Age of Discovery

Bom Dia!

We returned Monday from Portugal after two fantastic weeks roaming and pedaling this land famed for its explorers. We stood at Cape St. Vincent, once the end of the known world where Vasco da Gama, Ferdinand Magellan and Christopher Columbus sailed off to what many thought was a ride over the edge.

In a sense, the investor-relations and stock-picking professions are at Cape St. Vincent. The market we’ve known, the one driven by business fundamentals, is a spit of rock projecting into a vast sea of unknown currents.  We are explorers on a forbidding shore.

Henry the Navigator, father of the Age of Discovery, challenged fear, superstition and entrenched beliefs to create the Harvard of sailing schools on the barren shoals of Sagres, a stone’s throw south of Cape St. Vincent. From it went intrepid adventurers who by sailing what proved to be a globe laid the cornerstones of today’s flattened earth that’s interconnected economically and culturally.

Speaking of conquering the unknown, I’m paneling for the NIRI Virtual chapter at noon ET today on the impact of Exchange Traded Funds, then tomorrow addressing the Capital Area NIRI group on how ETFs drive the market.

It’s what the money is doing. If as IR professionals we’re to fulfill our responsibilities to inform our boards about important facets of equity valuation, we have to know these things as explorers knew the sextant.

By the same token, investors, if you know only how stocks should be valued bottom-up but not how the market transforms stocks into products and data priced by arbitrage, then you’ll fail to beat the benchmark.  Market Structure is as essential to navigation as was knowing currents and stars and weather patterns for yesteryear’s seafarers.

How do we at ModernIR know we’ve got the right navigational tools for today’s market?  Vasco da Gama combined knowledge and forecasts learned at the School of Navigation to find a passage by sea to India.

We combine knowledge of market rules and the behavior of money with software and mathematical models that project outcomes – passages.  If our knowledge is correct, our sextant will mark a course.

Our models are roughly 93% accurate in forecasting short-term prices across the entire market – a startling achievement. For comparative purposes, moving averages have no measurable statistical capacity to forecast prices, and variances between them and actual prices are factors larger than that in our models. Why use tools that don’t tell you where you’re going?

Ownership-change is a tiny fraction of trading volume. What does it tell you about how your price is set?  Nothing. By contrast, patterns of behavioral change are as stark as waves in Cascais – or the world’s biggest surfers’ waves off Nazare.  We see waves of sector rotation, short-term turns in the market – just like weather patterns.

We’re in an age of discovery. Some will cling to a barren spit of land, doing what they’ve always done. The rest will set a new course to a future of clarity about how stocks are priced and valued and how money behaves.  Which group will you be in?

Hope to see you at a NIRI chapter meeting soon!  And ask us how we can help you navigate the coming earnings season with better tools.

Borrowed Time

“If a stock trades 500,000 shares daily,” said panelist Mark Flannery from hedge fund Point72 last Thursday on my market-structure panel, “and you’ve got 200,000 to buy or sell, you’d think ‘well that should work.’ It won’t. Those 500,000 shares aren’t all real.”

If you weren’t in Austin last week, you missed a great NIRI Southwest conference.  Mr. Flannery and IEX’s John Longobardi were talking about how the market works today.  Because a stock trades 500,000 shares doesn’t mean 500,000 shares of real buying and selling occur.  Some of it – probably 43% – is borrowed.

Borrowing leads to inflation in stocks as it does in economies.  When consumers borrow money to buy everything, economies reflect unrealistic economic wherewithal. Supply and demand are supposed to set prices but when demand is powered by borrowing, prices inevitably rise to unsustainable levels.  It’s an economic fact.

All borrowing is not bad. Borrowing money against assets permits one to spend and invest simultaneously.  But borrowing is the root of crises so watching it is wise.

Short interest – stock borrowed and sold and not yet covered and returned to owners as a percentage of total shares outstanding – isn’t unseemly. But it’s not a predictive indicator, nor does it describe risk. The great majority of shares don’t trade, yet what sets price is whoever buys or sells.

It’s far better to track shares borrowed as a percentage of total traded shares, as we described last week. It’s currently 43%, down one percentage point, or about 2.3%, as stocks have zoomed in latter August.

But almost 30% of stocks (excluding ETFs, routinely higher and by math on a handful of big ones averaging close to 60%) have short volume of 50% or more, meaning half of what appears to be buying and selling is coming from something that’s been borrowed and sold.

In an up market, that’s not a problem. A high degree of short-term borrowing, much of it from high-speed firms fostering that illusory 500,000 shares we discussed on the panel, means lots of intraday price-movement but a way in which short-term borrowing, and covering, and borrowing, and covering (wash, rinse, repeat), may propel a bull market.

In the Wall Street Journal Aug 25, Alex Osipovich wrote about how Goldman Sachs and other banks are trying to get a piece of the trading day’s biggest event: The closing auction (the article quotes one of the great market-structure experts, Mehmet Kinak from T Rowe Price). Let’s dovetail it with pervasive short-term borrowing.

We’ve mapped sector shorting versus sector ETF shorting, and the figures inversely correlate, suggesting stocks are borrowed as collateral to create ETFs, and ETFs are borrowed and returned to ETF sponsors for stocks.

A handful of big banks like Goldman Sachs are primary market-makers, called Authorized Participants (as opposed to secondary market-makers trading ETFs), which create and redeem ETF shares by moving stock collateral back and forth.

The banks give those using their versions of closing auctions the guaranteed closing price from the exchanges.  But it’s probably a great time to cover short-term ETF-related borrowings because trades will occur at an average price in effect.

The confluence of offsetting economic incentives (selling, covering borrowings) contribute to a stable, rising market. In the past week average intraday volatility dropped to 1.9% from a 200-day average of 2.5% at the same time shorting declined – anecdotal proof of the point.

What’s the flip side?  As with all borrowing, the bill hurts when growth stalls. When the market tips over at some future inevitable point, shorting will meet shorting. It happened in January 2016 when shorting reached 52% of total volume. In February this year during the correction it was 46%. Before the November election, short volume was 49%.

The point for both investors and public companies is that you can’t look at trading volume for a given stock and conclude that it’s equal and offsetting buying and selling. I guarantee you it’s not.

You don’t have to worry about it, but imbalances, however they may occur, become a much bigger deal in markets dependent on largescale short-term borrowing. It’s another market-structure lesson.

Going Naked

Today this bull market became the longest in modern history, stretching 3,453 days, nosing out the 3,452 that concluded with the bursting of the dot-com bubble.

Some argue runs have been longer before several times. Whatever the case, the bull is hoary and yet striding strongly.

Regulators are riding herd. Finra this week fined Interactive Brokers an eyebrow-raising $5.5 million for short-selling missteps. The SEC could follow suit.

Interactive Brokers, regulators say, failed to enforce market rules around “naked shorting,” permitting customers to short stocks without ensuring that borrowed shares could be readily located.

Naked shorting isn’t by itself a violation. With the lightning pace at which trades occur now, regulators give brokers leeway to borrow and sell to investors and traders to ensure orderly markets without first assuring shares exist to cover borrowing.  I’m unconvinced that’s a good idea – but it’s the rule.

Interactive Brokers earned penalties for 28,000 trades over three years that failed to conform to rules. For perspective, the typical Russell 1000 stock trades 15,000 times every day.

What’s more, shorting – borrowed shares – accounts for 44% of all market volume, a consistent measure over the past year.  Shorting peaked at 52% of daily trading in January 2016, the worst start to January for stocks in modern history.

In context of market data then, the violations here are infinitesimal. What the enforcement action proves is that naked shorting is not widespread and regulators watch it closely to ensure rules are followed. Fail, and you’ll be fined.

“Wait a minute,” you say.  “Are you suggesting, Quast, that nearly half the market’s volume comes from borrowed shares?”

I’m not suggesting it. I’m asserting it.  Think about the conditions. Since 2001 when regulations forced decimalization of stock-trading, there has been a relentless war on the economics of secondary market-making. That is, where brokers used to carry supplies of shares and support trading in those stocks with capital and research, now few do.

So where do shares come from?  For one, SEC rules make it clear that market makers get a “bona fide” exemption from short rules because there may be no actual buyers or sellers. That means supply for bids and offers must be borrowed.

Now consider investment behaviors.  Long-term money tends to buy and hold. Passive investors too will sit on positions in proportion to indexes they’re tracking (if you’re skewing performance you’ll be jettisoned though).

Meanwhile, companies are gobbling their own shares up via buybacks, and the number of public companies keeps falling (now just 3,475 in the Wilshire 5000) because mergers outpace IPOs.

So how can the shelves of the stock market be stocked, so to speak? For one, passive investors as a rule can loan around a third of holdings. Blackrock generates hundreds of millions of dollars annually from loaning securities.

Do you see what’s happening?  The real supply of shares continues to shrink, yet market rules encourage the APPEARANCE of continuous liquidity.  Regulators give brokers leeway – even permitting naked shorting – so the appearance of liquidity can persist.

But nearly half the volume is borrowed. AAPL is 55% short. AMZN is 54% short.

Who’s borrowing? There are long/short hedge funds of course, and I’ll be moderating a panel tomorrow (Aug 23) in Austin at NIRISWRC with John Longobardi from IEX and Mark Flannery from Point72, who runs that famous hedge fund’s US equities long/short strategy.  Hedge funds are meaningful but by no means the bulk of shorting.

We at ModernIR compare behavioral data to shorting. The biggest borrowers are high-frequency traders wanting to profit on price-changes, which exceed borrowing costs, and ETF market-makers.  ETF brokers borrow stocks to supply to ETF sponsors for the right to create ETF shares, and they reverse that trade, borrowing ETF shares to exchange for stocks to cover borrowings or to sell to make money.

This last process is behind about 50% of market volume, and hundreds of billions of dollars of monthly ETF share creations and redemptions.

We’re led to a conclusion: The stock market depends on short-term borrowing to perpetuate the appearance of liquidity.

Short-term borrowing presents limited risk to a rising market because with borrowing costs low and markets averaging about 2.5% intraday volatility, it’s easy for traders to make more on price-changes (arbitrage) than it costs to borrow.

But when the market turns, rampant short-term borrowing as money tries to leave will, as Warren Buffett said about crises, reveal who’s been swimming naked.

When? We’d all like to know when the naked market arrives. Short-term, it could happen this week despite big gains for broad measures. Sentiment – how machines set prices – signals risk of a sudden swoon.

Longer term, who knows? But the prudent are watching short volume for signs of who’s going naked.

August Currents

“Treasury yields rise as Turkey worries fade,” declaimed a headline at Dow Jones Marketwatch yesterday.

This one day after the New York Times bleated, “Plunge in Lira, Turkey’s Currency, Fuels Fears of Financial Contagion.”

Why are stocks, ostensibly propelled by fundamentals (earnings and revenue growth this reporting cycle were strong), instead wracked by the machinations of a minor monetary unit for an economy that ranks 19th, behind the Netherlands and Indonesia and just ahead of Saudi Arabia?

They’re not.  It’s the dollar. Every investor and investor-relations professional should understand currency valuation, just as we all must grasp how the market works and what the money is doing (we wrote about that last week).

(To Turkey, for a prescient economic perspective, read this piece by Jim Rickards – whose gold views fuel skepticism but who always writes thoughtfully.)

The dollar is the world’s reserve currency. Simplistically, instead of holding gold, countries own dollars, and sell or buy them to adjust the value of their own currencies.

The USA by contrast only mints the buck and the Federal Reserve uses interest rates to regulate its value. In effect, higher interest rates mean a stronger dollar, lower interest rates a weaker buck, all other things being equal. (In fact, some economics ingenue somewhere should write a thesis establishing that the definition of inflation is low rates.)

Anyway, stocks are risk assets that reflect fluctuations in currencies every bit as much as they are supposed to offer a barometer of economic activity.

Take Turkish stocks.  The lira has been falling in value for years while Istanbul’s stocks shined, especially last year. Yet the economy has slipped a couple notches in global rankings.

The US economy is booming, and yet markets have stalled in 2018. The dollar is at a 52-wk high, spiking lately. In 2017, the dollar devalued 12% and stocks soared. There’s consistent inverse correlation between broad US equity measures and the dollar’s value.

We’ve described Teeter Totter Monetary Theory before. The nexus of the Teeter of supply meeting the Totter of demand should determine prices.

But under the modern floating-rate currency construct, central bankers move the fulcrum, which is money, to balance out the teeter totter. To encourage investment (supply) increase the value of the dollar (also lifting productivity, something few in orthodox economics recognize). To fuel consumption, depress interest rates so people borrow more and save less.

The problem is these policies over time erode the veracity of stock prices – and the value of everything from debt to art to homes to money.

Yes, many economists will disagree. But the evidence is stark, as is the math. Goods are the numerator, dollars, the denominator. If the dollar depreciates, things like stocks and beer cost more. Increase its value – more purchasing power – and prices fall.

August has had a recent history of currency volatility.  August 2010 and August 2011 were rocked by the euro, which nearly failed. August 2015 brought a sudden Chinese currency devaluation and on the 24th a thousand Exchange Traded Funds were volatility halted. Stocks didn’t recover until October.

As August 2018 fades like summer grass, there are currents.  The dollar is strong and market-structure Sentiment is sluggish, positive now but without a vital mean-reversion. Options expire the 16th-17th and 22nd, a split cycle for derivatives. (NOTE: Speaking of August, don’t miss NIRI SWRC next week — I’ll be there.)

If stocks top into expirations with a rising dollar, we could have a hard mean-reversion to finish the summer. It’s no prediction, just a higher probability. And it’s not fundamental – yet another reminder that the stock market cannot be seen merely as an economic gauge.

 

Rules and Money

There are two pillars to market intelligence: The Rules, and The Money.

By market intelligence, I mean information about what’s pricing a stock. So, translating, information about what’s pricing a stock must derive from the rules that govern stock-trading, and how money conforms to those rules.

Wouldn’t that be supply and demand?  Would that it were! There are instead four big rules for stocks now, tenets of Regulation National Market System about which every investor and investor-relations officer should have a basic grasp.

“Quast,” you say. “This sounds about as exciting as cleaning a tennis court with a tooth brush. In Houston. In the summer.”

It can be very exciting, but the point isn’t excitement.  If you don’t know the rules (always expect your market intelligence provider to know the rules for stocks), your conclusions will be wrong.  You’ll be guessing.

For instance, if you report strong results and your stock jumps on a series of rapid trades, can a human being do that?  Refer to the rules. What do they require?  That all marketable trades – an order to buy or sell stock – be automated.

No manual stock order can be marketable. Manual orders are nonmarketable, meaning prices for the stock must come to them instead. Picture a block of cheese and a grater passing by it and shaving some off.

The rule creating this reality in stocks is the Order Protection Rule, or the Trade-Through Rule. Same thing. It says traders cannot trade at $21.00 if the same stock is available for $20.99 somewhere else. To ensure compliance, regulators have mandated that orders wanting to be the best bid to buy or offer to sell must be automated.

And the bid to buy will always be lower than the offer to sell. Stocks may only trade at them, or between them.  There can only be one best price (though it may exist in several places).

Now start thinking about what money will do in response.  Orders will be broken into pieces. Sure enough, trade size has come down by factors, and block trades (we wrote about it) are a tiny part of the market.

Big Commandment #2 for stocks is the Access Rule. It goes hand-in-glove with the first rule because it’s really what turned the stock market into a data network.

The Access Rule says all market centers including stock markets like the five platforms operated by the NYSE, the three owned by the Nasdaq, the four owned by CBOE, the newest entrant IEX, and the 32 broker markets that match stock trades must be connected so they can fluidly share prices and customers.

It also capped what exchanges could charge for trades at $0.30/100 shares – paid by brokers trading in the stock market for themselves or customers (the SEC Fee Pilot Program aims to examine if these fees, and their inverse, incentive payments, cause brokers to execute trades in ways they would not otherwise choose).

The third big rule outlaws Sub-Penny Pricing, or quoting in increments so small they add no economic value.  You may still see your stock trading at $21.9999 because of certain exceptions for matching at midpoints of quotes.

Reg NMS lastly imposed new Market Data Rules. Since everyone is sharing prices and customers on this network called the stock market, plans had to be refined for pooling data-revenue (prohibiting sub-penny trading was meant to prevent a proliferation of tiny meaningless prices).

Yet, data is a byproduct of prices. There are hundreds of millions of dollars of revenue governed by the Consolidated Tape Association, which divides proceeds according to how various platforms and brokers quote and trade in accordance with best prices. Outside the CTA, there may be billions of dollars now in proprietary data feeds.

These rules drive how money behaves. The fastest machines will price your stock to start the day no matter where you trade, because they have the quickest bids and offers. But their purpose is to profit on changing prices, not to own stocks.

Passive investment dominating the market is aided by rules. What lies between the bid and the offer? The average price. Those tracking benchmarks like index mutual and exchanged-traded funds get a boost toward their objective.  Prices become uniform (our data show very tight Poisson distribution in the stock market – which helps securities tracking benchmarks).

And because stock prices are highly unstable – average intraday spread in the Russell 1000 the past five trading days is 2.6%, and the typical stock trades over 16,000 times daily in 167-share increments – investors turn to substitutes like derivatives. Even Warren Buffett who once famously skewered them as instruments of mass financial destruction has large derivatives positions.

Let’s finish where we started. Why doesn’t supply and demand drive stock prices? Because rules governing trades don’t let supply and demand manifest naturally. The greatest proportion of trades are now driven by machines wanting to own nothing, the opposite of a market animated by supply and demand.

When you look at your stock or stocks in your portfolio, remind yourself: What’s driving them up and down are rules, and money racing around a course in compliance with those rules.  Some part is rational. A bunch of it isn’t.  We all – investors and public companies – can and should know what’s going on. The first rule, after all, is to be informed.

Welcome to the 21st century stock market.

Lab Knowledge

We are finally watching Breaking Bad five years after the most successful basic cable series in television history ended.

It’s symbolic of the era that we’re viewing it via Netflix. And NFLX Market Structure Sentiment is bottomed, and shorts have covered. We’ll come to market structure in a moment because it intersects with Breaking Bad.

Launched in 2008, Breaking Bad is about high school chemistry teacher Walter White, who turns to cooking methamphetamine to cover medical bills. He becomes Heisenberg, king of blue meth.

I won’t give the story away but what sets Walter White apart from the rest of the meth manufacturers is his knowledge of molecular structure. Let’s call it Lab Knowledge.  With lab knowledge, Walter White concocts a narcotic compound that stuns competitors and the Drug Enforcement Agency alike. He produces it in a vastly superior lab.

In the stock market there’s widespread belief that the recipe for a superior investment compound is the right set of ingredients comprised of financial and operating metrics of businesses.

Same goes for the investor-relations profession, liaison to Wall Street. We’re taught that the key to success is building buyside and sellside relationships around those very same financial and operating metrics.

There’s a recipe. You follow it, and you succeed.

Is anyone paying attention to the laboratory?

The stock market is the lab. Thanks to a total rewriting of the rules of its chemistry, the laboratory has utterly transformed, and the ingredients that underpin the product it churns out now are not the same ones from before.

I don’t mean to toot the ModernIR horn, but we did the one thing nobody else bothered to do.  We inspected the lab.  We studied the compounds it was using to manufacture the products circulating in the market (ETFs, high-speed trading, etc.).

And we saw that stock pickers were failing because they didn’t understand what the lab was producing. It was not that they’d stopped finding the historically correct chemical elements –financial and operating metrics defining great companies of the past.

It’s that these ingredients by themselves can no longer be counted on to create the expected chemical reaction because the laboratory is compounding differently.

And the difference is massive. The lab determines the outcomes. Write that down somewhere. The lab determines the outcomes. Not the ingredients that exist outside it.

So investors and public companies have two choices.  Start a lab that works in the old way.  Or learn how the current lab works. The latter is far easier – especially since ModernIR has done the work. We can spit out every manner of scientific report on the ingredients.

Back to market structure, before NFLX reported results it was 10/10 Overbought, over 60% short and Passive money – the primary chemical compound for investments now – was selling.  The concoction was destined to blow up.

Everyone blamed ingredients like weaker growth and selling by stock pickers, when those components were not part of the recipe creating the explosion in NFLX. Now, NFLX will be a core ETF manufacturing ingredient, and it will rise.

Investors, what’s in your portfolio?  Have you considered the simmering presence of the laboratory in how your holdings are priced?  And public companies, do you have any idea what the recipe is behind your price and volume?

If you want to be in the capital markets, you need lab knowledge. Every day, remind yourself that the ingredients you’re focused on may not be the ones the lab is using – and the lab determines the outcome. The lab manufactures what the market consumes.

One of the things we’ll be talking about at the NIRI Southwest Regional Conference is the laboratory, so sign up and join us Aug 22-24 in Austin.  Hope to see you there!

 

 

Shell Game

The earnings-versus-expectations construct that fixates Wall Street and business journalism as companies report results fuels bets on which shell hides the pea.

In fact, the stock market is built now on hiding the pea and moving the shells, apparent in the Fee Pilot debate we’ve written about recently.

You know the shell game, right?  This cat is pretty good at it.

As to picking the shell that hides the pea, I’m surprised the investor-relations profession isn’t up in arms over claims like Google parent Alphabet’s good numbers reputedly “boosting earnings optimism,” as one headline read.

What stock picker following GOOG trends and drivers and listening to its IR team and executives providing color and guidance didn’t know the quarter would be good? Keen observers didn’t wake up shouting, “Shazzam! I’m shocked at the numbers!”

But yesterday was Counterparty Tuesday, the one day every month when banks backing directional bets – most very short term – square derivatives books. Every third month it falls amidst earnings. If your bets are right, you get paid. Wrong, you pay up.

Banks shuffle assets accordingly. Yesterday, blue chips were up (GOOG is one now), risky stocks were down.

Take the new Communications Services ETF, XLC (see here in sector ETFs), which presages a reshuffling of Consumer Discretionary and Technology stocks into a re-imagined and amalgamated General Industry Classification System (GICS) for everything from Twitter, to Disney, to Facebook, to Electronic Arts that officially hits markets Sep 21, 2018.

Just four companies accounted for XLC gains yesterday if you view Alphabet’s two stock classes as a single company. Alphabet is 24% of the ETF’s weighting. With Facebook, two stocks are 45% of purported assets (read our ETF White Paper for more on “assets”).

The others with gains were VZ and T, two of the spare coterie comprising the old Telecom GICS that’s going away.  Combined the five green elements of XLC yesterday are 54% of its weighting. The other 21 were all in the red.

If you bet on GOOG and you pile in regardless of numbers, your bet pays because GOOG is so massive that as counterparties cover, it drives the entire market up. No wonder betting abounds.

But it’s not fundamentals. It’s betting on the law of large numbers.

Coming back to the Fee Pilot proposed by the SEC to study whether trading incentives distort how orders are handled, we support it because Fast Traders turn the market into a shell game.

Take HRT Financial, a top high-speed trader. We’ve got nothing against the smart folks behind it. But look up its 13F reports. It trades many billions of shares of stocks every month yet owns almost nothing – a measly few hundred million dollars.

Public companies are led to believe that having a bunch of prices set by high-speed firms that don’t want to own anything is good. Well, where do they get shares to sell to investors?  They borrow most of them – from owners! If they didn’t, it would show up as ownership. Or they buy them elsewhere in the market, in tiny pieces, in fractions of seconds, and immediately sell them. They are moving the shells, not fostering a market with deep supply.

It all fits together.  The earnings-versus-expectations model shifts focus from long-term prospects to how something fluctuates.  What is betting on fluctuations? Arbitrage.

Next piece of the puzzle:  How are prices set in the stock market?  By the fastest order bidding to buy or offering to sell. Fast machines like those run by HRT Financial set prices in tiny increments.  Exchanges offer incentives to high-speed traders to set prices in tiny increments – to keep moving the shells, keep that pea in motion, keep fooling people about where the best price is.

And exchanges sell the data from this shell game because rules require everybody in pursuit of the pea to buy it to prove they’re not gaming their customers. It would be laughable if it weren’t true, and describing the stock market.

Three big lessons, investors and public companies. Number one, you’ve got to have better data than the operators of the shell game if you want to keep track of the pea.  And we’ve got it.  Number two, don’t trust a shell game to give you an accurate portrayal of either business fundamentals or future outcomes.

And number three, the best defense against any form of shell game is knowledge. Education. Knowing how the game works. I refer you to the cat above. If the cat can figure it out, so can we!  Market Structure knowledge is now essential for both investors and public companies.

Moon Rules

We spent last week in Summit County, famous for Breckenridge and Keystone. With windows open and the sun set, the temperature at 9,000 feet drops fast, great for sleeping.

It’s not great for staying awake reading a Kindle but I worked through some exciting pages of Artemis, the new novel by Andy Weir, who wrote The Martian, made into a Ridley Scott movie starring Matt Damon.

And yes, Artemis got me thinking about market structure. Not because of the profanity, the ripping pace, the clever characters, the exotic settings.  It’s a book set on the moon, where scientific rules matter.

Weir’s genius is the application of science to clever storylines. On the moon, if you want to commit a crime to save the community, you better understand how to blend acetylene and oxygen in zero atmosphere. Fail to follow or understand the rules, you die.

It’s not life and death in the stock market but rules play the same supreme role in dictating outcomes. If as public companies you think your story will determine the outcome for your stock, the rules will humble you.  How much of your trading volume comes from Active Investment? You can and should know – and it’s not what you’d think. But that’s not the point of being public, is it.  So don’t be afraid.

If you’re an investor and you think fundamentals will pace you to superior results, think again. The amount of money choosing company financials has plunged, while funds indexing to markets has mushroomed. Rules helping models will eat your lunch.

What rules? Start with Regulation National Market System. It creates a marketplace that forces revenue-sharing among intermediaries. Professional sports like basketball in the USA also operate with rules that shift focus from playing the sport to managing salary cap (Denver just traded three Nuggets for that reason).

If you don’t know this, you’ll have a false understanding of what drives the sport. The “haves” must distribute funds to the “have nots.” Some owners in money-losing markets might choose to skimp on salary to scrape mandated distributions from teams making bank (I wonder what the NBA Cavaliers will do now?).

Right now, stock market sentiment reflecting not the opinions of humans but the ebb and flow of money and the way machines price stocks (the rules, in other words) is topping again as it did about June 12. Options expire today through Friday.  So, no matter what you expect as earnings commence, the market will have a propensity to decline ahead.

It’s like the rules on the moon.  In one-sixth of earth’s gravity, harsh sun, no atmosphere, success depends on knowing how stuff works. Investors and public companies, welcome to the moon. You can’t treat it like earth. Rules determine outcomes. If your actions don’t account for the rules that govern how markets function, outcomes will reflect it.

But it’s fun on the moon once you know what you’re doing. It’s fun knowing when the market is topped, and bottomed, on rules. It’s fun doing investor-relations when you know what all the money is doing.  So, come on up to zero atmosphere! It’s not scary.

Block Monopoly

This year’s rare midweek July 4 prompted a pause for the Market Structure Map to honor our Republic built on limited government and unbounded individual liberty. Long may it live.

Returning to our market narrative: Did you know that 100% of Exchange Traded Fund creations and redemptions occur in block trades?

If you’ve got 48 minutes and a desire to understand ETFs, catch my podcast (you can get our ETF White Paper too) with IR Magazine’s Jeff Cossette.

In stocks, according to publicly reported data, three-tenths of one percent (0.03%) of NYSE trades are blocks (meaning 97.7% are non-block).  The Nasdaq compiles data differently but my back-of-the-envelope math off known data says blocks are about the same there – a rounding error of all trades.

Blocks have shrunk due to market regulation. Rules say stock trades must meet at a single national price between the best bid to buy and offer to sell.  That price relentlessly changes, especially for the biggest thousand stocks comprising 95% of volume and market cap (north of $2.5 billion to make the cut) so the amount of shares available at the best price is most times tiny.

We track the data.  At July 9, the average Russell 1000 stock traded 13,300 times per day in 160-share increments.  If you buy and sell shares 200 at a time like high-speed traders or algorithmic routers that dissolve and spray orders like crop-dusters, it’s great.

But if you buy cheese by the wheel, so to speak, getting a slice at a time means you’re not in the cheese-wheel buying business but instead in the order-hiding business. Get it? You must trick everybody into thinking you want a slice, not a wheel.

The cause? Market structure. Regulation National Market System, the regime governing stock trades, says one exchange must send to another any trade for which a better price exists there (so big exchanges pay traders to set price. IEX, the newest, doesn’t).

Put simply, exchanges are forced by rules to share prices. Exchanges cannot give preference to any customer over another.

ETFs get different rules. Shares are only created in blocks, and only traded between ETF creators and their only customers, called Authorized Participants.

I’m not making this up. When Blackrock wants more ETF shares, they create them in blocks only.  From Blackrock’s IVV S&P 500 ETF prospectus: Only an Authorized Participant may engage in creation or redemption transactions directly with the Fund. The Fund has a limited number of institutions that may act as Authorized Participants on an agency basis (i.e., on behalf of other market participants).

Why can ETFs offer preference when it’s against the law for exchanges? Fair question. There is no stated answer. The unstated one is that nobody would make markets in ETFs if a handful of firms didn’t have an unassailable competitive advantage, a sure chance to make money (why ETF fees are so low).

Again from the IVV prospectus:

Prior to trading in the secondary market, shares of the Fund are “created” at NAV by market makers, large investors and institutions only in block-size Creation Units of 50,000 shares or multiples thereof.

Each “creator” or authorized participant (an “Authorized Participant”) has entered into an agreement with the Fund’s distributor, BlackRock Investments, LLC (the “Distributor”), an affiliate of BFA. A creation transaction, which is subject to acceptance by the Distributor and the Fund, generally takes place when an Authorized Participant deposits into the Fund a designated portfolio of securities (including any portion of such securities for which cash may be substituted) and a specified amount of cash approximating the holdings of the Fund in exchange for a specified number of Creation Units.

And down a bit further (emphasis in all cases mine):

Only an Authorized Participant may create or redeem Creation Units with the Fund. Authorized Participants may create or redeem Creation Units for their own accounts or for customers, including, without limitation, affiliates of the Fund.

Did you catch that last bit? The creator of ETF shares – only in blocks, off the secondary market (which means not in the stock market) – may create units for itself, for its customers, or even for the Fund wanting ETF shares (here, Blackrock).

And the shares are not created at the best national bid to buy or offer to sell but at NAV – Net Asset Value.

Translating to English: ETF shares are created between two cloistered parties with no competition, off the market, in blocks, at a set price – and then sold to somebody else who will have to compete with others and can only trade at the best national price, which continually changes in the stock market, where no one gets preference and prices are incredibly unstable.

It’s a monopoly.

Two questions:  Why do regulators think this is okay? The SEC issued exemptive orders to the 1940 Investment Company Act (can the SEC override Congress?) permitting it.

We wrote about the enormous size of ETF creations and redemptions. Which leads to Question #2: Why wouldn’t this process become an end unto itself, displacing fundamental investment?

The Actionable Hoax

What’s actionable?

It’s a buzzword of business and the investor-relations profession. And, yes, my title violates a rule of grammar because you can’t tell if the topic is a hoax about actionability or if a hoax out there has proved actionable.

We’ll answer using the market. Like this: Trade-war threats are wrecking markets!  Right?

Wrong.  Pundits tying moves in the market to headlines don’t understand market structure. Suppose you’re getting “actionable” information from pundits who don’t know how the market works. Are the recommended actions reliable?

While you ponder that, consider this: If trade concerns for tech stocks caused the correction in February, why did the Nasdaq hit an all-time high June 20? Did the same money that rejected the market back then on trade fears three months later without resolution to those concerns pay more?

You can say, “No, they were sellers.” Okay, so who bought?

Market experts are often offering actionable intelligence based on outdated ideas. But they have a duty to understand how the market works and what the money is doing.

In fact, these two pillars – how the market works, what the money is doing – should be the bedrock for understanding markets.

What’s the money doing?  It’s not choosing to be directed by rational thought. We know  because a vast sea of data on fund flows tells us so. If we as investors or investor-relations practitioners continue doing what we did before fund flows surged to passive money, who is the bigger fool?

Exchange Traded Funds (ETFs) are driving 50% of market volume now. They are passive vehicles. But they uniquely among investment products permit ETF creators like Blackrock and Vanguard a step-up in tax basis through creation and redemption.

How? Say NFLX is up 100% in three months, imputing tax costs to ETF shares. Creators of ETFs collateralized by NFLX shares will put it in redemption baskets exchanged to brokers for returned ETF shares.  (NOTE: If you don’t know how ETFs work, ask us for our ETF whitepaper.)  NFLX then plunges as brokers sell and short it.

Five days later, the ETF creator can bring NFLX back now in a creation basket of new ETF shares that it will issue only in exchange for NFLX – laundered of tax consequences.

Apply this to the Technology sector (or the whole market for that matter).  We just had Russell index rebalances, and Technology is a big part of market cap.  S&P indices rebalanced June 22 and Technology is over 25% of the S&P 500 now.

This week is quarter-end window-dressing. ETFs are trying to bleed taxes off runups in Tech stocks.  We could see it coming in Sentiment by June 14, when it topped, signaling downside, and when behavioral volatility indicated big price-swings. Data say we have another rough day coming this week.

Headlines may help prioritize what gets tax-washed, so to speak, but the motivation is not investment. It’s aiming at picking gains and packing off tax consequences.

The market is driven far more by these factors than rational thought, which we know by studying the data. ETF creations and redemptions are hundreds of billions of dollars monthly. Inflows and outflows from buy-and-hold funds are nonexistent by comparison.

Ergo, it can’t be rational thought driving the market no matter the talking heads declaiming trade threats.

It’s what lawyers call a “fact pattern.” ETFs dominate passive investment, drive 50% of market volume, depend on tax efficiency, which process is an arbitrage trade that involves a continual shift of hundreds of billions monthly in underlying assets, and a corresponding continual shift in collateralizing assets called stocks – with market-makers profiting, and ETF creators profiting – without regard to market direction.

It’s poor fodder for a 24-hour news cycle. But it explains market behavior. Moves have become more pronounced because money stopped pouring into US equities via ETFs this year. Volatility exploded because getting tax efficiency got harder.

Which brings us to the “actionable” hoax. The word “actionable” says consumers of products or services are fixated on a prompt, a push, an imprimatur.

Fine. But flinging the word around causes investors and IR professionals to miss what matters more, and first.  Investors and public companies should be asking: “How does this service or that tool help me understand what the money behind stocks is doing?”

Ask your service provider to explain how your stock trades. Then ask us to explain it.

If they don’t match, ask why. The beginning point of correct action is an understanding of what you can and cannot control, and how the environment in which you operate works.

Take the weather. We can’t control it. But it determines the viability of our actions. The same applies to understanding market structure. It determines the viability of actions.

If you want to learn market structure, ask us how, IR professionals and investors.  It’s the starting point. What you think is actionable may be a hoax. Compare how the market works to what you’re doing. Do they match? If not, change your actions. We’ll help you.