and gruelling travel of the traditional IPO “roadshow” is really necessary, and whether the rigmarole will return after the pandemic. …

The lack of a physical roadshow did not deter coffee business JDE Peet’s from pursuing an IPO this month. “You don’t get to shake someone’s hand and look them in the eye, but you do get to speak to a lot more people. That’s a trade-off that people like,” said Andreas Bernstorff, head of equity capital markets at BNP Paribas, one of three lead banks on the deal. ...

Gareth McCartney, global head of equity syndicate at UBS, said IPO roadshows would probably emerge as a hybrid of the glitzy productions of the past, and a series of efficient video meetings. “There’s no doubt that you could look back in hindsight and say running around 15 countries in 15 days . . . seems a bit crazy,” he said.

I think one lesson of the direct listing mini-boom is that a lot of stuff in equity capital markets happens mostly because it has always happened that way. These are high-stakes transactions that most companies only do once; they rely on banks for their specialized expertise, and the banks tend to be conservative. “What if instead of a roadshow we just stayed home and did some videoconferences,” an issuer could have asked three years ago, and its banks would have said “no no no that’s never been done, investors need to meet you and feel loved and courted, besides videoconferences are too glitchy, if you do it that way there's a risk of your deal failing and you don’t want that do you?”

And issuers never pushed back, because the banks were the experts. But then Spotify Ltd. pushed back, and did a direct listing, and it was fine. A small crack opened up. And now you can’t meet investors at all, so everyone agrees that videoconferencing is the way to go, and it’s hard to go back from that. Now you know that videoconference roadshows can work; there are tradeoffs—video lag on looking people in the eye, etc.—but businesses deal with tradeoffs all the time. “It’s never been done and it’s too risky to try it now” is generally a good argument against ever changing anything about IPOs. But now it’s been done, and it worked out fine, so that argument doesn’t work anymore.

Things happen

Hedge Funds Plan Extreme Lengths to Protect Staff After Lockdown. Hedge Funds Pay Up in U.S. to Poach From Rivals Stung by Turmoil. Salaries Get Chopped for Many Americans Who Manage to Keep Jobs. Hertz Paid Out $16 Million in Bonuses, Days Before Bankruptcy. New York Lawmakers’ Last-Minute Move May Cost Argentina Dearly. Three Senators No Longer Being Investigated on Stock Trades. SpaceX passenger brought down to earth by tax evasion allegations. Facebook Renames Blockchain Division After Libra Confusion. The U.S. Is Spending Millions of Dollars Rearing Flesh-Eating Worms. Squirt Gun Baptisms. “The recent Twitter spat between “Black Swan” author Nassim Nicholas Taleb and quant investing pioneer Cliff Asness over hedging against highly remote events reminded me why Luke Skywalker needed two droids: R2-D2 to ignore chaos and calmly proceed with the long-term plan, and C-3PO to point out all the exotic dangers that make everything hopeless.”

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1. There are different ways this can happen. For instance a venture capitalfund might own a chunk of a private company and have a board seat, and then keep the board seat (and a big stake) when the company goes public. Or a private equity fund might make a negotiated investment in an already-public company, and get board seats along with a chunk of stock. Or an activist hedge fund might buy a bunch of stock in the market and then go to the company to demand changes andboard seats, and the company might give it a board seat in a settlement. Etc.
2. There’s a range. Sometimes the window closes as late as the last day of the quarter, i.e., you are only blacked out from the time the quarter ends until the time that quarter’s earnings are announced. Other times it closes just a couple of weeks after earnings, i.e., you are blacked out from trading for most of the quarter, with just a couple of weeks of open window.
3. Or set up 10b5-1 plans, which is how a lot of corporate executives actually sell stock. But you need to be in an open window to do that.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net