Best of MSM: Market Structure Matters

EDITORIAL NOTE: We returned last night on a 7-hour flight from Iceland, weighed down with breathtaking photography. As with market structure, there’s too much material to offer more than a snippet at a time.  I wish we could show you everything. It’s the land of fire and ice (we trekked well into the mountains to soak in hot springs). Water pours from glaciers (and we hiked one). And Reykjavik enchants.  As with markets now, Iceland sits atop turbulent plumbing that at any moment can spout like a geyser or volcano. In markets, I returned to see the volatility gauges shaking in the data.  We’ll talk about that next week. This week, let me take you back nearly six years to March 2013: 

“I get out and meet investors. Tell the story. The rest is noise.”

That’s what an IRO I’ve known since the 1990s said last week over a web meeting about Market Structure Analytics.

Speaking of which, we’ll be discussing this notion with two investor-relations officers who make Market Structure part of complete and exciting IR programs at IR Magazine’s West Coast Think Tank April 4 in Palo Alto. Space is limited. If you want to join our conclave, email me for an invitation.

There are three big reasons why telling the story and ignoring the market is a bad idea. First, anybody can do that (I know – I used to do it!). It’s IR measured by setting meetings, which is like monitoring the success of an advertising campaign by counting the ads you’ve run. It’s clerical.

IR is not a clerical function. It’s not about setting meetings. It’s a strategic effort with direct implication to the reason your business exists: To deliver shareholder value. As I once contended with my CFO when I was in the IR chair, if we’re not willing to spend the price of one non-deal road show on tools to measure what we’re doing, then why are we doing it? (I got the tool, by the way, but it didn’t do what we needed…and that’s why Market Structure Analytics exist today).

A decade ago when I was an IRO, rules were swiftly swinging into place that now have transformed trading. Enron and Worldcom and Elliott Spitzer’s contention that research and trading should be separated and an SEC decision to replace vibrant and unimpeded commerce with a National Market System were just flaring like dust devils in plowed Midwest fields. Fundamental investment hadn’t yet been routed from public markets to private equity by the Indy Racing version of equity-trading, and a majority of volume still had bottom-up roots.

Which leads to Reason No. 2 why telling the story and ignoring the market is a bad idea. If we know these things have transformed markets, how could institutional investment behavior not similarly transform? It’s a bit like assessing the climate in Phoenix with the rain gauge you had in Seattle.

Which highlights Reason No. 3 why telling the story and ignoring the market is a bad idea. There’s a better gauge. You don’t have to use a smart phone, but the technology exists. You don’t have to check the weather report before heading up the hill to ski, but you can, and should. You don’t have to guess your way driving around town. There’s GPS.

Business managers measure operations for feedback. IROs should measure the market (as it functions now, not as it did in 1980) for feedback. That technology exists. It’s transformative, exhilarating, to move from guessing to knowing. To see behaviors in living color telling you the risk or reward ahead in your shares.

Few things can elevate IR to a higher strategic plane of value and importance than defining and owning success measures. These become tools that help you command a regular chair in the Boardroom. Yesterday’s measures won’t earn today’s success.

Watch the Machines

As dawn spreads across the fruited plain today, we’re plunging into Iceland’s Blue Lagoon.  If we learn market-structure secrets here, we’ll report back next week.

Meanwhile, stocks have been emitting the effervescence of a Sunday brunch mimosa bubbling a happy orange hue.  Market Structure Sentiment™ for stocks as measured daily has posted a record stretch at 6.0/10.0 or higher.

What’s that mean ahead?

Here’s back-story for those new to the Market Structure Map. We formalized what we first called MIRBI (merbee), the ModernIR Behavioral Index, in Jan 2012. Market Structure Analytics is the science of demographics in the money behind prices and volume. We can measure them in your stock, a sector, the whole market.

Correlated to prices, volatility and standard deviation, behaviors proved predictive. We built a ten-point quantitative scale from Oversold at 1 to Overbought at 10. Stocks mean-revert to 5.0 and trade most times between 4.0-6.0. Market Structure Sentiment™ has signaled nearly every short-term rise and fall in stocks since 2012, large and small.

In both late January 2018 and late Sep 2018 preceding market corrections, Market Sentiment topped weakly, signaling stocks were overbought and pressure loomed.

If corporate fundamentals consistently priced stocks, this math wouldn’t matter. Active Investment can only blunt market structure periodically. Just the way it is.

It reflects a truth about modern markets: Machines set prices more than humans. So, if you want to know what prices will do, watch the machines. Investor-relations professionals and investors must know market structure now. Otherwise we blame humans for things machines are doing.

Getting back to the future, we recorded a couple long 6.0+ stretches in 2012. They presaged plateaus for stocks but nothing else. It was a momentum market rich with Fed intervention, and European bond-buying to prop up the euro.  Scratch those as comparatives.

Same drill in two 2013 instances, May and July. We had a blip, but the rocket sled was burning central-bank nitrous oxide and barely hiccupped.

After the Federal Reserve hiked rates in December 2015 for the first time in ten years, the market nearly imploded in January. This would prove – till further notice – to be the last time the Fed overtly intervened.

After stocks showed gaping cracks to begin the year, by Mar 2016 excess reserves at the Fed had soared by $500 billion.  The dollar swooned.  Stocks surged. And Market Structure Sentiment™ marked the longest recorded stretch above 5.0.

By Nov 1, 2016, before Donald Trump’s election, however, stocks were back to Dec 2014 levels. I think the bull market was ending but Trump’s ascendency gave it new life.

Cycles have shortened because the bulk of behaviors changing prices every day are motivated by arbitrage – profiting on price-differences. True for Fast Traders, ETF market-makers, market-neutral strategies, global-macro allocations, counterparties.

The length of trading cycles, I believe, depends on the persistence of profits from arbitrage.  Volatility bets expire today, index options tomorrow, with full options expirations and index true-ups Feb 15th.

We may not yet mark a cycle terminus, but arbitrage profits are thinning. For the week ended Feb 2, spreads between sector ETFs and sector stocks totaled 10.5%. Last week it was down to 5.6%.

Further illustrating, Healthcare stocks were up 1.6% the five days end Feb 2, and down 1.6% the week of Feb 8 (and the sector is down the past five days). Real Estate and Utilities offered behavioral data saying they were market hedges – and they’re the two best performers the past five trading days.

I’m confident we’ll see this trading cycle end first in peaking Market Structure Sentiment™ (linked here for Sep 4-Feb 11). It faltered briefly but hasn’t fallen.

As to a big prediction? Past performance guarantees nothing, yet forgetting history condemns us to repeating mistakes. There’s a balance. Seen that way, this long positive run may be the earliest harbinger of the last bull run ending 6-9 months out. Machines will be sifting the data. We’ll watch them.

Now if you’ll excuse us, we’re going to slip into this wildly blue lagoon.

 

Flowing

The Investment Company Institute (ICI) says US equities saw net outflows of $5.1 billion Jan 2-23, the latest data. Add the week ended Dec 26 and a net $26.2 billion left.

So how can stocks be up?

Maybe flows reversed after the 23rd?  Okay, but the S&P 500 rose 12.2% from Dec 24-Jan 23.  It’s now up about 16%, meaning 75% of gains occurred during net outflows.

Is the ICI wrong?  In a way, yes.  It treats redeemed Exchange Traded Fund (ETF) shares as outflows – and that’s not correct.

Let me explain. The stock market is up because of whatever is setting prices. We measure that stuff. The two big behaviors driving stocks Dec 26-Feb 4 were Passive Investment, and Risk Mgmt, the latter counterparties for directional bets like index options.

That combination is ETFs.

ETF shares are redeemed when brokers buy or borrow them to return to ETF sponsors like Blackrock, which exchanges them for stocks or cash of equal value.

If ETF shares are removed from the market, prices of ETFs tighten – and market makers bet long on index and stock options. That’s how derivatives rally underlying assets.

See, ETFs depend on arbitrage – different prices for the same things. And boy do prices differ. We track that data too.  When ETFs rise more than underlying stocks, the spreads are small. Stocks are far less liquid than ETFs because share-supplies don’t continually expand and contract like ETFs.

As an example, Consumer Discretionary stocks were up 1.6% last week (we meter 197 components for composite data on behaviors, shorting, Sentiment, etc.).  But the State Street Sector SPDR (pronounced “spider,” an acronym for S&P Depository Receipts, an ETF) XLY was up just 0.2%.

XLY is comprised of 65 Consumer Discretionary stocks. As we’ve explained before, ETFs are not pooled investments.  They’re derivatives, substitutes predicated on underlying assets.

So it really means State Street will take these stocks or similar ones in exchange for letting brokers create ETF shares, and vice versa.

You can’t short a mutual fund because it’s a pooled investment.  You can short ETFs, because they’re not. In fact, they’re a way to short entire sectors.

Want to pull down a swath of the market? Borrow key components correlated to the ETF and supply them to a big broker authorized to create ETF shares, and receive off-market blocks of a sector ETF like XLY. Then sell all of it on the open market.

It happened in December.

Here’s how. A staggering $470 BILLION of ETF shares were created and redeemed in December as the market plunged, putting the Nasdaq into bear territory (down 20%) and correcting major indices (down 10% or more).

And guess what?  There were $49 billion more creations than redemptions, which means the supply of ETF shares expanded even as the market declined.

I doubt regulators intended to fuel mass shorting and supply/demand distortion when they exempted ETFs from key provisions of the Investment Company Act of 1940 (and how can they do that, one wonders?).

But it’s happening. More proof: shorting in stocks topped 48% of all volume in December.

Returning to spreads, we’ve since seen the reverse of that trade. Stocks are being arbitraged up in value to reflect the supply of ETF shares outstanding, in effect.

And shorting has come down, with 5-day levels now below 20- and 50-day averages.

We’ve showed you ETF patterns before. Here’s the Industrials sector, up 5% the past week. Those purple and green bars?  ETFs. Stocks, plus leverage.  The purple bars are bigger than the green ones, meaning there is more leverage than assets.

That was true Jan 8-15 too, ahead of expirations the 16th-18th, the only period during which the sector and the market showed proportionally flat or down prices (see linked image).  Traders used their leverage (options volumes in 2018 crushed past records – but the culprit is short-term ETF leverage, arbitrage. Not rational behavior).

Why should you care about this stuff, investor-relations professionals and investors? We should know how the market works and what the money is doing. With ETF-driven arbitrage pervasive, the market cannot be trusted as a barometer for fundamentals.

Your boards and executive teams deserve to know.

What can we do? Until we have a disaster and the SEC realizes it can’t permit a derivatives invasion in an asset market, we must adapt. Think ahead.

For companies reporting results next week or the week after, risk has compounded because this trade is going to reverse. We don’t know when, but options expire Feb 14-16. Will bets renew – or fold?

Whenever it happens, we’ll see it coming in the data, by sector, by stock, across the market, just as we did in late September last year before the tumult.

Short-Term Borrowing

Half the volume in the stock market is short – borrowed. Why?

It’s the more remarkable because stocks since late December have delivered an epic momentum rebound. A 15% gain is a good year. Half the sectors in the market were up 15% in just the last 25 trading days.

Yet amid the stampede from the depths of the December correction, short volume, the amount of daily trading on borrowed shares, rose rather than fell, and remains 48%.  That means if daily dollar-volume is $250 billion, $120 billion is borrowed stock.

What difference does it make? We’ve written before that the stock market now has characteristics of a credit market.  That is, if lending is responsible for half the volume, the market depends on short-term loans rather than long-term investment.

And share-borrowing, credit, will give the market a false appearance of liquidity.

Think about the sudden and massive December declines that included the worst-ever points-loss for the Dow Jones Industrial Average.  Was that a liquidity problem? Does a V-shaped recovery signal a liquidity problem?

Before the Dodd-Frank financial legislation, large banks might carry a supply of shares to meet the needs of customers, especially stocks covered by equity research.

With rigid value-at-risk regulations now, banks don’t hold inventory.  The supply chain for the stock market has shifted to proprietary fast traders, which don’t carry inventory either. They borrow it.

We define liquidity as the number of shares that can be traded before the price changes.  Prior to electronic markets, trade-sizes were ten times larger than today.  The mean trade-size the last five days was 181 shares, or about $13,500 against an average market price of $74.61.

But a few liquid stocks skew the average.  AAPL’s liquidity is over $23,000, its average trade-size. WMT is the average, about $13,000. GIS is half that, about $6,800.

AAPL is also 57% short – over half its liquidity is borrowed.  And AAPL is used as collateral by 270 Exchange-Traded Funds (ETFs). Related?

(Side note: Why would AAPL be used more than other stocks in an index if ETFs are tracking an index? Because ETFs only use a sample, often the biggest stocks that are liquid and easy to borrow.)

These three elements – fast traders, high borrowing levels, ETFs – are intertwined and they create risks of inflation and deflation in stocks that bear no correlation to fundamentals.

The market, as we’ve said before, always reflects its primary purposes. If the parties supplying the market with shares are borrowing them, they have an economic interest that will compete with the objectives of those buying shares as an equity investment.

Second, borrowing is a back-office brokerage function. With massive short-term securities lending, the back office becomes as important as the cash equities desk. And it’s a loan business, a credit market (a point made by the insightful academics comprising the Bogan family).

And ETFs? If you want to know how they work, read our white paper. ETFs are not pooled investments. They are collateralized stock substitutes. Derivatives.

Collateral is something you find in a credit market. ETF collateralization, the wholesale market where ETF shares are created and redeemed, is a staggering $400 billion per month in US equities, says the Investment Company Institute.

It’s cheap and easy for brokers to borrow the shares of a basket of stocks and supply them as collateral to the Blackrocks of the world (does Blackrock then loan them out, perpetuating the cycle?) for the right to create and sell ETF shares (or provide them to a hedge-fund customer wanting to short the whole Technology sector).

And how about the reverse? Brokers can borrow ETF shares and return them to Blackrock to receive collateral – stocks and/or cash that Blackrock puts in the redemption basket to offer in-kind for ETF shares.

These are the mechanics of the stock market.  It works well if there’s little volatility – much like the short-term commercial paper market that froze catastrophically during the financial crisis.

We are not predicting doom. We are highlighting structural risks investors and public companies should understand. The stock market depends for prices and liquidity on short-term borrowing. In periods of volatility, that dependency will amplify moves.

In extreme cases, it’s possible the stock market could seize up not through investor panic but because short-term borrowing may freeze.

How might we see that risk? Behavioral volatility. When the movement of money becomes frantic behind prices and volume where only a few firms like ours can see it, market volatility tends to follow (as Sept 2018 behaviors presaged October declines).

Currently, behavioral volatility is muted ahead of the Fed meeting concluding today, loads of earnings, and jobs data Friday. It can change on a dime.

Form Follows Function

We’re told that on Friday Jan 18, the Dow Jones Industrial Average soared on optimism about US-China trade, then abruptly yesterday “global growth fears” sparked a selloff.

Directional changes in a day don’t reflect buy-and-hold behavior, so why do headline writers insist on trying to jam that square peg every day into the market’s round hole?

So to speak.

It’s not how the market works. I saw not a single story (if you did, send it!) saying options expired Jan 16-18 when the market surged or that yesterday marked rare confluence of new options trading and what we call Counterparty Tuesday when banks true up gains or losses on bets.

Both events coincided thanks to the market holiday, so effects may last Wed-Fri.

The point for public companies and investors is to understand how the market works. It’s priced, as it always has been, by its purposes. When a long-term focus on fundamentals prevailed, long-term fundamentals priced stocks.

That market disappeared in 2001, with decimalization, which changed property rights on market data and forced intermediaries to become part of volume. Under Regulation National Market System, the entire market was reshaped around price and speed.

Now add in demographics.  There are four competing forces behind prices. Active money is focused on the long-term. Passive money is focused on short-term central tendencies, or characteristics. Fast Traders focus on fleeting price-changes. Risk Management focuses on calculated uncertainties.

Three of these depend for success on arbitrage, or different prices for the same thing. Are we saying Passive money is arbitrage?  Read on. We’ll address it.

Friday, leverage expired. That is, winning bets could cashier for stock, as one would with the simplest bet, an in-the-money call option. The parties on the other side were obliged to cover – so the market soared as they bought to fulfill obligations.

Active money bought too, but it did so ignorantly, unaware of what other factors were affecting the market at that moment.  The Bank for International Settlements tracks nearly $600 trillion of derivatives ranging from currency and interest-rate swaps to equity-linked instruments. Those pegged to the monthly calendar lapsed or reset Friday.

Behavioral volatility exploded Friday to 19%. Behavioral volatility is a sudden demographic change behind price and volume, much like being overrun at your fast-food joint by youngsters buying dollar tacos, or whatever. You run out of dollar tacos.

That happened Friday like it did in late September. The Dow yesterday was down over 400 points before pulling back to a milder decline.

And there may be more. But it’s not rational thought. It’s short-term behaviors.

So is Passive money arbitrage?  Just part of it. Exchange-Traded Funds (ETFs) were given regulatory imprimatur to exist only because of a built-in “arbitrage mechanism” meant to keep the prices of ETFs, which are valueless, claimless substitutes for stocks and index funds, aligned with actual assets.

Regulators required ETFs to rely on arbitrage – which is speculative exploitation of price-differences. It’s the craziest thing, objectively considered. The great bulk of market participants do not comprehend that ETFs have exploded in popularity because of their appeal to short-term speculators.

Blackrock and other sponsors bake a tiny management fee into most shares – and yet ETFs manage nobody’s money but the ETF sponsor’s. They are charging ETF buyers a fee for nothing so their motivation is to create ETF shares, a short-term event.

Those trading them are motivated by how ETFs, index futures and options and stocks (and options on futures, and options on ETFs) may all have fleetingly different prices.

The data validate it.  We see it. How often do data say the same about your stock?  Investors, how often is your portfolio riven with Overbought, heavily shorted stocks driven by arbitrage bets?

What’s ahead? I think we may have another rough day, then maybe a slow slide into month-end window-dressing where Passive money will reweight away from equities again.  Sentiment and behavioral volatility will tell us, one way or the other.

Ask me tomorrow if behavioral volatility was up today. It’s not minds changing every day that moves the market. It’s arbitrage.

Exchanging Data

Do we need another stock exchange?

I’ve been asked this question repeatedly since Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*TRADE, Fidelity Investments, Morgan Stanley, TD Ameritrade, UBS, and Virtu Financial agreed Jan 7 to collaborate on seeking approval for a 14th official US stock market.

The answer? It depends on who “we” is, or are.

Adam Sussman of block-trading firm Liquidnet wrote that it’s an effort to lower trading costs which, thanks to high prices from exchanges for data feeds, have gone the opposite direction of trading commissions.

As to further fragmentation – more venues, less aggregation of buyers and sellers – Sussman says amusingly (the whole piece is funny) that “fragmentation is like having kids – after you have three of them, you just go numb to the pain.”

Michael Friedman, formerly of proprietary trading shop and technology vendor Trillium Management, said at TABB Forum (registration required) that these trading firms representing perhaps more than half of all volume resent how the exchanges keep raising prices for market data that brokers themselves create.

Before the exchanges IPO’d – all but IEX are now owned by public shareholders – they were member-owned, and members didn’t pay for data. Coincidentally the new market is called MEMX, or Members Exchange, anachronistically hailing a different era.

Friedman artfully unfolds market structure, explaining how a bid to buy shares at $9.08 at the NYSE cannot execute if the Nasdaq has a bid to buy at $9.10 because buyers willing to pay more are given legal priority and the trade must route out to the Nasdaq.

What if these firms were to route all the best trades – ones wanting to be the highest bid to buy or offer to sell – to themselves?  They could conceivably ravage market-share among big exchange groups until costs fell to a new equilibrium.

I think there are two other big reasons for this new cooperative.

One is easy to understand. Brokers are required to prove to customers that they provide “best execution,” or trading services that are at least as good as the average.  Paradoxically, that standard is predicated on averages for customer trades in the market – which concentrate heavily into the largest firms, including several MEMX backers.

If the order flow is consistently better than the average, it’s conceivable these firms could use their own data for free to meet best-execution requirements, a tectonic fist-bump amidst market rules.

So how would they boost odds that their data are better?  Look at who’s involved. They are mostly retail brokerage firms, or firms buying retail flow.

At Fidelity, about 97% of the firm’s retail orders are “nondirected,” lacking instructions about where the trades should occur. And well over 50% of those orders are sent to Virtu and Citadel.

Schwab says 99.6% of its trades are nondirected and 70% of them go to Virtu, Citadel and UBS.

And guess what?  Retail orders are permitted under rules to, in the jargon of market structure, “price-improve” trades.  The NYSE says its Retail Liquidity Program “can be used by retail firms directly as well as by the brokers who service retail order flow providers.”

Interactive Brokers, a firm for sophisticated retail traders and hedge funds, says retail orders with a limit, or set price, can be hidden from display at exchanges in increments of a thousandth of a dollar better than the displayed one, and the orders will float with a changing bid to buy or offer to sell.

That is, if the best bid to buy everyone sees is $9.08, a hidden limit order can be set at $9.081 and bounce like a bobber, staying always a fraction of a penny better than visible prices.

Under market rules, stocks cannot quote in increments below a penny. But they sure can trade in smaller increments, and they do all the time.

By aggregating retail order flow that market rules give a special dispensation to be better than other orders the members of MEMX believe they can not only match more orders but create the best market data.

How is it possible? Regulators wanted to be sure the little guy wouldn’t get screwed, so they give retail trades preference. They never dreamed innovative high-speed traders would buy it, or take advantage of rules permitting these trades to have narrower spreads.

It may work.

The problem is that the advantage MEMX hopes to leverage is a regulatory one that gives special access to one kind of activity.  (Editorial note: As we’ve written repeatedly, it’s just as Exchange Traded Funds have proliferated not by being better but through unique regulatory advantages giving them a private, wholesale block market with no transparency).

What’s it mean to investors and public companies? Investors, you could be picked off because MEMX could have compounded capacity to price-improve non-displayed orders. Public companies, something other than capital-formation is driving markets, which is not in your best interest.

We’d prefer a fair, level playing field serving investors and issuers, not rules permitting exceptions traders can game.

Leveraged Market

Paul Rowady writing at Alphacution says 67% of securities in US stock markets are derivatives dependent on an underlying 33%, made up of company stocks. It’s leveraged.

We can talk about ramifications at the end. To begin, the point is to understand, investors and investor-relations professionals, what it means to how stocks perform.

A derivative is a security that gets its value from an underlying asset. Mr. Rowady is referring to the proliferation of stock and index options and exchange-traded funds (ETFs) predicated on stocks.

It seems helpful to understand the linkage between how the market falls or rises, and how instruments that are derived from shares comprising market capitalization contribute to these cycles.

With derivatives outnumbering stocks two-to-one, the market behaves in a sense like a 2x leveraged vehicle, such as QLD, the ProShares Ultra QQQ ETF, which aims to correspond to two times the performance of the Nasdaq 100.

I’m oversimplifying. For a pure comparison, all the derivatives would have to be long, and they’re not of course, and there’s wide disparity in performance among securities across the market.

Follow me here.  Leveraged markets compound performance both directions. Take QLD. Suppose its underlying asset, the Nasdaq 100 represented by QQQ, is up 5%. QLD would rise 10%. Say for simplicity QQQ trades at $100. QQQ closes at $105, QLD at $110.

QQQ then retreats 5% the next trading day, back to $100. QLD closes at $99, 10% below $110. Compound that daily 5% up-and-down pattern over 30 days and QLD loses 50% of its value while QQQ is still worth $100.

Borrowing is leverage.  If I buy 100 shares of AAPL and borrow $15,000 or so to buy another 100 shares, and AAPL drops 8%, I’m down not 8% but the compounding effect of losses on the asset serving as collateral. I may be forced to sell core portfolio positions to cover my losses on borrowings.

Routinely, brokers are borrowing stocks to supply to ETF sponsors like Blackrock for the right to create ETF shares. We’ve studied shorting in ETFs and component stocks and have found them inversely correlated – validation.

Borrowed stock here isn’t a bet on declines but a defined value. If I exchange $1 million of borrowed stock for the right to create ETF shares that then fall to $950,000, I’ve lost 5% of my money.

I’ve got an obligation to cover borrowings even though I’ve lost money creating and selling ETF shares.  I may be forced to sell something else to align value at risk with internal compliance requirements.

This isn’t a dissection of detailed trading practices but rather a reflection on what can happen in volatile markets when leverage is pervasive. At Jan 7, 48% of all stock-trading volume was short – borrowed. That’s 1x leveraged. On top of the derivatives-to-stock ratio.

When considerations of losses or gains on leverage are ubiquitous, the market isn’t a reliable barometer for how the economy is faring, what investors think of trade practices or government shutdowns, or how your business is performing fundamentally.

The good news is it’s measurable! IR pros, we track every day what behavior is long or short, the role of Risk Mgmt reflecting leverage, and what trends signal. Investors, Sector Insights meter Sentiment, behaviors, shorting, intraday volatility and other factors by industry group.

Investors, you can turn market structure to your advantage (ask us about Market Structure EDGE). IR people, you can proactively inform management – a key action as chief intelligence officers for the capital markets. Ask us how to learn more.

Is there systemic threat in leveraged markets? Of course. We wrote about how stocks have taken on characteristics of a credit market, and credit is always leverage, which grows where interest rates are low and money is artificially plentiful. The reset at the end of the gravy train tends to wipe out leverage.

When? Who knows?  Debt deflations that follow credit booms begin with outlier failures that cause people to say, “Huh. Wonder what happened there?”  Let’s watch trends.

Down Maiden Lane

For the Federal Reserve, 2018 was the end of the lane. For us, 2019 is fresh and new, and we’re hitting it running.

The market comes stumbling in (anybody remember Suzy Quatro?). The Dow Jones dropped 6% as it did in 2000. The index fell 7% in 2001 and 17% in 2002. The last year blue chips were red was 2015, down 2%.

Everybody wants to know as the new year begins what’s coming.  Why has the market been so volatile? Is a recession at hand? Is the bull market over?

We only know behavior – what’s behind prices. That’s market structure.

Take volatility. In Q4 2018, daily intraday volatility marketwide (average high-low spread) averaged 3.7%, a staggering 61% increase from Q3.  Cause? Exchange-Traded Funds. It’s not the economy, tariffs, China, geopolitics, or Trump.

Bold assertion?  Nope, math.  When an index mutual fund buys or sells stocks, it’s simple: The order goes to the market and gets filled or doesn’t.

ETFs do not buy or sell stocks. They move collateral manually back and forth wholesale to support an electronic retail market where everything, both ETF shares and stocks serving as collateral for them, prices in fractions of seconds. The motivation isn’t investment but profiting on the difference between manual prices and electronic ones.

When the market goes haywire, that process ruptures. Brokers lose collateral exchanged for ETF shares, so they trade desperately to recoup it. There were over $4.1 trillion of ETF wholesale transactions through Nov 2018.

The other $4.1 trillion that matters is the Fed’s balance sheet. If the bull market is over, it’ll be due to the money, not the economy. We have been saying for years that a reckoning looms, and its size is so vast that it’s hard to grasp the girth (rather like my midsection during the holidays).

On Dec 18, 2008, the Federal Reserve said its balance sheet had been “modified to include information related to Maiden Lane II LLC, a limited liability company formed to purchase residential mortgage-backed securities (RMBS) from…American International Group, Inc. (AIG).”

The biggest Fed bank sits between Liberty Street and Maiden Lane in New York. Maiden Lane made the Fed over the next six years owner of seas of failed debts.

Ten year later, on Dec 27, 2018, The Fed said its balance sheet had been “modified to reflect the removal of table 4 ‘Information on Principal Accounts of Maiden Lane LLC.’ The table has been removed because the remaining assets in the portfolio holdings of Maiden Lane LLC have been reduced to a de minimis balance.”

There were at least three Maiden Lane companies created by the Fed to absorb bad debts. At Dec 2018, what remains of these bailouts is too small to note.

Wow, right? Whew!

Not exactly. We used the colossal balance sheet of US taxpayers – every Federal Reserve Note in your wallet pledges your resources to cover government promises – to save us.  We were able to bail ourselves out using our own future money in the present.

We’ve been led to believe by everyone except Ron Paul that it’s all worked out, and now everything is awesome.  No inflation, no $5,000/oz gold.  Except that’s incorrect.  Inflation is not $5,000/oz gold.  It’s cheap money.  We’ve had inflation for ten straight years, and now inflation has stopped.

Picture a swing set on the elementary-school playground. Two chains, a sling seat, pumping legs (or a hand pushing from behind). Higher and higher you go, reaching the apex, and falling back.

Inflation is the strain, the pull, feet shoved forward reaching for the sky.  What follows is the stomach-lurching descent back down.

We were all dragged down Maiden Lane with Tim Geithner and Hank Paulson and Ben Bernanke. They gave that sling seat, the American economy, the biggest shove in human history. Then they left. Up we went, hair back, laughing, feet out, reaching for the sky.

Now we’re at the top of the arc.

The vastness of the economic swing is hard to comprehend. We spent ten years like expended cartridges in the longest firefight ever to get here. We won’t give it up in a single stomach-clenching free-fall.

But the reality is and has always been that when the long walk to the end of Maiden Lane was done, there would be a reckoning, a return to reality, to earth.

How ironic that the Fed’s balance sheet and the size of the ETF wholesale market are now roughly equal – about $4.1 trillion.

It’s never been more important for public companies and investors to understand market structure – behavior. Why? Because money trumps everything, and arbitraging the price-differences it creates dominates, and is measurable, and predictable.

The trick is juxtaposing continual gyrations with the expanse of Maiden Lane, now ended. I don’t know when this bull market ends. I do know where we are slung into the sling of the swing set.

It’s going to be an interesting year. We relish the chance to help you navigate it. And we hope the Fed never returns to Maiden Lane. Let the arc play out. We’ll be all right.

 

A Credit Market

In the stock market the beatings have been consistent while we all wait for morale to improve. What’s causing it?

I’m surprised conservatives haven’t blamed midterm elections. Alert reader Pat Davidson in Wisconsin notes CNBC viewers say tariffs, global economic weakness and Fed rate-hikes are behind the stock swoon.

Is it a coincidence that these are what the media talk about most?

I think stocks are down because of market structure. Exchange Traded Funds infect them with characteristics of a credit market.

The big hand pelting backsides of stocks has been uneven. Broad measures have corrected off highs. I tallied the FAANGs (FB, AMZN, AAPL, NFLX, GOOG) and they’re down 20-40% from peaks. Same with small-caps.

We last week launched our Sector Insights reports that compile readings on composite stocks by sector. Surveying them, only one, Communications Services, showed recent Active buying. The rest were uniformly beset by ETFs. As was the broad market. ETFs were favoring Utilities and shedding everything else.

Two sectors had positive Sentiment, Real Estate and Utilities, but both were in retreat. Financials and Industrials were tied for worst Sentiment at 2.2/10.0.

Note that Monday, Real Estate and Utilities were the worst performers, down nearly 4%. Financials and Industrials were best, down less than the rest.

The point is that our measures are quantitative. They are not rational factors like tariffs, global economic weakness, or Fed rate-hikes. Yet they accurately and consistently predict what stocks, sectors and the market will do, short-term.

Therefore, the cause for much of the short-term behavior in stocks cannot be rational.

Sure, we’ve written about our expectation that a strong dollar would be deflationary for commodities and risk assets. Inflation is low interest rates. Excess availability of capital fostered by artificially depressed costs. It’s not rising prices. When excess availability vanishes, prices fall regardless of whether they first rose.

The Federal Reserve has removed nearly $1 trillion from its balance sheet and excess reserves through policies, which translates on a reserve-ratio basis to a reduction in capital of roughly $8-10 trillion. That will deflate prices.

But the problem isn’t deflation. It’s the inflation that preceded it. Fed, are you listening?  How about not creating inflation in response to crises? How about instead letting things that should fail do so by setting rates high and accepting only good collateral? Then human creativity can restore productivity, and economies can soar anew.

A financial instrument that extends reach to an asset class is a form of credit.  Credit creates bubbles that collapse when the extension of credit is curtailed.

Let’s use the Healthcare sector as an example. Year to date, Healthcare before Friday was the top-performing sector (now eclipsed by Utilities, up nearly 8%). From Nov 15-Dec 3, comparative performance for the sector was positive.

Suddenly in December the sector fell apart, with the red tide coming on green and purple bars, signaling ETFs.  It happened before JNJ plunged 14%. The credit bubble burst.

ETFs are a form of credit. Blackrock itself describes ETFs as a tool that equalizes supply with demand. ETFs are collateralized substitutes for buying and selling stocks. They offer artificially low costs. They permit elastic supplies of money to chase finite US shares.

The result on the way up is soaring equities. The consequence on the way down is collapsing stocks.

Here’s an analogy. Suppose you have a line of credit on your house and you buy something with it – say a vacation home.  Your capacity to borrow derives from the rising value of your house, which in turn is driven by demand for homes around you.

What if banks extending credit are out of lending capacity and lift rates?  Suddenly, demand for houses around yours declines. Home prices begin to fall. The value of your house drops.

And the bank that extended credit to you becomes concerned and wants more collateral.

Suppose that’s happening in the wholesale market where ETFs are created and redeemed. It far outstrips any other form of fund-flows — $4 trillion already this year through November (estimated), $400 billion per month.

If the value of the collateral used to create ETF shares – stocks – is of indefinite and unpredictable and falling value, the capacity to extend credit collapses. And prices start falling everywhere.  Those who borrowed must sell assets to cover obligations.

What if that’s the cause, not the economy or tariffs? That should matter to pundits, investors and investor-relations professionals (and CEOs by extension).

We have the data. Use it. We expect markets to jump Dec 19-21 through the final expirations period of 2018. But it’s a credit market subject to credit shocks.

Surly Furious

Surly Furious would be a great name for a rock band. And maybe it describes stocks.  It’s for certain the name of a great Minnesota beer.

We are in Minneapolis, one of our favorite cities, where Midwest client services Director Perry Grueber lives, and where nature sprays and freezes into the artful marvel of Minnehaha Falls, and where over pints of Furious IPA from Surly Brewing we deconstructed investor-relations into late evening.

It got us thinking. ModernIR launched Sector Insights this week to measure how money behaves by sector. The data we track show all sectors topping save Consumer Staples.

“Wait, topped? The market has been declining.”

We’re not surprised that closing prices are reverting to the mean, the average, after big swings. You need to understand, public companies and investors, that the market isn’t motivated by your interests.

It’s driven by profit opportunity in the difference in prices between this group of securities or that, over this period or that.

How do we know?  Because it’s what market rules and investment objectives promote. Prices in stocks are set by the best bid to buy or offer to sell – which can never be the same – and motivated most times not by effort to buy or sell stocks but instead by how the price will change.

Who cares?  You should, investors and public companies.

Suppose I told you that in this hotel where you’re staying the elevator only goes to the 5th floor.  You decide it’s immaterial and you set out to reach the 6th floor. You lead your board of directors and executives to believe it should be their expectation that they can reach the 5th floor. Yet as you arrive at the elevator you learn it goes only to the 4th floor.

Whose fault is that?

The beer that put Minneapolis on the map is from Surly Brewing, an India Pale Ale called Furious. What’s better in a name than Surly Furious?  It’s worth drinking.

When the market is surly and furious, you should know it. We can see it first in Market Structure Reports (we can run them for any company), and then in Sector Insights (just out Dec 10) and in the broad market.

Number one question: How does it change what I do?  Investors, it’s easy. Don’t buy Overbought sectors or markets. Don’t sell Oversold sector or markets, no matter how surly and furious they may seem.

Public companies, we expend immense effort and dollars informing investors. Data suggest disclosure costs exceed $5 billion annually for US public companies.

If we discovered the wind blows only from the west, why would we try to sail west? If we discover passive investors are attracting 100% of net new investor inflows, and investors don’t buy or sell your stock, should you not ask what the purpose is of all the money you’re spending to inform investors who never materialize?

We can fear the question and call it surly, or furious. Or we can take the data – which we offer via Market Structure Reports and Sector Insights – and face it and use it to change investor expectations.

Which would you prefer? We’ve now released Sector Reports. If you’d like to know what Sentiment indicates for your stock, your sector — or the broad market — ask us.