Yearly Archives: 2019

Time and Sentiment

Time matters.

We’ve gone 42 trading days with the ten-point Market Structure Sentiment index, our proprietary measure of the propensity of algorithms to lift or lower prices, over 5.0. That’s a growth-at-a-reasonable-price (GARP) market since Oct 17.

It’s by no means the longest. More on that in a moment.

The market seems impervious to fault lines as we move into year-ending options-expirations tomorrow through Friday, and index rebalances, and portfolio window-dressing.

It’s nothing like either 2010, the Year of the Flash Crash, or 2012, the Year of the Glitch. I wrote an editorial for IR Magazine on those, a retrospective ahead of 2020 on the last decade of market structure.

The market’s capacity to relentlessly rise through a corporate earnings recession (we’ve had three quarters of falling comparative profits), trade disputes, Presidential impeachment, on it goes, shows how both the IR profession and investors need different data in the arsenal to understand how stocks are valued.

Two other terrific IR Magazine pieces highlight the value of data to IR. We’re not alone! Reporter Tim Human describes how AI Alpha Labs uses deep-learning to help investors understand how to achieve better returns – something IR must know.

Oliver Schutzmann of Iridium Advisors says future IR will be data science – because that’s how the market works.

Speaking of data, ours for the S&P 500 show Active money the past year was the lead buying behavior 7% of the time. The worst day was Dec 19, 2018, with just one company earning what we call a new “Rational Price” from Active Investment. The best day came a month later on Jan 18, 2019, when 26% of the index had new Rational Prices.

Add selling, and Active money leads the S&P 500 behaviorally about 14% of the time.

Back to Sentiment, over the 42 days where the market has gone up, up, up on positive Sentiment, Active money led buying just 6% of the time. Exchange Traded Funds have led, our data indicate, 67% of the time, directly or indirectly.

Data points like these are requisites of the IR job the next decade. And measuring changing behavioral trends will be essential to understanding stock prices. Case in point, I saw a client’s data yesterday where Fast Traders, automated machines creating price-changes, were responsible for a 40% 2019 decline in equity value.

Machines don’t know what you do. But they can trigger negative and positive chains of events divergent from fundamentals.

In this case, trading machines blistered shares on consecutive earnings reports, which in turn pushed Passive money to leave because volatility created tracking errors, which caused market cap to fall out of the Russell 1000 – which is 95% of market value today.

Active money was incapable of overcoming the overwhelming force of Passive behavior.

Back to Sentiment and Time, before the market tipped over in the fourth quarter of 2018 Sentiment stayed around 5.0 or higher for 66 days. When it finally dipped below 4.0, a Sentiment bottom, the market was cast into tumult.

Part of the trouble was delayed portfolio rebalances. When markets go up, investors put off aligning positions to models. When the turn comes, there’s a scramble that compounds the consequence.

We’re hitting one of those crucial points this week, delayed rebalances colliding with options-expirations, index-rebalances and year-end.

We may see nothing. After all, it’s only been 42 days. Sentiment went 45 days at 5.0 or better this spring on the great January rally. There were 42 positive days from June 11 to Aug 8, too.

My final thought in the final fresh blog for 2019 (we’ll do retrospectives to finish out the year) is a monetary one. Karen reminds me that monetary policy clears a room like a fart – so you can’t talk about it often.

But it’s another data point driving market behavior. As the Federal Reserve has turned accommodative again – that is, it’s shifted from shrinking its balance sheet and raising rates to expanding assets and lowering rates – we’ve seen a corresponding fall in shorting and derivatives-leverage in stock-trading.

In fact, a steep drop for shorting coincided with a sudden spike in what’s called the Fed Funds overnight rate. Remember that? Happened in September. The rate the Fed had set near 1.5% exploded to 10% as the market ran out of cash.

Ever since it’s been troubled, the Fed Funds market. The Fed keeps injecting tens of billions of dollars into it. That market is meant to provide banks with temporary liquidity to process payrolls, taxes, credit-card payments, transaction-settlements and so on.

What if ETFs are using cash to collateralize transactions (rather than actual stocks) at the same time rising consumer debt is beginning to weigh on bank receipts and liquidity?

If that’s at all the case, time matters. We’re not worried about it – just watchful. But with so vast a part of market volume tracing to ETFs, and Sentiment getting long in the tooth, we’re cautiously wary as this fantastic trading year ends.

Hummingbird Wings

I recall reading in high school that the military’s then new jet, the FA-18 Hornet, would fall out of the sky if not for computers.

Could be that’s exaggerated but the jet’s designers pushed the wings forward, creating the probability of continual minute turbulence events too frequent for human responses.  Why do that? Because it made the plane vastly nimbler in supersonic flight.

You just had to keep the computers on or the craft would go cartwheeling to earth.

As we wrap a remarkable year for stocks in a market too fast for humans and full of trading wings whipping fleeting instances of turbulence, we’re in a curious state where the machines are keeping us all airborne.

I don’t mean the market should be lower.  Valuations are stretched but not perverse. The economy is humming and the job market is great guns. And while the industrial sector might be spongy, the winds in the main blow fair on the fruited plain.

So why any unease about stocks, a sense the market is like an FA-18 Hornet, where you hope the computers keep going (ironic, right)?

It’s not just a feeling.  We at ModernIR as you longtime readers know are not touchy-feely about data. We’re quantitative analysts. No emotion, just math.  Data show continual tweaking of ailerons abounds.

You see it in fund flows. The WSJ wrote over the weekend that $135 billion has been pulled from US equities this year. Against overall appreciation, it’s not a big number. But the point is the market rose on outflows.

And corporate earnings peaked in real terms in 2014, according to data compiled by quantitative fund manager Julex Capital. We’ve got standouts crushing it, sure.  But if earnings drive stocks, there’s a disconnect.

I’m reading the new book on Jim Simons, the “man who solved the market,” says author and WSJ reporter Greg Zuckerman. Simons founded Renaissance Technologies, which by Zuckerman’s calculations (there’s no public data) has made more than $100 billion the past three decades investing in stocks. Nobody touches that track record.

It’s a riveting book, and well-written, and rich with mathematical anecdotes and funny reflections on Simons’s intellectually peripatetic life.

Renaissance is not a stock-picking investment firm. It’s a quant shop. Its guys and gals good at solving equations with no acumen at business or income statements proved better at investing than the rest.

It’s then no baseless alchemy to propose that math lies at the heart of the stock market.

And son of a gun.

There’s just one kind of money that increased the past year.  Exchange Traded Funds (ETFs). This currency substituting for stocks is $224 billion higher than a year ago and about a trillion dollars greater the past three years.  As we learned from Milton Friedman and currency markets, more money chasing the same goods lifts prices.

Stocks declined in 2018, yet ETF shares increased by $311 billion, more than this year.  In 2017, ETF shares increased by $471 billion.

Behind those numbers is a phantasmagorical melee of ETF creations and redemptions, the ailerons keeping the market’s flight level through the turbulent minutia flying by.

I’ve explained it numerous times, so apologies to those tiring of redundancy. But ETFs are substitutes for stocks.  Brokers take a pile of stocks and give it to Blackrock, which authorizes the brokers to create and sell to the public a bunch of ETF shares valued the same as the pile of stocks.

If you sell ETF shares, the reverse happens – a broker buys the ETF shares and gives them to Blackrock in trade for some stocks of equal value.

This differential equation of continuous and variable motion doesn’t count as fund-turnover. But it’s massive – $3.2 trillion through October this year and $10.7 trillion, or a third of the market’s total value, the past three years.

Why the heck are there trillions of ETF transactions not counted as fund flows? Because our fly-by-wire stock market is dependent on this continuous thrum for stable harmonics.

That’s the hummingbird wings, the Butterfly Effect, for stocks.

We can see it.  In July a seismic ripple in behavioral patterns said the market could tumble. It did. Dec 3-5, a temblor passed through the movement of money behind prices. The market faltered.

If the ETF hive goes silent, we’ll cartwheel.  It won’t be recession, earnings, fundamentals, tariffs, Trump tweets, blah blah.  It will be whatever causes the computers to shut off for a moment.  It’s an infinitesimal thing.  But it’s why we watch with machines every day.  And one day, like a volcano in New Zealand, it’ll be there in the data.

Jim Simons proved the math is the money. It’s unstable. And that’s why, investor-relations pros and investors, market structure matters.

Boxed Yellow Pencils

“How do you think about ESG?” said my friend Moriah Shilton at a San Francisco NIRI summit some weeks back with hedge fund Citadel.

Silence. The four panelists shifted around.  A couple whispered to each other. Finally, somebody offered with a throat-clearing cough, “It doesn’t factor into our portfolio decisions.”

For those not fluent in Investor Relations (IR) Speak, ESG is “Environmental, Social, Governance.”  NIRI is the National Investor Relations Institute, professional association for the liaison between public companies and Wall Street.

ESG dominates the contemporary IR educational platform. NIRI has made a policy statement on ESG. There are at least two ESG sessions here at the NIRI Senior Round Table meeting (and NIRI national board meeting) this week in Santa Barbara.

The ESG heat isn’t coming from stock-picking investors, the “long-only” audience of public companies spending billions annually on communication through compliance-driven reports like 10Ks, 10Qs, press releases and proxies and via proactive outreach aimed at increasing share-ownership.

Nor is it, apparently, coming from hedge funds like Citadel, the other key audience – and I’d argue now the vital IR constituency because of its capacity to compete with the Great Passive Investment Wave – for public companies.

In fact, the Citadel team later said, “We vote with management on proxy matters, or we vote with our feet by selling shares.”

It’s passive money that’s obsessed with ESG. Passive investment to us is any form of capital allocation for a day or more (by contrast Fast Trading is an investment horizon of a day or less) driven by rules. That’s index investing, Exchange Traded Funds, or any variety of quantitative investment, from global macro to statistical arbitrage.

True, passives may oppose a proxy measure that doesn’t comport with an ESG platform. They will, however, continue owning the stock. Index funds pegged to a benchmark like the S&P 500 are required to own the securities comprising the benchmark.

It’s cognitively dissonant to own things you oppose.

But aren’t they trying to promote practices that make companies better stewards for stakeholders?

From my first exposure to it, good business has been sound financial management, the right people, products, markets, capital structure, the advancement of the best interests of your customers, employees, communities. These are essential strands of business DNA.

In fact, turning those into a checklist promotes the possibility that mediocre firms are treated the same as stellar ones by virtue of filling out a form.  Rules breed uniformity.

Nowhere is that more apparent than in the stock market, where rules push prices toward a mean. Track the midpoint – as Passive money does – and returns become superior by pegging the average.

The investor-relations profession, the pursuit of excellence, Warren-Buffett-style investment strategies, are about unique differentiation.  What makes a company better, superior?

Rules-based investing makes things the same. Passive money has boomed because shares of companies are increasingly products defined by shared criteria, like ESG. The more of that there is, the greater the probability the market will become homogeneous.

Without dismissing its merits, I’m perplexed by why public companies and stock-picking investors would promote shared criteria like ESG (why not differentiate with ESG if you’re so moved?).  We don’t want the stock market to become a bunch of yellow pencils in a box.

I think a form of guilt has gripped the passive-investment colossus like what manifests among the Silicon Valley nouveau riche who ofttimes with minimal effort realize vast wealth, and then feel compelled to browbeat the rest about the “greater good.”

How one favors the greater good should be individually chosen, not directed by rules.

So from atop vast heaps of assets gained through doing nothing more than tracking a benchmark, Massive Passives are compelled to berate the market over purpose.

If that purpose is an ESG checklist, the purpose is a dictated set of rules.  The very thing passive investment promotes.  Ironic, right? By subtly suggesting moral superiority, passive investment advances its own self-interest: rules-based investing.

Rather than mindlessly embracing ESG as good for all, a sentient species capable of staggering creativity and achievement through the individual pursuit of happiness that inures to the benefit of the masses owes itself moments of objective reflection.

And the question to ponder is whether a uniform ESG blanket tossed over the capital markets furthers the pursuit of the excellence the IR profession and stock-pickers seek.

Blurry

As Thanksgiving nears, we’re giving thanks for a rock-star stock market since last December, when it fell 20%. Can it hold?

In the simplest sense, whatever has been driving it must continue. Thanksgiving is to me the best holiday because it’s introspective. So let’s reflect on what’s behind stocks.

Everyone says corporate earnings, the economy, monetary policy.  The US economy is strong.  Earnings though are weaker the past three quarters than comparable earlier periods, so it’s not that. Monetary policy is easy, which helps by fueling leverage.

Buybacks?  Sure, a contributor. Geopolitics, trade deals, tariffs?  You’d think those might be headwinds. So far, no. Remember, news doesn’t buy or sell stocks. People and machines do.

Fund-flows? Research from Ed Yardeni says bonds have benefited while stocks have suffered. Domestic trends are disturbing – steep declines for years (See Figure 5) as money steadily shifts toward bonds and foreign equities.

Along our path of reflection we come to market structure – and why both companies and investors should learn it. Between Jul 1, 2015 and present there are 1,097 trading days. Of those, 589 are between 4.5-6.0 on ModernIR’s 10-point Market Structure Sentiment buy/sell scale.

Do the math. The ratio (589/1097) is 5.4/10.0. Reads over 5.0 mean machines will lift prices.  It’s a GARP market – growth at a reasonable price.

Now let’s add in the time the market has spent in “Overbought” territory, above 6.0. It’s 301 days, or 27% of the time. It’s been Oversold (below 4.5) 207 days, 19%.

There’s our answer. It’s GARP 54% of the time, momentum 27% of the time, value 19% of the time. It’s more growth than value, more buying than selling.  Whether money comes or goes, if what comes is disposed to pay up, stocks rise.

Contrast with Sep-Dec 2018. During that period when stocks fell about 20%, they were Oversold 44% of the time and Overbought just 16% of the time.

Narrow the data to 2019 and stocks are GARP just 44% of the time, Overbought 39% of the time. It’s become momentum almost as much as growth.

Zoom on Aug 1-present. GARP behavior is down to 41% of trading, Overbought, 36% of the time, Oversold 23% of the time.

Shouldn’t we be measuring that? By sector, industry, stock? Well. We do, at ModernIR.

Shifting our lens, in the past three weeks across the eleven market sectors, selling has outpaced buying 61% to 39%.

How does money leave stocks while the market sustains GARP or momentum (more Overbought than Oversold) characteristics?

The money behind prices is increasingly short-term, and leveraged. Add up everything that’s not long-only investing and it’s 86% of trading. The AMOUNT of money chasing stocks can shrink and stocks will still rise because the TIME dedicated to buying or selling is increasingly up-or-down, not buy-and hold.

Lesson? Public companies and investors, you cannot count on fundamentals, macroeconomics, central banks, to predict what the market will do. It moves in response to its temporal behavioral biases.

Or put another way, direction hinges on the short-term propensity of money to plow back into stocks tomorrow or to stop doing that.  It shifts to GARP, to growth, to value, and back. When the bias in the data blurs, money falters.

Data are getting blurry (as rock band Puddle of Mudd would say). It’s not a GARP market anymore.

For that reason, I’ll go out on a limb and say it’s too early to call this a record year (like Eric Church, for you country fans).  What got us here has begun eroding. We’re only 1% above the GARP levels for stocks in Q4 2018.

Wrapping up, it’s a great season, this one of Thanksgiving.  Give thanks!  And be alert to changing behaviors.  When lines blur – in your stock, your peers, your sector, industry – you should know. It’s a weather report on what’s coming. We want to stay clear-eyed.

The Fortress

Happy birthday to Karen Quast! My beloved treasure, the delight of my soul, turns an elegant calendar page today. It’s my greatest privilege to share life with her.

Not only because she tolerates my market-structure screeds.

Speaking of which, I’m discussing market structure today at noon ET with Joe Saluzzi of Themis Trading and Mett Kinak from T Rowe Price. In an hour you’ll mint a goldmine of knowledge.  Don’t miss it.

A citadel by definition is a fortress.  I think of the one in Salzburg, Austria, the Hohensalzburg castle perched on the Salzach, “Salt River” in German, for when salt mined in Austria moved by barge.  We rode bikes there and loved the citadel.

It’s a good name for a hedge fund, is Citadel. We were in San Francisco last week and joined investor-relations colleagues for candid interaction with Citadel. IR pros, hedge funds are stock-picking investors capable of competing in today’s market.

Blasphemy?  Alchemy?  I’ve gone daft?

No, it’s market structure. Exchange Traded Funds (ETFs) have proliferated at the expense of what we call in the IR profession “long-only” investors, conventional Active managers buying stocks but not shorting them.

Since 2007 when Regulation National Market System transformed the stock market into a sea of changing stock-prices around averages, assets have fled Active funds for Passive ones.  ETF assets since 2009 have quadrupled, an unmatched modern asset-class boom.

Underperformance has fueled the flight from the core IR audience of “long-onlys.” Returns minus management fees for pricey stock-pickers trails tracking a benchmark. So funds like SPY, the ETF mirroring the S&P 500 from State Street, win assets.

Why would a mindless model beat smart stock-pickers versed in financial results? As we’ve written, famous long-only manager Ron Baron said if you back out 15 stocks from the 2,500 he’s owned since the early 80s, his returns are pedestrian. Average.

That’s 1%. Smart stock-pickers can still win by finding them.

But. Why are 99% of stocks average? Data show no such uniformity in financial results. We come to why IR must embrace hedge funds in the 21st century.

Long-onlys are “40 Act” pooled investments with custodial assets spent on a thesis meant to beat the market.  Most of these funds must be fully invested. That is, 90% of the money raised from shareholders must be spent.  To buy, they most times must first sell.

Well, these funds have seen TRILLIONS OF DOLLARS the past decade leave for ETFs and indexes (and bonds, and target-date mixed funds). Most are net sellers, not buyers.

Let’s not blindly chase competitively disadvantaged and vanishing assets. That confuses busy with productive. And “action” isn’t getting more of the shrinking stock-picking pie.

First, understand WHY ETFs are winning:

  • ETFs don’t hold custodial assets for shareholders. No customer accounts, no costs associated with caring for customers like stock-pickers support.
  • They don’t pay commissions on trades. ETFs are created and redeemed in large off-market blocks (averaging $26 million a pop, as we explained).
  • They don’t pay taxes.  ETFs are created and redeemed tax-free through in-kind exchanges.
  • ETFs avoid the volatility characterizing the stock market, which averages about 3% daily in the Russell 3000, by creating and redeeming ETFs off-market.
  • And fifth, to me the biggest, stock-market rules force trades toward average prices. All stocks must trade between the best bid to buy and offer to sell. The average.

So.  Stocks are moved by rule toward their average prices. Some few buck it.  Stock-pickers must find that 1%. Money tracking benchmarks picks the 99% that are average. Who’s got the probability advantage?

Now add in the other four factors. Who wins?  ETFs. Boom! Drop the mic.

Except dropping the mic defies market rules prohibiting discrimination against any constituency – such as stock-pickers and issuers.

SEC, are you listening? Unless you want all stocks to become ETF collateral, and all prices to reflect short-term flipping, and all money to own substitutes for stocks, you should stop. What. You. Are. Doing.

Back to Citadel. The Fortress. They admit they’re market neutral – 50% long and short. They use leverage, yes. Real economic reach isn’t $32 billion. It’s $90 billion.

But they’re stock-pickers, with better genes. Every analyst is covering 25-55 stocks, each modeled meticulously by smart people. Whether long or short they meter every business in the portfolio. Even analysts have buy-sell authority (don’t poo-poo the analysts!). And they’re nimble. Dry powder. Agile in shifting market sand.

They can compete with the superiority modern market structure unfairly affords ETFs.

So. Understand market structure. Build relationships with hedge funds. This is the future for our profession. It’s not long-onlys, folks. They’re bleeding on the wall of the fortress. And don’t miss today’s panel.

Time Changes

Public companies, are you still reporting financial results like it’s 1995?

Back then, Tim Koogle and team at Yahoo! made it a mission to be first, showing acuity at closing the books for the quarter faster than the rest. Thousands turned out for the call and – a whiz-bang new thing – webcast.

Ah, yesteryear and its influence.  It’s still setting time for us all.  No, really.  Benjamin Franklin penned a 1784 letter to a Parisian periodical claiming his experiments showed sunlight was available the moment the sun rose and if only Parisians could get out of bed earlier instead of rising late and staying up, they could save immense sums on candles.

Some say his levity gave rise to the notion of Daylight Savings Time. A closer look suggests it was the Canadians.  Sure, scientist George Hudson of the Wellington Philosophical Society presented an 1895 paper saying New Zealand would improve its industry by turning clocks forward two hours in October, back two in March.

But the occupants of Thunder Bay in northern Ontario first shifted time forward in 1908.

What do Canada and New Zealand have in common besides language and erstwhile inclusion in a British empire upon which the sun never set?  They’re at extreme latitudes where light and dark swing mightily.

The push to yank clocks back and forth swept up much of the planet during World War I in an effort to reduce fuel-consumption.

Here in Denver we’re neither at war and hoarding tallow nor gripping a planetary light-bending polar cap in mittened hands.  So why do we cling to an anachronistic practice?

Speaking of which, in 1995 when the internet throngs hung on every analog and digital word from the Yahoo! executive fearsome foursome (at least threesome), most of the money in the market was Active Investment. That was 24 years ago.

Back then, investor-relations pros wanted to be sellside analysts making the big bucks like Mary Meeker and Henry Blodget. Now the sellsiders want to be IR pros because few hang on its words today like it was EF Hutton and the jobs and checks have gone away.

Volume is run by machines. The majority of assets under management are Passive, paying no attention to results. Three firms own nearly 30% of all equities. Thousands of Exchange Traded Funds have turned capital markets into arbitrage foot races that see earnings only as anomalies to exploit. Fast Traders set most of the bids and offers and don’t want to own anything. And derivatives bets are the top way to play earnings.

By the way, I’m moderating a panel on market structure for the NIRI Virtual Chapter Nov 20 with Joe Saluzzi and Mett Kinak. We’ll discuss what every IRO, board member and executive should understand about how the market works.

Today 50% of trades are less than 100 shares.  Over 85% of volume is a form of arbitrage (versus a benchmark, underlying stocks, derivatives, prices elsewhere).

Active Investment is the smallest slice of daily trading. Why would we do what we did in 1995 when it was the largest force?

Here are three 21st century Rules for Reporting:

Rule #1: Don’t report results during options-expirations.  In Feb 2019 Goldman Sachs put out a note saying the top trading strategy during earnings season was buying five-day out of the money calls. That is, buy the rights (it was 1996 when OMC offered that same advice in a song called How Bizarre.). Sell them before earnings. This technique, Goldman said, produced an average 88% return in the two preceding quarters.

How? If calls can be bought for $1.20 and sold for $2.25, that’s an 88% return.  But it’s got nothing to do with your results, or rational views of your price.

The closer to expirations, the cheaper and easier the arbitrage trade. Report AFTER expirations. Stop reporting in the middle of them. And don’t report at the ends of months. Passives are truing up tracking then. Here’s our IR Planning Calendar.

Rule #2: Be unpredictable, not predictable.  Arbitrage schemes depend on three factors: price, volatility, and time. Time equals WHEN you report. If you always publish dates at the same time in advance, you pitch a fastball straight down the middle over the plate, letting speculative sluggers slam it right over the fence.

Stop doing that. Vary it. Better, be vague. You can let your holders and analysts know via email, then put out an advisory the day of earnings pointing to your website.  Comply with the rules – but don’t serve speculators.

Rule #3: Know your market structure and measure it before and after results to shape message beforehand and internal feedback afterward. The bad news about mathematical markets is they’re full of arbitragers.  The good news is math is a perfect grid for us to measure with machines. We can see everything the money is doing.

If we can, you can (use our analytics!).  If you can know every day what sets your price, how it may move with results, whether there are massive synthetic short bets queued up and looming over your press release, well…why wouldn’t you want to know?

Let’s do 21st century IR. No need to burn tallow like cave dwellers. Go Modern. It’s time.

 

Hot Air

Balloons rise on hot air. Data suggest there’s some in stocks.

Lipper says about $25 billion left US equities in October, $15 billion if you weed out inflows to Exchange Traded Funds (ETFs). Bond flows by contrast were up $21 billion. So how did stocks rise 5%?

In September 2019 when the S&P 500 closed roughly unchanged for the month, the Investment Company Institute reported a net increase in ETF shares of over $48 billion, bringing total YTD ETF creations and redemptions to $2.96 trillion.

For what?  More money has gone than come in 2019, so why more ETF shares?

And should we be concerned that stocks are rising on outflows?

Drawing correct conclusions about stocks depends on a narrative buttressed by data.  If we stay “stocks are up on strong earnings,” and earnings are down, it’s incorrect.

With about 80% of S&P 500 components having reported, earnings are down (FactSet says) about 3% year-over-year, the third straight quarterly contraction. Analysts currently expect Q4 2019 earnings to also contract versus 2018.

I’m not bearish. We measure behavioral data to see WHY stocks act as they do, so we’re not surprised by what happens.  It was simpler when one could meter inflows and outflows to explain ups and downs. More buyers than sellers. Remember those good old days?

Some $70 billion has exited US equities in 2019 yet stocks are at records. If holdings are down while stocks are up, the simplest explanation left to us now is it’s hot air – balloons lifted on heated atmosphere.

What’s heating the air? Well, one form of inflow has risen in 2019: The amount of ETF shares circulating. It’s up $200 billion.

The industry will say it’s because more money is choosing ETFs.  Okay, but is a dollar spent on ETFs hotter than one spent on underlying stocks, or mutual funds? There shouldn’t be more ETF shares if there are less invested dollars.

And if ETFs are inflationary for equities, how and why?

The reason investors are withdrawing money from stocks is because the market cannot be trusted to behave according to what we’re told is driving it. Such as people withdraw money and stocks rise.

Now ahead in the fourth quarter, if indeed rational money is forward-looking, we may see rising active investment on an expected 2020 pickup in earnings.

But measuring the rate of behavioral change from Jan-Nov 2019, the biggest force is ETFs. It’s not even close.  That matches ETF-creation data.

The inflationary effect from ETFs is that the market is hitting new highs as earnings decline and money leaves stocks.

The bedrock of fundamental investment is that earnings drive the market. Apparently not now.  What’s changed? ETFs.

How do they create inflation? Arbitraging spreads between stocks and ETFs has become an end unto itself. The prices of both are thus relative, not moored to something other than each other. And with more ETF shares chasing the same goods, the underlying stocks, the goods inflate.

We see it in the data. Big spreads periodically develop between stocks and ETFs, and stocks rise, and spreads wane, and stocks fall. In the last six weeks, correlation between the movement of stocks and ETFs has collapsed to 39% from over 91% YTD.

That’s not happened since we’ve been tracking the data. If ETFs are substitutes, they should move together (with periodic gaps), not apart. That they are indicates a fever-pitch in the focus on profiting on stock-ETF spreads.

That’s hot air.  The chance to trade things that diverge in value.

The problem with inflation is deflation, and the problem with rising on hot air is falling when it cools. We’re not predicting a collapse. But the risk in a market levitating on hot air is real.

Knowing the risks and how they may affect your stock, investor-relations people, or your portfolio, investors, is pretty important. We have the data to demystify hot air.

Wholesale Profits

CNBC’s Brian Sullivan invited me to discuss shrinking market liquidity last Friday. Riveting, huh!

Well, it is to me! Unraveling the mystery of the market has turned out to be a breathtaking quest. I had another aha! moment this weekend.

Jane Street, a big Exchange Traded Funds (ETF) Authorized Participant, commissioned a study by Risk.net on ETF liquidity.  As a reminder, APs, as they’re called, are essential to the ETF supply chain.  They’re independent contractors hired by ETF sponsors such as State Street to create and redeem ETF shares in exchange for collateral like stocks and cash.

Without them, ETFs can’t function. In fact, they’re the reason why ETFs have been blanket-exempted from the Investment Company Act of 1940 under SEC Rule 6c-11, recently approved.

Exempted from what? The law that all pooled investments be redeemable for a portion of the underlying assets. There is no underlying pool of assets for ETFs, as we’ve explained before.

If you’re thinking, “Oh, for Pete’s sake, Quast, can you move on?” stay with me. If we don’t understand how ETFs are affecting equities and what risks they present, it’s our own darned fault.  So, let’s learn together.

As I was saying, ETFs don’t pool assets. Instead, firms like Jane Street gather up baskets of stocks and trade them straight across at a set price to ETF sponsors, which in turn “authorize” APs, thus the term, to create an equal value of ETF shares wholesale in large blocks and sell them retail in small trades.

I explained to Brian Sullivan how the math of the stock market shows a collapse in stock-liquidity. That is, the amount of stock one can buy before the price changes is down to about 135 shares (per trade) in the S&P 500. Nearly half of trades are less than 100 shares.

Block trades have vanished. The Nasdaq’s data show blocks are about 0.06% of all trades – less than a tenth of a percent. Blocks are defined as trades of $200,000 in value and up. And with lots of high-priced stocks, a block isn’t what it was. For BRK.A, it’s 1.5 shares.  In AMZN, around 130 shares.

Yet somehow, trade-sizes in the ETF wholesale market have become gigantic. Risk.net says 52% of trades are $26 million or more.  A quarter of all ETF trades are over $100 million. Four percent are over $1 billion!

And almost $3 TRILLION of ETF shares have been created and redeemed so far in 2019.

Guess what the #1 ETF liquidity criterion is?  According to the Risk.net study, 31% of respondents said liquidity in the underlying stocks. Another 25% said the bid-offer ETF spread.

Well, if stock liquidity is in free-fall, how can ETF liquidity dependent on underlying stocks be so awesome that investors are doing billion-dollar trades with ETF APs?

We’re led to believe APs are going around buying up a billion dollars of stock in the market and turning around and trading it (tax-free, commission-free) to ETF sponsors.

For that to be true, it’s got to profitable to buy all the products retail and sell them wholesale. So to speak. My dad joked that the reason cattle-ranching was a lousy business is because you buy your services retail and sell the products wholesale.

Yet the biggest, booming business in the equity markets globally is ETFs.

We recently studied a stock repurchase program for a small-cap Tech-sector company.  It trades about 300,000 shares a day. When the buyback was consuming about 30,000 shares daily, behaviors heaved violently and Fast Traders front-ran the trades, creating inflation and deflation.

That’s less than a million dollars of stock per day.  And it was too much. Cutting the buyback down to about 10,000 shares ended the front-running.

I don’t believe billions in stocks can be gobbled up daily by ETF APs without disrupting prices. Indeed, starting in September we observed a spiking breakdown in the cohesion of ETF prices and underlying stock-prices and a surge in spreads (not at the tick level but over five-day periods).

But let’s say it’s possible. Or that big passive investors are trading stocks for ETF shares, back and forth, to profit on divergence. In either case it means a great deal of the market’s volume is about capturing the spreads between ETFs and underlying stocks – exactly the complaint we’ve made to the SEC.

Because that’s not investment.

And it’s driving stock-pickers out of business (WSJ subscription required) with its insurmountable competitive lead over long-term risk-taking on growth enterprises, which once was the heart of the market.

The alternative is worse, which is that ETF APs are borrowing stock or substituting cash and equivalents. We could examine the 13Fs for APs, if we knew who they were. A look at Jane Street’s shows its biggest positions are puts and calls.  Are they hedging? Or substituting derivatives for stocks?

Public companies and Active investors deserve answers to these questions. Market regulation prohibits discriminating against us – and this feels a lot like discrimination.

Meanwhile, your best defense is a good offense:  Market Structure Analytics. We have them. Ask us to see yours.  We see everything, including massive ETF create/redeem patterns.

Suppy Chain Trouble

If you go to the store for a shirt and they don’t have your size, you wait for the supply chain to find it.  There isn’t one to buy. Ever thought about that for stocks?

I just looked up a client’s trade data. It says the bid size is 2, the ask, 3.  That means there are buyers for 200 shares and sellers of 300.  Yet the average trade-size the past 20 days for this stock, with about $27 million of daily volume, is 96 shares.  Not enough to make a minimum round-lot quote.

That means, by the way, that the average trade doesn’t even show up in the quote data. Alex Osipovich at the Wall Street Journal wrote yesterday (subscription required) that the market is full of tiny trades. Indeed, nearly half are less than 100 shares (I raised a liquidity alarm with Marketwatch this past Monday).

Back to our sample stock, if it’s priced around $50, there are buyers for $10,000, sellers of $15,000. But it trades in 96-share increments so the buyer will fill less than half the order before the price changes. In fact, the average trade-size in dollars is $4,640.

The beginning economic principle is supply and demand. Prices should lie at their nexus. There’s an expectation in the stock market of endless supply – always a t-shirt on the rack.

Well, what if there’s not? What if shares for trades stop showing up at the bid and ask?  And what might cause that problem?

To the first question, it’s already happening. Regulations require brokers transacting in shares to post a minimum hundred-share bid to buy and offer to sell (or ask). Before Mr. Osipovich wrote on tiny trades, I’d sent data around internally from the SEC’s Midas system showing 48% of all trades were odd lots – less than 100 shares.

Do you see? Half the trades in the market can’t match the minimum. Trade-size has gone down, down, down as the market capitalization of stocks has gone up, up, up.  That’s a glaring supply-chain signal that prices of stocks are at risk during turbulence.

Let’s define “liquidity.”

I say it’s the amount of something you can buy before the price changes. Softbank is swallowing its previous $47 billion valuation on WeWork and taking the company over for $10 billion. That’s a single trade. One price. Bad, but stable.

The stock market is $30 trillion of capitalization and trades in 135-share increments across the S&P 500, or about $16,500 per trade.  Blackrock manages over $6.8 trillion of assets. Vanguard, $5.3 trillion. State Street. $2.5 trillion.

Relationship among those data?  Massive assets. Moving in miniscule snippets.

Getting to why trade-size keeps shriveling, the simple answer is prices are changing faster than ever.  Unstable prices are volatility.  That’s the definition.

I’ll tell you what I think is happening: Exchange Traded Funds (ETFs) are turning stocks from investments to collateral, which moves off-market. As a result, a growing percentage of stock-trades are aimed at setting different prices in stocks and ETFs. That combination is leading to a supply-chain shortage of stocks, and tiny stock-trades.

ETFs are substitutes dependent on stocks for prices. The ETF complex has mushroomed – dominated by the three investment managers I just mentioned (but everyone is in the ETF business now, it seems) – because shares are created in large blocks with stable prices. Like a WeWork deal.

A typical ETF creation unit is 50,000 shares.  Stocks or cash of the same value is exchanged in-kind. Off-market, one price.

The ETF shares are then shredded into the stock market amidst the mass pandemonium of Brownian Motion (random movement) afflicting the stocks of public companies, which across the whole market move nearly 3% from high to low every day, on average.

Because there are nearly 900 ETFs, reliant on the largest stocks for tracking, ever-rising amounts of stock-trading tie back to ETF spreads. That is, are stocks above or below ETF prices? Go long or short accordingly.

Through August 2019, ETF creations and redemptions in US stocks total $2.6 trillion.  From Jan 2017-Aug 2019, $10.1 trillion of ETF shares were created and redeemed.

ETFs are priced via an “arbitrage mechanism” derived from prices in underlying stocks. Machines are chopping trades into minute pieces because the smaller the trade, the lower the value at risk for the arbitragers trading ETFs versus stocks.

ETFs are the dominant investment vehicle now. Arbitrage is the dominant trading activity. What if we’re running out of ETF collateral – stocks?

It would explain much: shrinking trade-sizes because there is no supply to be had. Rising shorting as share-borrowing is needed to create supply. Price-instability because much of the trading is aimed at changing the prices of ETFs and underlying stocks.

Now, maybe it’s an aberration only. But we should consider whether the collateralization feature of ETFs is crippling the equity supply-chain. What if investors tried to leave both at the same time?

All public companies and investors should understand market liquidity – by stock, sector, industry, broad measure. We track and trend that data every. Data is the best defense in an uncertain time, because it’s preparation.

Spread Spoofing

I’ve never bet on sports, but the bulk of wagers is on the spread – whether the outcome will be above or below a range.

In the stock market spreads rule too, and data suggest market-makers are gambling on which things will move. The most shocking spread is the one between assets flowing to Exchange Traded Funds and the dollar-volume of ETF shares.

Wall Street Journal writer Akane Otani reported last weekend (subscription required) using data from Strategas that US equity ETFs saw about $36 billion of inflows to date this year, the majority into low-volatility strategies favoring defensive plays like large-caps and Utilities.

To accommodate these flows, ETF shares must be created. Data from the Investment Company Institute through August 2019 (the latest available) show a staggering $2.6 trillion of ETF shares have been created and redeemed this year.

Put another way, actual increases in ETF assets are 1.4% of total ETF share-transactions.  Talk about a spread.

I wonder what effect that’s having on the stock market?

First, let’s understand “creations” and “redemptions.”  We’ve written about them before and you can read our ETF white paper for more.  ETF shares are manufactured by brokers, which receive that right from Blackrock and other ETF sponsors in (tax-free) exchange for stocks and cash of equal value.

Say investors are buying Utilities ETFs because they want to avoid volatility. Communication Services sector stocks like Facebook and CBS are 84% more volatile on average over the past 50 trading days (we study that data) than Utilities stocks like Southern Co. and Duke Energy.

Brokers will find (buy, borrow, substitute) Utilities stocks worth, say, $12 million, and receive in trade from an ETF sponsor like State Street (XLU is the Utilities sector ETF) authority to create $12 million worth of ETF shares to sell to the eager investing public.

The data are saying the process of creating and redeeming ETF shares is vastly more peripatetic behind stocks than the actual dollars coming from investors.

Why? We’ll come to that.

Continuing the explanation, ETF shares are created off the market in giant blocks typically numbering 50,000 or more. The price does not move.  These shares are then sold in tiny trades – about 130 shares at a time – that move wildly, as do the prices of stocks exchanged for ETF shares.

There is, as the statistics folks would say, mass Brownian Motion (random movement) amid stocks – and the pursuit of profits via instability is leviathan.

We’ve done the math. An average of $325 billion of ETF shares are created and redeemed every month.  Barely more than a tenth of that has been invested in equity ETFs en toto in 2019.

What’s going on? What we’ve been telling financial reporters and the SEC for the last three years – to withering recrimination from ETF sponsors and resounding silence from the press and regulators.

ETF shares are being created and redeemed so short-term money can profit on the spreads that develop between stocks and ETFs (ironically, the same parties doing this are decrying short-termism).

Create ETF shares, and prices of ETFs will deteriorate versus stocks. Redeem (remove them) and prices firm. Contraction/expansion is relentless and way bigger than flows.

That’s not investing.  It’s gambling on (and fostering) spreads.  The math on its face says nearly 99% of creation/redemption volume is a form of gambling, because it doesn’t match investment-flows.

No doubt now there’s epithet-riddled screaming and shouting occurring across ETF trading rooms and ETF boardrooms.  Perhaps some part of the spread is legitimate.

But I’ll say again, regulators:  You owe the investing public a look into why trillions of dollars of ETF shares are created to serve billions of dollars of investment-flows. And we don’t know who the parties to creations and redemptions are, or what’s being exchanged.

It feels like spoofing – issuing and canceling trades to distort supply and demand. What effect is it having on the prices of stocks that both public companies and investors think reflect investment behavior?

I’ll wager there’s an answer.  Do you want to take the over or under?