Yearly Archives: 2018

Day to Day

Here in CO we can count on sun much of the time but we still watch the weather forecast.

It would be a real pain to drag the skis out and drive up the mountain only to find the resorts bereft of snow.  For one, it’s an hour and a half on I-70 through the Eisenhower Tunnel to Summit County and the Arapahoe Basin, Keystone, Breckenridge and Copper Mountain ski resorts (and double that to our fave, Steamboat).

“You could use social media, Tim.  You can have the resorts text you about conditions.  You can go to onthesnow.com, opensnow.com, coloradoski.com—”

Right, I know that. I’m making a point about dealing with things as they come without thinking about the future. What’s called living day-to-day.  Some of us might want to do that. Get away from the schedule, the rat race. But it’s not a life strategy.

How come we do it with stocks?

Let me explain. Investor-relations folks, for the moment I’m talking to you.  (Investors, listen and see how it applies.) This is typically what you’ll get if you ask an exchange what’s happening with your stock:

The stock opened just above the blah blah blah level then broke out to the upside before basing around noon as profit-takers took over. The bulk of the volume occurred in the morning hours. There was one block, the opening trade, and BAML led most actives (880k), along with Interactive Brokers (615k), GSCO (325k) and JPM (70k).  IBKR often handles retail while the rest generally trade for institutions.

I’m not picking on exchanges. I’m asking what this tells you? It’s the same information I was getting fifteen years ago. No comparative forecast, no indication of what behavior set price, no trends, patterns. It’s a narrative suggesting the day is an end unto itself.

This is lugging skis to Breck on a shorts and flip-flops day.

Compare to the oft-maligned weatherperson.  They’re not always right but they give reliable forecasts. It’s math.  The weather keeps changing but we don’t stop reading forecasts. Right?

Like the weather, the stock market is continually changing. And like weather it’s got measurable patterns because it too is governed by mathematical principles.

Patterns abound. We give Wall Street general expectations of financial trends and patterns through guidance. The Peloton stationary web-connected exercise bike we love gives us troves of trend and pattern data on our performances (sometimes to our chagrin).

I know executives love trends and patterns because they tell me. They like to know what’s coming because they’re people responsible for outcomes and it’s how they think. They appreciate seeing patterns behind price-moves.

We have your trends, patterns and forecasts.  If you’d like to see them, let me know.

The stock market isn’t a set of disconnected events one upon the next called trading days that begin at zero, crescendo, and conclude at a finish line. It’s impossible for everything material to investment behavior to wrap by 4:00 p.m. Eastern Time each day. There’s a pattern at work you can be sure. The average stock trades 13,000 times per day in 200-share increments (and the last price of the day is the 13,000th then).

I’ll share some patterns and trends to finish. Broadly, the key behavior the past week driving big gains and yesterday’s intraday volatility is Risk Mgmt – the use of derivatives to protect and leverage portfolios. Second is Passive Investment. That combination means ETFs are responsible (passive money, plus a risk-transfer effort by market-makers).

Options expire tomorrow through Friday. The Sentiment trend in the market is white-hot growth behavior slamming into a ceiling, based on past trends and patterns. Shorting is rising, intraday volatility is rising.

While the market has persistent upside fervor, near-term volatility is baked in via behavior and options-expirations regardless of a government shutdown. Trends and patterns show it. It may change again next week. That’s how the market works.

If you’re an observer it’s nice to know what’s coming. If you’re an investor, it’s very material to know patterns and trends because your money is on the line. And if you’re in investor-relations, it’s your job.  You don’t want to live it day-to-day. That’s not a strategy.

Can It Last?

It’s the number one question.  Tack “how long” on the front.

I’m asked all the time: “Tim, do you think the stock market is sustainable? Are fundamentals driving it or is this a bubble? Stock buybacks?  The Fed is behind it, right? Isn’t bitcoin proof of irrational exuberance?”

And everybody with an opinion is asked, and answers. I’ve offered mine (read The 5.5 Market from last week) and I’ll add today what we’ve further learned about the behavior of money.

Speaking of money, Karen and I joke that we miss the recession. Hotels were a bargain.  They gave you free tickets to shows if you just came to Las Vegas. Vacations were affordable (I’m not making light of great stock returns but if we give it all back, how is that helpful?).

Now suppose at the same time interest rates would rise. People and companies with too much debt would suffer, sure. But society would save money and take on less debt. That’s what higher interest rates encourage. From Hammurabi in Babylon until fairly recently we understood this to be the formula for prosperity.

“Quast, do you know nothing about contemporary behavioral economics? What kind of idiot would think it’s better to save money and avoid debt?  Economists agree that debt and spending drive the global consumption economy.”

Ask your financial advisor if you should borrow money and spend more, or save money and invest it.  So how come the Federal Reserve encourages borrowing and spending?

Recessions have purpose – and they’re packed with opportunity!  Seriously. They reset the economic calculus.

I’ll give you an example from the Wall Street Journal yesterday, which reported that here in Denver we have 16,000 vacant metro apartments, most in the luxury category. And 22,000 more are being built. Since they’re unaffordable, the city has launched a program to subsidize rents.

This is the kind of warped outcome one gets from promoting debt and spending, and it’s influencing our stock market too. I’m not the least worried because I know boundless opportunity awaits when prices reset, and that’s the right way to see it.  Warren Buffett said it’s unwise to pay more for a thing than it’s worth.  All right, I look forward to attractive prices ahead.

And prices are products of the behavior of money.  Last week we described how the market could not correctly be credited with rational valuation because stock-picking was not the principal behavior. Over the past ten years, all the NET new inflows into US equities have gone to index and exchange-traded funds. They follow a benchmark. They don’t pick stocks.

They also rarely sell them. If things are bought and not sold, prices rise.  There is a paucity of stocks for sale. In its 2016 prospectus for the S&P 500 ETF SPY, State Street said its turnover – proportion of holdings bought and sold – was 4%.  The fund that year, the latest available, had $197 billion in net asset value. Four percent is about $8 billion.

Yet SPY traded $25 billion daily in 2016 (still does!), about three times the entire annual fund turnover. Explanation? Right there on page 2 of the prospectus: The Trust’s portfolio turnover rate does not include securities received or delivered from processing creations or redemptions of Units.

On page 30 we learn this:  For the year ended September 30, 2016, the Trust had in-kind contributions, in-kind redemptions, purchases and sales of investment securities of $177,227,631,568, $167,729,988,725, $7,783,624,798, and $6,444,954,759, respectively.

Translating to English, it means brokers called Authorized Participants created $177 billion worth of new ETF shares by exchanging assemblages of stocks for them that were not counted as sales by SPY. It counted sales of only about $8 billion – as I said above.

The functional turnover rate for SPY is closer to 100%. If it really was, the market would be volatile. Prices would fall as shares hit the market. SPY drives 10% of the entire stock market’s dollar volume.

But what trades is ETF shares. The creation and redemption process occurs away from the market in some secretive block-transaction fashion that means the natural buying or selling that would otherwise be done is not happening.

Selling lowers prices. The absence of selling, the replacement of selling with trading in ETF shares predicated primarily on price-differences – arbitrage – produces a market that relentlessly rises with very little volatility.

And which notably means investors don’t actually own anything when they buy ETF shares. If they did, that $177 billion SPY exchanged for ETF shares would carry a taxable ownership interest, and transaction costs. It doesn’t.

Think about that.

When the recession comes because of this bizarre displacement of actual buying and selling by derivatives, I look greatly forward to all the bargains, the affordable vacation homes in desirable places, the cheap stocks, and the free show tickets in Las Vegas.

I just can’t tell you when. The wise are always prepared.

The 5.5 Market

The capital markets are riven with acronyms.

One of the first you learn in IR (acronym for investor relations) is “GARP.” Growth at a Reasonable Price.  As 2018 begins, GARP is a great way to describe the stock market, just as it was in 2017. Will it continue?

Let’s set ground rules. What “reasonable” means varies with circumstances but the idea is you’re paying a fair price for appreciation, what investors want and companies hope to deliver.

If arguments were colors, you could hear every hue of the rainbow on whether stocks are overpriced or not. Here at ModernIR, we’re statisticians studying how money behaves. We measure what it’s doing rather than whether it should be doing what it’s doing.

What I’ve learned from observing data is that there is an elegant and uniform explanation for why we have a GARP market. I’ll come to it in a moment.

But to ModernIR GARP is a number: 5.5/10.0 on the ModernIR Behavioral Sentiment Index.  Take the FAANGGs – Facebook, Amazon, Apple, Netflix, the two Alphabets. For 2017, the ModernIR BSI is 5.44 for them. The Russell 1000 is 5.48.  The BSI comprised of our client base with more energy and telecom is 5.39 for 2017.

As 2018 begins, it’s 5.6. All these numbers are within two-tenths of a point. It’s a GARP market.

It means it’s a little better than neutral, which is GARP investment.  For instance, if an economy’s population grew, and the ratio of people employed remained constant, and purchasing power outpaced inflation, you’d have a GARP economy.  Buying and holding it would mean appreciation.

Don’t think too long about that one. You’ll become disturbed by incongruity – but that’s a separate story. We’re after an elegant and uniform explanation to why our market runs according to GARP.

CNBC’s Jim Cramer believes it’s this: “There aren’t enough shares!!!”

It’s a point we’ve made too.  Both the number of companies in the US stock market and the total number of outstanding shares has been in steady decline while the amount of money chasing the shrinking product pool continues to rise.

Is inflation the elegant explanation? More money chasing fewer goods? Discounting fundamentals entirely seems incorrect.

But money chases the goods, and what form is money taking? A passive form. Statistically, 100% of the net inflows to stocks the past decade have gone to index and exchange-traded funds. Over that time, stock pickers have lost trillions.

Therefore, the money chasing the goods is pegging a benchmark, not picking outperformers. And by far the big winner is ETFs. What can ETFs do that no other investment vehicle can? They can substitute shares representing stocks, so they don’t have to buy or sell them like other investors do.

More ETF shares are created to accommodate inflows, and then destroyed during outflows, so ETFs bob on the surface of the market, which otherwise fluctuates with supply and demand.

And since all the new money is using ETFs, the entire market has become the bobber.  ETFs create the capacity for ever more money to have access to the same underlying goods. And that is why the market is up, all other things being equal.

It struck me over the holidays that the structure of ETFs, which depends on arbitrage – profiting on price-differences – would inevitably produce a declining market IF the number of shares or public companies or both were expanding. Arbitrage would consume appreciation, leading to an investor exodus from ETFs.

Thus, the elegant explanation for our GARP market is that ETFs arbitrage stocks back to the mean, which is 5.0, and rising flows of capital and shrinking numbers of public companies combine to breed a 5.5 market. GARP.

Why? Because there are ever more ETF shares to accommodate flows to ETFs. For stocks it means multiple-expansion, since ETFs, unlike IPOs, do not create shares of more value-creating enterprises. They only give more money access to the same stocks.

What stops it? The same thing that haunts the global currency system. If at any point, global currencies stop expanding, the prices of all assets could plummet. Why? Because expanding currency supplies drive up prices and create credit, so people keep borrowing more money to buy things. If that process freezes up, prices will implode. Witness 2008.

For ETFs, the danger is as simple as a market in which inflows stop.  What would cause that?  I don’t know right now!  But for the moment it’s not something to fear. We’re in a GARP world.