What’s Changed

We’ve been pandemicking across the fruited plain and through the stock market for better than two months. Now what?

I still rue my decision Friday Mar 13 to delay skiing in Steamboat till the next day (it was Fri the 13th after all). The next day the slopes closed for the season.

It’s a reminder not to put off till tomorrow what you can do today. And it raises this question:  What’s changed in the stock market since fear drove us to ground?

Let me wrest your eyes from the headlines over to what the money is doing, demographically. Under Regulation National Market System, exchanges can’t have a “no shirt, no shoes, no service” rule for who buys and sells stocks in the store. Reg NMS requires fair access for all.

We can debate whether giving the public a cheap, slow look at stock prices and volume – the consolidated tape – while selling the pros with fat wallets better, faster and deeper data is fair access. And exchanges handle only about 60% of volume.

But I digress.

On Jan 20, 2020, about 13% of trading volume came from Active Investment, your Benjamin Grahamers, your stock-pickers.

About 16% tied to managing risk and leveraging returns. This is who’s on the other side when there is buying or selling of puts and calls. Or, say, a bank selling a swap for the returns in Financials, then offsetting the risk by shorting Consumer Staples.

Around 24% was Passive investment like quants and index funds.

Nearly 47% was Fast Trading, machines with a horizon of a day or less modeling the math of changing prices.

By Mar 30, coming off the current market bottom, boy had behaviors changed.  Active Investment was up 8% even as volume had exploded to record levels.  That means Active money was buying the bottom, value-style.

Passive Investment tracking the mean, or following global macro factors, or parrying volatility risk was rocked off the balance beam. It plunged 29% as a share of volume.

Moving in opposite fashion, Fast Trading exploded to 57% of trading volume, up 21%. This is what was driving record trading.  WMT, Sam Walton’s globe-crushing consumer staples empire, was averaging 45,000 trades daily Jan 20.  On Mar 30 as stocks were boomeranging out of pandemic hell, it was averaging 146,000 trades daily – an astonishing 224% increase.  Blame Fast Traders.

And finally, Risk Mgmt, the counterparties to derivatives and borrowing for leverage that depend on future prices, dropped 25%.

These behavioral changes describe what happened better than all the headlines, all the Daily Pandemic Updates with Dr. Fauci and team, the Death Clock ticking on the right side of the TV screen, all the Federal Reserve actions, the 40 million people out of work, the 50 million getting paid by loans from the Fed instead of revenue from the job.

Really, 50% of the market’s value vanished as the engine of today’s equities, Passive Investment and the implied leverage in Risk Mgmt, imploded like an unused football stadium where demolition charges change it in seconds from the Roman Coliseum to a pile of steaming dust.

But the market didn’t lose 50% of its value.

Exactly.  You’re catching on.

About 21% of the market’s rebound is speculation on the tick data.  Another 8% is Active investment, stock-pickers putting in a bottom on Fed action, American resilience.

Maybe only 8% of the bounce is real.  Regardless, the combination gives us a 30% (close to it) recovery for the S&P 500.

What about now? At May 20?

Active Investment remains the same. Zero percent change. Risk Mgmt is unchanged too, 0% difference from Mar 30 to May 20. Passive is up 12%, Fast Trading down 4%.

Apply these data to what’s ahead.  Active money is content, committed to a “bottom is in” posture. Risk Mgmt is expensive and uncertain.  Passive money is trying to get its mojo back but it’s half what it was.  And Fast Traders gaming those moving parts, the prices of stocks, are retreating, uncertain.

You’d be hard-pressed to see how these data take us to new highs. You’d also say they don’t smack of another smackdown.

But the pandemic data are still here. They’ve not changed much the past six weeks. Market structure is like water. Disturbances roil it.  When those events pass, it reverts to stillness.

The data are still sloshing.

If the waters are troubled, then even as commuter traffic picks up, gas prices tick up, the city stirs again, keep one eye on the deep. What’s changed at this point is bigger than what’s returned to normal.  Keep your hands inside the gunwales.

Reg Nemesis II

In the Colorado mountains at Steamboat Springs, the pixie dust florescence of greening aspen leaves paints spring onto the high country.

In the bowels of equity markets there gurgles an emergent leviathan (maybe I should choose different imagery – but we’ll talk about what stinks and what doesn’t in this…movement).  The Securities Exchange Commission (SEC) in January asked stock exchanges to rethink Reg NMS.

Everybody who trades stocks, every investor-relations officer for a public company, should know some key facts about this regulation.

Yes. Of course it’s a pain in the butt (I need a new motif).  Who wants to read regulations?

Reg NMS is Regulation National Market System. In one of our all-time most frequented posts, called Reg Nemesis, we described the effects this law has had on the stock market.

We also explained in our recent NIRI webcast on market structure that its four components regulate stock data, stock quotes, stock prices, and access to all three.

Now the SEC wants to modernize it. I think that’s not a stinker at all. Rules should reflect how the market works, and Reg NMS hatched in the contemporary minds of members of Congress in 1975.

Then, amid caroming inflation and screaming currency volatility of the post-gold, bell-bottomed pandemic-haired hippie era, the legislative halls of Columbia echoed with calls to protect the vital “system” of our stock market.

So Congress added the 11A national market system amendments to the Securities Act.  And thirty years later, the SEC got around to regulating Congress’s will upon free markets, and in 524 sweepingly droll pages that one cannot help but read in the same soporific nasal tone as Ben Stein in Ferris Bueller’s Day Off, the stock market became the national market system.

You cannot bear imagining the cacophony with which the stock exchanges met this plan, back then.  There was shrieking and gnashing of legal teeth, the rending of garments and the donning of sack cloth. Ashes were poured on heads. Hieratic beseeching, a great priestly tumult, roared over capital markets.  It was like a pandemic.

Reg NMS was approved in 2005, about four years after the drumbeat began, and implemented in 2007.

Thirteen years on now, nobody loves Reg NMS like stock exchanges love Reg NMS. They’ve even sued the SEC to stop the regulator from questioning its own rules.

As Dave Barry, one of my favorite humorists (if your car is making a knocking noise, turn the radio up) of all time, used to say, “We are not making this up.”

So the SEC basically said, to quote Jerry Stiller (RIP, Ben Stiller’s dad), “Do you want a piece of me!!!!????”

And they’ve instructed exchanges and other market participants to help redraw Reg NMS.  And somehow the sequel is even longer than the original, at 595 pages.

And once again, even though the Securities Act of 1933 and 1934 as amended (oh so very many times amended) specifically includes issuers as constituents not to be discriminated against, we’re omitted from this re-imagining.

That’s a major reason to me why more than 55% of all trading volume currently comes from firms that don’t know what you do or who you are, public companies. They care only that your price profitably changes in fractions of seconds at your investors’ expense.

But I digress.

The Festivus for the rest of us that’s thus far been as elusive as holiday aluminum poles and feats of strength is a market that really works for our profession.

What would that be?  For one, a market that produced more IR jobs rather than fewer (we continue to lose more stocks each year than we gain and there are less than half what there were when I started in this profession in 1995).

And a market where stock pickers favoring your story have the same chance to make money as ETF market-makers and Fast Traders (so blissfully optimistic you want to start humming Fred Rogers, and, were we not socially distanced, hugging your neighbor).

Hey, maybe this is our chance. We can form opinions, speak up.  We’ll have that opportunity as this process, likely to take years as it did the first time around, unfolds.

So, what’s the SEC wanting to put in Nemesis II?  It wants competition for consolidated market data.  The Securities Information Processor (SIP) is a monopoly run by one firm (currently the Nasdaq).  It’s the official source of price and quote information – but it’s slower than all the proprietary data feeds. So everybody sells access even though the law says access must be uniform.

That needs fixing and the SEC is right.

And they want to redefine a “round lot” to reflect an Amazon market. Right now, stocks quote in 100-share increments.  The problem is AMZN, BKNG, GOOG and other stocks trade for well more than $1,000.  The average trade-size in these is about 30 shares.

In fact, almost 60% of trades now are for less than 100 shares, so stocks are trading at prices differing from quotes. It merits analysis, we agree. But do we further “yellow pencil” the market? Should we force all stocks to be $25-50? Is the round lot dead?

I haven’t finished reading all 595 pages yet. We’ll have more to say. We need rules that reflect reality. But we also need simple, comprehensible markets that work for all of us, and not just for speedy machines and stock exchanges.

Maybe we should all yell at them, “Do you want a piece of me!!!!????”

Benjamin Graham

A decade ago today, stocks flash-crashed.  I’m reminded that there are points of conventional market wisdom needing reconsideration.

It’s not because wisdom has diminished. It’s because the market always reflects what the money is doing, and it’s not Ben Graham’s market now. I’ll explain.

There are sayings like “sell in May and go away.”  Stocks fell last May. You’ll find bad Mays through the years. But to say it’s an axiom is to assert false precision.

Mind you, I’m not saying stocks will rise this month. They could plunge. The month isn’t the reason.

Graham protégé Warren Buffett told investors last weekend that he could find little value and had done the unthinkable: Reversed course on an investment. He dumped airlines. Buffett owned 10% of AAL, 11% of DAL, 11% of LUV and 9% of UAL.

Buffett and Berkshire Hathaway, sitting on $137 billion, believe in what Buffett termed “American Magic.” But they’ve sold, and gone away in May.

There are lots of those sayings. As January goes, so goes the market.  Santa Claus rallies come in December.  August is sleepy because the traders are at the Cape, the Hamptons.

These expectations for markets aren’t grounded in financial results or market structure.

Blackrock, Vanguard and State Street own 15-20% of the airlines, all of which are in 150-200 Exchange Traded Funds (ETF).  Passive money holds roughly half their shares.

Passives don’t care about the Hamptons, January, or May.  Or what Warren Buffett does.

In JBLU, which Buffett didn’t own, the Big Three own 20%, and Renaissance Technologies and Dimensional Fund Advisors, quants with track records well better than Buffett’s in the modern era, invest in the main without respect to fundamentals.

Unlike Buffett, RenTech and DFA continually wax and wane.

It’s what the money is doing now.  Its models, analysis, motivation, allocations, are not Benjamin Graham’s (he wrote Security Analysis, The Intelligent Investor, seminal tomes on sound stock-picking from the 1930s and 1940s).

And that’s only part of it.  New 13fs, regulatory details on share-ownership, will be out mid-May. Current data from the Sep-Dec 2019 quarters for DAL show net institutional ownership down 17m shares, or 3%.

But DAL trades over 70 million shares every day. Rewinding to the 200-day average before the market correction exploded volumes, DAL still traded over 16m shares daily.  The total net ownership change quarter-over-quarter was one day’s trading volume.

Since there are about 64 trading days in a quarter, and 13fs span two quarters, we could say DAL’s ownership data account for about 1/128th of trading volume. Even if we’re generous and measure a quarter, terribly little ownership data tie to volume.

Owners aren’t setting prices.

Benjamin Graham was right in the 1930s and 1940s.  He’s got relevance still for sound assessment of fundamental value.  But you can’t expect the market to behave like Benjamin Graham in 2020.

The bedrock principle in the stock market now is knowing what motivates the money that’s coming and going, because that’s what sets prices.  Fundamentals can’t be counted on to predict outcomes.

In DAL, Active Investment – call it Benjamin Graham – was about 12% of daily volume over the trailing 200 days, but that’s down to 8% now. Passive money is 19%, Fast Traders chasing the price long and short are 62% of the 73m shares trading daily. Another 11% ties to derivatives.

Those are all different motivations, reasons for prices to rise or fall.  The 11% related to derivatives are hoping for an outcome opposite that of investors. Fast Traders don’t care for more than the next price in fractions of seconds. They’re the majority of volume and will own zero shares at day’s end. You’ll see little of them in 13fs.

The airline showing the most love from Benjamin Graham – so to speak – is Southwest.  Yet it’s currently trading down the most relative to long-term performance. Why? Biggest market cap, biggest exposure to ETFs.  It’s not fundamental.

If you’re heading investor-relations for a public company or trying to invest in stocks, what I’ve just described is more important than Benjamin Graham now.

The disconnect between rational thought and market behavior has never been laid so bare as in the age of the pandemic.  It calls to mind that famous Warren Buffett line:  Only when the tide goes out do you discover who’s been swimming naked.

Might that be rational thought?

How airlines perform near-term depends on bets, trading, leverage. Not balance sheets.  It’s like oil, Energy stocks – screaming up without any fundamental reason.  And market structure, the infinite repeating arc from oversold to overbought, will price stocks. Not Ben Graham.  Though he was wise.

Money for Nothing

How much does free money cost?

Everything, apparently.

The play Hamilton by Lin Manuel Miranda has grossed over $620 million, seventh all-time on Broadway but still a long way from Phantom of the Opera, Wicked, and Lion King, theater’s billion-dollar trio.

Hamilton is about Alexander, our first Treasury Secretary and the man behind the first bank of the United States, now the Federal Reserve Bank, which concludes its Open Market Committee meeting today.

Hamilton’s generous pen proliferates in the Federalist Papers, required reading for any serious defender of the republic.

In Federalist 78, Hamilton wrote that while it’s a republican axiom that the people may alter or abolish the Constitution if it’s inconsistent with their happiness, no momentary inclination laying hold of a majority of constituents justifies departure from it unless or until the people have by solemn act approved it.

My governor here in CO issued an order shutting down the economy, citing the emergency powers in Article IV Section 2 of the CO Constitution. I read it.  There are no emergency powers. It says the governor is the chief executive.

I sent a note to his chief of staff, Eve Lieberman, saying that not only had the governor construed meaning from the Constitution that it doesn’t contain, but that he also had overlooked Article II, which among other things says that all political power derives from the people, and that all persons have certain natural, essential and inalienable rights, among which may be reckoned the right of enjoying and defending their lives and liberties; of acquiring, possessing and protecting property; and of seeking and obtaining their safety and happiness.

If the governor suspends these by decree and uses the power of the police to enforce it, is he suspending the Constitution and imposing martial law?

I didn’t get an answer.

I’ve got a point about markets, the Fed and this country post-Pandemic. Stay with me.  You may disagree, but I’ll say it anyway.

People with political power and the best intentions reasoned that we could not have sick and dying people. Maybe that’s the ultimate ideal. It’s not in the US Constitution or any of the 50 state Constitutions.

It should not evade the collective conscience of this free people that the rule of law was suspended.  What should we do next time?  The political power, if not the will, is ours.

Let’s get to The Fed. The only reason we could realize the high self-actualized ideal of switching off the economy was because of the promise of free money.  If the Fed couldn’t write the checks, the economy couldn’t shut down.  Period.

I’ve told this story before: When we visited her hometown of Lake Jackson, TX for a school reunion, the fathers of two of Karen’s high-school classmates related vignettes to me about their grandfathers from the 19th century.

The grandfathers were about 12 years old each when their sharecropper parents told them, “We can’t afford you.  Here’s a lunch and our last silver dollar. Seek your fortune.”

Both went west. One become a big West Texas rancher, the other a wealthy Galveston mercantilist. Both sent their kids to school, and they in turn sent theirs to college.

And those kids were these fathers, now in their 70s, both college-educated, wealthy retired Dow Chemical executives.

The Fed’s balance sheet is now $6.6 trillion, laden with government debt, private mortgages, and soon high-yield-debt-backed Exchange Traded Funds, even facilities buying municipal debts, underwriting direct-lending to businesses and consumers.

The cost of free money is bigger than you think.  It’s the lost spirit of a 12-year-old on his own.  It’s liberty and the rule of law.

And free money is worth less than you suppose. My grandparents and parents never had mortgages or car payments and they concluded life with wealth as blue-collar farmers and ranchers. My grandfather bought his first house for $500.  Built his next on two acres for $5,500, sold that one in 1980 for $55,000.

I bought my first house for $370,000.  Sold that first house for $800,000.

Inflation. If we keep creating money to solve problems, it buys less and less, so you need more and more until there isn’t enough to retire on and we need unemployment of 3% instead of 10-12% just to keep it all going. And checks from the Fed for any crisis.

We are bleeding ourselves dry, ostensibly for our financial health, just like doctors once bled patients to make them well.

The stock market will buy free money – until suddenly it doesn’t. Japan stopped believing (despite rock band Journey’s anthemic counterargument).  The stock market there, the Nikkei, was nearly twice as high in 1990 than it is now.

It takes almost unimaginable character today to hand somebody a lunch and a dollar and say you’re on your own.  Yet it’s the strait and narrow way to wealth.

It’s never too late to change what we’re doing.  Can we give up free money and become rich again?

Roll Call

Apr 21, yesterday, is Texas A&M Aggie Muster.  Aggies everywhere gather to say “here” for Aggies lost in the past year, a roll call. It’s more poignant this time for my Aggie, Karen, and the many friends and family hailing from College Station.  Gig’em, Aggies.

Speaking of Texas, let’s talk oil.  We’ve been saying for years that volatility during the next crisis, whenever it came, would be exacerbated by Exchange Traded Funds (ETFs) and lead to large failures.  It’s now happened in oil, which freakishly settled Monday at $37 below zero.

Oil prices are predicated in the USA on futures contracts for West Texas Intermediate (WTI). Overflowing storage facilities mean few parties want to take delivery of oil. That pressures prices.

But oil isn’t worth nothing. It’s not worth less than nothing. That futures went south of zero is a product of the supply/demand distortions ETFs introduce.

Futures are themselves derivatives that obligate one to action only if held to settlement. ETF investors are not buying barrels of oil. They’re buying the PRICE of oil.

But they’re really buying derivatives that represent derivatives that represent the price of oil.  The massive oil ETF, USO (always among the most active stocks, it yesterday traded a billion shares, one of every twelve, leading the market), currently claims assets of $3 billion comprised heavily of June and July WTI contracts.  It’s down 80% in a year.

We’ve explained before that ETFs work similarly to, say, buying poker chips.  You pay cash to the house and receive chips of equal value. The chips represent the cash.  The difference with ETFs is there’s an intermediary between you and the house.

So the intermediary, the broker, pays the house for the chips and sells them to you.  Suppose the intermediary, the broker, gave energy futures as payment for the chips, rather than cash.

Then the value of the futures plunged. ETFs compound the damage. The broker is out the value of it collateral, futures, and you’re out the value of your chips, which also collapse.

The broker may stop transacting in the ETF because it’s out a lot of money. Now you can’t find a buyer – and you suffer even more damage.

This happened.  Interactive Brokers said it lost $88 million, its portion of the excess losses by its customers, some of whom lost everything in their accounts. The firm’s CEO said in a CNBC interview yesterday it had exposure to about 15% of the May WTI futures contracts behind the damage, meaning some $500 million more exists.

And the damage yesterday to the June WTI contract, the next in the series, was as impactful.  Massive Singapore futures broker Hin Leong, which moves physical commodities, filed for bankruptcy. It had been in business since 1963.

Banks most exposed to Hin Leong’s billions in obligations:  HSBC and ABN Amro.  We’ve long said we thought HSBC was a counterparty at risk in a financial crisis, on exposure to derivatives.  ABN Amro lost big already, on Ronin Capital’s March failure.

The biggest derivatives counterparties though are all names you know: JP Morgan, Goldman Sachs, Morgan Stanley, BofA, Citi (which has vastly more derivatives exposure via swaps than anyone).  They may be fine – but the world relies on these firms to make every meaningful market, from helping the Fed, to trading ETFs.

We’re leaving out a key piece of the story. The big way ETFs cause trouble is by distorting the market’s perception of supply and demand. In 2008, securitized mortgage derivatives bloated the appearance of demand for real estate.

USO owned some 25% of the subject oil futures contract. Yes, we’ve got too much oil (remember peak oil? Cough, cough.) because travel died. Sure, we know supply exceeds demand.

But.

Demand from derivatives of derivatives is extended reach to an asset class – which inflates its price.  I submit:  WTI May futures traded to -$37 Apr 20 because ETFs grossly inflated the price despite its apparent weakness. When books were squared and inflationary “financial” demand from ETFs removed, oil was worth 200% less than zero.

Said another way, when money in ETFs not wanting to take delivery of oil didn’t even want its price, we discovered that demand implied in futures misrepresented reality.

Thank you, ETFs.

Barclays shuttered two oil instruments. A dozen more are at risk.  USO is at risk. The roll call of the threatened is lengthening.

Where else are ETFs inflating prices relative to underlying demand? Well, the greatest instance of asset-class extension is in US equities. Especially the FAANGs – FB, AAPL, AMZN, NFLX, GOOG (and the pluses are MSFT, AMD, TSLA, a handful of others).

These bellwethers have weathered better than the rest in a global shutdown.  But they all depend on consumer-discretionary income. People have to be working to pay for subscriptions, and businesses must be operating to spend advertising dollars.

The drums are drumming. I expect we’ll see some even more surprising ETF failures before the roll call is done.  The sooner we’re back to work, the quicker the drumbeat ends.

Nothing

I rest my case, and it only took 15 years.

On Dec 29, 2009, we wrote in this very blog we’d then been clattering off the keyboard since 2006: “Now, why would you care about Iron Condors, IROs and execs? Because once again something besides fundamentals affected market prices.

Has the market ever offered more proof than now of the absence of fundamentals?  SPY, the S&P 500 Exchange Traded Fund (ETF), is up 27.3% since Mar 23 after falling 34.1% from a Feb 19 peak.  It’s still 19% down but, boy.  That’s like a Patriots Super Bowl comeback.  And what happened?

Nothing.

I’ll explain.

Note: We’re going to discuss what’s happened to the market in the age of the virus at 2p ET today, and it’s free and open to anyone. Join us for an hour: https://www.niri.org/events/understanding-wild-markets-age-of-virus

What I mean by nothing is that the virus is still here, the economy is still shut down.  Quarterly earnings began with the big banks yesterday and they were bad and Financials fell.  The banks are the frontlines of the Viral Response (double entendre intended).

Many say the market’s expectations are improving. But we have NO IDEA what sort of destruction lies beyond the smoky wisps floating up from quarterly reporting. Future expectations are aspirational. Financial outcomes are rational facts.

And do they even matter?

Consider the Federal Reserve. Or as people are calling it on Twitter, the Freasury (Fed merged with Treasury).  The Fed is all-in, signaling that it’ll create plenty of money to replace shrunken consumption (why is that good if your money buys less?). It’s even buying bond-backed ETFs, which are equities (we’re Japan now).

The market’s reaction to Fed intervention cannot be said to reflect business fundamentals but rather the probability of asset-price inflation – or perhaps the analogous equivalent of enough poker chips for all the players including the losers to stay in the game.

It’s a reason for a 27% rally in equities. But it’s confusing to Main Street, as it should be.  We’ll have 20 million unemployed people (it’s coming) and capital destruction in the trillions of dollars when we sort out the mess in our consumption-driven society.

Yet the market doesn’t seem to depend on anything. That’s what I mean by nothing.  The market does its thing, rises and falls, shifts money from Real Estate to Tech and back, without respect to the virus or fundamentals. As investors flail to describe the unexpected.

Stocks dependent on consumption like Consumer Discretionary, Energy, Materials, led sector gainers the last month.  These include energy companies like Chevron, Exxon and Valero that sell gasoline to commuters. Chipotle, Starbuck’s, Royal Caribbean, selling stuff to people with discretionary income. Dow, Dupont and Sherwin-Williams selling paint, chemicals, paper.

They’ve soared, after getting demolished. And nothing has changed. Sure, Amazon, Zoom, Netflix, the chip companies powering systems behind all our stay-at-home video-use are up, and should be.

But the central tendency is that the market plunged down and bucked up, without data to support either move.  That’s what I’ve been talking about so long. The market is not a barometer for rational thought.

It IS a barometer for behaviors, one of which is rational.  And we’ll explain what this image means when you tune to the webcast. (Click here for larger version.)Active Investment - Mar 2020 Correction

Think of the risk in a market motivated by nothing.  In Dec 2019 when we described the market as surly furious, the steep decline had no basis. During it, pundits tried to explain the swoon as expectation of a recession. Stocks roared to epic gains after Christmas 2018.

Nothing motivated either move.  That was a stark illustration of market structure form trumping capital-formation function.

Now stocks have zoomed back up 27% off lows, and everything is still wrong, and the wrongness doesn’t yet have defined parameters.

I don’t know which instance is most stark. Maybe it doesn’t matter. Come ask questions today at 2p ET at our webcast on market structure during the age of the virus.  I would love nothing more!

Sneeze Cloud

I know this Friday will be good.

I’ll let you think about that one. By the way, markets are closed then.

For a decade we’ve written about the way the stock market has disconnected from reality.  Nothing lays bare the truth like a Pandemic.  More on that later.

First I’ve got to get something off my chest.

I’m not a doctor. But ModernIR is as good at the physiology of American equities as those medically trained are with humans. We’re experts at threshing dense, complicated information for central tendencies, patterns.

We’ve studied and validated data around this Pandemic.  The Centers for Disease Control reports (statistics as of 2017) that in New York annually more than 4,500 people die from the flu and pneumonia.

I saw a headline yesterday saying New York City Covid-19 deaths had surpassed those on Sep 11, 2001, as if the two were related.  At least seven morbidities kill more New Yorkers every year.

I’m proud of my fellow Americans for their indefatigable patience. And I’m also tired of hysteria, propaganda turning mask-wearers against non-mask-wearers, false correlations.

Over 115,000 New Yorkers die per annum, chiefly from heart disease (a co-morbidity with Covid-19) and cancer. And 3.5 million Americans die every year.

Now we find that our rush to respirators for a Coronavirus response may be wrong.  Read about Cytokine storms. See this. We put our haste to confront a threat ahead of understanding it.

You know viruses are inanimate?  We think they’re “bugs,” malevolent living things. In fact they’re hunks of protein, sequences of RNA or DNA coated in a fatty lipid layer. They’re inert unless they encounter susceptible hosts like mucosal cells.

In the truest sense, computer viruses are like human viruses, both meaningless unless they encounter code to corrupt, incapable of corrupting otherwise.

Healthy skin is impervious to them. Alcohol dissolves lipids, proteins decay under foamy soap. Sunlight and air are also enemies of proteins.

One could say, “Yeah Quast. But they’re transmitted by people.”

True. Viruses replicate in host cells and spread through human contact.  As ever.  Karen and I joke that every time we board a plane we leave our little antibody bubble world.

Fifteen million people die yearly around the globe from viruses.  The CDC offers vastly greater numbers falling ill from virally triggered maladies. It’s always true and will be tomorrow as much as today.  We’re ever walking into someone else’s sneeze cloud.

This paper’s opening salvo says: “Influenza-like illness (ILI) accounts for a large burden of annual morbidity and mortality worldwide (WHO 2020). Despite this, diagnostic testing for specific viruses underlying ILI is relatively rare (CDC 2019). This results in a lack of information about the pathogens that make between 9 million and 49 million people sick every year in the United States alone (CDC 2020).”

Yet we’re telling people, “Trust the government. We’ll find a vaccine.” Coronaviruses cause the bulk of the one billion common colds in the USA annually.  Look it up.

“Big Short” Michael Burry, an MD turned hedge fund manager famed for betting against mortgage securities before 2008, says our response to Covid-19 is worse than the virus.

A bigger sneeze cloud.

We stipulate that any Presidential administration would be excoriated for less than pulling out all the stops, whatever that phrase means.

Today it means monetizing any economic deficiency.  Or in English, having government compensate loss with money it borrows or creates. Yet government has only the money the people surrender to it.

So the government instead reaches far into the future through the central bank and hands the future the Coronavirus and takes from the future its money, for us.

We might laugh and say, “Suckers!”

But the Constitution that’s ostensibly the supreme law of this land prohibits taking private property for public use without just compensation. No scepter for any mayor or governor or other official exists under it. There is no authority to order people to do anything unless the people first agree to it. That’s the bedrock of self-government.

In this crisis we’ve taken millions of businesses for public use (here, safety) without just compensation, offering people who expended their lives building restaurants, bars, salons, hotels, stores, gyms, on it goes, on which they depended for retirement, inheritance to pass on to children, a loan.

I’m heartsick. It will take a generation to recover, not a quarter or two.

Most people think viruses are alive and it’s untrue. Most people think the stock market is a barometer for economic outcomes, and it’s untrue. Too many suppose government can save us from life, or death. And it’s untrue.

In a way, the stock market is a sneeze cloud. Trillions in Exchange Traded Fund transactions aren’t counted as turnover (thus Blackrock is unchanged in your 13Fs when it trades frantically). Half the volume is borrowed. Fast Traders set prices. Arbitrage dominates trading. You can’t trust what it signals.

We’re going to show you the behaviors driving stocks during this Pandemic next Wed Apr 15 via a NIRI-sponsored webcast.  We’ll post details at our website, or visit NIRI.org. If you want an email update sent to you, let us know.

I can live with sneeze clouds.  Or die.  We all do someday.  I can’t live with our markets, monetary policy, crisis-response, as masquerades. We can do better.  And we better.

Epiphany

DoubleLine’s famed Jeff Gundlach says we’ll take out March lows in stocks because the market is dysfunctional.

Karen and I have money at DoubleLine through managed accounts with advisors.  Mr. Gundlach is a smart man. Maybe it’s splitting hairs if I say the stock market isn’t dysfunctional but reflecting its inherent structural risks.

We know as much as anyone including Mr. Gundlach about market mechanics. And I still learn new stuff daily.  Matter of fact, I had an epiphany over the weekend. I compared market behaviors during the Great 2020 Market Correction.

Wow is that something to see.  We might host a webcast and share it.  If you’re interested, let us know.

Over the past decade, the effort to produce returns with lower risk has spread virally in the US stock market.  Call it alpha if you like, getting more than you’re risking.  Hedge funds say it’s risk-adjusted return.

The aim is to protect, or insure, everything against risk, as we everyday people do. We protect our homes, cars, lives, appliances, even our entertainment expenditures, against risk by paying someone to replace them (save for our lives, where beneficiaries win at our loss).

Stock traders try to offset the cost of insurance by profitably transacting in insured assets. That’s the holy grail.  No flesh wounds, no farts in our general direction (for you Monty Python fans).

It works this way. Suppose your favorite stock trades for $20 and you’re a thousand shares long – you own 1,000 shares. For protection, you buy 20 puts, each for 50 shares. You’re now long and short a thousand shares.

If the stock rises, the value of your puts shrinks but you’re up. If the stock declines, your long position diminishes but your puts are worth more.  Say the stock rises to $23. The value of your puts declines, making you effectively long 1,300 shares, short 700.

To generate alpha (I’m simplifying, leaving out how options may decrease in value near expiration, the insurance-renewal date, so to speak), you need to offset the cost of insurance. With a good model built on intraday volatility, you can trade the underlying stock for 20 days, buying high and selling low, going long or short, to mitigate costs.

Everybody wins. Your counterparty who sold you the puts makes money.  You make money trading your favorite stock. You have no fear of risk. And because more money keeps coming into stocks via 401ks and so on, even the losers get lucky (thank you Tom Petty, rest in peace, for that one).

One big reason this strategy works is the rules.  Regulation National Market System requires all stocks to trade at a single daily average price in effect. Calculating averages in a generally rising market is so easy even the losers can do it.

Now, what would jack this model all to hell?

A virus (frankly the virus is an excuse but time fails me for that thesis today).

Understand this:  About 80% of all market volume was using this technique. Quants did it. Active hedge funds. Fast Traders. Exchange-Traded Funds (ETF) market-makers.

Big volatility doesn’t kill this strategy. It slaughters the parties selling insurance. Observers are missing this crucial point. Most active money didn’t sell this bear turn.  We can see it.  Again, a story for later via webcast if you’re interested.

What died in the great 2020 Coronavirus Correction was the insurance business.

Casualties litter the field. The biggest bond ETFs on the planet swung wildly in price. Big banks like Dutch giant ABN Amro took major hits. Twenty-six ETFs backed by derivatives failed. The list of ETFs ceasing the creation of new units keeps growing and it’s spilling into mainstream instruments. Going long or short ETFs is a fave hedge now.

The Chicago Mercantile Exchange auctioned the assets of a major high-speed trader that sold insurance, Ronin Capital (around since 2006. If its balance sheet and leverage can be believed, it may have imputed a loss of $500 billion to markets.

Just one firm. How many others, vastly bigger, might be at risk?

Forget stock-losses. Think about how funds mitigate volatility. How they generate alpha. We’ve been saying for years that if the market tips over, what’s at risk is whatever has been extended through derivatives. ETFs are derivatives. That’s 60% of volume.

And now key market-makers for stocks, bonds, ETFs, derivatives, commodities, currencies, are tied up helping the Federal Reserve. Including Blackrock. They can’t be all things to all people at once.

The market isn’t dysfunctional.  It’s just designed to function in ways that don’t work if insurance fails. And yes, I guess that that’s dysfunctional. That was my epiphany.

I’ll conclude with an observation. We shouldn’t shut down our economy. Sweden didn’t. This is their curve. Using a population multiplier, their curve is 27% better than ours – without shutting down the economy, schools, restaurants. We are the land of the free, the home of the brave. Not the land of those home, devoid of the brave. I think it’s time to put property rights, inalienable rights, above the government’s presumption of statist power.

Many Tiny Trades

All 20 biggest points-losses for Dow Jones Industrials (DJIA) stocks in history have occurred under Regulation National Market System.

And 18 occurred from 2018-2020. Fifteen of the 20 biggest points-gains are in the last two years too, with all save one, in Mar 2000, under Reg NMS (2007-present).

It’s more remarkable against the backdrop of the Great Depression of the 1930s when the DJIA traded below 100, even below 50, versus around 20,700 now and small moves would be giant percentage jumps. Indeed, fifteen of the twenty biggest percentage gains occurred between 1929-1939. But four are under Reg NMS including yesterday’s 11.4% jump, 4th biggest all-time.

Just six of the biggest points-losses are under Reg NMS (we wrote this about the rule). But ranked second is Mar 16, 2020. And 19 of the 20 most volatile days on record – biggest intraday moves – were in the last two years, and all are under Reg NMS.

Statistically, these concentrated volatility records are anomalous and say what’s extant now in markets promotes volatility.  Our market is stuffed full of many tiny trades.

Volume the past five days has averaged 9.9 million shares per mean S&P 500 component, up 135% from the 200-day average.  But intraday volatility is up nearly 400%, trade-size measured in dollars is down 30%.

That’s why we’re setting volatility records. The definition of volatility is unstable prices.

I’m delighted as I’m sure CVX is that the big energy company led DJIA gainers yesterday, rising 22%.  But stocks shouldn’t post an excellent annual return in a day.

CVX liquidity metrics (volume is not liquidity!) show the same deterioration we see in the S&P 500, with intraday volatility up 400%, trade-size down 47%, daily trades up over 240% to 196,000 daily versus long-run average of about 57,000.

Doing way more of the same thing in tiny pieces means intermediaries get paid at the expense of investors.

Every stock by law must trade between the best national visible (at exchanges) bid to buy and offer to sell.  When volatility rises, big investors lose ability to buy and sell efficiently, because prices are constantly changing.

Regulators and exchanges have tried to deal with extraordinary volatility by halting trading.  We’ve tracked more than 7,500 individual trading halts in stocks since Mar 9 – twelve trading days.  Marketwide circuit breakers have repeatedly tripped.

Volatility has only worsened.

In financial crises, we inject liquidity to stabilize prices.  We can do the same in stocks by suspending the so-called “Trade Through Rule” requiring that stocks trade at a single best price, if the market is more than 5% volatile.

Trade size would jump, permitting big investors to move big money, returning confidence and stability to prices. We’ve proposed it three times to the SEC now.

Investors and public companies need to understand if the market is working. Let’s define “working.” The simplest measure is liquidity, which is not volume but dollars per trade, the amount one can buy or sell before price changes.  By that measure, the market has failed utterly during this tumult.

Let’s insist on a market capable of burstable bandwidth, so to speak, to handle surges.  Suspending Rule 611 of Reg NMS during stress is a logical strategy for the next time.

Let’s finish today by channeling the biblical apostles, who came to Jesus asking what would be the sign of the end of the age?  Here, we want to know what the sign is that market tumult is over.

At the extremities, no model can predict outcomes.  But given the nature of the market today and the behaviors dominating it, the rules governing it, we can inform ourselves.

This market crisis commenced Feb 24, the Monday when new marketwide derivatives traded for March expiration.  In the preceding week, demand for derivatives declined 5% at the same time Market Structure Sentiment topped.

We had no idea how violent the correction would be. But these signals are telling and contextual. They mean derivatives play an enormous role.

We had massive trouble with stocks right through the entire March cycle, which concluded Mar 20 with quad-witching.  Monday, new derivatives for April expiration began trading.

It’s a new clock, a reset to the timer.

You longtime clients know we watch Counterparty Tuesday, the day in the cycle when banks square the ledger around new and expired derivatives. That was yesterday.

That the market surged means supply undershot demand. And last week Risk Mgmt rose by 5% and was the top behavior – trades tied to derivatives, insurance, leverage. Shorting fell to the lowest sustained level in years. Market Structure Sentiment bottomed.

It’s a near-term nadir. The risk is that volatility keeps the market obsessed with changing the prices, which is arbitrage. Exchange Traded Funds depend on arbitrage (and led the surge in CVX).  Fast Traders do too. Bets on derivatives do.

The tumult ends in my view when big arbitragers quit, letting investment behavior briefly prevail.  We’ll see it. We haven’t yet.  The market may rise fast and fall suddenly again.

The End

In crises I think of Winston Churchill who said, “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Let’s start now with lessons from a health crisis that became a market crisis and proceeded to an economic crisis.

This last leg is yet murky but with hotels at 15% occupancy and the great American service industry at a standstill in an economy 70% dependent on consumption, it’s big.

First, the stock market. Intraday volatility in the S&P 500 averaged 10% the past week – a daily market correction between mean high and low prices by component.

Volatility is unstable prices, and big money needs stability to move. If the market exists for public companies and investors, it has served them poorly. Short-term machines have dominated. Investors were unable to get in or out without convulsing the whole construct of a $30 trillion edifice now smashed a third smaller.

Energy companies should be the first ones knocking at the SEC because the sector was 22% volatile the past week amid losing vast value. Sure, oil prices fell. Should it be the worst month ever for oil? The sector was battered more than in the maw of 2008.

Market structure is the hubris of equities. We’ve said it for years. We warned that Exchange Traded Funds, derivatives, had pervaded it, spreading the viral threat of severe inflation and deflation if stocks and ETFs move in unison.

There’s another basic problem. I’ll give you an analogy. The local grocery store down the street in Steamboat was denuded of wares as though some biblical horde of incisor-infested critters had chewed through it. I guess in a sense it was.

If there’s no lettuce, you can’t buy it. The price of lettuce doesn’t carom though. Demand ceases until supply arrives.

And it did. We later found lettuce, carrots, onions, eggs in abundance, but no limes (drat! A vital gin-and-tonic component).

We bought what they had.

In the stock market as with groceries there is no limitless supply of XOM or AAPL or whatever. But rules permit machines to behave as though lettuce and carrots always exist on the shelves when they don’t (a majority of volume was shorting and Fast Trading the past week – phantom products).

It’s why prices bucked and seized like a blender hucked into a bathtub. Investors would reach a hand for the proverbial lettuce and it would vanish and lettuce prices would scream smoking off like bottle rockets on July 4.

We don’t do that with groceries. Why in stocks? Energy companies, are you happy that machines can manufacture a crisis in your prices (that rhymes) and destroy the bulk of your value in days?

Look at Utilities. Producing energy to heat and cool American homes is vulnerable to tornadoes. Not viruses. Why did a preponderance of Utilities lose half their market capitalization in days – and then get 20% back yesterday?

These are questions every public company, every investor, should ask.

(Here’s what happened: Utilities were overweight – we warned of it! – in “low volatility” investments. Those blew up, taking Utilities with them.)

And they jumped on options bets. Volatility as an asset class lapses today around VIX expirations, and resets. Tomorrow index options expire, Friday is the first quad-witch of 2020. Derivatives have demolished swaths of equity capital like a runaway Transformer in one of those boom-boom superhero movies trampling through a trailer park.

It should be evident to the last market-structure skeptic – whoever you are – that market structure overwhelms reason, fundamentals, financials. If you’re in stocks, you need to get your head around it (we have, removing that burden for you).

If you want to be prepared and informed, ask us. We have a product that will fit your budget and put you in with the – socially distanced – cool kids who make market structure part of the investor-relations and investing processes.

Speaking of social distancing, there are 71 million American millennials (meaningful numbers living paycheck-to-paycheck). Viral mortality rate for them globally: 0%. There are two million hoary heads over 90. Covid-19 mortality is 19% (and most over 80 have chronic medical conditions).

I’m a data guy. How about keeping oldsters out of bars and youngsters out of nursing homes? I don’t mean to be insensitive and I know the concern is healthcare facilities. But destroying the finances of millennials over sequestering the vulnerable is troubling.

Last, central banks once were lenders of LAST resort taking good collateral at high cost. I would be pulling out all stops too, were I leading. I’m casting no aspersions. But governments are funded by people, not the other way around, and cannot carry the freight by idling productive output. That’s cognitively dissonant, intellectually incongruous.

This may be the last time we get away with it. Let’s stop that before it ends us. Find a new plan.

And investors and IR people, understand market structure. This is a beginning. It’ll again roar in our faces with slavering fangs.