Time Changes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Here are three 21st century Rules for Reporting:

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

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

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

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

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

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

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

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

 

Hot Air

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Wholesale Profits

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Because that’s not investment.

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

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

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

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

Suppy Chain Trouble

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

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

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

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

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

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

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

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

Let’s define “liquidity.”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Spread Spoofing

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

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

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

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

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

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

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

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

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

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

Why? We’ll come to that.

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

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

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

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

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

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

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

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

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

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

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

Six See Eleven

What do you do in Steamboat Springs when autumn arrives at the Botanic Park? Why, have a Food & Wine Festival of course!

Meanwhile the derivatives festival in equities continues, thanks to the SEC, which through Rule 6c-11 is now blanket-exempting the greatest financial mania of the modern era, Exchange Traded Funds (ETFs), from the law governing pooled investments.

I’ll explain what this means to companies and stock-picking investors.

Look, I like Chairman Clayton, Director Redfearn, and others there.  But the SEC isn’t Congress, legislating how the capital markets work (one could argue that the people never delegated that authority to government through the Constitutional amendment process at all. But I digress).

The point is, the SEC is supposed to promote free and fair markets – not one purposely tilted against our core audience of stock-pickers.

The problems with ETFs are they’re derivatives, and they foster arbitrage, or profiting on different prices for the same thing. If arbitrage is a small element – say 15% – it can highlight inefficiencies. But thanks to ETFs, 87% of volume (as we measure it) is now directly or indirectly something besides business fundamentals, much of it arbitrage.

Do we want a market where the smallest influencer is Benjamin Graham?

ETFs in fact can’t function without arbitrage. ETFs have no intrinsic value.  They are a traded substitute for a basket of underlying stocks that depend on prices of those stocks for a derivative price applied to the ETF shares. So, unless brokers trade both ETF shares and stocks simultaneously, ETF prices CAN collapse.

That was an outlier problem until ETFs became the fastest-growing financial instrument of all time outside maybe 16th century Dutch tulip bulbs.

But collapse is not the core threat from ETFs. Arbitrage distorts the market’s usefulness as a barometer of fundamentals, warps the market toward speed, and shrivels liquidity.

How and why are these conditions tied to ETFs and arbitrage?  I’m glad you asked!

The motivation for arbitragers is short-term price-changes.  The motivation for investors is long-term capital formation. These are at loggerheads.  The more arbitrage, the faster prices change.  Price-instability shrinks the size of trades, and liquidity is the amount of something that can trade before prices change. It’s getting smaller as the market balloons.

If money can’t get into or out of stocks, it will stop buying them and start substituting other things for them. Voila! ETFs.

But.

We’ll get to that “but” in a minute.

ETFs are a fantastic innovation for ETF sponsors because they eliminate the four characteristics that deteriorate fund-performance:

Volatility. ETF shares are created off-market in big blocks away from competition, arbitrage, changing prices, that war on conventional institutional orders.

Customer accounts. ETFs eliminate asset-gathering and the cost of supporting customers, offloading those to brokers. Brokers accept it because they arbitrage spreads between stocks and ETFs, becoming high-frequency passive investors (HFPI).

Commissions. ETF sponsors pay no commissions for creating and redeeming ETF shares because they’re off-market.  Everyone else does, on-market.

Taxes. Since ETFs are generally created through an “in-kind” exchange of collateral like cash or stocks, they qualify as tax-exempt transactions.  All other investors pay taxes.

Why would regulators give one asset class, which wouldn’t exist without exemptions from the law, primacy? It appears the SEC is trying to push the whole market into substitutes for stocks rather than stocks themselves.

The way rules are going, stocks will become collateral, investments will occur via ETFs. Period.  If both passive and active investors use ETFs, then prices of ALL stocks will become a function of the spread between the ETFs and the shares of stocks.

Demand for stocks will depend not on investors motivated by business prospects but on brokers using stocks as collateral. Investors will buy ETFs instead of stocks.

If there is no investment demand for stocks, what happens when markets decline?

What would possess regulators to promote this structure? If you’ve got the answer, let me know.

And if you’re in IR and if you play guitar (Greg Secord? You know who you are, guitar players!), start a rock band. Call it Six See Eleven. Book some gigs in Georgetown. Maybe Jay Clayton will pop in.

Meanwhile, your best defense is a good offense, public companies and investors. Know how the market works. Know what the money is doing. Prepare for Six See Eleven.

Bad News

Markets swoon and again comes a hunt for why, because news offered no warning. The news has bad data, which makes for bad news. ModernIR warned. More shortly.

Meanwhile in Steamboat Springs the slopes are painted the palette of Thanksgiving, and a road leads to paradise.

We were in New York with the United Nations last week. Well, not with them. Navigating around them. On foot. We walked fifteen miles over two days of meetings. Trump Tower looked like a siege camp, loaded dump trucks lining the front and frantic 5th Avenue closed to traffic and so quiet you could stroll to the middle and snap a photo.

Wednesday we railed with Amtrak into Washington DC’s Union Station, and Thursday and Friday we trooped with the NIRI contingent up Capitol Hill. Strange time. The halls of congressional buildings Longworth and Rayburn vibrated in partisan division.

NIRI is flexing muscle, however. We had 50 people scattered through more than 30 legislative visits, and the SEC told us, “You’ve brought an impressive number!”

Numbers matter.  We keep that up and we might change the world. So next year, come along! NIRI CEO Gary LaBranche and team deserve all credit for ratcheting up our reach to regulators and legislators.

Now to the data that makes the news look bad. Last week in our piece called Curtains, we explained how market structure leads headlines around by the nose. Yes, news may be the feather that tilts a domino. But it’s not The Big Why.

Structural conditions must first permit daily chatter to move markets. Thus news one day is “stocks are down on trade fears,” and when they rebound as quickly, they’re “up on easing trade fears.”

We’re told the Dow Industrials dropped 340 points yesterday because the ISM Manufacturing Index dipped to a decade low. That index has been falling for months and slipped to contraction in late August. Yet the S&P 500 rose last month.

Anyone can check historical data. The ISM Index routinely bounced from negative (more than now) to positive during the go-go manufacturing days of the 1950s when the USA was over 50% of global output. It was lower routinely in the booming 1980s and 1990s. It was lower in the post-Internet-bubble economic high.

Lesson? Manufacturing moves in cycles. Maybe the data mean the cycle is shortening, as it did in past boom periods. You can see the long-range data here, courtesy of Quandl.

There’s rising and worrisome repetition of news that’s wrong about what’s behind market-moves. Many trust it for reasons, policy, direction. Decisions thus lack footing.

A year ago, ModernIR warned clients about collapsing ETF data in latter September related to the creation of the new Communication Services sector. The market rolled over. Headlines blamed sudden slowing global growth.

Since that headline splashed over the globe, US stocks have posted the best three quarters since 1997. But not before pundits blamed the 20% drop last December on impending recession and monetary policy.

Stocks surged in January 2019, regaining all the media blamed on what never happened.

Why don’t we expect more from the people informing capital markets? Shouldn’t they know market structure? If you get our Sector Insights reports (ask us how), you know what the data said could happen.

For the week ended September 27, selling outpaced buying across all eleven sectors two-to-one. Not a single sector had net buying. Staples, the best performer with gains of 2.7%, got them on outliers only. The sector had one buying day, four selling days, last week.

We asked: Could all that selling land with a splat in early October?

Remember, liquidity is so paltry – now 20% worse than in Sep 2018 – that what got on the elevator (so to speak) last week got off this week, leading the news, which watches the wrong data, to incorrect conclusions.

We saw a bigger behavioral change for ETFs last week than in late Sep 2018. I’ll ask again: If the data signal selling, or buying, and the data predicts where news reacts, why isn’t everyone, especially pundits, watching that data?

Are you?

If you’ve never seen market structure analytics, ask us. It’s the vital predictive signal now. That’s good news rather than bad.

Curtains

Curtains are window-dressing. Curtains loom. But not the way you think. I’ll explain.

Before that, here in New York it’s Indian Summer, and Karen snapped this midtown shot after we stopped in at The Smith before two busy days of client visits. Next up, Washington DC with the NIRI contingent at Congress and the SEC, as I wrote last week.

Back to curtains, the news cycle forces us to address it. Democrats hope developments are curtains for President Trump. The market fell today. One could say Democrat glee clashes with market euphoria. Impeachment talks snowballed and down went stocks.

Short-term traders can push the snowball where it may want to go, sure. But the DATA changed more than a week ago. Market Structure Sentiment™ topped between Sep 12-17. This is not mass psychology. Our Sentiment index measures whether the probability of prices to rise has peaked or bottomed.

The great bulk of stock orders – around 96% – feed through algorithms and smart order routers. When those systems using extremely high-speed techniques find diminishing probability that trades will fill at the rate, price, and cost desired, they stop buying.

We translate that condition into a sentiment measure on a ten-point scale. For single stocks it’s 10/10 Overbought. For the total stock market or key benchmarks within it (S&P 500, reflecting about 88% of market capitalization, Russell 1000 comprising 95% of market cap), 7.0 is Overbought, and topped. Readings below 4.0 are Oversold and bottomed, meaning machines can fill orders better than models show.

The stock market measured this way rather than by fundamentals, headlines, blah blah, was topped more than a week ago and thus unlikely to rise further.

On Monday, Sep 23, new options and futures on everything from individual stocks to currencies and US Treasurys and indexes began trading.  We feared that disruptions in the overnight lending market coupled with big currency volatility would alter demand.

What’s more, as we’ve written, there was no momentum to value shift by INVESTORS in the first part of September. It’s happening now only because business journalists have written about it so relentlessly that people are beginning to believe it.

What manifested in the data was a massive short squeeze on Exchange-Traded Fund (ETF) market-makers, caught out by a surge in Fast Trading of VALUE stocks (and corresponding rejection of growth stocks) propelled by one stock, AT&T, where Activist investor Elliott showed. Machines duped humans. Spreads gapped, a squeeze formed.

What’s that got to do with curtains? I’m getting to it.  Stay with me.

Short-covering is a margin call. Margin calls drive up the cost of borrowing (it rippled through the overnight lending market, forcing the Federal Reserve to intervene), which meant the next time around, leverage would cost more.

That recalibration occurred yesterday, and behavioral change in ETFs exploded to near 30% – a black swan, three standard deviations from norms. You didn’t see it in price and volume. You can’t see it that way.

But with Sentiment topped, the market was destined to give us a swoon.  What if there’d been no news on impeachment? Which thing would have been blamed instead?

Behavioral change in markets is CAUSING pundits to cast about for reasons and incorrectly assign motivation.

Window-dressing, when passive money adjusts assets to reflecting benchmarks, has got to get done the next few days. Volatility skews benchmark-tracking.  Fear feeds through markets to investors. The cost of hedging continues rising.

And there’s a vital futures contract for truing up index-tracking that expires the last trading day of each month. That’s next Monday.

The needs of passive money, leviathan in stocks now, means the patterns of window-dressing stretch long either side of the last trading day. We’re seeing them already (and if you want to know what they say, use our analytics!).

What this means for both investors and public companies is that you must track the underlying data if you want to know what’s coming. It’s there. And we have it.

Headlines are being driven by data-changes behind stocks rather than the other way around (we warned you, clients, in a special private note Monday before stocks opened for trading that we feared just this outcome).

Curtains – window-dressing, the movement of money – are more important than the window, the headlines used to justify unexpected moves.

So every public company, every investor, should put MORE weight on the data than the headlines. We’ve got that data.

Reality Disconnect

In 1975, there were no electronic exchanges in the United States.  Now the average S&P 500 component trades electronically 17,000 times daily in 134-share increments totaling a mean of $500 million of stock.

Yet public companies still have a 1975 standard of shareholder disclosure from the SEC, called 13F filings, referencing the section of the Securities Act with instructions for investment advisors of specified size to report positions 45 days after each quarter-end.

It’s a reality disconnect. Retaining this standard says to executive teams and boards for public companies that “regulators and legislators want you to believe this is what’s driving your share-value.”

You can’t believe what the market is telling you on a given day, let alone over a quarter. We’ll come to that.

In 1975, there were no Exchange Traded Funds, no Fast Traders.  The first index fund open to the public launched Dec 31, 1975, from Vanguard, with $11 million of assets.

Today, index investing has surpassed active stock-picking in the US for assets under management. ETFs are the phenomenon of the era, with growth surpassing anything modern markets have ever seen. There is one ETF for each Russell 1000 stock now.

Total US market capitalization is more than $30 trillion, and 1% of it trades every day – over $300 billion of stock. By our measures, ETFs are responsible for roughly 60% directly or indirectly. ETFs are priced by arbitrage. Arbitrage blurs delineation between Fast Traders and ETF “market-makers.” Both make trade decisions in 10 nanoseconds.

None of this money we’ve just highlighted pays attention to earnings calls or reads 10-Ks and 10-Qs or press releases.  It’s rules-based investing. Asset allocation. Trading.

As money has shifted tectonically from Active to Passive, regulatory and disclosure costs for public companies – to serve Active investors – have gone the opposite direction.

We estimate costs related to quarterly and annual reporting, associated public reviews and audits, and Sarbanes-Oxley and Dodd-Frank and other regulations total $5-6 billion annually. For the roughly 3,400 companies traded nationally, investor-relations budgets consumed by communications tools, travel, reports and services are $3-4 billion.

Unless the point of regulation is busywork, the rules are confusing busy with productive. As the money ceases to listen – there’s been a diaspora of sellside analysts from Wall Street to the IR chair because the buyside has gone passive – the chatter from companies has exponentiated.

The Securities Act says no constituency of the national market system including issuers is to be discriminated against. Failing to modernize data to reflect reality is a disconnect.

Summing up, public companies, beset by a leviathan load of regulatory costs for investors, which are moving in math-driven waves and microseconds, wait to see what funds file 13F records of shareholdings 45 days after the end of each quarter.

There’s more.  The average stock has four distinct trading patterns per month, meaning traders unwind and return, funds rebalance, derivatives bets wax and wane, in 20 trading days. Not over a quarter.

About 45% of all trading volume is borrowed. Another 45% comes from Fast Trading machines (with heavy overlap as machines are automated borrowers) that close out 99% of positions before the trading day ends.

All told, 87% of market volume comes from something other than stock-picking. The disclosure standard supposes – because it dates to 1975 – that all volume is rational.

The reality disconnect is so bad now that machines look like humans. As we wrote last week, the whole of financial punditry has been caught up in a vast reputed momentum-to-value shift.

Except it didn’t happen.

Sure, momentum stocks plunged while value stocks surged.  Yet as this story from Marketwatch yesterday notes (I’m a source here too), AAPL is a core component of flying value indices.  Isn’t AAPL a growth stock?

Here’s the kicker.  The principal reason for swooning momentum and soaring value was a rush by Fast Trading machines that spread through markets, and a corresponding short-squeeze for ETF market-makers, which routinely borrow everything but were caught out in ripping spreads between ETFs and component stocks.

What if today’s Federal Reserve monetary policy decisions reflect belief money has shifted to value?  What if investment decisions are incorrectly recalibrated?  What if observers falsely suppose growth is slowing and crow anew about impending recession?

The market is disconnected from 13Fs. How about modernizing them, regulators? I’ll be going to Capitol Hill and the SEC with the NIRI delegation next week to make this case.

Meanwhile, be wary of markets. The Fed was intervening yesterday and likely cuts rates today by 25-50 basis points, just as volatility expirations hit now, and before a raft of stock, index, ETF, currency, Treasury and interest-rate derivatives expire through Friday. And Market Sentiment is topped.

Maybe it’s nothing. But if the market rolls, there are data-driven reasons.  And it’s about time disclosures took a leap forward past the reality disconnect for public companies.

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.