We’re back after a week off acquiring the first sunburn of the season at The Boulders Resort north of Scottsdale AZ. We endorse nearly every single thing about that place, tucked under the Fountain Mountains and south of Cave Creek. By the way, the latter may have more public houses per capita than any little village in America. Why Arizona in summer? Bargains, people. Bargains.
Speaking of bargains, on June 20 we observed a tectonic shift of international money away from US equity markets. How do we know? We don’t absolutely…but the data evidence was pretty overwhelming. The symmetry and function of order-flow execution bespoke massive asset-allocated money and churned out through Deutsche Bank and Goldman Sachs in particular, firms that have made solid inroads with sovereign wealth funds. Deutsche Bank took eighteen floors in China’s Kowloon district (Hong Kong) for its capital-markets outreach to China, and Dubai’s wealth fund is a serious Deutsche Bank shareholder. Goldman Sachs has been in China for two decades, represents with its Gao Hua relationship the largest international investment banking operation in China, and opened a Dubai office in March 2007 to support what it called “a major client base across the entire Middle East region.”
Anyway, the effect of this massive shift was what we’ve described as a lowering of the water level in US markets. Absent the tens and perhaps hundreds of billions of dollars these firms represented with their combined order flow, the reservoir level receded, dropping the values of many US equities. Was it coincidentally ahead of the Russell Indices Rebalance on June 27? We don’t know.
But let’s now talk about the Russell Rebalance. Each year, Seattle’s Frank Russell Company reconfigures its (currently 25 domestic) indices to reflect straight market capitalization ranking of the 4,000 largest companies traded on US national markets. Reconstitution measures market cap on the last day of trading in May. The actual rebalance then occurs on the last trading day in June. The gap between is intended to marginalize speculation, and in fact, while volumes can be massive as they were on June 27, pricing tends to be rational. Most issues, we observe, price around their volume-weighted average that day (because issues move around in rankings and get re-benchmarked in most cases). Since indices are not volume weighted, they simply reflect a ranking relevant to Russell’s focus on the engines of economic growth – smaller companies. As companies mature and grow, they move out of the Russell 2000 and Russell 3000, and different companies take their places.
You might conclude that increased market capitalization versus last year would correspond to a positive impact on your stock, and conversely, declines would be negative. Not necessarily. Dropping out of the Russell 2000 could put you at the top of the Russell 3000 – resulting in a nearly neutral pricing event. The same could be true moving out of the 1000 and into the 2000.
What’s perhaps of greater magnitude – we don’t pretend to offer more than anecdotal and logical support for this conclusion – is how money benchmarks anew after the reconstitution (in 2007, about $4.4 trillion tied to Russell indices). The amount of money pegging to these benchmarks is what ultimately determines the value of the indices and the impact of rebalancing on component issues. If there’s lower belief in the engines of economic growth, you might expect fewer dollars to align with the indices. June was the worst month for the Russell indices since 2002, by the way. So if you expected a different outcome from the rebalance than what you experienced, it’s likely because funds aren’t putting as much money into Russell measured models right now.
We’ll go further and postulate that international monies formerly pegged to Russell indices further departed the US scene in the last few trading days. We’re hoping that stability will soon manifest itself through a resumption of program trading strategies for the summer quarter. We don’t mean to sound negative! We’re realists here, and our job is to keep you IR folks and public company execs apprised of what the money does, not what people say or think.
Margaret E. Wyrwas - Knight Capital Group, Inc. (Nasdaq: NITE)
Senior Managing Director, Corporate Communications & Investor Relations
Equity Analysis™ subscriber since March 2007
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