Rate of Change

Every investor and public company experiences volatility – the rate of change in prices.

So every investor and public company should come to the market with a baseline grasp on what others do about the rate of change in prices.

Notwithstanding how Rate of Change would be a good name for a rock band, let’s think about the kinds of money that would be concerned about rate of change, volatility.

Hedge funds. Though as we learned in the hedge-fund panel at NIRI Annual a couple weeks ago (with the help of my good friend Rich Barry, I assembled the group on the stage), hedge funds may have longer horizons than you think.

One of those folks said, however, putting emphasis on rate of change, “Whatever assets we’ve got under management, put a multiplier of 5-8 times on it, because that’s our economic impact on markets.”

You’ve got pension funds, commodity funds, insurance companies.  All are impacted by the rate of change in prices.

There are Fast Traders – machines in the markets driving about 45% of trading volume in US stocks that continuously calculate recovering and deteriorating prices. They’ll want to extend their influence in a way that profits from these rates of change.

Am I going somewhere with this?  Yes. And it’s happening right now. Stay with me.

Mutual funds too, especially indexers.  Index funds are the biggest consumer of options and futures because they track the mean, a benchmark. Volatility causes tracking errors.

They can adjust for index errors by buying or selling options (or futures, or repurchase agreements, or forwards, and so on). Most prospectuses include provisos for using about 10% of funds toward these ends.

Only one asset class, however, owes its existence to the rate of change: Exchange Traded Funds. They’re the only financial instrument ever created that was imbued with special regulatory dispensation to pursue arbitrage.  Which is…anyone?  Anyone?

Profiting on the rate of change in prices.

Arbitrage cannot exist if prices don’t change. There was almost no currency arbitrage before the USA left the gold standard in 1971. Exchange rates were fixed. Today, there are $544 TRILLION of over-the-counter derivatives swaps, most tied to currencies and interest rates designed to compensate for continual rates of change.

You know the VIX, the fear gauge?  Instruments tied to it expire today. It’s a way to profit on the rate of change.

Heard of the VVIX?  It tracks the annualized presence of volatility. It was created in 2006 and closed that year over 71%. It’s never been sustainably lower. It’s currently at 96%, about where it was in December last year.

Volatility is rising, not muted as the VIX suggests. Why? Blame can be spread around but it concentrates in ETFs. ETFs aren’t compensating for it. They’re depending on it.

ETF volatility – we track it – averaged 11% PER WEEK between Dec 14, 2018-Jun 14, 2019. Annualized, that’s nearly 600%. In fact, volatility between ETFs and the underlying stocks they’re supposed to track was 23% in April 2019 but a staggering 481% in May when stocks were down for six straight weeks. It suggests low spreads (April) triggered weak markets (May).

Maybe the Dow Jones would be at 50,000 if so many didn’t feed on the rate of change.

Is it good for investors and companies that the focus of the stock market has shifted from what rises or falls to what the gaps are between those items?

We get to today. Options expire today through Friday. These instruments tie to the rate of change in prices.  S&P indices, the benchmarks, true up quarterly this week. Russell indices are in phase three, the penultimate, of annual reconstitution, and they depend on the absence of a rate of change.

New options trade Monday, Jun 24. Counterparties will true up exposure Tuesday the 25th. We’ll see reality around Jun 26-27.

The bigger the money tracking a benchmark, the bigger the assets pegged to ETFs, the more consequential the rate of change of prices becomes.

And it warps any interpretation of fundamentals.

We cannot suppose that fundamentals price stocks when 100% of NET new inflows to stocks the entire past decade have gone to instruments attempting to mitigate the rate of change by tracking some measure.

I hope I’ve made the point.

The data tell us the rate of change could take a stomach-jerking step. Why? Too much money depends on preventing it or fostering it. Tug of war.  It may not happen. But be ready.

Russelling Stocks

We’re back!

At the NIRI Annual Conference last week in Phoenix (where foliage defied fiery environs) we launched an ad campaign for investor-relations professionals that graced the escalator wall into the hall, and the ModernIR booth hummed.

I had the honor of co-vice-chairing, and my market structure panel with hedge-fund legend Lee Cooperman, market commentator Joe Saluzzi, and SEC head of Trading and Markets Brett Redfearn kicked off the conference Monday June 3rd.

Due to an inadvertent clerical error, I was also named a NIRI volunteer of the year (here with NIRI CEO Gary LaBranche and board chair Ron Parham) along with TopBuild’s Tabitha Zane.  And I met NIRI co-founder Dick Morrill who at 97 can still deliver a ringing speech.

Post-conference, Karen and I bolted briefly to our mountain home, Steamboat Springs, where frost dusted the grass twice the last week and Sand Mountain jutted white-capped above a voluptuous carpet of grasses and blooms.

Meanwhile back in the stock market, with trade fears gripping the world – US stocks zoomed at the best rate in 13 months, posting six straight days of gains, a 2019 record, beating even the heady January start.

Against this backdrop loom big index rebalances. The Russell indices have been morphing toward July 1 reconstitution in phases that persist through the next three Fridays. On June 21, S&P quarterly rebalances will join the jammed queue, as will stock and index options and futures expirations June 19-21.

And expiring June 28 when the Russell finalizes are monthly CBOE futures contracts created to help indexers true up benchmark-tracking on the month’s last trading day.

Russell says $9 trillion of assets are pegged to its US equity indexes.  For perspective, the Russell 1000 is 95% of US market cap, the Russell 2000 most of the remaining 5%, as there are only 3,450 public companies.

What’s at stake with rebalances is thus more than pegged assets. It’s all the assets.

Passive assets are now over 50% of managed money, Exchange Traded Funds alone drive more than 50% of volume. The effects of these events are massive not due to susurrations in construction but in the capacity for price-changes to ripple through intertwined asset classes and the entirety of equity capitalization.

It’s like being in Group One on a United Airlines flight.  The fewer the airlines, the bigger the audience, the longer the line.

When the money wanting to queue up beside a benchmark was an eclectic conclave outside Palm Springs, rebalances were no big deal. Now passives are Los Angeles and rebalances are a Friday afternoon rush hour.

Put together the trillions tied to Russell and S&P indexes, the trillions in equity-linked swaps benchmarked to broad measures, the hundreds of trillions tied to expiring currency and interest rate swaps, the ETF market-makers trying to price ETFs and stocks driving $125 billion of daily trading volume, the Active “closet indexers” mimicking models, the Fast Traders with vast machine-computing power trying to game all the spreads. It’s keying the tumblers on the locks to the chains constraining the Kraken.

It’s not a myth. It’s already happening. Stocks imploded when the Communication Services sector was yanked like a rib from the torso of Tech and Consumer Discretionary stocks last September. It happened repeatedly through October, November and December 2018 as sector and market-cap ETFs washed like tides over stocks.

It happened in January, March, May, this year.

And it just happened again. What was it? Strafing waves of short-term passive shifts.

Lead market behavior in June so far? Risk Mgmt – continuous recalibration of derivatives bets.  Followed by Fast Trading – machines changing prices. Followed by Passive Investment (which tied to Risk Mgmt is ETFs, far and away the biggest combined influencer).

All these behaviors are 30%-43% higher than Active Investment as influencers. Defined as percentages of trading volume the past five days, Active is 11.6%, Passive, 26.9%, Fats Trading 41.4%, Risk Mgmt 20.1%.

What’s rustling the thickets of equity volatility, introducing unpredictability into stocks across the board, are vast benchmarked behaviors and their trading remoras.

The longer everyone persists in trying to assign rational motivation to moves, the more dangerous the market becomes. This isn’t complicated: The elephant in the room is the money watching prices – passive, speculative, hedged.  If observers are looking elsewhere, we’ll sooner or later get caught off-guard.

Let’s not.  Instead, be aware. Know the calendar.  Listen for Russelling stocks.

Phones and Wristwatches

Numbers matter. But not the ones you think, public companies and investors.

For instance, the best sector the past month is Utilities, up 3.5%, inversing the S&P 500’s 3.5% decline over that time (a 7% spread trade, we could say).

Utilities were worst for revenue surprises among the eleven sectors last quarter, says FactSet, and ninth of eleven for earnings surprises. Financial returns were mid-pack among sectors. It wasn’t results.

Sure, Utilities are defensive, along with Staples, Real Estate, Health Care. Those are up too the last month but less than Utilities.

One number sets Utilities apart: volatility.

Or lack thereof. Measured intraday, it’s 1.5% daily between high and low prices for stocks comprising the sector. Broad-market intraday volatility is 2.7%, 50% higher than Utilities.

Staples and Real Estate trail market volatility too, while Health Care, only of late returning to the safe-harbor fold, is more than twice as volatile as Utilities.

The worst sector in the market the last month is Energy, down 8.4% as measured by State Street’s sector ETF, XLE. And Energy stocks, with daily swings of 3.9%, were 44% more volatile than the broad market – and 100% more volatile than Utilities.

Among the most popular recent investments, the WSJ reports (posted here by Morningstar), are low-volatility ETFs like $SPLV and $USMV. Assets have exploded. These funds are disproportionately exposed to Utilities. And our models show massive ETF patterns in Utilities stocks.

Remember, ETFs are not pooled investments. They’re derivatives. If money flows to these ETFs, it’s not aggregating into a big lake of custodial money overseen by Blackrock or Invesco.

Suppose I traded my cell phone for your wristwatch. You’re free to do what you want with my phone because it’s yours now. But in a sense we’re saying the phone and the wristwatch are of similar value.

Say we’re day-trading phones and wristwatches.  Neither of us has a claim per se to the phone or the wristwatch. But we’ll be inclined to buy the wristwatch when it’s worth less than the phone and sell it when it’s worth more.

Same with ETFs. Low-vol ETF sponsors want assets such as Utilities and big stocks like WMT or PFE that don’t move much intraday (about 1.3% for those two).

ETFs are priced on spreads. Low-volatility instruments demand comparatives with low volatility (creating a run on low-vol assets?). They have no intrinsic value. You can’t find an ETF lying on the sidewalk and trade it to, say, Blackrock for its face value in cash.

It has no face value. Unless there’s another item with similar value to which it compares. ETFs are priced via in-kind exchange. Phone and wristwatch.

The ETF, phones, will be attractive to a trader to buy if it’s discounted to the stuff it’s supposed to track, wristwatches, and less attractive (and a short) if it’s currently priced above that stuff (phones). Prices constantly change as a result. Volatility.

The same thing will by extension invade your stock’s pricing, because your stock is the stuff ETFs track.

This is vital to understand, public companies and investors.

If the majority of money in the market fixates on spreads, the spread becomes more important than your financial results. Spreads become better predictors of future stock values than fundamentals.

EDITORIAL NOTE: Come to the NIRI Annual Conference June 2-5 in Phoenix! I’m hosting a session on ETFs with Rich Evans from the Univ of VA Wed morning Jun 5.

Also, the Think Tank chaired by Ford Executive Director of Investor Relations Lynn Tyson has released its white paper on the future of Investor Relations. Adapting to evolving market structure and investment behavior is key.

This image (linked) looks like robot-generated modern art. It’s our data on spreads between ETFs and stocks from Dec 2018 to present.  Wide spreads matched strong markets. Diminishing spreads correlated to weakening stocks. Maybe it’s false correlation.

But what if as spreads narrow the incentive to swap phones for watches fades? Markets could be imperiled by numbers we’re not watching. Shouldn’t we know?

Are you listening, financial reporters?

Jekyll and Hyde

Your stock may collateralize long and short Exchange-Traded Funds (ETFs) simultaneously.

Isn’t that cognitive dissonance – holding opposing views? Jekyll and Hyde? It’s akin to supposing that here in Denver you can drive I-25 north toward Fort Collins and arrive south in Castle Rock. Try as long as you like and it’ll never work.

I found an instance of this condition by accident. OXY, an energy company, is just through a contested battle with CVX to buy APC, a firm with big energy operations in the Permian Basin of TX (where the odor of oil and gas is the smell of money).

OXY is in 219 ETFs, a big number.  AAPL is in 271 but it’s got 20 times the market-capitalization.  OXY and its short volume have moved inversely – price down, shorting up. The patterns say ETFs are behind it.

So I checked.

Lo and behold, OXY is in a swath of funds like GUSH and DRIP that try to be two or three times better or worse than an index. These are leveraged funds.

How can a fund that wants to return, say, three times more than an S&P energy index use the same stock as one wanting to be three times worse than the index?

“Tim, maybe one fund sees OXY as a bullish stock, the other as bearish.”

Except these funds are passive vehicles, which means they don’t pick stocks. They track a model, and in this case, the same model.  If the stock doesn’t behave like the ETF, why does the fund hold it?

I should note before answering that GUSH and DRIP and similar ETFs are one-day investments. They’re in a way designed to promote ownership of volatility. They want you to buy and sell both every day.

You can see why. This image above shows OXY the last three months with GUSH and DRIP.

Consider what that means for you investor-relations professionals counting on shares to serve as a rational barometer, or you long investors doing your homework to find undervalued stocks.

Speaking of understanding, I’ll interject that if you’re not yet registered for the NIRI Annual Conference, do it now!  It’s a big show and a good one, and we’ve got awesome market structure discussions for you.

Back to the story, these leveraged instruments are no sideshow. In a market with 3,500 public companies and close to 9,000 securities, tallying all stock classes, closed-end funds and ETFs, some routinely are among the top 50 most actively traded.  SQQQ and TVIX, leveraged instruments, were in the top dozen at the Nasdaq yesterday.

For those juiced energy funds, OXY is just collateral. That is, it’s liquid ($600 million of stock trading daily) and currently 50% less volatile than the broad market. A volatility fund wants the opposite of what it’s selling (volatility) because it’s not investing in OXY. It’s leveraging OXY to buy or sell or short other things that feed volatility.

And it can short OXY as a hedge to boot.

All ETFs are derivatives, not just ones using derivatives to achieve their objectives. They are all predicated on an underlying asset yet aren’t the underlying asset.

It’s vital to understand what the money is doing because otherwise conclusions might be falsely premised. Maybe the Board at OXY concludes management is doing a poor job creating shareholder value when in reality it’s being merchandised by volatility traders.

Speaking of volatility, Market Structure Sentiment is about bottomed at the lowest level of 2019. It’s predictive so that still means stocks could swoon, but it also says risk will soon wane (briefly anyway). First though, volatility bets like the VIX and hundreds of billions of dollars of others expire today. Thursday will be reality for the first time since the 15th, before May expirations began.

Even with Sentiment bottoming, we keep the market at arm’s length because of its vast dependence on a delicate arbitrage balance. A Jekyll-Hyde line it rides.

Euripides Volatility

Question everything.

That saying is a famous Euripides attribution, the Athenian playwright of 2500 years ago. The Greeks were good thinkers and their rules of logic prevail yet today.

Let’s use them.  Blue chips dropped over 600 points Monday and gained 200 back yesterday. We’re told fear drove losses and waning fear prompted the bounce.

What do you think the Greeks would say?

That it’s illogical?  How can the same thing cause opposing outcomes?  That’s effectively the definition of cognitive dissonance, which is the opposite of clear thinking.

The money motivated to opposite actions on consecutive days is the kind that profits on price-differences. Profiting on price-differences is arbitrage.

Could we not infer then a greater probability that arbitragers caused these ups and downs than that investors were behind them?  It’s an assessment predicated on matching outcome to motivation.

Those motivated by price-changes come in three shades. The size of the money – always follow the money, corollary #1 to questioning everything – should signal its capacity to destabilize markets, for a day, or longer.

There are Risk Parity strategies.  Simon Constable, frequent Brit commentator on markets for the Wall Street Journal and others, suggested for Forbes last year following the February temblor through US stocks that $500 billion targets this technique designed to in a sense continually rebalance the two sides of an investing teeter-totter to keep the whole thing roughly over the fulcrum.

Add strategies designed to profit on volatility or avoid it and you’ve got another $2 trillion, according to estimates Mr. Constable cites.

The WSJ ran a story May 12 (subscription required) called “Volatility in Stocks Could Unravel Bets on Calm Markets,” and referenced work from Wells Fargo’s derivatives team that concluded “low-vol” funds with $400 billion of assets could suddenly exit during market upheaval.

Add in the reverse. Derivatives trades are booming. You can buy volatility, you can sell it, you can hedge it.  That’s investing in what lies between stocks expected to rise (long bets) and stocks thought likely to fall (short bets).

This is the second class:  Volatility traders. They are trying to do the opposite of those pursuing risk-parity. They want to profit when the teeter-totter moves. They’re roughly 60% of daily market volume (more on that in a moment).

The definition of volatility is different prices for the same thing.  The definition of arbitrage is profiting on different prices for the same thing.

The third volatility type stands alone as the only investment vehicle in the history of modern capital markets to exist via an “arbitrage mechanism,” thanks to regulatory exemptions.

It’s  Exchange-Traded Funds (ETFs). ETFs by definition must offer different prices for the same thing. And they’ve become the largest investment vehicle in the markets, the most prolific, having the greatest fund-flows.

EDITORIAL NOTE: I’m hosting a panel on ETFs June 5 at the NIRI Annual Conference, one of several essential market-structure segments at the 50th anniversary event. You owe it to your executive team to attend and learn.

Size matters. Active Investment, getting credit for waxing and waning daily on tidal trade fear, is about 12% of market volume. We can’t precisely break out the three shades of volatility trading. But we can get close.

Fast Trading, short-term profiteering on fleeting price-changes (what’s the definition of arbitrage?), is about 44% of volume. Trades tied to derivatives – risk-parity, bets on price-changes in underlying assets – are 19%.  Passive investment, the bulk of it ETFs (the effects of which spill across the other two), is 25%.

One more nugget for context:  Options expire May 16-17 (index, stock options expirations), and May 22 (VIX and other volatility bets). Traders will try to run prices of stocks to profit not on stocks but how puts, calls and other derivatives increase or decrease far more dramatically than underlying stocks.

The Greeks would look at the math and say there’s an 88% probability arbitrage is driving our market.

Euripides might call this market structure a tragedy. But he’d nevertheless see it with cold logic and recognize the absence of rational thought.  Shouldn’t we too?

Dragon Market

As the market fell yesterday like a dragon from the sky (Game of Throners, the data are not good on dragon longevity now), 343 companies reported results, 10% of all firms.

Market fireworks were blamed yet again on tariff fears. Every tantrum is the Fed or tariffs it seems, even with hundreds publishing earnings. What happened to the idea that results drive markets?

Speaking of data, on May 6, the market first plunged like a bungee jumper off a bridge – and then caromed back up to a nonevent.

Behind the move, 21% of companies had new Rational Prices – Active money leading other behaviors and buying. That’s more than twice the year-long average of about 9% and the third-highest mark over the entire past year.

Talk about buying the dip. Smart money doesn’t see tariffs as threats to US interests (and likes the economic outlook, and likes corporate financial results). We’ve been using them to fund government since the Hamilton Tariffs of 1789.

So if not tariffs, why did stocks fall?

Before I tell you what the data show: Come to the NIRI Annual Conference, friends and colleagues. I’m moderating a panel the first day featuring hedge-fund legend Lee Cooperman, market-structure expert and commentator Joe Saluzzi, and SEC head of Trading and Markets Brett Redfearn.

We’ll talk about the good and bad in market-evolution the past 50 years and what’s vital to know now.  Sign up here.

IR folks, you’re the chief intelligence officer for capital markets. Your job is more than telling the story. It’s time to lead your executive team and board to better understand the realities driving your equity value, from Exchange Traded Funds to shorting and event-driven trends. It’s how we remain relevant.

Before you report results, you should know what the money that’s about you, your story, your results, your strategy, is doing – and what the rest of it is doing too. 

Take LYFT, which reported yesterday for the first time. Just 8% of LYFT volume is from Active Investment. By contrast about 22% is quantitative event-driven money, and over 58% is fast machines trading the tick. The balance ties to derivatives.

From that data, one can accurately extrapolate probable outcomes (ask us for your Market Expectation, or LYFT’s, and we’ll show you).

Every IR team should be arming its board and executives with a view of all the money, not just musing on how core holders may react – which is generally not at all.

And investors, if you’re focused only on fundamentals without respect to market structure, you’ll get burned.  I can rattle off a long list of companies beating and raising whose shares fell. The reasons aren’t rational but arbitrage-driven.

Having kept you in the dark like a Game of Thrones episode, let’s throw light on the data behind the late equity swoon: Always follow the money (most in financial media are not).

ETFs are 50% of market volume.  There have been $1.4 trillion (estimating for Apr and May) of ETF shares created and redeemed in 2019 already.

ETF shares are collateralized with stocks, but ETFs do not pool investor assets to buy stocks. In exchange for tax-free collateral, they trade to brokers the right to create ETF shares to sell to investors. The collateral is baskets of stocks – that they own outright.

The motivation, the profit opportunity, for that collateral has got nothing to do with tariffs or earnings or the economy. It’s more like flipping houses.

An Invesco PowerShares rep quipped to one of our team, “You see that coffee cup? I’d take that as collateral if I could flip it for a penny.”

ETF sponsors and brokers in very short cycles flip ETF shares and collateral. As with real estate where it works

Tech Sector Composite Stocks — Behavioral Data

great until houses start to fall in value, the market craters when all the parties chasing collateral try to get out at once (and it happens suddenly).

ETF patterns for the top year-to-date sector, Tech, are elongated way beyond normal parameters (same for two of three other best YTD sectors). It suggests ETFs shares have been increasing without corresponding rises in collateral.

With the market faltering, there’s a dash to the door to profit on collateral before the value vanishes. One thing can trigger it. A tweet? Only if a move down in stocks threatens to incinerate – like a dragon – the value of collateral.

How important is that for IR teams, boards, executives and investors to understand?

The Vital Day

Which is the most important trading day of the month?

“The one when my company reports results,” you say.

Good guess, and you’re usually right. Not this time. It’s the last day.  Yesterday was it, the vital day of April, the benchmark for monthly fund-performance.

All funds want to clock results, punch the timer when the sprinter hits the tape. But it’s most true for money tracking a measure like the S&P 500.

CBOE, the giant derivatives and equities market operator, began in 2014 offering an options contract to “allow asset managers to more precisely match SPX option expirations to end-of-month fund cycles and fund performance periods.” SPX is the S&P 500. CBOE offers many ways for investors to improve tracking or profit on variances.

CBOE describes SPX securities as “flexible tools that allow investors to synthetically adjust their positions to a 500-stock portfolio.”

All three big exchange groups (NYSE, Nasdaq, CBOE) operate equity and derivatives markets, and all promote pricing advantages for firms trading equities and derivatives simultaneously.

That means, public companies and investors, these exchanges are encouraging traders to speculate. How often are prices of stocks affected by the prices of derivatives ranging from options on individual stocks to futures on indexes and ETFs?  (Heck, there are options on futures.)

Answer: Behavioral analytics ModernIR developed show that about 19% of volume marketwide the last five days ties to derivatives. By sector, Communication Services was highest at 20.6%; Industrials the lowest, 17.7%.

Active Investment by comparison was 11.2% of volume in Communication Services stocks, and 12.6% in Industrials (sellers, however).

AAPL, trading today on results, had 23% of volume on Apr 29 – $1.03 billion! – driven by derivatives-related trades. About 150 S&P 500 components, and hundreds of others, release this week.

Derivatives are bigger than investment. Do stocks then reflect fundamentals?

BK plunged Apr 17 – index options expired that day – and the biggest behavioral change was in Risk Mgmt, reflecting derivatives. Shorting peaked Apr 17. Bets preceding results were quantitative, and big. Math.  Active money then bought the dip.

SIRI dropped on results like a diver off a cliff, and over 23% of its trading volume beforehand traced to counterparties for derivatives bets.

TWTR exploded from about $34 to over $40 intraday on long (not short) derivatives bets made with new options that traded Apr 22, driving more than 20% of TWTR volume. Active money played no price-setting role and was a profit-taker on the move.

INTC rag-dolled down Apr 26 with results, on volumes approaching 80 million shares, and the biggest behavior was Risk Mgmt – counterparties to derivatives bets.

CHRW was 70% short and 25% of its trading volume tied to derivatives – a resounding bear bet – before shares blinked out this week to December levels.

Imagine the value you’d add – what’s your name, IR professional? Portfolio manager? – if you knew the behaviors behind price and volume BEFORE stocks went wild.

A lesson: 

Fast Traders arbitrage the tick. That is, computerized trades profit by churning many securities long and short fleetingly, netting gains. The more money seeks a measure – indexes, ETFs, closet indexers, money trying to beat a benchmark – the more machines change prices. Fast Trading is 42% of volume the past five days.

Passive investment must track the benchmark. ETFs need variance versus the index to price shares. That combination is 27% of volume.

Active money chasing superior stories defined by fundamentals is 12% of market volume the five days ended Apr 29. So, during earnings season stocks had a 1-of-8 chance of being priced by story.

Derivatives (Risk Mgmt to us at ModernIR) used by indexes to true up tracking and traders to profit on volatility are 19% of volume.

Got bad news to dump, companies? Do it the last three trading days of the month. You’ll get hammered. But then it’s done. Money will return in the new month. Investors, in the new month the stuff hammered to finish the last month could win.

There’s a vital day: The last trading day each month. It trumps story. You should understand it. We can help you.

Driverless Market

Suppose you were human resources director for a fleet of driverless taxis.

As Elon Musk proposes streets full of autonomous autos, the market has become that fleet for investors and investor-relations professionals.  The market drives itself. What we measure as IR professionals and investors should reflect a self-driving market.

There’s nothing amiss with the economy or earnings. About 78% of companies reporting results so far this quarter, FactSet says, are beating expectations, a tad ahead of the long-term average of 72%.

But a closer look shows earnings unchanged from a year ago. In February last year with the market anticipating earnings goosed by the corporate tax cut of 2017, stocks plunged, and then lurched in Q3 to heights we’re now touching anew, and then nosedived in the fourth quarter.

An honest assessment of the market’s behavior warrants questioning whether the autonomous vehicle of the market has properly functioning sensors. If a Tesla sped down the road and blew a stop sign and exploded, it would lead all newscasts.

No matter the cacophony of protestations I might hear in response to this assertion, there is no reasonable, rational explanation for the fourth-quarter stock-implosion and its immediate, V-shaped hyperbolic restoration. Sure, stocks rise and fall (and will do both ahead). But these inexplicable bursts and whooshes should draw scrutiny.

Investor-relations professionals, you are the HR director for the driverless fleet. You’re the chief intelligence officer of the capital markets, whose job encompasses a regular assessment of market sensors.

One of the sensors is your story.  But you should consistently know what percentage of the driving instructions directing the vehicle are derived from it.  It’s about 12% marketwide, which means 88% of the market’s navigational data is something else.

Investors, the same applies. The market is as ever driven by its primary purpose, which is determined not by guesses, theory or tradition, but by what dominates price-setting.  In April, the dominating behavior is Exchange-Traded Funds.  Active investment was third of four big behaviors, ahead only of Fast Trading (curious, as Fast Traders avoid risk).

ETF shares are priced by spreads versus underlying stocks. Sure, investors buy them thinking they are consuming pooled investments (they’re not). But the motivation driving ETFs is whether they increase or decrease in price marginally versus stocks.

ETF market-makers supply stocks to a sponsor like Blackrock, which grants them authority to create an equal value of ETF shares to sell into the market. They aim to sell ETFs for a few basis points more than the value of exchanged shares.

The trade works in reverse when the market-maker borrows ETF shares to return to Blackrock in exchange for a group of stocks that are worth now, say, 50 basis points more than the stocks the market-maker originally offered.

If a market-maker can turn 30-50 basis points of profit per week this way, it’s a wildly winning, no-risk strategy. And it can and does carry the market on its updraft. We see it in patterns.

If it’s happening to your stock, IR professionals, it’s your job to know. Investors, you must know too, or you’ll draw false conclusions about the durability of cycles.

Big Market Lesson #1 in 2019: Learn how to measure behaviors. They’re sensors. Watch what’s driving your stock and the market higher (or lower – and yes, we have a model).

Speaking of learning, IR people, attend the 50th Anniversary NIRI Annual Conference. We have awesome content planned for you, including several not-to-be-missed market-structure sessions on hedge funds, the overall market, and ETFs.  Listen for a preview here and see the conference agenda here.  Sign up before May 15 for the best rate.

Big Market Lesson #2: Understand what stops a driverless market.

ETF-led rallies stall when the spread disappears. We have a sensor for that at ModernIR, called Market Structure Sentiment™ that meters when machines stop lifting or lowering prices.

It’s a 10-point scale that must remain over 5.0 for shares to rise. It’s averaged 6.2 since Jan 8 and has not been negative since. When it stalls, so will stocks, without respect to earnings or any other fundamental sensor.

I look forward to driverless cars. But we’ll want perfected technology before trusting them. The same should apply to a driverless stock market.

 

Melting Up

Blackrock CEO Larry Fink sees risk of a melt-up, not a meltdown for stocks.

Speaking of market structure, I’m a vice chair for NIRI’s Annual Conference – the 50th anniversary edition.  From the opening general session, to meeting the hedge funds, to a debate on how ETFs work, we’ve included market structure.  Catch a preview webcast on So-So Thursday, Apr 18, (before Good Friday) at 2pm ET (allow time to download Adobe Connect): https://niri.adobeconnect.com/webinar041819

Back to Larry Fink, is he right?  Who knows. But Blackrock wants to nudge record sidelined retail and institutional cash into stocks because revenues declined 7%.

Data tell us the market doesn’t need more buyers to melt up. Lipper said $20 billion left US equities from Jan through Apr 3, more than the $6 billion Bloomberg had earlier estimated. Stocks rallied 16%.

We wrote April 3 that no net cash fled equities in Q4 last year when the market corrected. If stocks can plunge when no money leaves and soar when it does, investors and public companies should be wary of rational expectations.

We teach public companies to watch for behavioral data outside norms.  Investors, you should be doing the same. Behavioral-change precedes price-change.  It can be fleeting, like a hand shoved in a bucket of water. Look away and you’ll miss the splash.

Often there’s no headline or economic factor because behaviors are in large part motivated by characteristics, not fundamentals.

Contrast with what legendary value investor Benjamin Graham taught us in Security Analysis (1934) and The Intelligent Investor (1949): Buy stocks discounted to assets and limit your risk.

The market is now packed with behaviors treating stocks as collateral and chasing price-differences. It’s the opposite of the Mr. Market of the Intelligent Investor. If we’re still thinking the same way, we’ll be wrong.

When the Communication Services sector arose from Technology and Consumer Discretionary stocks last September, the pattern of disruption was shocking. Unless you saw it (Figure 1), you’d never have known markets could roll over.

Larry Fink may think money should rush in (refrains of “fools rush in…”) because interest rates are low.  Alan Greenspan told CNBC last week there’s a “stock market aura” in which a 10% rise in stocks corresponds to a 1% increase in GDP. Stocks were down 18% in Q4, and have rebounded about 16%. Is the GDP impact then neutral?

To me, the great lesson for public companies and investors is the market’s breakdown as a barometer for fundamentals.  We’ve written why. Much of the volume driving equities now reacts to spreads – price-differences.

In a recent year, SPY, the world’s largest and oldest Exchange Traded Fund, traded at a premium to net asset value 62% of the time and a discount 38% of the time. Was it 2017 when stocks soared?  No, it was 2018 when SPY declined 4.5%.

Note how big changes in behavioral patterns correspond with market moves. The one in September is eye-popping. Patterns now are down as much as up and could signal a top.

SPY trades 93% of the time within 25 basis points of NAV, but it effectively never trades AT net-asset-value. Comparing trading volume to creations and redemptions of ETF shares, the data suggest 96% of SPY trading is arbitrage, profiting on price-differences.

This is the stuff that’s invaded the equity market like a Genghis Kahn horde trampling principles of value investment and distorting prices.

So, what do we DO, investors and public companies?

Recognize that the market isn’t a reliable barometer for rational thought. If your stock fell 40% in Q4 2018 and rebounded 38% in Q1, the gain should be as suspect as the fall.

Ask why. Ask your exchange. Ask the regulators. Ask the business reporters. These people should be getting to the bottom of vanishing rationality in stocks.

It may be the market now is telling us nothing more than ETFs are closing above net asset value and ETF market-makers are melting stocks up to close that gap.  That could be true 62% of the time, and the market could still lose 20% in two weeks.

When you hear market-behavior described in rational terms – even during earnings – toss some salt over a shoulder.  I think the market today comes down to three items: Sentiment reflecting how machines set prices, shorting, and behavioral change.

Behavioral patterns in stocks now show the biggest declines since September. Sentiment reflecting how machines set prices is topped ahead of options expirations that’ll be truncated by Good Friday. Shorting bottomed last week and is rising.

(Side note: patterns don’t vary during earnings. They fluctuate at month-ends, quarter-ends and options-expirations, so these are more powerful than results.)

Nobody knows the future and we don’t either. Behaviors change. But the present is dominated by characteristics, powerful factors behind behavioral patterns.

Bad Liquidity

JP Morgan’s global head of macro quant and derivatives research (if you have that title, you should be a big deal!), Marko Kolanovic, says the market’s rising propensity toward violent moves up and down reflects bad liquidity.

Bad Liquidity would be a great name for a rock band. But what’s it mean?

Most measure volatility with the VIX.  The trouble with it predictively is it’s not predictive. It spikes after the fact, not ahead.

It was not always so. Modern Portfolio Theory (MPT), a hot investment thesis of the 1990s stock market, said rising volatility reflected growing price uncertainty. Managers like Louis Navellier flew private jets on fortunes made shifting from stocks as volatility mounted.

I’d argue it’s the opposite now. When volatility vanishes, arbitrage opportunities, the primary price-discovery mechanism today (“price discovery” means “trying to figure out the price of a thing”), have been consumed. What happens then? Money leaves.

Speaking of money leaving, Mr. Kolanovic blames falling Active investment for a lack of liquidity. He says algorithm

Image shows weekly spreads between composite stocks and State Street sector SPDR ETFs, with negative numbers indicating more volatility in ETFs, positive numbers, more volatility in composite sector stocks.

s – “stock recipes” run by computers – are present when markets rise and absent when markets fall, exacerbating liquidity shortages.

Active investors tend to sell when prices are high and buy when they’re low, helping to ease liquidity constraints. As Active investment declines (he says just 10% of trading, presumably he means at JP Morgan, comes from Active stock-picking, eerily near the figures we measure – with algorithms no less), stabilizing liquidity shrinks.

Liquidity boiled down (so to speak!) is the availability of a thing at a stable price.  The more that’s available, the better your chance of getting it at the same price.

Investors tend to want a lot of something – a truckload.  Arbitragers tend to want the price to change. These aims are diametrically opposed.

By the way, I’m speaking to the NIRI Minneapolis chapter today on Exchange Traded Funds, which are predicated on an arbitrage mechanism. That means they can only exist as investment instruments if there is volatility. Mr. Kolanovic thinks volatility is the root rot.  Connection?

Yes. ETFs distort liquidity in two crucial ways that compound risk for stocks. As we’ve explained, ETFs are not pooled investments. They are most closely akin to put and call options, in that they are created when people want more of them and removed from the market when people don’t want them.

As with puts and calls, they become ends unto themselves. Too many mistake options prices for future stock prices. Sometimes that’s true. But changes in the value of options are a discrete profit opportunity themselves.

Goldman Sachs wrote in February this year as Q4 2018 results were coming in (thank you to an alert reader!): “What’s interesting this quarter is that buying calls for earnings reports has posted its best return in over thirteen years (record). In fact, buying the closest out of the money call 5 days ahead of earnings and closing the day after has produced an average return of 88%.”

Eighty-eight percent! That’s not a bet on results but pure arbitrage in options.

ETFs offer the same opportunity. Shares are created when investors want exposure to equities and redeemed when investors want out. But the investors to a large extent now are ETF market-makers profiting on spreads between ETFs and the underlying stocks comprising a tracking instrument. It’s arbitrage. Profiting on price-differences.

The problem with this liquidity is it’s continuously fluctuating. We can have no consistent, measurable idea of the supply of ETFs or the demand for stocks. That means the market at any given time cannot be trusted to provide meaningful prices.

The data to me say it’s the arbitrage mechanism in ETFs behind bad liquidity. ETFs can only establish prices through spreads with stocks. The market is now stuffed with ETFs. The motivation is the spread. Not fundamentals – or even fund-flows.

We track spreads between ETFs and composite stocks. Our data say spreads totaled hundreds of percentage points from Dec 2018 to Mar 2019. At Apr 5, stocks are 33% more volatile in 2019 on net than ETFs. That’s way more than the market has risen.  Somebodies will want to keep it.

If we want to know where the next financial crisis will develop, we need look no further than ETFs. They are now a mania. They depend on spreads. As liquidity goes, that’s bad.