Yearly Archives: 2016

Root Cause

Karen and I are in the Windy City visiting the NIRI chapter and escaping gales on the Front Range that were delaying flights to Denver and blowing in spring snow due Friday while we’re in Palo Alto for the Silicon Valley NIRI Spring Seminar (we sponsor both chapters). Hope to see you!

I’m going to challenge economic orthodoxy. Whatever your reaction as an adult to hearing the term “Santa Claus” (follow me here; it’s a mechanism, not commentary on religion or culture), you know the imagery of adolescent expectations is a myth. Even so, parents perpetuate it generationally.

Today we’ll unravel the Saint Nicholas Theory of economics. Because at root equities reflect economics even when the barometer is errant. Economic orthodoxy – conventional wisdom on economies – says we need rising prices. For businesses selling things it’s called “pricing power,” the capacity to increase the cost of goods and services. The Federal Reserve and other global central banks have an “inflation target,” and bureaucrats wearing half-glasses at droll news conferences pore over boorish scripts about “structural malaise” and the exigency of combating deflation.

Few know what they’re saying except we gather they think prices should rise. Yet we consumers stop spending when things cost too much. If our spending is the engine of the economy – what economists call consumption – how is it that rising prices are going to drive more of it? In fact when stuff’s not selling, businesses hold sales. They cut prices.QuastCurve

Big Economic Idea No. 2 (we all know from childhood what “number two” means) is that access to credit – borrowed money – is the key to more consumption. If the economy slows, the problem, we’re told, is we need more spending. Central banks the world round want you whipping out a credit card lest the global economy slip into falling prices.

This is Santa Claus Economic Theory. It says spending drives the economy, which grows when prices rise. There is only one reliable way to drive up prices: Inflation.  Milton Friedman taught us “inflation is always and everywhere a monetary phenomenon.” While prices temporarily increase when more buyers chase fewer goods (say, Uber at rush hour), costs will revert when supply and demand equalize. So inflation – rising prices – is sustainable only if the supply of money increases faster than economies produce things.

Money as we presently know it can only expand one way:  Through debt. If the Federal Reserve wants to increase currency in circulation, it buys debt from the Treasury with cash it manufactures (backed by you and me).  Likewise, when you use a credit card, you create money. A bank isn’t reaching into dInflationeposits to pay a bill you incurred. The bank creates electronic funds.  When you pay your bill, that electronic money disappears.

Stay with me. We’ve almost arrived at the bizarre and impossible logic that animates the entire global monetary system, as I’ve illustrated with three charts here.  Today Janet Yellen will try to convince us we need inflation.  Rising prices. What drives prices up? More money. How does the global monetary system create money? Through debt.  So we’re left to conclude that prosperity can only happen if debt and spending perpetually rise. Because if you pay off debt, money is destroyed and prices fall.

Two weeks ago I was on CNBC with Rick Santelli declaiming how rising debt and rising prices are the enemies of prosperity, and purchasing power is the engine of growth. Purchasing power is when your money buys more than it did before, not less.  Example:  Uber.  It used to cost $100 for a cab to the Denver airport. Uber is about $40. Guess what? Cabs are coming down.  Purchasing power is improving.

Central banks are perpetuating a myth that will destroy the global economy, and I’ve proved it with three charts. The first – call it the Quast Curve – shows what happens to the US economy if the value of the money denominating goods and services is consistently diminished over time.  Growth rises but then collapses (eerily, in this model it topped in the 1960s before we left the gold standard and hit zero around 2008). USDebt

What will follow from the Quast Curve is rising debt and rising prices, illusions of growth – exactly what images two and three show. As money buys less and less, prices go up, and consumers have to replace the missing money with debt, a terminal cycle.  It’s now on the balance sheet of the Federal Reserve.

Real economies are simple. If money has stable value, and enterprising humans create things that improve lives, costs should stay steady or decline, not rise, which increases purchasing power and wealth rather than debt.  It’s infinitely sustainable.  Economist Herb Stein said if something cannot last forever it will stop.  You never want an economy built on things that will stop. What should stop instead are bad policies.

Culmination

Outcomes are culminations, not events.

Denver bid farewell this week to retiring Broncos quarterback Peyton Manning who for eighteen years accumulated the byproducts of focus, discipline and work, twice culminating in Super Bowl victories.

The idea that outcomes are culminations translates to the stock market. What happens today in your stock-trading is a product of things preceding today’s culmination just as our lives are accumulations of decisions and consequences.

Rewind to Feb 11, 2016. The S&P 500 hit a 52-week low of 1829. Recession fears were rippling globally. European banks were imploding, with some pundits predicting another 2008 crisis. China was lowering growth views and weakening its currency to pad the landing (word since is some 5-6 million workers will be laid off through 2017).

In apparent response, the US stock market soared, recovering to November levels. If the market is a proxy for the economy, it’s a heckler hurling eggs. Wiping away yolk, pundits said markets expecting monetary tightening from the Federal Reserve saw stasis instead. Recession fears were overblown and an overly reactive market rebounded.

But headlines don’t buy or sell stocks, people and machines do.  Markets move on money. This is what we’ve learned from more than a decade of market lab work, repeating behavioral measurements with software, servers, algorithms and models.

Follow the money.  The most widely traded equity in the world, SPY, is a derivative. It’s an Exchange-Traded Fund (ETF) tracking the S&P 500.  Nearly 50% of all options volume ties to it.  In 2016 so far almost every trading day at least 12 of the 25 most actively traded stocks were ETFs.

Why do we say ETFs are derivatives? Because derivatives extend access to assets, exactly the thing ETFs do. They’re securities trading on underlying stocks without owning them. The sponsor owns assets, yes. But ETF investors hold only a proxy.

ETFs depend on arbitrage. Rules the SEC approved for ETFs effectively sanction use of information the rest of the market doesn’t know about demand by the big brokers who produce ETF shares for trading.  These brokers are continually shorting index components and derivatives or ETF shares to close the gaps that form between the value of the ETF and what it represents (stocks, sectors, commodities, bonds, indices).

In the stock market, the price-setters are primarily short-term traders (high-frequency firms) arbitraging small price-divergences in many things simultaneously. ETFs are stocks that provide exposure to other stocks, sectors, commodities, bonds and indices. For arbitragers, they’re a massive additional layer of arbitrage permutations:  How might this financial ETF vary with that energy futures contract, and this basket of energy stocks?

What develops in this market is a disregard for fundamental factors. Prices are mathematical facts. Spreads drive directional-change. The market’s purpose devolves from economics to how to price a stock, sector, commodity, bond, futures contract, option or index relative to things associated with it or its value at a point ranging from fractions of seconds to next month before a derivatives contract expires.

It’s not investment but arbitrage of such scale and size that few recognize it. Yesterday, the most actively traded stock was the VelocityShares 3x Long Crude ETN linked to the S&P GSCI Crude Oil Index Excess Return (UWTI).  Yes, that its name! It’s an exchange-traded product backed by Goldman Sachs, and it dropped 13.3%. Offsetting, the eighth most active stock was DUST, the Direxion Daily Gold Miners Index Bear 3x Shares, which rose 13.7%.

Neither DUST nor UWTI owns tangible assets. Their returns depend on derivative contracts held by banks or other counterparties. Now step back. Look at stocks. They are moving the same way but over longer periods. Market moves are a culmination of whichever directional trade is winning at the moment, plus all the tiny little arbitrage trades over ETFs, stocks, commodities, bonds and indices, tallied up.

There are two links back to fundamentals. First, banks back this market. Some of them are losing badly and this is what European bank trouble last month signaled. And this IS a consequence of Fed policy.  By artificially manipulating the cost of capital, the Fed shifted money from scrutinizing economics to chasing arbitrage opportunities.

When arbitrage has exhausted returns, the market will change direction again. It’s coming soon.  The bad news is the market has not yet considered economic threats and is ill-equipped to do so.

Inconvenience

Follow the money. Or the currency.

Yesterday markets soared on queue with a Chinese currency devaluation in the form of lower bank reserve requirements (which increases money and reduces its value). For those who at the words “currency devaluation” feel like collapsing into catatonia, resist the urge. There’s a lesson ahead.

WSJ Intelligent Investor columnist Jason Zweig described Feb 19 how active investors are using Exchange Traded Funds (ETFs). He wrote, “Picking stocks has become so hard that some stock pickers have given up pretending to try.”  One manager told Mr. Zweig he keeps 50% of his assets in ETFs because with 90% of active money trailing the averages, “half of my fund will beat 90% of managers over time.” The winning half is polling the crowd.  It’s more convenient.

The crowd today is comprised of leviathan passive investment typified by the $8 trillion held at Blackrock and Vanguard.  But that’s not what moves daily.  It’s inconvenient for Blackrock and Vanguard to maneuver massive assets like a race car through less than ten big banks executing most trades now for large institutional investors.

But investing is supposed to be inconvenient. Value that lasts should take time. Warren Buffett is 85 and began investing in his teens.  The average holding period for Berkshire Hathaway shareowners is 27 years based on annual turnover. Rome wasn’t built in a day.

Yet today’s market sells convenience. Leveraged ETFs – those using derivatives like swaps to outperform underlying benchmarks – seek one-day outperformance. From Direxion, a sponsor: “The use of derivatives such as futures contracts, forward contracts, options and swaps are subject to market risks that may cause their price to fluctuate over time. The funds do not attempt to, and should not be expected to, provide returns which are a multiple of the return of the Index for periods other than a single day.”

In yesterday’s big market move, over half of the 25 most actively traded securities were ETFs, most of them trading more than stocks like Pfizer and GE.  Several were 3x leveraged ETFs – that is, trades designed for a single day to beat a broad measure by 200%. If your stock was up twice as much as the market, there’s your probable answer.

ETF sponsors hold assets, and big brokers called Authorized Participants create ETF shares for trading or remove them from the market to match inflows and outflows and fluctuations in underlying stocks and indices. That’s a derivative. What’s traded isn’t the asset but a proxy. A key reason why stock pickers struggle is because long-term investments are inconvenient, and the many parties in the market chasing one-day moves or short-term divergences drown out fundamental differences in businesses.

There’s a triune reason for volatility that’s getting bigger, not smaller.  First, the whale in the market is money tracking benchmarks like the S&P 500. Clustered next around the benchmarks are options and futures and ETFs. The ETF SPY yesterday traded nearly ten times the dollar-amount ($26.3 billion) of the nearest active stock (VRX, $2.7 billion). And last, every ETF has what’s in effect counterparties –authorized participants maintaining coherence between ETFs and indexes (to us it’s sanctioned arbitrage since the APs know which direction money is moving and can go long or short advantageously, which is ethically questionable). So also do counterparties back the options, futures and swaps fueling leveraged ETFs and trading schemes and index-tracking by big funds.

Line these up.  Money is tracking indexes. Leveraged ETFs are trying to beat them. Counterparties are supplying options and futures to achieve those returns. Every day it changes and the movements are like a freight train on a twisting track, picking up speed, as each gets a day or two out of step with the others.

At what point does it rupture? Making homes too easy to buy through loose credit led to mushrooming mortgage-backed derivatives and later mass demise. Making money too easy for governments to get through central banks is behind the creaking mountain of global debt that the private sector long ago largely stopped buying (so it’s instead held by central banks that pledged the full faith and credit of the same citizens refusing to buy in private markets).

We’d benefit from old-fashioned inconvenience. Investments taking more than a day to produce a return. What’s valuable – time, money, risk, production, thrift, prudence, diligence – shouldn’t be marginalized into a derivatives trade.  Alas, we humans seem to recognize mistakes only in hindsight.

Side Deals

Yesterday on what we call Counterparty Tuesday, stocks plunged.

Every month options, futures and swaps expire and these instruments represent trillions of notional-value dollars. Using an analogy, suppose you had to renew your homeowners insurance each month because the value of your house fluctuated continually.  Say there’s a secondary market where you can trade policies till they expire. That’s like the stock market and its relationship to these hedging derivatives.

As with insurance, somebody has to supply the coverage and take the payout risk. These “insurers” are counterparties, jargon meaning “the folks on the other side of the deal.”  They’re banks like Deutsche Bank, HSBC, Morgan Stanley, Citi.

Each month the folks on the other side of the deal offer signals of demand for insurance, a leading indicator of investor-commitment. We can measure counterparty impact on market volume and prices because we have an algorithm for it.  Last week (Feb 17-19) options and futures for February expired and the folks on the other side of the deal dominated price-setting, telling us that trading in insurance, not the assets themselves, was what made the market percolate. That’s profoundly important to understand or you’ll misinterpret what the market is doing.

On Monday Feb 22, a new series of derivatives began trading. Markets jumped again. Yesterday on Counterparty Tuesday, the folks on the other side of the deal told us they overshot demand for options and futures or lost on last week’s trades.  And that’s why stocks declined.

The mechanics can be complicated but here’s a way to understand. Say in early February investors were selling stocks because the market was bearish. They also then cut insurance, for why pay to protect an asset you’re selling (yes, we see that too)?

Around Feb 11, hedge funds calculating declines in markets and the value of insurance and the distance to expirations scooped up call options and bought stocks, especially ones that had gone down, like energy and technology shares and futures.

Markets rose sharply on demand for both stocks and options. When these hedge funds had succeeded in chasing shares and futures up sharply in short order, they turned to the folks on the other side of the deal and said, “Hi. We’d like to cash these in, please.”

Unless banks are holding those stocks, they’re forced to buy in the market, which drives price even higher. Pundits say, “This rally has got legs!” But as soon as the new options and futures for March began trading Monday, hedge funds dumped shares and bought puts – and the next day the folks on the other side of the deal, who were holding the bag (so to speak), told us so. Energy stocks and futures cratered, the market swooned.

It’s a mathematical impossibility for a market to sustainably rise in which bets produce a loser for every winner. If hedge funds are wrong, they lose capacity to invest.  If it’s counterparties – the folks on the other side of the deal – the cost of insurance increases and coverage shrinks, which discourages investment.  In both cases, markets flag.

Derivatives are not side deals anymore but a dominant theme. Weekly options and futures now abound, more short-term betting. Exchange-Traded Funds (ETFs), derivatives of underlying assets, routinely populate lists of most active stocks. Both are proof that the tail is wagging the dog, and yet financial news continues casting about by the moment for rational explanations.

Every day we’re tracking price-setting data (if you don’t know what sets your price the problem is the tools you’re using, because it’s just math and rules).  Right now, it’s the counterparties. Short volume remains extreme versus long-term norms, telling us horizons are short. Active investment is down over $3 billion daily versus the long-term.

You can and should know these things. Stop doing what you’ve always done and start setting your board and your executives apart. Knowledge is power – and investor-relations has it, right at our fingertips.

Bieber in a Bottle

Volumes are big but trades are small as markets pitch and buck.  On this restless sea, is there a message in a bottle?

That would seem poetic, were literature a help to your CFO in a stock market seeming the same hot mess as Justin Bieber’s Grammy performance Monday night. And what exactly was Kendrick Lamar doing?

If you didn’t see the Grammys, never mind. Back to US stocks, volume daily is leviathan, approaching 10 billion shares that as we noted last week must ionize through fewer than 20 firms on the way to sea spray. Markets last broke so furiously upon the shoals in August 2011 when it seemed the Euro might collapse (which begs that question anew and again leaves it unanswered).

Is it sound or just fury? Amid steep losses shifting to sharp gains into February options expiring today through Friday, trade-sizes have shrunk to the smallest on record.  TABB Group, the market structure consultancy, says average shares per trade in equities was of late 202 shares, dipping from the previous all-time low of 203 last October as markets surged like war from the trenches of August.

Conventional wisdom holds that blocks mark bigs. We’re told whales move in schools. But wait. The buyside and sellside have spent billions on trading technologies to make buying look like selling. The purpose of algorithms is deception.

Let me repeat that:  The purpose of algorithms is deception. Looking for blocks or watching the buy/sell balance means missing the technological revolution in trading the past fifteen years. At ModernIR, we preach a behavioral gospel.  All money is not the same. All prices are not equal.  The purpose of algorithms is deception (repetition is the best form of emphasis). Exchanges sell data, not products.

Against that backdrop, one key to understanding why stock-prices shift is recognizing that the market is not comprised of one behavior.  Suppose you were at the Super Bowl. Would you expect every person in the stands to act the same or might you anticipate bifurcation? Some portion of the audience will be rooting for one team and silent when the other excels. The weighting on sides determines the size of the roar and the silence.

Apply that to your stock.  The greatest mistake currently committed by executives of public companies is supposing the money in the market is a Super Bowl full of unilateral fans rooting for The Team. Recently I encountered an IR officer convinced that revamping the call script was the reason shares were up with earnings mid-November after falling with the call mid-August. That’s akin to supposing you caused an earthquake by slamming a door (August was China and expirations, not earnings).

There is one concrete fact you can know from big volume and small trades by taking the market at face value: A bidding war is underway. What’s knowable on the surface ends there. The rest resides lower.

You can measure the behaviors comprising your daily volume (this is what we pioneered – and if you don’t know what’s setting your price, you’re doing IR like a caveman).  Google, Amazon, Facebook, parse internet traffic. In the 21st century, companies should be parsing volume into demographic bands (if you think your exchange should be doing it, you’re right but misunderstanding what business exchanges are in).

Measure the market as it is. Because an approving roar may have the same timbre as derogatory boos. The last thing you want is your CFO before the Board like Justin Bieber on stage convinced the noise is coming from fans.

And that is the note in the bottle.

Eroding Banks

“Other than that, everything’s okay.”

My friend Gary, a smart guy with an MBA from the University of Chicago, uses that line to herald dire situations. It’s from the old UK sitcom starring John Cleese, Fawlty Towers. In one episode, Cleese the restaurateur receives a visit from a health inspector, who excoriates him for a host of violations and threatens to shutter the restaurant. After an uncomfortable silence, Cleese says, “Otherwise everything’s okay?”

Large banks including Morgan Stanley, UBS, Credit Suisse, Deutsche Bank, Citigroup and Bank of America are down about 30% this year.  A great deal has been made of reasons. Sovereign wealth funds, big holders in most, are sellers. Exposure to oil debt. Growth and recession fears crimping expectations for loans. Low or spreading negative rates further restraining interest income.

All perhaps valid.  We’re looking at banks for a different reason. Investor-relations practitioners must understand (really, everyone should) the form and function of the stock market to know what to expect from it. Nine banks are behind 50% of equity-market volume now including the six above plus Goldman Sachs, Barclays and JP Morgan.

Add nine other firms whose principal focus is high-speed trading (I wrote for CNBC last week on the origin of fast markets) and we’ve tallied 90% of market volume, recently averaging 9.7 billion shares daily. Just 25 firms including trading platforms individually handle 0.5% or more of daily volume. Using one anecdote, in 2010 there were about 240 participants executing CSCO trades (different from advertising volume). Today, barely a hundred. There are ever fewer entrances and exits.

Why? Rules require brokers with customers to meet standards of trade-execution or be fined by regulators. Standards reflect averages created by brokers executing trades. Over time, smaller brokers unable to meet them route orders to bigger ones and the market becomes ever more concentrated.

Trillions flowed to stocks through indexes and Exchange Traded Funds (ETFs) after the financial crisis as they rose and rose. Investors supposed diversifying – indexing the market – would reduce risk. But everybody is doing it, so it’s uniformity. ETFs dominate volume ranks (only BAC, a bank, can keep up with the likes of QQQ, SPY, XLF, VXX, GDX, EWJ and other ETFs for daily volume).

Who are the authorized participants, the firms furnishing and removing shares of these ETFs to match inflows and outflows?  The same big banks. Often large investors rely on options or futures to track indexes and hedge risks. The same big banks are major derivatives counterparties.

Speaking of which, add hundreds of trillions of dollars in currency and interest-rate swaps that financial market-participants use to keep pace with ever-changing global money. Counterparties?  The same banks.

The same banks dominate the IPO market, fixed-income underwriting, loan-syndication and equity research. Where the global financial marketplace once was a huge tent with sides furled, today it’s a giant gymnasium with nine exits.

If the money that tracked the market on the way up decided to depart on the descent, and the risk associated with moving was transferred to derivatives and the trades handed off for execution, the weight of the building would poise over each exit, the big banks.

And who buys? Unless active stock pickers show up en masse the parties that must purchase are these big firms providing prime brokerage (trading capital and management services). So they’re executing trades, backing derivatives, redeeming ETF shares, committing capital around imbalances as money departs.

It’s easy to imagine liabilities accumulating. Banks have strict rules for value-at-risk that diminish capacity for after-market support as equity capital sinks. Periodically, capital rules will force shedding of risk – which may have contributed in part to technology carnage Feb 5 as weekly options expired.

Unless we visualize the trusses, plumbing, wiring of the market, we’ll be baffled when the structure creaks.  On June 10, 2015 we warned clients in a note that a down market dependent on derivatives would reveal risk through the failure of one or more big counterparties the same way it did during the mortgage-related financial crisis.  We singled out Deutsche Bank.

Lest you fear, markets are resilient and nothing serves better to correct error than failure.  Besides, other than that everything is okay.

Receding

The X-Files are back on TV so the pursuit of paranormal activity can resume. Thank goodness, because the market appears to be paranormal (X-Files theme in background).

Volatility signals behavioral-change, the meaning of which lies in patterns. Sounds like something Fox Mulder would utter but we embrace that notion here at ModernIR. It’s not revolutionary, but it is universal, from ocean tides to personalities, weather forecasts to stock-market trading.  Volatility, patterns.

Stocks are volatile. Where’s the pattern?

Let’s find it. A headline yesterday splashed across news strings said CEOs have “unleashed recession fears” on earnings calls. Fact Set’s excellent Earnings Insight might buttress that assertion with data showing S&P 500 earnings down 5.8% so far, revenues off 3.5%. It marks three straight quarters of declines for earnings, the worst since 2009, and four in a row for revenues, last seen in late 2008.

What happened then was a recession. That’s a pattern, you say.

Hard to argue your reasoning. We’re also told it’s oil pulling markets down. China’s slowing growth is pulling us down.  Slowing growth globally is the problem, reflected in Japan’s shift to negative interest rates. First-read fourth-quarter US Gross Domestic Product (GDP) last week was a wheezing 0.6%.  Slowing is slowing us, is the message.

But what’s the pattern?  One would expect a trigger for a recession so where is it?  In 2008, banks had inflated access to real estate investments by securitizing mortgage debt on the belief that demand was, I guess, infinite. When infinity proved finite, leverage shriveled like an extraterrestrial in earth atmosphere. Homes didn’t vanish. Money did. Result: a recession in home-values.

It spread.  In 2007, the gap between stock-values and underlying earnings was the widest until now, with the S&P 500 at 1560 trading more than 10% higher than forward earnings justified. Oil hit $150.

But by March 2009 oil was $35 and the S&P 500 below 700. To reverse this catastrophic deflation in asset prices, central banks embarked on the Infinite Money Theorem, an effort to expand the supply of money in the world enough to halt the snapping mortgage rubber band.  Imagine the biggest-ever long-short pairs trade.

It worked after a fashion. By the end of 2009, a plunging dollar had shot oil back to $76.  The S&P 500 was over 1100 and rapidly rising earnings justified it. Trusting only broad measures, investors in pandemic uniformity stampeded from stock-picking to index-investing and Exchange-Traded Funds (ETFs).

The Infinite Money Theorem reached orbital zenith in Aug 2014 when the Federal Reserve stopped expanding its balance sheet.  The dollar shot up.  Oil began to fall. By Jan 2015 companies were using the words “constant currency” to explain why currency-conversions were crushing revenues and profits.  In Aug 2015 after the Chinese central bank moved to devalue the yuan, US stocks caterwauled.

On Nov 19, 2015, the Fed’s balance sheet showed contraction year-over-year. Stocks have never returned to November levels. On Dec 16, 2015, the Fed lifted interest rates.  Stocks have since swooned.

Pattern? Proof of the paranormal?  No, math. When a trader shorts your stock – borrows and sells it – the event raises cash but creates a liability. Borrow, sell shares, and reap cash gain (with a debt – shares to return).  When central banks pump cash into the global economy, they are shorting the future to raise current capital.

How?  Money can’t materialize from space like something out of the X-Files. The cash the Fed uses to buy, say, $2 trillion of mortgages is from the future – backed by tax receipts expected long from now. That’s a short.

We’re getting to the root.  Say the global economy fell into a funk in 2008 from decades of overspending and never left it. Let me explain it this way.  One divided by one is one.  But one divided by 0.9 is 1.11.  The way the world counts GDP , that’s 11% growth.  But that growth is really just a smaller denominator – a weaker currency.

Now the dollar is revaluing to one and maybe more (it did the same in 2001 and in 2008). Why? Since the financial crisis trillions of dollars have benchmarked markets through indexes and ETFs.  In 2015, $570 billion flowed to Blackrock and Vanguard alone.  All that money bought rising markets until the excess money was used up by assets with now sharply higher prices.

The denominator is reverting and the economic growth we thought we had is receding back toward its initial shape, such as $35 oil (with stretch marks related to supply/demand issues). That’s what’s causing volatility. This is the pattern.  It’s colossally messy because the dollar is the world’s reserve currency and thus affects all other currencies (unevenly).

Volatility signals behavioral-change, the meaning of which is in patterns. This is it. A boomerang (read Michael Lewis’s book by that title for another perspective).  The dollar was made small to cause prices to grow large and create the illusion of growth in hopes it would become reality.  At the top of the orbit nothing had really changed and now that seven-year shadow on the planet is receding.

We’ll be fine. We humans always are.  But this is no short-term event. It’s a huge short.

Pricing Models

The 1,200 NYSE stocks supported by Barclays were the last redoubt of the old market-making guard.

Yesterday, New York City-based Global Trading Systems (GTS) said it will buy the Designated Market Maker (DMM) unit from Barclays at the NYSE. GTS joins KCG Holdings, IMC Financial Markets and Virtu Financial Inc. (which may have to call itself VFI to keep acronym pace) as the quad core making markets and setting prices for NYSE stocks trading at the home exchange.

Barclays likely exited the DMM business because it couldn’t compete. For one, banks are under regulatory pressure to quit trading for their own accounts. Second, rules on the floor prohibit DMMs from using customer orders to price the market. Barclays has customers. The rest were free from the task of sorting those from proprietary trades.

GTS is a high-frequency trading (HFT) firm like its floor brethren. KCG alone has an agency brokerage business with customers, but it’s the progeny of a marriage between Knight Securities and seminal HFT firm GETCO (the Global Electronic Trading Co., the first curiously anonymous massive volume-maker to grab our attention ten years ago).

DMMs pay roughly $0.03 per hundred shares to buy stock, and earn about $0.30 a hundred to sell it. It works poorly for a conventional broker-dealer like Barclays matching buyers and sellers, or crossing the transaction. Proprietary traders find it a money-minting model.

Lest you Nasdaq companies feel special, you’re no different. Prices at the Nasdaq are set by incentives and dominated by HFT too.  Real buyers and sellers rarely price shares – a fact we establish with Rational Price, our fair-value measure, which changes infrequently.

Virtu and IMC Financial Markets, like GTS, say they’re automated market-makers, an innocuous term implying a robotic form of erstwhile human effort. But GTS isn’t matching buyers and sellers.

In its own words: “Today HFT makes up approximately 51% of trades in U.S. equities, and technology-driven innovations continue to transform the investment and financial sectors in profoundly positive ways. At GTS, our advanced algorithms and ultra-fast computers execute thousands of transactions in fractions of a second.  This automation provides liquidity in all the markets we trade and enables our trading venues to provide lower transaction costs.  GTS is proud to be one of the industry innovators contributing to the evolution of the modern market.”

You see? Not a word about match-making. GTS hopes to convince us that its brilliant technology is profoundly positive when in fact it’s exploiting our ignorance.

Various markets for thousands of years have experienced arbitrage – capturing spreads that develop because of inefficiencies in pricing, supply, demand and information. Take theater tickets. Scalpers arbitrage supply and information asymmetries. They are intermediating intermediation. What if we were all forced to buy tickets from scalpers – somebody wanting to profit from owning nothing? Scalpers should be a small part of a market, not 51%.

There are four primary problems with a market priced by HFT:

Risk. If regulators think proprietary trading is risky, why then is 100% of the DMM model proprietary trading?  Why are regulators propagating rules that fashion a market inhospitable to firms taking companies public and supporting them with research and true market-making (carrying inventory, serving customers)?  Following the August 24 trading debacle, JP Morgan changed DMMs from KCG to Barclays because, rightly or wrongly, it lost confidence.

Volatility.  HFT claims to smooth volatility with rapid-fire transactions. That’s muddying the definition. Volatility means “tending to vary often.” Things vary often when they’re broken into fragments and bounced around. That’s intraday volatility, or the spread between high and low daily prices. Tally yours for a month. For AAPL over 20 trading days ended Jan 25, it’s 55.8% – or in dollars, $56.39. That’s the sum of spreads between highs and lows. The Fed shoots for a 2% annual inflation target (wrong but a separate story). AAPL changes more than that each day.

HFT isn’t intermediation but arbitrage. Intermediating by definition is fostering agreement or reconciliation. It involves a vested interest in outcomes. Customers are a tacit requirement. HFT firms have no customers and care not about direction. They create fleeting price-changes for profit.  That’s not market-making.

HFT distorts supply, demand and price. Deduct half your volume because it’s HFT (and over 48% of volume is borrowed so add that to the risk equation). But it set prices and created impressions of supply and demand.  These firms commit little capital, manage no investment portfolios and execute no trades for investors. They’ve devised proprietary pricing models that find short-term inefficiencies (fractions of seconds at once in equities, currencies, commodities and derivatives). They obscure the truth in effect, and in a crisis of magnitude, discovering that most of the prices and half the volume are arbitrage could have devastating consequences for multiple asset classes simultaneously.

Solutions? In Swiftian spirit, there’s the Berkshire-Hathaway Option.  If every US-listed company would reverse-split its shares to $200,000 each, the cost would force arbitragers out. Our serene market would lack arbitrage and intermediation and trade about 1.5 million shares daily. Of course traders, brokers and exchanges, even the regulators (the SEC budget depends wholly now on Section 31 trading fees), would go broke.

Moral of the story? If intermediaries are half our market, it’s a poor one. That should make us mad (why doesn’t it?). It matters not what altruistic oratory streams from the community of high-speed traders. Calling arbitrage market-making will not magically make it so, nor will a better deal materialize from a multitude of middle men.

Volatility

You’ve heard the saying that’s it all in your perspective. It applies to volatility.

Volatility is up 150% since the post-financial-crisis nadir of 10.32 for VIX Volatility in mid-2014. The “Fear Index” closed yesterday over 26, the highest since August 2015 when it topped 28 (way below 43 in 2011 and nearly 80 in 2008). VIX expirations are hitting today.

I’ve been seeing Mohamed El-Erian, whom I admire, chief economic advisor to Allianz and former right hand to Bill Gross at PIMCO, also now gone from the bond giant, on the business TV circuit saying central banks are ending programs designed to dampen financial volatility.

I think he’s got a point, and he means they’re starting to broaden trading ranges in everything from interest rates to currencies (as if we want them setting prices). But volatility is price-uncertainty reflecting evolving valuation.  Conventional measures often fail to reveal change because behaviors in markets morph while the metrics used to understand them don’t.

Figure 1

Figure 1

I can prove it.  In the first chart here (Figure 1), a small-capitalization technology stock on the Nasdaq hasn’t moved much in the year ended Dec 16, 2015 (I’ll explain that date shortly) but the stock rose from a 200-day average price of $20.67 to a five-day mean of $21.05, up 1.8%.  Not too great – but the Russell 2000 Index was off 1.3% in the year ended Dec 16, 2015. Perspective matters.

Now notice:  Daily volatility, or the difference between highest and lowest prices each day, is greater than the change in average price in all four periods.  Think about that. The price changes more every day than it does in moving averages for months and quarters.

Now see Figure 2 showing short volume Dec 1, 2015-Jan 15, 2016 for the same stock. The upper half is long volume (owned shares), the bottom short volume, or rented stock. The blue line is closing price. The data further back show short volume over the trailing 200 days averaged 60.2% daily.

Figure 2

Figure 2

Combine the charts. The stock moved less than 2% on average over the entire period but 60% of the shares trading every day were borrowed, and the spread between high and low prices was nearly 3% every single day.

Do you understand? On the surface this stock is not volatile. But up close it’s torrid – on rented shares. For a solid year, traders have kept this stock in stasis by borrowing and trading, borrowing and trading, because the cost of borrowing was substantially lower than daily price-movement. That’s market-neutral arbitrage.

Everything changed recently. Short volume in Figure 2 plunged Dec 22, 2015.  On Dec 16 (here’s that date now) the Federal Reserve bumped short-term rates to 0.25-0.50%. On Dec 17-18 vast swaths of interest-rate swaps tied to options-expirations lapsed. On Dec 21, the new series of options and futures (and interest-rate swaps) began trading. And on Dec 22, our small-cap’s short volume imploded, finally landing at 33% Jan 11, down from 71% Dec 10, a decline of 54%.

We’ve slung numbers here, I know. But the conclusion is simple. Whatever traders were doing in this small-cap, the Fed’s rate-hike ended it.  We think that’s good. But markets have been addicted for years to cheap credit, which includes borrowing shares for next to nothing, which shifts attention from long-term owning to short-term renting. That changed when the Fed bumped rates. And equites corrected.

There’s another lesson by extension.  What sets your stock’s price may be radically different than you think.  We’ve offered one example that shows short-term borrowing fueled persistent volatility trading masked by apparent long-term placidity. When interest rates crept up minutely, the strategy stopped working.

What’s your stock show?  Price-performance isn’t story alone, perhaps even over the long run, as we’ve just shown. There’s so much to see when measurements reflect current behavior (as ours do). Volatility is price-uncertainty that thanks to policies promoting short-term behavior is now concentrated intraday.  Sorting this out will take time. We won’t change seven fat years with a lean month. The good news is it’s all measurable.

Weighing Options

There’s no denying the connection between tulips and derivatives in 1636.

The Dutch Tulip Mania is often cited as the archetype for asset bubbles and the madness of crowds. It might better serve to inform our understanding of derivatives risk. In 1636, according to some accounts, tulip bulbs became the fourth largest Dutch export behind gin, herring and cheese. But there were not enough tulips to meet demand so rights were optioned and prices mushroomed through futures contracts. People made and lost fortunes without ever seeing a tulip.

While facts are fuzzy about this 17th century floral fervor, there’s a lesson for 2016 equities. Grasping the impact of derivatives in modern equities is essential but options are an unreliable surveillance device for your stock.

I’ll explain. ModernIR quantifies derivatives-impact by tracking counterparty trade-executions in the percentage of equity volume tracing to what we call Risk Management. We can then see why this implied derivatives-use is occurring.

For instance, when Risk Management and Active Investment are up simultaneously, hedge funds are likely behind buying or selling, coupling trades with calls or puts. If Risk Management is up with Fast Trading, that’s arbitrage between equities and derivatives like index options or futures, suggesting rapidly shifting supply and demand (and therefore impending change in your share-price). Options won’t give you this linkage.

Dollar-volumes in options top a whopping $110 billion daily. But 70% of it is in ETFs.  And almost 48% ties to options for a single ETF, the giant SPY from State Street tracking the S&P 500.

As Bloomberg reported January 8, SPY is a leviathan instrument. Its net asset value would rank it among the 25 largest US equities, ahead of Disney and Home Depot. It trades over 68 million shares daily, outpacing Apple. It’s about 14% of all market volume.  Yet trading in its options are 48% of all options volume – three times its equity market-share.

Why? Bloomberg’s Eric Balchunas thinks traders and investors are shifting from individual equity options where demand has been falling (further reason to question options for surveillance) into index options. SPY is large, liquid and tied to the primary market benchmark.

Bigger still is that size (pun intended) begets size, says Mr. Balchunas. Money has rushed – well, like a Tulip Mania – into ETFs. Everyone is doing the same thing. And just a handful of firms are managing it.  Bloomberg notes that Blackrock, Citigroup, Goldman Sachs and Citadel are the biggest holders of SPY options. Three of these are probably authorized participants for ETFs and the fourth is the world’s largest money manager and an ETF sponsor.

Mr. Balchunas concludes: “The question is how much more liquidity can ETFs drain from other markets—be they stocks, commodities, or bonds—before they become the only market?”

SPY options are an inexpensive way to achieve exposure to the broad market, which is generally starved for liquidity in the underlying assets. As we’ve written, ETFs are themselves a substitute for these assets.

The problem with looking at options to understand sentiment, volatility and risk is that it fails to account for why options are being used – which manifests in the equity data (which can only be seen in trade-executions, which is the data we’ve studied for over ten years).  If Asset-allocation is up, and Risk Management is up, ETFs and indexes are driving the use of derivatives. These two behaviors led equity-market price-setting in 2015. If you were reporting changes in options to management as indications of evolving rational sentiment, it was probably incorrect.

In the Tulip Mania, people used futures because there was insufficient tulip-bulb liquidity. The implied demand in derivatives drove extreme price-appreciation. But nobody had to sell a bulb to pop the bubble. It burst because implied future demand evaporated (costing a great lost fortune).

Options expire tomorrow and Friday, and next Wednesday are VIX expirations (two inverse VIX ETNs, XIV and TVIX, traded a combined 100 million shares Tuesday). Vast money in the market is moving uniformly, using ETFs and options to gain exposure to the same stocks. This is why broad measures don’t yet reflect the underlying deterioration in the breadth of the market (the Russell 2000 this week was briefly down 20% from June 2015 highs).

And now you know why. People tend to frolic in rather than tiptoe through the tulips. Be wary when everybody is buying rights.