Rotation

There’s a story going around about an epochal rotation from momentum (growth) to value in stocks. It may be a hoax.

I’ll explain in a bit. First the facts. It began Monday when without warning the iShares Edge MSCI USA Value Factor ETF (VLUE) veered dramatically up and away from the iShares Edge MSCI USA Momentum Factor ETF (MTUM).

CNBC said of Monday trading, “Data compiled by Bespoke Investment Group showed this was momentum’s worst daily performance relative to value since its inception in early 2013.”

The story added, “The worst performing stocks of 2019 outperformed on Monday while the year’s biggest advancers lagged, according to SentimenTrader. This year’s worst performers rose 3.5% on Monday while 2019’s biggest advancers slid 1.4%, the research firm said.”

A tweet from SentimenTrader called it “the biggest 1-day momentum shift since 2009.”

It appeared to continue yesterday. We think one stock caused it all.

Our view reflects a theorem we’ve posited before about the unintended consequences of a market crammed full of Exchange Traded Funds, substitutes for stocks that depend for prices on the prices of stocks they’re supposed to track.

To be fair, the data the past week are curious. We sent a note to clients Monday before the open. Excerpt:

“Maybe all the data is about to let loose. It’s just. Strange.  Fast Trading leading. ETFs more volatile than stocks. Spreads evaporating. Sentiment stuck in neutral. More sectors sold than bought….Stocks should rise. But it’s a weird stretch ahead of options-expirations Sep 18-20.  It feels like the market is traversing a causeway.”

That stuff put together could mean rotation, I suppose.

But if there was a massive asset shift from growth to value, we’d see it in behavioral change. We don’t. The only behavior increasing in September so far is Fast Trading – machines exploiting how prices change.

What if it was AT&T and Elliott Management causing it?

If you missed the news, T learned last weekend that Activist investor Elliott Management had acquired a $3.2 billion stake in the communications behemoth and saw a future valuation near $60.  On that word, T surged Monday to a 52-week high.

T is the largest component of the MSCI index the value ETF VLUE tracks, making up about 10% of its value.  ETFs, as I said above, have been more volatile than stocks.

Compare the components of MTUM and VLUE and they’re shades apart. Where T is paired with VLUE, CMCSA ties to MTUM, as does DIS.  MRK is momentum, PFE is value. CSCO momentum, INTC, IBM value. PYPL, V, MA momentum, BAC, C, value.

Look at the market. What stuff did well, which did poorly?

The outlier is T. It’s a colossus among miniatures. It trades 100,000 times daily, a billion dollars of volume, and it’s been 50% short for months, with volatility 50% less than the broad market, and Passive Investment over 20% greater in T than the broad market.

T blasted above $38 Monday on a spectacular lightning bolt of…Fast Trading. The same behavior leading the whole market.  Not investment. No asset-shift.

What if machines, which cannot comprehend what they read like humans can, despite advances in machine-learning, artificial intelligence (no learning or intelligence is possible without human inputs – we’re in this business and we know), improperly “learned” a shift from growth to value solely from T – and spread it like a virus?

Humans may be caught up in the machine frenzy, concluding you gotta be in value now, not realizing there’s almost no difference between growth and value in the subject stocks.

Compare the top ten “holdings” of each ETF. Easy to find. Holdings, by the way, may not reflect what these ETFs own at a given time. Prospectuses offer wide leeway.

But let’s give them the benefit of the doubt. What’s the difference between MRK and PFE? V, MA, and PYPL and C, BAC and, what, GM and DIS?

Stock pickers know the difference, sure.  Machines don’t. Sponsors of ETFs wanting good collateral don’t.  Except, of course, that cheap collateral is better than expensive collateral, because it’s more likely to produce a return.

Such as: All the worst-performing stocks jumped. All the best-performing stocks didn’t.

What if this epochal rotation is nothing more than news of Elliott’s stake in T pushing a domino forward, which dropped onto some algorithm, that tugged a string, which plucked a harp note that caused fast-trading algorithms to buy value and sell momentum?

This is a risk with ETFs. You can’t trust signs of rotation.

We have the data to keep you from being fooled by machine-learning.

Liquidity

Want a big ranch out west?

Apparently you don’t. The Wall Street Journal last month ran a feature (subscription required) on the mushrooming supply of leviathan cattle operations from Colorado to Idaho, legacy assets of the rich left to heirs from the era of Ted Turner and John Malone.

A dearth of demand is saddling inheritors with big operating expenses and falling prices.  Cross Mountain Ranch near Steamboat Springs, CO is 220,000 acres with an 11,000 square-foot house that costs a million dollars annually to run. It can be yours for a paltry $70 million, $320 an acre (I wonder if that price holds for a thousand?).

What have cattle ranches got to do with the stock market?  Look at your holders, public companies.  What’s the concentration among the largest?

The same thing that happened to ranches is occurring in stocks.  The vast wealth reflected in share-ownership came considerably from generations now passing on inheritance or taking required minimum distributions. The youngsters, at least so far, aren’t stockowners. They’re buying coffee, cannabis and café food.

Juxtapose that with what we’ve been saying about liquidity in stocks, and as the WSJ wrote today.

Liquidity to us is how much of something can be bought or sold before the price changes.  Those landed dynasties of western dirt are discovering people eschew large land masses and monolithic homesteads.

In stocks, the same is true.  Back up five years to Sep 4, 2014. The 200-day (all measures 200-day averages) trade size was 248 shares and dollars/trade was $17,140. Short volume was about 42%, the average Russell 1000 stock traded about $230 million of stock daily. And intraday volatility, the difference between highest and lowest daily prices, was about 2.2%.

Five years later? Average trade-size is 167 shares, down 33%.  Dollars/trade is down 26% to $12,760. Shorting is nearly 47% daily. Dollars/day is down 17% to $170 million. Volatility is up 32% to 2.9% daily.

But market-capitalization has increased by some 40%.  It’s as though the stock market has become a giant ranch in Colorado teetering over millennials loitering in a coffee shop. No offense, millennials.

Every investor and public company should understand these liquidity characteristics because they increase risk for raising capital or making stock investments.

Why is liquidity evaporating like perspiration out of an Under Armor shirt?

Rules and behaviors. Rules force brokers – every dollar in and out of stocks passes through at least one – into uniform behavior, which decreases the number capable of complying. Picture a grocery store near dinnertime with just three checkout lanes open.

In turn, concentration means more machination by brokers to hide orders. They break them into smaller pieces to hide footsteps – and machines become more sophisticated at interrupting trades in ever smaller increments to reveal what’s behind them.

And all the liquidity measures shrink. We see it in the data. A blue bar of Active Investment rarely manifests without an array of orange bars swarming to change prices, Fast Traders who have detected the difference in the data where human influence drives machine behavior.

What can you do, public companies and investors?  Prepare for bigger and unexpected gyrations (volatility erodes investment returns and increases equity cost of capital).

Examples: HRB reported results before Labor Day. The quarter is fundamentally inconsequential for a company in the tax-preparation business. Yet the stock plunged. Drivers?  Shares were 71% short and dominated by machines setting prices and over 21% of trading tied to short derivatives bets.

Those structural facts cost holders 10% of market cap.

Same with ULTA. While business conditions might warrant caution, they didn’t promote a 30% reduction in equity value.  Market structure did it – 58% short, 55% of total volume from machines knowing nothing about ULTA and paying no heed to the call.

We have the data. Market structure is our sole focus. No public company or investor should be unaware of liquidity factors in stocks and what they predict.

Put another way, all of us on the acreage of equities better understand now that vast tracts of value are tied up by large holders who don’t determine the price of your stocks anymore than your grandfather’s capacity to buy 100,000 acres will price your big Wyoming ranch now.

What does is supply and demand. And liquidity is thin all over.  Data can guard against missteps.

 

Beneath the Surface

I don’t think it should be overlooked that “Quants” and “Quasts” differ by only a letter.

Scott Patterson’s 2010 book, The Quants, is a great read.  You’ll be riveted by what was cascading beneath the market’s surface before the financial crisis.  Here’s a taste:

“That Wednesday, what had started as a series of bizarre, unexplainable glitches in quant models turned into a catastrophic meltdown the likes of which had never been seen before in the history of financial markets….

“Oddly, the Bizarro World of quant trading largely masked the losses to the outside world at first, since the stocks they’d shorted were rising rapidly, leading to the appearance of gains on the broader market that balanced out the diving stocks the quants had expected to rise.

“Monday, the Dow Industrials actually gained 287 points. It gained 36 more Tuesday, and another 154 points Wednesday. Everyday investors had no insight into the carnage taking place beneath the surface, the billions in hedge fund money evaporating.”

Key phrase:  Beneath the surface.

What the market appears to be saying may be the opposite of what gurgles in its depths.

It’s why we say price and volume are CONSEQUENCES, not metrics.  What’s causing price or volume to change?  This is the question every public company, every investor, should answer today (we have that data, so there’s no reason to go begging!).

Take the broad market Monday, with the Dow Industrials up 260 points. Cause? Risk Mgmt – counterparties to bets, covering their exposure.

And shorting rose. Yesterday, 47% of all volume marketwide was borrowed – short.  Intraday volatility, the average move from highest to lowest price, is 3%.

That’s 50% of market volume, combined. Can the market sustainably rise if half its volume depends on lower or fluctuating prices?  Well, it’s not impossible. But probability is poor.

High shorting doesn’t mean the market will tank. But short-covering is necessary for shares to rise.  Consider Jan 2018.  Shorting dropped, volatility vanished, stocks surged.

The VIX (coming volatility destroyed two synthetic ETFs), price and volume, gave everyday folks no clue to the looming maw.  But under the surface the gurgling hit a fever pitch. Market Structure Sentiment, our 10-point gauge of price peaks and troughs, topped Jan 19. Behavioral change was a black swan – more than three standard deviations from norms.

Behavioral change is the daily demographic evolution in the money behind price and volume. A surge is a stampede – with delayed effects. Sentiment usually says which way.

On Jan 22, the market’s Chernobyl core melted under a staggering six-standard-deviations move in behaviors.  The market continued to rise. Nobody on CNBC was warning people.

By mid-February, from peak to trough the S&P 500 fell over 10%.

On Sep 19, 2018, Market Structure Sentiment topped weakly, not even regaining 6.0 (the market trades between 4.0-6.0 most of the time).  Black swans crashed through behavioral-change Sep 14-19.  The market kept rising.

Sep 25-28, behavioral-change demolished every record we’d ever seen, cascading daily at an average six standard deviations over norms.  SPY, the S&P 500 ETF, hit 293.58 Oct 1, 2018.  Yesterday it closed at 286.87.

From its Oct 1 zenith to the Dec 24 nadir of 234.34, SPY declined 20.2%.

SPY reached an all-time peak Jul 15, 2019 as Market Structure Sentiment topped just over 6.0. And yup, you guessed it. Black swans flapped in Jul 31 and Aug 1. Another struck Aug 13.

Why has the market become so mathematical? Behaviors.  All trades must occur between the best bid and offer, and the bid must be lower. Somebody can make a half-penny on each side of the trade – the aim of Fast Traders.  Arbitrage.

ETFs have ten TIMES the assets they did in 2008 — $4 trillion in the US alone, the bulk in equities. There’s one ETF for every four companies. ETFs depend on arbitrage for prices.

Derivatives are an arbitrage trade. What is something worth now versus what it might be in the future?  Put these all together.  It’s 87% of volume. The market runs on arbitrage. Continuously differing prices.

It’s transformative to see, beneath the surface, why your stocks behave as they do.  Then what, public companies?  You have a duty to know what the money is doing and to understand when it’s story and when it’s not. That’s a puzzle solved only with data.

Investors, if you’re one day wrong, you can lose your gains.  Data are protection.

When you’re ready to go spelunking, let us know.

Interesting Year

“It’s going to be an interesting year.”

We wrote that phrase in the Jan 2, 2019 edition of the Market Structure Map. (By the way, we’re in Rhode Island this week visiting customers, and in Newport you’ll see the sea in everything.)

I don’t mean to suggest we’re amongst those arrogant buffoons quoting themselves. I do think we drew the right line from Dec 2018 to the future. We noted, and it’s worth reading, that the Federal Reserve had shut down the Maiden Lane financial entity used to buy assets from AIG. An epochal event.

We said it could mark a top for the inflationary arc in risk assets spawned by the flood of cheap central-bank money.  We’ve had no gains in stocks from Sep 20, 2018 to present.

In December last year, pundits blamed the market maelstrom on impending recession. It was false then and it’s false now. Sure, all economies contract – fall into recession.  It wasn’t a uniformly engrossing event before central banks, though.

The human propensity to borrow and spend on growth, which at some point slows, leading to the collapse of borrowers and lenders alike, is normal and not something we should be trying to eradicate by juicing credit markets.

The bigger the credit wave, the farther the economic surfboard skims, and everyone marvels at the duration of the expansion cycle. And then the wave dies on the shoals. We’re now riding it, wind in our hair, with a vast curl beginning to form overhead.

But that’s not what sparked the market’s volatile descent.

One client (thank you!) shared notes from a JP Morgan conference call on recent volatility. JPM says economic underpinnings are reasonably sound and no cause for market troubles. Hedging strategies leading to the consumption of fixed income securities and sale of equities generated market duress (and skyrocketing bond prices), says JPM.

What prompted hedging strategies to change?  The cries of “recession!” didn’t commence until the market had already plummeted.

The same thing happened last December. After the market tanked, people were searching for reasons – failing to consider the structure of markets today and once again errantly supposing rational thought was at fault – and decided that so large a drop could only mean economic contraction had arrived.

It had not.

Think about how incorrect premises cost public companies money. There’s lost equity value. Higher equity cost of capital on volatility. Time and money spent messaging to the market about recession defenses.

CNBC had data yesterday on the spiking occurrence of Google searches around “the R word,” as they say.  No doubt a chunk of readers were searching earnings-call transcripts and press releases for it.

Behavioral data show no evidence of rational thought behind the market’s decline. Passive Investment plunged 20% the week ended Aug 2.  Stocks cratered.

Further, our data show the same thing JPM discussed. At Aug 19, order flow related to directional bets is down 11% versus the 200-day average. Occurring with expiring August options and newly trading September instruments Aug 15-21, it’s telling. Bets and hedges have gone awry. Low volatility schemes have failed. Insurance costs are up.

Low volatility investing is the most popular “smart beta” technique used to beat general market performance with rules-based investments. The dominance of smart beta is largely responsible for the outperformance of Utilities stocks tied to smart beta Exchange Traded Funds (ETFs.). Those strategies failed in August.

Volatility bets like the VIX expire today, Aug 21.

We can often peg the amount a stock will fall on bad earnings news to the percentage of market-cap tied to derivatives. Why? If future prices become indeterminate, the value of the instruments predicated on them declines near zero.

Currently, 16.4% of market cap traces back to derivatives and leverage, such as borrowing, down from pre-August levels over 18%. Volatility clouds predictability. The cost of leverage and protection increases, while use diminishes.

What if the market fell because Passive money was overweight equities and overdue for rebalancing, and stopped buying stocks in late July, which caused a gut-lurching swoon, which in turn rendered hedges worthless?

Talk of recession is a consequence of the market’s decline. Not causality.  Think about your own stock, IR professionals. Do you understand what drives it?  Investors, if you weight your portfolio for a recession that doesn’t exist, you’ll be wrong.

Our premise Jan 2 was that the end of Maiden Lane was the end of a monetary era, and it had the potential to create an interesting year. So far, seems right.  We also know what kind of money is waxing or waning. You should too. It’s not just interesting. It’s essential to correct actions.

Why Traders Trade

Albert Einstein reputedly quipped that compounding was the 8th wonder of the world. What would he think of negative interest rates?

The 10-year German government bond yield is -0.61%. The Rule of 72, which nobody mentions now, says dividing 72 by the expected rate of investment return tells you when it’ll double. At 6%, that’s 12 years. At 2%, 36 years. Try compounding negative rates.

Believe it or not, the stock market is weirder still.

Volatility in US stocks averaged 3.4% daily the past week, 55% higher than the risk-free return of 2.2% for 30-year US Treasurys.

Plug those figures into an equity cost of capital calculation where the expected return is 8%.  You with me?  It’s 22%!  So, the interest you earn on cash has vanished while the cost of raising it in public markets has exploded.

You may say, investor-relations professionals, there’s no way my equity costs 22%.  The truth is, volatility introduces value-uncertainty, which both increases what you pay for money, and on the other side, decreases returns on it.

University of Chicago professors Eugene Fama, who won a Nobel Prize in 2013, and Kenneth French, who also serves as head of investment policy for quant investor Dimensional Fund Advisors, co-authored a paper describing how equity-market volatility diminishes the apparent superiority of equities over bonds.

To wit, three-month Treasury Bills are returning 2% annualized. The S&P 500 since Sep 20, 2018 is down 0.4% even after yesterday’s gains. What if you’d sold Monday when the Dow Industrials dropped 391 points and bought yesterday when they rose 372? One day can make or break returns for investors.

Same for public companies. Say you issued stock in Dec 2018 and implemented an aggressive buyback in Jan 2019.  On the wrong side of the market, cost of capital skyrockets.

Rather than rationalizing market behavior, we should be asking why it’s become so volatile. And yes, it’s vastly more so now than during earlier epochs.

The answers? Rules. Stocks must trade between the best bid to buy and offer to sell, which cannot be the same. Thus, machines change prices. They’re 45% of volume.

On top of that, stock exchanges give firms economic incentives to trade stocks and derivatives simultaneously, accelerating the rate of change for prices.

For instance, the Nasdaq pays traders with more than 0.6% of sell volume (they call it adding liquidity but it’s paying traders to set the offer, the highest price for a stock) $0.29 per hundred shares.

Sell 1.75% of Nasdaq volume, with 0.6% in derivatives like options and futures, and if that amount is 0.1% of total Nasdaq derivatives volume, the exchanges pays $0.32 per hundred shares. That’s a 10% kicker for more prices.

Now add Exchange Traded Funds, which have no intrinsic value and depend for prices on the stocks that collateralize them. The two – stocks, and ETFs – are always a bit out of step.

Take Energy stocks last week.  XLE, a big Energy ETF, was down 2.2%. But composite Energy stocks were down 5.5% – a spread of 150%!

Capture half that by buying the ETF and selling the stocks, and it’s a 75% return.  No wonder traders trade.

ETFs drive what we estimate is 60% of total market volume now. ETFs exist via a regulatory exemption from the Investment Company Act of 1940 permitting them to trade as stock substitutes around an “arbitrage mechanism.”

That is, they depend on changing prices. There are thousands of ETFs, worth trillions of dollars. It’s a mania.

I’ll summarize: Market rules and investment behavior built on continually changing prices have transformed the market from a place where long-range horizons are the objective, to one where continuously changing prices are the objective.

Changing prices is the definition of volatility. Traders trade to profit on it. They rule.

What we expect from the stock market should derive from these facts. Public companies and investors alike should adapt. How? Understand the ebbs and flows and surf them like waves (we have that data). Modulate your buybacks, your stock issuances, your tactical investor-outreach, your investment decisions, to reflect behavioral facts.

Investors and public companies could also band together to petition the SEC to stop giving arbitrage a leg up.  The first step toward that goal is understanding how and why the market’s focus is now today’s spread, not tomorrow’s capital appreciation. I’ve explained it.

Mark Twain would say: Is the market run by smart people who are putting us on or imbeciles who really mean it?

Yet Arrived

Bula!

That’s Fijian for “greetings!” You say it “boo-lah.” Fiji is among the friendliest places on the planet. Karen and I are just back from the South Pacific, as this compilation illustrates.  Do you know it’s traditional in Fiji to invite anyone passing by to breakfast?

Maybe that’s the answer to the world’s woes.

And maybe we should have stayed out to sea!  Our first day back the market tumbled.

We left you July 18 with our concern that the market had become a runaway train. In a private client note Jul 19 as options expired we said, “Right now, the data say the market will next tick up. If it’s a weak top – check page 3 of your Market Structure Reports – we could have trouble. At this moment, I don’t think that’s set to occur. Yet.

Well, “yet” arrived.

Is it possible to know when yet is coming?

Yes. At least the way one knows a storm front is forming. It’s not mystical knowledge. It’s math. Weather forecasters track patterns because, as it turns out, weather is mathematical.  It follows rules that can be modeled.

We put a man on the moon 50 years ago because escaping gravity and traveling four days at predictable velocity will get you there. It’s math – which smart people computed on devices less powerful than your smart phone.

Even human behavior, which isn’t mathematical, can often be predicted (somebody needs to develop a model for mass-shooting nutcases). For instance, in the stock market rational people predictably buy weakness and sell strength.

What kind of money sells weakness and buys strength? We’ll come to that.

Conventional wisdom says stocks imploded because a) people wanted the Federal Reserve to cut rates Jul 31 more than it did, b) President Trump tweeted about Chinese tariffs, c) and the Chinese retaliated by letting the yuan slide.

Relative currency values matter. We’ve written often about it. The pandemonium routing equities Aug 24, 2015 followed a yuan devaluation too. Stocks inversely correlate with the dollar because currencies have no inherent value today.

So if the supply of dollars rises, the value of the dollar falls, and the prices of assets denominated in dollars that serve as stores of value, such as stocks, rise. Value investor Ron Baron said he puts depreciating assets, dollars, into appreciating assets, stocks.

With dollars increasing, the relative value of other currencies like the euro and the yen rises, so prices of goods denominated in them fall – which governments and central banks interpret as “a recession,” leading to interest-rate cuts, negative bond yields, banks buying stuff to create money, and other weirdness.

Makes you wonder if these central planners actually understand economics.

I digress. That’s not the root reason why stocks rolled over. Headlines, Fed actions and currencies don’t buy or sell stocks. People and machines do.

The majority of the money in the market pegs a benchmark now – machine-like behavior. Market Structure Sentiment, our index for short-term market-direction, has been above 5.0 for an extended period without mean-reversion.

That matters because money tracking a measure must rebalance – mean-revert. If it goes an unusual stretch without doing so, risk of a sudden mean-reversion rises.

We saw the same condition before stock-corrections in Jan 2016, June 2016 around Brexit, ahead of the US election in late Oct 2016, in Jan 2018, and in Sep 2018. Each featured an extended positive Sentiment run with a weak top, as now.

The week ended Aug 2 also had another mathematical doozy: Exchange Traded Fund flows as measured not by purchases or sales of ETFs but market-making by brokers plunged 20%.  In some mega capitalization stocks it was the largest decline in ETF flows since early Dec 2018.

Passive money buys strength, until it stops. When it stops, weakness often follows. And if it has not rebalanced, it sells weakness because weakness means deteriorating returns.

The last day of trading every month is the most important one for money tracking benchmarks. That was July 31. Stocks deteriorated in the afternoon. Pundits blamed Jay Powell’s comments. What if it was long overdue rebalancing on the last trading day?

That selling coupled with a big overall decline in ETF flows converged with a currency depreciation Monday, and whoosh! What yet we feared arrived.

And yet. It’s not fundamental. Why does that matter? Monetary policy, portfolio positioning, and economic predictions may be predicated on a false premise that rational people had unmet expectations.

I think that’s a big deal.

So. Since yet has arrived, is yet over?  Data say no. It’s a model with predictiveness that may be a step ahead or behind. But a swoon like this should produce a mean-reversion. That’s not – yet – happened.

With that, I say Bula! And if you’re in the neighborhood, drop by for breakfast on us.

Unstoppable

Any of you Denzel Washington fans?

He starred in a 2010 movie loosely based on real events called Unstoppable, about a runaway freight train (I have Tom Petty’s “Runaway Train” going through my head).

In a way, the market has the appearance of an unstoppable force, a runaway train.  On it goes, unexpectedly, and so pundits, chuckling uncomfortably, try to explain why.

Tellingly, however, in the past month, JP Morgan said 80% of market volume is on autopilot, driven by passive and systematic flows.  Goldman Sachs held a conference call for issuers on what’s driving stock-prices – focusing on market structure. Jefferies issued a white paper called When the Market Moves the Market (thank you, alert readers, for those!).

We’ve been talking about market structure for almost 15 years (writing here on it since 2006). We’re glad some big names are joining us. You skeptics, if you don’t believe us, will you believe these banks?

Market structure has seized control. Stock pickers say the market always reflects expectations.  Well, stocks are at records even as expectations for corporate earnings predict a recession – back-to-back quarterly profit-declines.

There’s more. Last week the S&P 500 rose 0.8%, pushing index gains to 9.3% total since the end of May. But something that may be lost on most: The S&P 500 is up less than 2.5% since last September. The bane of stock-investing is volatility – changing prices.

Hedge funds call that uncompensated risk. The market has given us three straight quarters of stomach-lurching roller coasters of risk. For a 2.5% gain?

We all want stocks to rise!  Save shorts and volatility traders.  The point is that we should understand WHY the market does what it does. When it’s behaving unexpectedly, we shouldn’t shrug and say, “Huh. Wonder what that’s about?”

It’s akin to what humorist Dave Barry said you can do when your car starts making a funny noise:  Turn the radio up.

Let me give you another weird market outtake.  We track composite quantitative data on stocks clustered by sector (and soon by industry, and even down to selected peers).  That is, we run central tendencies, averages, for stocks comprising industries.

Last week, Consumer Discretionary stocks were best, up 1.5%. The sector SPDR (XLY, the State Street ETF) was up 2% (a spread of 33% by the way). Yet sector stocks had more selling than buying every day but Friday last week.

You know the old investor-relations joke:  “Why is our stock down today?”

“Because we had more sellers than buyers.”

Now stocks are UP on more selling than buying.

An aside before I get to the punchline:  ETF flows are measured in share creations and redemptions. More money into ETFs? More ETF shares are created.  Except there were $50 billion more ETF shares created than redeemed in December last year when the market fell 20%.

The market increasingly cannot be trusted to tell us what’s occurring, because the mechanics of it – market structure – are poorly understood by observers. ETFs act more like currencies than stocks because they replace stocks. They don’t invest in stocks (and they can be created and shorted en masse).

With the rise of ETFs, Fast Trading machines, shorting, derivatives, the way the market runs cannot be seen through the eyes of Benjamin Graham.

Last week as the S&P 500 rose, across the eleven industry groups into which it’s divided there were 28 net selling days, and 27 net buying days (11 sectors, five days each).

How can Consumer Discretionary stocks rise on net selling? How can the market rise on net selling? Statistical samples. ETFs and indexes don’t trade everything. They buy or sell a representative group – say 10 out of a hundred.

(Editorial note: listen to five minutes of commentary on Sector Insights, and if you’re interested in receiving them, let us know.)

So, 90 stocks could be experiencing outflows while the ten on which this benchmark or that index rests for prices today have inflows, and major measures, sector ETFs, say the market is up when it’s the opposite.

Market Structure Sentiment™, our behavioral index, topped on July 12, right into option-expirations today through Friday.  On Monday in a flat market belying dyspepsia below the surface, we saw massive behavioral change suggesting ETFs are leaving.

Stay with me. We’re headed unstoppably toward a conclusion.

From Jan 1-May 31 this year, ETFs were less volatile than stocks every week save one. ETFs are elastic, and so should be less volatile. Suddenly in the last six weeks, ETFs are more volatile than stocks, a head-scratcher.

Mechanics would see these as symptoms of failing vehicle-performance. Dave Barry would turn the radio up.  None of us wants an Unstoppable train derailing into the depot.  We can avoid trouble by measuring data and recognizing when it’s telling us things aren’t working right.

Investors and public companies, do you want to know when you’re on a runaway train?

The Canary

For a taste of July 4 in a mountain town, featuring boy scouts serving pancakes, a camel amongst horses, sand crane dancers, and Clyde the glad hound, click here.  Americana.

Meanwhile back in the coal mine of the stock market, the canary showed up.

We first raised concern about the possible failure of a major prime broker in 2014. By “prime,” we mean a firm large enough to facilitate big transactions by supplying global trading capacity, capital, advice and strategy.

We homed in on mounting risk at HSBC and Deutsche Bank.

Last weekend Deutsche Bank announced an astonishing intention:  It will eliminate global equity trading and 18,000 jobs. It’s a long-range effort, the bank says, with targeted conclusion in 2022.

But will a bank erasing the foundation of investment-banking, cash equities, retain key people and core customers? Doubtful. In effect, one of the dozen largest market-makers for US stocks is going away.

It matters to public companies and investors because the market depends on but a handful of firms for market-efficiency in everything from US Treasurys, to stocks, to derivatives, and corporate bonds.

And Exchange Traded Funds.  Industry sources say over 80% of creations and redemptions in ETF shares are handled by ten firms. We don’t know precise identities of the ten because this market with over $300 billion of monthly transactions is a black box to investors, with no requirement that fund sponsors disclose which brokers support them.

We know these so-called “Authorized Participants” must be self-clearing members of the Federal Reserve system, which shrinks the pool of possibilities to about 40, including Deutsche Bank, which hired an ETF trading legend, Chris Hempstead, in 2017.

It’s possible others may fill the void. But you have to be an established firm to compete, due to rigorous regulatory requirements.

For instance, brokers executing trades for customers must meet a stout “best execution” mandate that orders be filled a large percentage of the time at the best marketwide prices. That standard is determined by averages across aggregate order flow dominated in US markets by yet again ten firms (we presume the same ones), including Deutsche Bank.

It’s exceedingly difficult to shoulder in.  The great bulk of the 4,000 or so brokers overseen by Finra, the industry regulator, send their trades to one of these ten because the rest cannot consistently achieve the high required standard.

So the elite club upon which rests the vast apparatus of financial markets just shrank by about 10%.

Already the market is susceptible to trouble because it’s like a soccer stadium with only a handful of exits.  That’s no problem when everyone is inside.  But getting in or out when all are in a rush is dangerous, as we saw in Feb 2018 and Dec 2019, with markets swooning double digits in days.

Let’s go back to a basic market-structure concept.  The “stock market” isn’t a place. It’s a data network of interconnected alcoves and eddies.  What’s more, shares don’t reside inside it.  The supply must continuously be brought to it by brokers.

Picture a farmers’ market with rows of empty stalls. When you move in front of one, suddenly products materialize, a vendor selling you goat’s milk soap. You go to the next blank space and instantly it’s a bakery stand with fresh croissants.  As you move along, contents vanish again.

That’s how the stock market works today under the mandatory market-making model imposed by Regulation National Market System. High-speed traders and gigantic brokerage firms are racing around behind the booths and stands at extreme speeds rushing croissants and goat’s milk soap around to be in front of you when you appear.

The network depends on the few.  We have long theorized that one big threat to this construct is its increasing dependency on a handful of giant firms. In 2006, a large-cap stock would have over 200 firms making markets – running croissants to the stand.

Today it’s less than a hundred, and over 95% of volume concentrates consistently at just 30 firms, half of them dealers with customers, the other half proprietary trading firms, arbitragers trading inefficiencies amid continuous delivery of croissants and goat’s milk soap – so to speak – at the public bazaar.

We said we’ll know trouble is mounting when one of the major players fails. Deutsche Bank hasn’t failed per se, but you don’t close a global equity trading business without catastrophic associated losses behind the scenes. The speedy supply chain failed.

Why? I think it’s ETFs. These derivatives – that’s what they are – depend on arbitrage, or profiting on different prices for the same thing, for prices. Arbitrage creates winners and losers, unlike investment occurring as growing firms attract more capital.

As arbitrage losers leave, or rules become harder to meet, the market becomes thinner even as the obligations looming over it mount.

We are not predicting disaster. We are identifying faults in the structure. These will be the cause of its undoing at some point ahead.  We’ve seen the canary.

 

Flying Machines

While France roasts on both the heat of the US women’s soccer strikers and mother nature’s summertime glow, in Steamboat Springs Lake Catamount sits alpine serene, and it was 46 degrees Fahrenheit (about the same read in Celsius in France) on our early bike ride yesterday.

In the USA, we join figurative thankful hands with you across the fruited plain to mark this amazing republic’s 243rd birthday.  Long may the stars and stripes fly.

What’s flying in markets are a bunch of machines.

Joe Saluzzi, one of our marquee panelists at the NIRI Annual Conference last month, spoke to IR Magazine on how the market works and why investor-relations professionals need to educate themselves. As Joe says, much of your volume isn’t investment but trading. It distorts perceptions of real supply and demand.

Why does that matter?  Because your board, your executive team, your investors, see your stock as a barometer of fundamentals. You need to know when that’s true – and when it’s not.  Misunderstanding what the market is doing can lead to big mistakes.

What if your stock declines sharply with results and management believes it has miscommunicated key messages (and blames you)?

Suppose market structure shows Active money bought in the preceding two weeks – because you’ve been talking regularly over the quarter about what you’re trying to do strategically. Then before the call, they stop buying to pay attention to what you say.

The absence of what had been present will be patently apparent to Fast Traders. They will sell and short you.  Whoosh! The flying machines take you down.

Every IRO should understand, and observe, and report internally to the executive team and the board, the starkly apparent data demonstrating these facts. We have that data. For anyone traded in US markets.  Including your peers. And yes, you can see that data.

Story is vital, sure.  But the way we think about the influence of story, fundamentals, strategy, should be predicated on facts, not a perception diverging from reality.

Illustratively, CNBC ran a headline last Saturday reading “80% of the stock market is now on autopilot.”  Referencing a JP Morgan client note, the reporter said about 60% of assets are in passive indexes and Exchange-Traded Funds (ETFs), with another 20% following systematic strategies.

An aside, I think Morningstar is behind the curve on measuring the pervasive and endemic shift to passive in stocks. It’s not just assets under management but the composition of volume.

A WSJ article (registration required) last December describing the “herdlike behavior of computerized trading” also quoted JP Morgan officials estimating that 85% of market volume was something other than Active investing.

Those of you using our analytics know we track the facts with precision. Currently, it’s 87%, with just 13% of market volume the past week from Active investment.

Does it render IR obsolete?  Of course not!  Stop thinking your job consists of talking to investors.

That’s part of the job, sure. But IR is a strategic management function. Your job is to know what all the money is doing, all the time, and communicate important facts about trends and drivers to the board and executives so they’ll have realistic expectations.

And your job is to manage the market for your shares, which includes sorting out what’s controllable and what’s not, and providing important metrics on equity health and drivers around news, earnings, and non-deal road shows – and on a regular basis, proactively, as all good business managers do.

That’s IR today. The market is not full of “noise.” It’s full of flying machines, amazing sensors feeding back vital data to observers like us, who in turn help you take command of the equity-market battlefield as trusted strategic advisor to your executive team.

Ponder that with a cold beer (or a cold Rose from Provence!) and a flag this holiday week.  Happy birthday, USA!

In Control

This is what Steamboat Springs looked like June 21, the first day of summer (yes, that’s a snow plow).

Before winter returned, we were hiking Emerald Mountain there and were glad the big fella who left these tracks had headed the other way (yes, those are Karen’s shoes on the upper edge, for a size comparison).

A setup for talking about a bear market?  No.  But there are structural facts you need to know.  Such as why are investor-relations goals for changes to the shareholder base hard to achieve?

We were in Chicago seeing customers and one said, “Some holders complain we’re underperforming our peers because we don’t have the right shareholder mix. We develop a plan to change it.  We execute our outreach. When we compare outcomes to goals after the fact, we’ve not achieved them.”

Why?

The cause isn’t a failure of communication. It’s market structure.  First, many Active funds have had net outflows over the last decade as money shifted from expensive active management to inexpensive passive management.

It’s trillions of dollars.  And it means stock-pickers are often sellers, not buyers.

As the head of equities for a major fund complex told me, “Management teams come to see my analysts and tell the story, but we’ve got redemptions.  We’re not buying stocks. We’re selling them. And getting into ETFs.”

Second, conventional funds are by rule fully invested.  To buy something they must sell something else.  It’s hard business now.  While the average trade size rose the past two weeks from about 155 shares to 174 shares, it’s skewed by mega caps.  MRK is right at the average.  But FDX’s average trade size is 89 shares.  I saw a company yesterday averaging 45 shares per trade.

Moving 250,000 shares 45 at a time is wildly inefficient. It also means investors are continually contending with incorrect prices. Stocks quote in 100-share increments. If they trade in smaller fractions, there’s a good chance it’s not at the best displayed price.

That’s a structural problem that stacks the deck against active stock pickers, who are better off using Exchange Traded Funds (ETFs) that have limitless supply elasticity (ETFs don’t compete in the market for stocks. All stock-movement related to creating and redeeming ETF shares occurs off-market in giant blocks).

Speaking of market-structure (thank you, Joe Saluzzi), the Securities Traders Association had this advice for issuers:  Educate yourself on the market and develop a voice.

Bottom line, IR people, you need to understand how your stock trades and what its characteristics are, so you and your executive team and the board remain grounded in the reality of what’s achievable in a market dominated by ETFs.

Which brings us to current market structure.  Yesterday was “Counterparty Tuesday” when banks true up books related to options expiring last week and new ones that traded Monday.  The market was down because demand for stocks and derivatives from ETFs was off a combined 19% the past week versus 20-day averages.

It should be up, not down.

Last week was quad-witching when stock and index options and futures lapsed. S&P indexes rebalanced for the quarter. There was Phase III of the annual Russell reconstitution, which concludes Friday. Quarterly window-dressing should be happening now, as money tracking any benchmark needs to true up errors by June 28.

Where’d the money go?

If Passive money declines, the market could tip over. We’re not saying it’s bound to happen.  More important than the composition of an index is the amount of money pegged to it – trillions with the Russells (95% of it the Russell 1000), even more for S&P indices.

In that vein, last week leading into quad witching the lead behavior in every sector was Fast Trading.  Machines, not investors, drove the S&P 500 up 2.2%, likely counting on Passive money manifesting (as we did).

If it doesn’t, Fast Traders will vanish.

Summing up, we need to know what’s within our control.  Targeting investors without knowing market structure is like a farmer cutting hay without checking the weather report.  You can’t control the weather. You control when you cut hay – to avoid failure.

The same applies to IR (and investing, for that matter) in modern markets.