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So Exchange Traded Index funds and the $1.2 trillion invested in them have increased volatility for small cap stocks making the whole IPO process less attractive for many founders of U. S. tech companies — our kind of companies. It’s not the end of the world but has been a downer of sorts for both the market and the tech industry for the last decade. What’s to be done about it, then?

“The problem as we see it could be 80-90 percent contained if only Exchange Traded Funds were subject to the same sort of trading circuit breakers that were imposed by the SEC on regular shares after the Flash Crash of earlier this year,” says Bob Litan from the Kauffman Foundation.

The fact that such circuit breakers haven’t already been imposed, stopping trading altogether when things get a little too crazy, makes no sense at all, at least not to me. What’s good for the stock is good for the index that trades like a stock. So do it.

The better question, though, is how do we actually benefit from this situation? How do we — smart nerdy we — make a few bucks on these ETFs that aren’t going away?

I have a plan.

Here’s where it might be a good idea to go back to my last column and read or re-read it so I don’t have to write that stuff all over again. Notice the comments, too, since those folks are far smarter than I am.

So we have this market that goes up and down based on, well, something (nobody is quite sure what) but smart traders can make a good living from it, so why can’t we? I think we can. I think we can make an extraordinarily good living from it simply because much of the Index ETF volatility has nothing at all to do with the individual stocks contained within the index. The price goes up or down for whatever reason and the ETF’s — huge institutional investors in their own rights — are required to rebalance their portfolios to reflect the new market values — values that are, for the most part, artificial.

As a result, shares of the Acme Transistor Company go up or down when it makes no sense for them to do so if you know much about the Acme Transistor Company. Because the bozos running the ETF that is the largest shareholder in the Acme Transistor Company by definition know nothing about what happens there. They simply don’t see it as their business — a very un-Buffettlike way to invest.

Warren Buffett, now that his name has been dropped, wouldn’t pay any attention to this because, as a value investor, he completely ignores this kind of volatility. And as a huge investor, he actually ignores these entire companies because there simply isn’t any way he can stuff enough of his money into any of them to satisfy Berkshire Hathaway’s hunger for shares.

If you are buy-and-hold, then by all means buy-and-hold. But if you want to try and play the game a bit, here’s what you need to remember: for intrinsically good companies this is a zero sum game. Prices that dramatically dip will eventually rise again. And those that dramatically rise will eventually dip again, absent any real news.

Become a specialist in a few little companies within an index like the Russell 2000. Follow both the rumors and the news. If the stock swings wildly and there is no news, no rumors, no insider head feints, no reason at all for that to be happening other than that when elephants fight the grass is trampled, well that’s actionable. Buy or sell as needed, maybe (definitely!) get some leverage by trading options. Short the stock if it is going up or go long if it is going down.

What we have here are two different trading universes and each is simply noise to the other. When you have a sense of the rhythm of an individual stock you can trade on the ETF noise. Rhythm and noise — it’s an inter-dimensional trading algorithm that actually works.

Weird, eh?

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I write a lot about technologies, companies and industries, some about economics, but hardly ever about stocks or trading, so this column is an unusual one. But because of the hard work of a couple economist friends of mine I’m finally coming to understand a stock market phenomenon that has been hurting tech startups for over a decade — Exchange Traded Funds. Forget about bad banks, cooked books and even the recession: Exchange Traded Funds are forcing more and more good tech companies to abandon the idea of ever going public.

We saw this trend on this summer’s Startup Tour where not one of more than 30 companies we visited saw an Initial Public Offering (IPO) in its future. Every company saw itself eventually being acquired. But there’s a problem with being acquired, which is that it greatly limits the upside for entrepreneurs. Had Microsoft been acquired by IBM, for example, would Bill Gates today be the richest man in America? Heck no. Lotus Development was acquired by IBM and the fortunes of those Lotus people haven’t fared any better than those of their colleagues at Big Blue. Yes, they got $3.3 billion, but today that’s not worth much more, maybe less.

IPOs are better if they work. IPOs make entrepreneurs big rich. So why aren’t there more of them?

That’s a very good question — one that until this week was generally answered by experts rolling their eyes like they were trying to explain the great frog die-off. IPOs are too expensive, we’re told. A positive upside is no longer as certain as it was in the 1990s, they say. Acquisition is just plain easier and big companies have learned better how to grow by acquisition: look at Cisco.

Then along this week came Harold Bradley and Bob Litan of the Kauffman Foundation with a completely new and novel reason for the decline in IPOs. They say in their new study that Exchange Traded Funds have caused such volatility for newly-public tech companies — volatility that has nothing at all to do with the companies themselves — that founders are being scared away from IPOs and into being acquired for substantially less money than they might have made.

Exchange Traded Funds have been around since the early 1990s and can be thought of as index mutual funds on steroids. Both types of funds have underlying assets that reflect their target index. If the mutual fund or exchange traded fund is intended to represent the Dow 30 Industrials, then it should own all 30 stocks in equal amounts. Where the funds differ is in how they are traded and taxed. Index mutual funds are priced to represent the value of their underlying shares so the redemption price is set once per day based on the closing Net Asset Value of the stocks in the portfolio. Day traders aren’t interested in index mutual funds because there is no intra-day price volatility. There’s no shorting, either. You can’t normally borrow and short a traditional mutual fund, nor would you want to because the tax consequences could ruin the deal. But ETFs, in contrast, vary in price throughout the day based on supply and demand so day traders might be interested. If the ETF price varies significantly from the price of the underlying basket of stocks, then there is an arbitrage opportunity that some trader will notice and take advantage of — buying the ETF while selling the underlying stocks, for example — generally without the tax concerns of a traditional mutual fund because the retail ETF shares are traded through intermediary market makers that effectively decouple share gains from underlying capital gains. Got that? Me neither, but that’s the way it works. Oh, and ETF shares can be shorted, which of course increases volatility even further.

ETFs change value constantly based on supply, demand, manipulation and rumor. And here’s the weirdest part: at the end of the day index mutual fund prices are changed to match their Net Asset Value while with index Exchange Traded Funds at the end of the day the underlying securities are bought or sold to reflect the notional value of ETF shares. As a result ETFs are constantly buying and selling, leading to yet more volatility.

Now that we have some vague understanding of ETF structure, here is how they screw things up for little companies. This happens in two very different ways, first by reducing market interest in individual stocks in favor of funds that hold those stocks and second by amplifying the share volatility of small companies that are not widely traded.

In relative term,s retail investing in the USA has died. The huge trading volume increases of the last two decades have been driven almost entirely by institutional traders with their computers buying or selling billions of shares per day. Compared to these institutions, you and I and our trades have almost no impact on where the market is going. Since we have no sense of efficacy, we trade mutual funds or ETFs, which is to say we let the institutional investors do it for us.

“People have given up on picking stocks,” said Bob Litan. “Indexes are cheaper and ETFs have tax advantages. So much money is now in the index ETFs that many investors no longer care about the individual companies that underly the index.”

If an ETF is comprised of large cap stocks like Microsoft and Dell, that’s fine, but if the index is composed of smaller companies like the Russell 2000 index, those companies with very few shares outstanding are in for a wild ride. One ETF, IWM-Russell 2000, is the largest shareholder for more than 800 of the companies in that index. If the ETF goes up then the ETF has to buy more shares of the underlying securities or issue more shares of the ETF, itself. If the ETF goes down then it may have to sell shares. And none of this has anything to do with the fundamentals of those particular underlying stocks.

The shares go up and down, well, because they go up and down, which makes a CEO feel helpless — sometimes so helpless that they my choose to opt out of the system by foregoing an IPO altogether.

“The index is the tail that wags the dog, ” Litan continued when I talked with him yesterday. “It’s like riding a bull. Why IPO into that?”

And so, more often than not, tech startups these days walk away from the public markets.

Next: What’s to be done about this problem and how can it make us all rich?

We’re well into our Startup Tour, visiting young companies so far in New York, Vermont, Pennsylvania, Michigan, Illinois, and Missouri.  Today we head to Kansas City and the Kauffman Foundation, one of our sponsors. That I’ve been slow to post the promised tour videos or write about these companies comes down to air conditioning failure, driving 4,000 miles, air conditioning failure (again), swiping a tree and tearing-off our retractable steps, air conditioning failure (yet again), and hitting a pothole so deep that our exhaust system literally fell off in the road.

Ah, the RV lifestyle!

We also learned a great truth about Travelocity when booking hotel rooms for the camera crew: did you know that when they take your money and promise you three rooms for two nights in St. Louis that promise means nothing? Sometimes those rooms turn out not to exist and the only recourse to being homeless in the rain at 11:30 PM is getting your money back in 12 business days.

But the startup companies we’ve visited so far has each been a joy and a surprise in a different way. I’ll start writing about those tonight as we finally get to rest for a couple days in Kansas City.

Or if you can’t wait for that and happen to be from Kansas City, drop by the Kauffman Foundation this afternoon at 3PM and meet us all for ice cream in the parking lot. And if you think to, please bring an unwrapped toy that my kids can take to local hospitals and homeless shelters. That’s their startup venture this summer.

See you at 3PM.

Ewing Marion Kauffman Foundation‎
4801 Rockhill Road Kansas City, MO 64110
(816) 932-1000
kauffman.org‎

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Just a week into nominations for the Cringely (NOT in Silicon Valley) Startup Tour we have 200 companies signed up to vie for the 24 positions. My hope to reach 600 in eight weeks, then, is very possible if I keep up the pressure and perhaps define the rules a little better. That’s what this column is for.

Non-U. S. companies are out. We’ve had a few Canadian companies enquire and one even claimed to be from Vancouver, WA instead of Vancouver, BC. No, that won’t do. This is a U. S. competition, but that doesn’t mean the next season won’t be international. In fact I can almost guarantee it will be.

Remember this is for TV as well as for the web so I might use a Canadian company or two as examples of how things are different for startups than in the U. S. but the 24 finalists will all be companies whose intergalactic headquarters are in the U. S.

While foreign startups are out of the running this time, companies based in Silicon Valley and other tech hotbeds definite are not disqualified.  I know this seems to go against the spirit of the competition, but I want the best startups I can find and if a few of those are San Jose or Boston that’s okay. My kids have never been to Boston.

Next, I’m sorry you don’t like the web site, but pouting doesn’t help, either, and it’s simply not attractive. We’re making changes to improve the site daily so let’s concentrate more on the potential of this competition and less on your personal disdain for certain kinds of javascript.

No multiple submissions! Before you nominate a company look to see if it is already there. And submitting in multiple categories won’t help, either, so stop it.

Now about those categories, I came up with the original six but there have been suggestions that maybe I’m being too strict, that perhaps there should be an education category and possibly one for finance. I am open to these changes, but only if there is real demand, so speak up in the comments section for this post.

Finally, there are some companies that want to nominate themselves but they are still in stealth mode and feel they dare not. Here’s what I suggest for you guys. if you believe your company is something really special and if you are fairly confident that you will be out of stealth mode six months from now (next September-October when the TV series starts to air) then contact me directly at bob@cringely.com and maybe we can still do something together.

I am willing to sign NDAs and will keep your grubby secrets until next fall. But you have to understand that each company I visit costs me about $20,000, so if you are going to change your mind about publicity next fall then let’s just forget it.

There’s always another startup.

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Small companies create jobs in America.

According to a recent study by the Ewing Marion Kauffman Foundation, companies less than five years old generated nearly two-thirds of the new jobs created in the U. S. in 2007. But what’s even more important is that without these startups more jobs would be lost than created, the U. S. economy would permanently shrink and America would eventually lose its superpower status, simple as that.

This is because big companies grow by increasing scale and productivity, which is to say by reducing the number of jobs per unit of sales, while startups grow by inventing cool stuff. See the difference?

The startups that most reliably become giant American corporations and creators of wealth are technology startups. Without startups to compete with or acquire, big technology companies would do almost nothing new. In the United States large companies depend on startups to explore new technologies and new markets. Startups play a particularly important role in growing jobs out of a recession. New companies produced all of the net new jobs in the U. S. from 2001-2007, and also from 1980-1983, the last big American downturn.

Why then, has U. S. economic policy been aimed almost entirely at saving large and dying industries (banks and car companies)? Because sometimes even Presidents don’t get it.

U. S. technology startups are born and die at astounding rates. Ninety-five percent of technology startups fail — ninety-five percent. With odds at 19-to-1 against success, why do entrepreneurs even bother to build these companies? Because the potential rewards are huge (Microsoft and Apple, Cisco and Intel were all startups, remember) and for real entrepreneurs there are some things even worse than failure, like boredom or being like everyone else.

American technology startups change the world all the time and are this country’s primary global advantage, though hardly anyone understands that. Encouraging technology startups is the key to keeping America competitive and prosperous, though hardly anyone does that. Technology startups succeed despite these adversities because Americans are full of ideas, startups are so darned fun to do, and they don’t have to cost that much, either — sometimes nothing at all.

Technology export sales drive the U. S. economy and technology startups drive U. S. industry, yet in this era of too-big-to-die companies hardly anyone knows about or understands this phenomenon. The experts are supposed to be the venture capitalists of Silicon Valley and Boston, but they don’t really know what they are doing. VC returns are way down for a variety of reasons mainly coming back to the same greed and stupidity we’ve been seeing at work in other financial markets.

Something needs to be done, then, to encourage America to restart itself, and I’m just the guy to try it.

Announcing the Cringely 2010 (Not in Silicon Valley) Startup Tour.

Starting next month I will be accepting from readers nominations for interesting startup companies in six general categories — biotech, energy, entertainment, information technology, materials, and transportation.  Over the course of about six weeks we will examine and discuss as a community these nominated companies of which I am hoping there will be hundreds, primarily not from Silicon Valley or any other tech hotbeds.  I’ll have some assistance in this process from the Kauffman Foundation.

Together we’ll whittle the number down to 24 then come June I will set off with my family in our RV to visit all 24.  We’ll camp in the parking lot or in the driveway of the CEO and spend a couple days at each startup, learning about the company, the people, their technology and their market.  I’ll take with me a small camera crew and we’ll produce what will begin with a summer of blogging and end with a 13-part TV reality series

That’s my plan for restarting America and I hope you’ll be along for the ride.  Look for details soon, but no nominations yet, please.

I recently participated in a conference for financial bloggers at the Kauffman Foundation in Kansas City, MO.  Kauffman, if you haven’t heard of it, is dedicated to the promotion of entrepreneurism and supports more economic research than any other foundation.  It is a fabulous place and I really enjoyed the conference.  For some reason they felt inclined to interview me, too.  There are plenty more interviews to be seen at the Kauffman web site (interviews with really smart people, too, not just folks like me): Kauffman Conversations

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Friday I was in Kansas City for a meeting of economics bloggers held at the Kauffman Foundation.  My claim to being an economics blogger is slim, I know, but it was a chance to hang with some interesting people and learn something so I went for it.  And in honor of that event, then, I’m making this column entirely about how we can tell when the economy is finally turning.  There’s a strong argument that time is right now.

Yet the economy doesn’t feel any better to me.  Does it feel better to you?  Probably not.  But what we’re looking for is the bottom, or rather that moment just past the bottom when things start to head north again.  The question on every investor’s mind, then, is “have we hit bottom?”

What we are looking for is a leading economic indicator, something we can easily measure that reliably rises in advance of the overall economy.  That’s easy, you say, just wait for the stock market.  And it’s true that the market always leads the economy by six months or more at the end of every recession.  So economists look for that unambiguous turn in the market indices to guide their own predictions that the overall economy is about to improve.

But what if you are an investor and aren’t interested so much in the economy, itself, but in the markets, where you want to make some money? I keep reading that the market is so over-sold that this is going to be one of the great long-term buying opportunities ever, that trillions of investment dollars are waiting, stuffed in money market funds, ready to buy-up depressed shares ONCE THE MARKET TURNS.

That’s the problem: the investors don’t want to buy now in case the market drops another 10 percent.  See how stupid even Warren Buffet is looking this week.  Remember Warren was the guy telling us all to buy stocks (and leading with his company’s money) last fall when the market was 30 percent higher than it is today.

What we want, then, is not just a leading economic indicator but an indicator that LEADS the traditional leading indicator – the stock market.  Well George Morton thinks he has one.

George is a double Cisco Certified Internetwork Expert or CCIE.  In the world of network techs earning a CCIE is as high as you can go and being a multiple CCIE (more than one subspecialty, like routing and switching, security, storage, voice, etc.) is like being an MD-PhD or, in Germany, a “doctor-doctor.” It’s a big deal and George is a smart cookie.

Just as an aside, notice that the “E” in CCIE stands for “expert,” not “engineer.”  Cisco learned a lesson from Novell’s Certified Netware Engineer program that ran afoul of licensing boards in several states that said only they could declare anyone to be an engineer.  So while nearly all CCIE’s are engineers, they only claim to be experts.

Cisco has taken to publishing statistics on how many CCIE’s of what type there are in various countries and regions and George pays attention to this stuff and sees wisdom in it where others see only Cisco PR.  It was George who suggested to me a couple years ago that CCIE’s were a good proxy for 21^st century economic leadership – that the nations showing the most CCIE growth were likely to be the most powerful for their size moving forward.  If that’s true, and I have no reason to doubt it, then China will be a LOT more powerful than India this century and Singapore will be a technology power to be reckoned with.

George’s new idea is to look for flux in CCIE numbers to use as a leading economic indicator.  Specifically the number of CCIEs in the U.S. has lately been going DOWN and the number of new CCIEs has stagnated.  This could be for many reasons and Cisco in its statistics makes no effort to educate us.  By the way, you can see George’s compiled numbers on the effect here.

The numbers may have dropped because companies aren’t willing to spend the money to send their people for CCIE training, because CCIEs who aren’t U.S. nationals may be going home, because CCIE’s who ARE U.S. nationals may have been recruited overseas — any number of reasons.  George doesn’t try to figure that out, he just sees the change in CCIEs as a leading indicator of sorts that suggests the market is about to turn.

 “An interesting event took place this month (when) the number of CCIEs grew at a greater pace than any time over the last six months,” said George.  “The six month average has been running around 300 a month, this period the number jumped to 460.  Now, we know that we are not counting month to month, but the sudden spike is refreshing for a number of reasons.”

George looks to the early work of Charles Dow, founder of Dow Jones, the Wall Street Journal, and author of the long-forgotten Dow Theory, which was intended to help investors understand what was going to happen next in the economy and the stock market.

Among the many rules that constituted the Dow Theory was that Railroads stocks would lead any market rally or decline.  That was because Dow figured that businesses would start (or stop) shipping items before the revenue from those sales hit their bottom-line. 

George’s theory is that IP networks are to the 21^st century what railroads were to the 19^th.

Over the last six months the CCIE numbers have been steadily going down.  Last August the U.S. CCIE number went down by one. The last report in January the number of U.S. CCIE’s grew by eight.  Over the last 50 or so days the number has grown by 83 new CCIEs in the U.S.

Is this a change in trend?  Are the markets starting to bottom?  With all of the bad news in the press, you have to want to be a contrarianIf this were the Dow Theory, then the prediction would be that companies are creating more CCIE’s in anticipation of expansion and adding new networks. 

Is George Morton correct?  I say “yes,” but wearing my economics blogger hat I’ll endorse his conclusion for what might be a surprising reason: it doesn’t matter.

The market will eventually bottom and turn.  It always does.  Those trillions of dollars parked in money market funds are real and will emerge when the market turns.  This CCIE number might indeed indicate that the market is turning for exactly the reasons George postulates, though the numbers are so small that it could really be for any number of reasons.  AT&T could simply have noticed, for example, that its top network folks aren’t CCIE’s and should be, so they sent them all in to take the test.  It could be that slim.

But investors are optimists, remember, or they wouldn’t invest.  That bit about the market turning followed by the overall economy is important.  I can argue that the economy turns BECAUSE of the market and the market turns IN ANTICIPATION of the economy, which means it’s all voodoo economics and always has been.

No matter.  If the market makes that bold turn in the next 30-60 days George will be shown to be the genius I always knew him to be, the market will in turn lead the economy (though because of the huge housing inventory I expect this to be a bumpy recovery and you should, too) and we’ll all be eventually prosperous again. 

It always happens, you know.  All we need is a sign.