Blocking Volatility


As the market raged high and low, so did Karen and I this week, from high in the Rockies where we saw John Denver’s fire in the sky over the Gore Range, down to Scottsdale and the Arizona desert’s 80-degree Oct 30 sunset over the Phoenician (a respite as my birthday is…wait for it…Oct 31).

Markets rise and fall.  We’re overdue for setbacks.  It doesn’t mean we’ll have them, but it’s vital that we understand market mechanics behind gyrations. Sure, there’s human nature. Fear and greed. But whose fear or greed?

Regulators and exchanges are tussling over fees on data and trades.  There’s a proposed SEC study that’ll examine transaction fees, costs imposed by exchanges for trading. Regulation National Market System caps them at $0.30/100 shares, or a third of a penny per share, which traders call “30 mils.”

The NYSE has proposed lowering the cap to $0.10/100, or a tenth of a penny per share, or 10 mils. Did you know there’s a booming market where brokers routinely pay eight cents per share or $8.00/100 shares?

What market? Exchange-Traded Funds (ETFs).

We’re told that one day the market is plunging on trade fears, poor earnings, geopolitics, whatever. And the next, it surges 430 points on…the reversal of fears. If you find these explanations irrational, you’re not alone, and you have reason for skepticism.

There’s a better explanation.

Let’s tie fees and market volatility together. At right is an image from the iShares Core MSCI EAFE ETF (CBOE:IEFA) prospectus showing the size of a standard creation Unit and the cost to brokers for creating one.  Divide the standard Unit of 200,000 shares by the usual cost to create one Unit, $15,000, and it’s $0.08/share (rounded up). Mathematically, that’s 2,600% higher than the Reg NMS fee cap.

Understand: brokers provide collateral – in this case $12.5 million of stocks, cash, or a combination – for the right to create 200,000 ETF shares to sell to the public.

Why are brokers willing to pay $8.00/100 to create ETF shares when they rail at paying $0.30/100 – or a lot less – in the stock market?

Because ETF shares are created in massive blocks off-market without competition. Picture buying a giant roll of paper privately, turning it into confetti via a shredder, and selling each scrap for a proportionate penny more than you paid for the whole roll.

The average trade-size for brokers creating IEFA shares is 200,000 shares.  The average trade-size in the stock market where you and I buy IEFA or any other stock is 167 shares (50-day average, ModernIR data).  Do the math on that ratio.

ETF market-makers are pursuing a realtime, high-speed version of the corporate-raider model. Buy something big and split it into pieces worth more than the sum of the parts.

In a rising market, it’s awesome.  These creations in 200,000-share blocks I’ve just described are running at nearly $400 billion every MONTH. Create in blocks, shred, mark up. ETF demand drives up all stocks. Everybody wins.

What happens in a DOWN market?

Big brokers are exchanging your stocks, public companies, as collateral for the right to create and sell ETF shares.  Suppose nobody shows up to buy ETF shares.  What brokers swapped to create ETF shares is suddenly worth less, not more, than the shredded value of the sum of the parts. So to speak.

Without ETF flows to drive up it up, the collateral – shares of stocks – plunges in value.

The market devolves into desperate tactical trading warfare to offset losses. Brokers dump other securities, short stocks, buy hedges. Stocks gyrate, and the blame goes to trade, Trump, earnings, pick your poison.

How do I know what I’ve described is correct?  Follow the money. The leviathan in the US equity market today is creating and redeeming ETF shares. It’s hundreds of billions of dollars monthly, versus smatterings of actual fund-flows. You don’t see it because it’s not counted as fund turnover.

But it fits once you grasp the weird way the market’s last big block market is fostering volatility.

What’s ahead? If losses have been sorted, we’ll settle down in this transition from Halloween to November. Our data are still scary.  We may have more ghouls to flush out.

Counterparty Tuesday

Anybody hear yesterday’s volatility blamed on Counterparty Tuesday?

Most pointed to earnings fears for why blue chips fell 500 points before clawing back.  Yet last week the Dow Jones Industrial Average zoomed 540 points on earnings, we were told.  We wrote about it.

Counterparty Tuesday is the day each month following expiration of the previous month’s derivatives contracts like puts, calls, swaps, forwards (usually the preceding Friday), and the start of new marketwide derivatives contracts the following Monday.

When grocery stores overstock the shelves, things go on sale.  When counterparties expect a volume of business that doesn’t materialize, they shed the inventory held to back contracts, which can be equities.

Counterparty Tuesday is a gauge indicating whether the massive derivatives market – the Bank for International Settlements tracks over $530 trillion, ten times the global economy – is overstocked or understocked. It’s much larger than the underlying volume of Active Investment behavior in the US stock market.

Let me use a sports analogy. Suppose your favorite NFL team is beating everyone (like the LA Rams are).  “They are killing everybody through the air,” crow the pundits.

You look at the data. The quarterback is averaging five passes per game and zero touchdowns.  But on the ground, the team is carrying 40 times per game and averaging four rushing touchdowns.

These statistics to my knowledge are fake and apply to no NFL team right now. The point is the data don’t support the proffered explanation. The team is winning on the ground, not through the air.

In the same vein, what if market volatility in October ties back to causes having no direct link to corporate earnings?

What difference does it make if the stock market is down on earnings fears or something else?  Because investor-relations professionals message in support of fundamental performance, including earnings.  Boards and management teams are incentivized via performance. Active stock-picking investors key off financial performance.

If the market isn’t swooning over performance, that’s important to know!

Returning to our football analogy, what data would help us understand what’s hurting markets?  Follow the money.

We wrote last week about the colossal shift from active to passive funds in equities the past decade.  That trend has pushed Exchange-Traded Funds toward 50% of market volume. When passive money rebalanced all over the market to end September, the impact tipped equities over.

Now step forward to options expirations, which occurred last week, new ones trading Monday, and Counterparty Tuesday for truing up books yesterday. Money leveraged into equities had to mark derivatives to market. Counterparties sold associated inventory.

Collateral has likely devalued, so the swaps market gets hit. Counterparties were shedding collateral. The cost of insuring portfolios has likely risen because counterparties may have taken blows to their own balance sheets. As costs rise, demand falters.

Because Counterparty Tuesday in October falls during quarterly reporting, it’s convenient to blame earnings. But it doesn’t match measurable statistics, including the size of the derivatives market, the size and movement of collateral for ETFs (a topic we will return to until it makes sense), or the way prices are set in stocks today.

The good news?  Counterparty Tuesday is a one-day event. Once it’s done, it’s done. And our Market Structure Sentiment index bottomed Oct 22. We won’t be surprised if the market surges – on earnings enthusiasm? – for a few days.

The capital markets have yet to broadly adapt to the age of machines, derivatives and substitutes for stocks, like ETFs, where earnings may pale next to Counterparty Tuesday, which can rock the globe.

Reactively Passive

As stocks fell last week, pundits declared that interest rates and trade fears had shaken confidence. Yesterday as the Dow Jones Industrial Average zoomed 540 points, earnings, they declaimed, had brought investors rushing back. Oh, and easing trade tensions.

Didn’t we know corporate profits would be up 20% on tax cuts?

Rational factors affect stocks. But often these convenient explanations are offered afterward, and few observers seem to look at the data surrounding investment behavior.

The first image here with data from the Investment Company Institute’s 2018 Factbook shows the staggering shift from active to passive funds over the past decade. It debunks most market reporting claiming rational thought is reactively propelling markets.

A fallacy that lacks comprehension of how passive money behaves is that it rides the coattails of rational money (In fact Active investors are closet indexing with ETFs). If your stock is 1% of a weighted index fund, and shares rise faster than other components and become 1.2%, sooner or later the fund must rebalance or slip out of compliance.

If equities are meant to be 40% of a targICI Data from 2018 Factbook - Active to Passive shiftet-date fund and become 50%, the fund will rebalance.  We see the patterns, most times at month-ends and quarter-ends, and around monthly expirations when options, futures, forwards, repurchases and other derivatives used widely by investors, market-makers and fund managers must be recalibrated.

The biggest culprit is Exchange Traded Funds.

We’re told by Blackrock, Vanguard and State Street that ETFs have little turnover.  Should we believe money pours into markets but does nothing? It cannot simultaneously be true that trillions of dollars shift to ETFs and true that ETFs don’t invest it.

Unless ETFs don’t buy and sell things. In which case, what are ETFs?

I looked at the turnover rate in the last prospectus for SPY from State Street, the largest and oldest ETF. The fund says it bought or sold just 3% of its $242 billion of assets.

But turnover is footnoted: “Portfolio turnover rate excludes securities received or delivered from in-kind processing of creations or redemptions of units.”

Huh. Creations and redemptions?  We researched it (as you already know!).

Creations and redemptions, it turns out, are tax-free, commission-free, off-market block transactions between large brokers and ETF creators like Blackrock.  The broker supplies collateral such as stocks or cash and receives in-kind rights to create and sell ETF shares.

Then trillions of investment dollars buy these collateralized stock substitutes, setting stocks afire. If investors sell ETFs, brokers buy and return them to Blackrock to get collateral back. Wash, rinse, repeat.

Blackrock makes money as the rush of investors into ETFs drives up the value of the underlying collateral (gotten by brokers where?), and by minimizing taxes.

For instance, under rules for ETFs, if your stock has gone way up, Blackrock will put your shares in the redemption basket to trade for an equal value of ETF shares from, say, Morgan Stanley, which then can sell and short your stock, which plunges.

Blackrock sheds associated capital gains.  Morgan Stanley at some future point will cover or buy your shares and return them to Blackrock for the right to create more ETF shares offering exposure to – whatever, the S&P 500, a sector ETF, a market-cap ETF.

These transactions are occurring in the hundreds of billions of dollars monthly, none of it recorded as fund turnover.

If creations and redemptions were counted for SPY, its turnover rate would be 165%, not 3%. SPY created and redeemed well more than $400 billion, nearly double its total assets, in the most recent full year.

As of Aug 2018, nearly $2.9 TRILLION of these transactions has occurred – all effectively commission-free and tax-free for Blackrock, Vanguard and State Street (but not for the end consumers of ETFs, who pay taxes and commissions).

Continually, brokers try to profit on differing prices for collateral and ETF shares, and ETF managers try to wash out capital gains, removing overvalued collateral and bringing in undervalued collateral (the reason you and peers diverge).

The relentless creation/redemption tides swing stocks, and human beings then cast about for explanations like interest rates or trade fears – or wait, trade fears have eased! The market rallies!

Tech Sector behaviors Sep-Oct 2018This is what it looks like in the Tech sector. We saw the same pattern at the same time in every GICS sector to varying degrees, the most in Materials (down 10%), the least in Utilities (down less than 2% the past five days).

The last time the market rebalanced was in early July, the first part of the third quarter of 2018.  Our Sentiment Index dipped below 4.0, a market bottom.  We observed no meaningful rebalancing again in July, or August, or September. Each time the market mean-reverted to 5.0 without turning negative, we warned of compounding imbalances.

Market Sentiment was about 4.0, a bottom, Oct 15, after topping Sep 26. Into expirations today through Friday, we expected a strong surge because all the stuff that was overweight is now underweight (the surge arrived a day early, before VIX expirations).

These cycles tend to shorten as markets break down. We had six bottoms in 2015, the last time the market was negative for the year. This is the third for 2018 after just one in 2017. Aging bull market?

Deal Data

From another rumor that game-maker Zynga might have a buyer, to a Trian bid for Papa John’s, to Bill Ackman’s stake in Starbucks, deals and rumors of them abound. Suppose it’s your company, investor-relations professionals. How do you add value for your executives?

These situations are often chess games.  Here’s an example, since much of the drama is now old news.  When Disney battled Comcast for 21st Century Fox and before bids were hiked, patterns of deal arbitrage signaled starkly that a war would ensue.

One could say it’s logical that the price would rise, and so it was.  But there is no certitude like the power of data – patterns of long bets, covered bets. They are stark in the market if one knows how to measure the data (which we do).

After Disney won the bidding war, data then showed high expectation Comcast would win Sky Broadcasting, the European unit partly owned by Disney.  Data then signaled a sudden turn toward accelerated bidding – before the UK Takeover Panel announced that a speeded process would indeed follow.

Think about the data-powered value investor-relations, so armed, delivers to those making important decisions.

I’ll give you more examples.  Two years ago, longtime client Energy Transfer tried a combination with The Williams Companies that would have created an energy giant. The deal-arbitrage data were woeful. Active money stopped buying. Massive short bets formed and never wavered. Ultimately, the firms called off the effort.

A later plan to consolidate Sunoco, an Energy Transfer unit, presented challenges. It would cut cash distributions by roughly a quarter.  Would holders support it?

Data patterns were opposite what we’d seen in the Williams deal – strong, long bets, solid Active investment. We were confident shareholders would approve. And they did.

The company is now consolidating its Master Limited Partnership into the general partner.  We highlighted big positive bets at September options expirations. A week later, both Glass Lewis and ISS came out in favor of the transaction.

Data are every bit as powerful an IR tool as telling the story.  Maybe more so, because we have a mathematical market today riven with behaviors that arbitrage events and track benchmarks passively, motivations fueled by mathematical probabilities and balances more than story.

Oh, did I mention? We have never yet missed an Activist in the data. We’ve always warned early. And we’ve seen a bunch of them.  We know legacy market intelligence struggles to find them because, as we wrote last week, routinely 98% of trading volume fails to manifest in settlement data.

In one instance years ago, Carl Icahn took a major stake in a pharmaceutical company that had two high-paid surveillance providers watching. Neither saw it. Suddenly, Icahn filed with over 8 million shares – accumulated without buying a single share (he used European-style puts.).

We showed the company Market Structure Analytics and the stark patterns of derivatives.  They hired us. Subsequently, our data showed investors were betting against Icahn. His proxy bid to put a slate of directors on the board failed.  We then tracked his gradual withdrawal in the data. Not through shares owned but in patterns of behavior (nearly realtime, at T+1).

Lips can lie. Data those behind it believe are hidden from view – but which shine like light through night-vision goggles for us – is truth.  We have an unfolding situation now where what hedge funds are doing and saying are diametrically opposite. That’s a negotiating tactic. Since management knows, they have the stronger hand.

That’s IR in the age of Big Data.  And it’s fun to boot!  Seeing patterns of behavior and reporting it to executives and board directors puts IR in the right-hand advisory seat.  Right where it belongs in this era of fast machines and market reavers.

If you want a confidential analytics assessment of what’s behind your price and volume (which are not metrics but consequences of behaviors), let us know.


Why is a paltry dab of trading volume showing up in settlement data?

Those of you with furrowed brows wondering what I’m talking about, let me explain. Speaking of explication, I’ll be sharing our discoveries about exchange-traded funds with the Connecticut/Westchester NIRI chapter this evening (and spending most of this week in New York).

So, when there is a buyer of shares interacting with a seller of shares, and one takes possession from the other, a process ensues whereby ownership of shares is transferred (blockchain would make this a snap).  That’s settlement data, today overseen by the Depository Trust and Clearing Corp (DTCC).

You’d think it would happen with every trade. Not so. If you use settlement-focused market intelligence, you can see it yourself. We’ll come to that in a moment.

In the 1980s before markets were electronic and interconnected, before high-frequency trading, exchange-traded funds, widespread share-borrowing, the explosion of passive investment, mushrooming use of derivatives, the implosion of stock-picking and the great vanishing of depository banks from hundreds to four, most trades settled.

You could reconstruct the trading day based on how shares shifted from one owner to another, traced through settlement accounts at banks. It worked roughly like this:

If accounts at this handful of depository banks declined by 500,000 shares, and these over here increased by 500,000, one could tie out to 13F reports (dating to 1975 and unchanged since, an inexcusable SEC failure) and say the seller was Fidelity, the buyer T Rowe Price, and track shifting ownership.

That was then.

This past summer I attended an event with the CFO of the DTCC and we talked about shareholder identification. She told me that one could not look at settlement data and observe changes today as in the past because the accounts are consolidated now.

Paraphrasing, she said the DTCC pays the dividends and consolidates shares for many investors. If buyers and sellers are in the same account, how could you see a change?

I presume those in the business of sorting it out will have an answer. But we’re getting to a more unsettling issue. If you use settlement-focused market intelligence, do this:

Tally the NET of buying and selling in your most recent period, be that a week, a month, etc. Compare that net number to your trading volume in the same timeframe.

I’ll give you an example. In the image here is a one-week change for a real company, a Nasdaq 100 stock.  In a one-week period, settlement data showed a net change in ownership of selling of 330,000 shares, against over 300 million shares outstanding.

But the stock traded about 3.7 MILLION shares every day.  Over that five-day settlement period, total trading volume was 18.5 million shares. Just 1.7% of trading volume settled. Put another way 98.3% of all activity driving equity value was something OTHER than measurable change in ownership.

What’s more, annualized trading volume equals three times total shares outstanding. Does the board of directors know these facts? The executive team?  If not, why not?

We in investor relations are the chief intelligence officers of the capital markets for our companies. If we leave the impression that owners are setting price when the data show something else, we are doing disservice to those with a fiduciary responsibility for oversight of what drives equity value. They sign on dotted lines, under pain of penalty.

What’s the cause? Since decimalization and how Regulation National Market System forced a market-making model on the entire market, intermediaries that own nothing but trade everything have become a large part of volume.

Nearly half of all trading volume is rented, not owned. It’s short. Borrowed. Used for a temporal purpose and returned to a margin account.  Next, derivatives account for approaching 20% of trading volume in markets – substitutes for ownership where volume comes from a counterparty, not an owner.  ETFs are a big culprit as collateralized stock substitutes, not ownership. We measure these effects every day for all clients.

Disclosure rules have not kept pace with market behavior.  Neither has settlement data. We have a solution that bridges the divide demographically.  We measure 100% of trading volume via broker-executions (not exchange data), reflecting the rules.

Those executions are comprised of mathematically distinct behaviors so you, the board, the executives, are never left with the unsettling sense of missing 98% of the answers.

The market has changed. We must adapt. And guess what? It’s far better all around!  It’s easy, reliable, contemporary and effective.  And test me on this:  Your board and executives will appreciate your leadership.

Electric Market Toothbrush

We were in Portugal and our electric toothbrush went haywire.

It would randomly turn on in the night, and no amount of pressing the button would silence it. We abandoned it in Evora in the shadow of 2,000-year-old Roman aqueducts that still work.

The point isn’t the ephemeral nature of manufactured products (Amazon assured we’d have a replacement waiting, so the modern era works!). But two recent events show how the stock market is built for the short-term – and may run of its own accord.

First, the Wall Street Journal reported Sep 21 that a judge is permitting a class action suit from customers to proceed against TD Ameritrade alleging the big discount broker with 11 million customers breached its “best execution” obligation.

For you investor-relations professionals who’ve heard about the Fee Pilot Program proposed by the SEC, this gets to the heart of it. For you investors, it illustrates how market structure is trumping investment motivation.

Let me explain.  The suit claims TD Ameritrade put its own interest above that of its customers because it routed customer trade-executions to high-speed traders for payment, earning $320 million. TD Ameritrade had net income of about $870 million in 2017 – so selling orders was over 35% of the bottom line.

There’s no law against it, and rules encourage it by forcing trading to occur between the national best bid to buy or offer to sell. Prices constantly change as machines move bids and offers, breaking trades into small pieces to profit on intermediating them.

Retail brokerages sell orders to high-speed firms to avoid these marketplace challenges (of note, the WSJ said Fidelity stopped selling its orders in 2015, an exception in the group). That fast traders paid $320 million for orders suggests they can sell them for more – money that should have gone to the customers rather than the intermediaries.

One could argue spreads are so low that what difference does it make?  What’s a few pennies on a hundred-share order?

The problem is that fees for orders change behavior. High-speed firms aren’t investors. They profit by changing prices. That’s arbitrage, and it becomes both means and end.

What’s the definition of volatility?  Unstable – changing – prices. Rules create economic incentives to change prices. Intraday volatility marketwide is 2.3%, far higher than what the VIX based on implied volatility suggests. Arbitrage is the opposite of long-term investment. Why would we want rules that encourage it?

This is why we support the proposed SEC study that would include eliminating fees in one group (an astute IR guy observed to me in Washington DC last week that every stock should spend time in each of the buckets so there is no discrimination). We don’t want arbitrage pricing the market we all depend on as a gauge of fair value.

Which leads to the second item. The ETFMG Alternative Harvest ETF, a pot fund amusingly tickered “MJ” (last dance with Mary Jane, one more time to kill the pain, sang Tom Petty), made headlines for sharp divergence from its intraday indicative value.

ETFs are required to report net asset value every 15 seconds. Traders can arbitrage – here it comes again – ETF shares as they cross above or below NAV.

(Programming note: I’ll be at the Connecticut/Westchester Chapter Oct 3 talking about the impact of ETFs on markets and your stock, and we’re sponsoring the NIRI Chicago Chapter this Friday the 28th so stop by and say hi!)

The SEC is now proposing to eliminate that requirement so ETFs would price once a day like actual pooled investments such as index mutual funds.  Here’s the kicker: The SEC in first permitting ETFs to trade exempted them from the “redeemable security” mandate in the Investment Company Act of 1940.

That is, all pooled investments must exchange investors’ shares for a proportionate part of the pool of assets when asked. ETFs are exempted from that provision. They are not redeemable. The SEC approved them because creators said the “arbitrage mechanism” would make them in effect redeemable because they would have the same value as an index.

What if the arbitrage incentive diminishes?

To me, the problem today for investors and public companies is the market’s staggering dependency on arbitrage. High-speed traders and Passive money, the latter mostly ETF market-making, are 80% of market volume. The two behaviors at issue in these situations. The math on SPY, the world’s largest ETF, suggests arbitrage is an astonishing 94% of its trading volume when compared to gross share-issuance.

It’s like an electric toothbrush you can’t shut off. What you thought was an instrument designed to serve a purpose can no longer be controlled.  It’s creditable that the SEC is investigating how its rules may be running the toothbrush – and courts could put a spotlight on a market priced by the fastest orders.

We don’t need to go back to Roman aqueducts (though they still work). We can and should recognize that the market has gotten awfully far removed from its intended purpose.

Age of Discovery

Bom Dia!

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

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

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

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

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

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

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

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

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

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

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

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

Borrowed Time

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Going Naked

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

August Currents

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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