A Rational Market

The market appears to have become the Walking Dead.

I don’t mean a collection of bodies reduced to bloody pulp by a barbed-wire encased baseball bat. That would be the Presidential election. (Aside: you who watched the new Dead episode know with nauseating certainty what I mean.)

No, market volume is a zombie compared to the summer. Volume was 6.7 billion daily shares Jun-Aug 2016.  Now we’re eking out 5.8 billion, a drag-footed, scar-faced amble.

Usually it’s the other way around.

Meanwhile, business media has been fixated (somewhat ironically) on the Passive invasion that’s digging a giant hole and burying stock-pickers. The Wall Street Journal last week ran a half-dozen stories on the death-grip indexes and exchange-traded funds have laid on investing. Not to be outdone, CNBC covered the big lurch into market passivity all last week.

Both reported how Blackrock has amassed $5 trillion of assets (while, we’d add, ignoring the sellside, discounted cash-flows and earnings calls).  A WSJ article titled Passive Can Be Very Active described how leveraged ETFs classified as passive vehicles drive immense daily volume (we told you about these things a long time ago).

But volume is moseying. So wither the wither?  It looks like Passive is responsible. Now, the market is a uniform beast in which every barcoded thing must behave like the rest or regulators fine it for looking different, by which I mean failing to trade at the averages. If any stock so much hints at departing from the crowd it’s immediately volatility-halted.

I exaggerate for dramatic effect but only some. Rules create uniformity that makes standing out difficult. So over time stocks cluster around the averages like, well, zombies. The world’s most widely traded equity by a country mile is SPY, State Street’s ETF proxy for the S&P 500.  It routinely manages $25 billion of daily volume.

But that was last summer. Monday with the November series of options and futures trading marketwide – routinely it’s hectic with new derivatives – it managed about $11 billion, just 45% of its summertime tally.

We measure the share of daily volume driven by Passive investment marketwide. It’s not down a lot, 100 basis points or so. But that’s every day. And it ripples into options and futures that counterparties back with equity-trading as placid measures mean indexes and ETFs use fewer of them to true up positions. Weaker Fast Trading follows, and anemic ETF market-making. Pretty soon it’s the walking dead.

But there’s a storyline of survival. While the corpus of passivity has shriveled like bacon in a hot pan, or perhaps more accurately like one of those flex hoses when you shut the water off, underneath there is a turgid Active current.

I mean Active investment. We’re a data-analytics firm so we measure everything.  We know each day what percentage of our clients earn new Rational Prices (fair value) when Active stock-pickers buy.

Amidst listless Passive volume, we have seen surging Rational Prices.  On Oct 13, a stunning 32.7% of our client base had new Rational Prices even as volume wilted like pumpkin leaves after the first frost.

Last Friday, the 21st, the penultimate Friday before Halloween and fittingly hosting triple-witching, an impressive 15.5% of our clients were valued rationally by Active investment.

There’s a post-mortem here, a timeless market-structure lesson. First, volume that’s not Rational distorts fair value. Stuff that pursues averages hurts stock-pickers.

And if volume decreases while Active Investment improves its price-setting authority, volume does not equal value.  What matters is the kind of money setting price. With less competition from zombies, the enterprising can make supply runs.

That’s really great news for the investor-relations profession. Our civilization will endure. You don’t need big volume. In fact, if you have big volume the old convention that “you have a big holder buying or selling” is more often wrong than right.  Active money doesn’t want others to know it’s buying. If it does, you better be wary. That’s what Activists do.

There’s more good news.  Where Passive money that puts no thought into its movement is incapable of knowing what lies ahead and can slouch unsuspecting right off cliffs, that Active money bought October brings comfort. There’s Rational Thought in that forest that so often we can’t see for the trees.

Yes, the market like the storyline in the show depends on the zombies. They move the broad measures from one point to the next. You have to be prepared for the occasional slaughter while recognizing that the humans win in the end.  Rational thought trumps.