The Little Short

In Michael Lewis’s The Big Short, a collection of eccentrics finds a flaw in real estate securities and shorts them.  The movie is great, the book even better.

Somebody will write a book about the 2020 stock market (anyone?) flaw.

The flaw? Depends who you ask. Writing for Barron’s, Ben Levisohn notes ZM is worth more in the market on $660 million of sales for the quarter than is IBM on $18 billion.

TSLA is up a thousand percent the last year, sales are up 3%. NVDA is trading at a hundred times quarterly revenue. AAPL is up 160% on 6% sales growth.

I know a lot about fundamental valuation after 25 years in investor relations. But 20 of those years were consumed with market structure, which our models show mechanically overwhelms fundamentals.

Why is market structure irrational?

Because most of the money in the market since Reg NMS isn’t rational. And still investor-relations professionals drag me to a whiteboard and sketch out how the performance of the stock – if it’s up – can be justified by prospects, or if it’s down is defying financials.

Market structure, rules governing how stocks trade, is agnostic about WHY stocks trade. The flaw is process has replaced purpose. Money inured to risk and reality can do anything. Just like government money from the Federal Reserve.

And yet that’s not what I’m talking about today.  The market is the Little Short.  Nobody is short stocks. I use the term “nobody” loosely.

Let me give you some history.

First, ignore short interest. It’s not a useful metric because it was created in 1975 before electronic markets, ETFs, Reg NMS, Fast Traders, exchange-traded derivatives, blah, blah. It’s like medieval costumes in Tom Cruise’s redux of Top Gun. It doesn’t fit.

After the financial crisis, rules for banks changed. The government figured out it could force banks to own its debt as “Tier 1 Capital,” and the Fed could drive down interest rates so they’d have to keep buying more.

Voila! Create a market for your own overspending. The Basel Accords do the same thing.

Anyway, so big banks stopped carrying equity inventories because they couldn’t do both.  Meanwhile the SEC gave market-makers exemptions from limitations on shorting.

Presto, Fast Traders started shorting to provide securities to the market. And that became the new “inventory.” Ten years later, short volume – borrowed stock – averages 45% of trading volume.

It was over 48% this spring.  And then it imploded in latter August, currently standing at 42.6%. The FAANGs, the giant stocks rocketing the major measures into the stratosphere, show even more short paucity at just 39%.

Realize that the market was trading $500 billion of stock before August, about 12 billion shares daily. So what’s the point? Short volume is inventory today, not mainly bets on declining stocks. It’s the supply that keeps demand from destabilizing prices, in effect. A drop from 48% to 43% is a 10% swoon, a cranial blow to inventory.

Higher short volume restrains prices because it increases the available supply. If demand slows, then excess supply weighs on prices, and stocks decline. We’ve been measuring this feature of market structure for a decade. It’s well over 80% correlated.

So the absence of inventory has the opposite impact on prices. They rise.  If the whole market lacks inventory, stocks soar. And the lowest inventory right now is in the FAANGs, which are leading the stampeding bulls.

Thinking about prices as rational things is wholly flawed. It’s not how the market works, from supply-chain, to routing, to quotes, prices, execution.

We thought temporal tumult in behaviors two weeks ago would derail this market. It didn’t. Or hasn’t yet. The big drop in shorting followed, suggesting those patterns included largescale short-covering by market-makers for ETFs.

When the market does finally reverse – and it will, and it’s going to be a freak show of a fall too, on market structure – low short volume will foster seismic volatility. Then shorting will explode, exacerbating the swoon as supply mushrooms and prices implode.

The good news is we can measure these data, and the behaviors responsible, and the impact on price. There’s no need to ever wonder if your stock, public companies, or your portfolio, traders, is about to step on a land mine.  We’re just waiting now to see how the Little Short plays out.

Indexed

Is it good to be part of the collective?

From Karl Marx to Friedrich Hayek, polemics ring like swords and plowshares on anvils.

But that’s not what we mean.

When Vanguard in 1975 created the 500 Fund, many called it “Bogle’s Folly,” suggesting founder Jack Bogle’s plan to buy and hold a collection of stocks on the notion that the wisdom of crowds was better than that of individuals was daft. If you have time, this is a great read.

Today the Admiral Shares version (the original fund closed to new investors and Vanguard points them to its Exchange Traded Fund VOO tracking the S&P 500, with $560 billion of assets) manages over $530 billion of indexed money tied to the S&P 500.

Jack Bogle was not daft. Passive money dominates, and it exploded after Regulation National Market System, the stock market’s equivalent of the IRS code, ordered stocks to trade at an average price by imposing the National Best Bid or Offer (the NBBO).

Now Dow Jones S&P is reshuffling the Dow Jones Industrial Average (DJIA), removing XOM, RTX and PFE and replacing them with HON, CRM and AMGN.

Aside: I’m representing our trading decision-support firm, Market Structure EDGE, at the Benzinga Trading Boot Camp this Friday at noon ET. It’ll be a good 30-min look at market structure.

Back to the narrative, if you follow the money and it’s benchmarked, then indexing should be good for investors, good for public companies. By extension, getting booted from the collective is bad. Indeed, the issues ousted were down, the ones added were up, though changes don’t occur till Aug 31.

It’s worth noting that a key futures contract used to true up S&P 500 exposure and hedge general market moves expires the last trading day of the month, which is Aug 31. All six stocks are in the S&P 500 and AMGN is in the Nasdaq 100 too.

And all are in many ETFs. RTX populates the fewest (150), AMGN the most (285) with the rest scattered between. XOM is in 269 despite declining 72% year-to-date. Why would the collective choose XOM when it’s down? And Energy is just 3% of the market?

Because ETFs use stocks as collateral. Market-makers trade XOM for S&P 500 ETF shares because they profit on the spread. Sponsors trade it back for appreciated ETFs but supply less than they received. Both parties win, and the sponsor earns ETF fees to boot.

Few know what I just described. It’s the principal objective of the parties trading ETF shares wholesale. If you want to understand, ask me.

CRM is in 208 ETFs and up 29% this year and Tech is 27% of the DJIA. In fact, Tech is the trigger here. AAPL announced a 4-for-1 stock-split that will drop it sharply in the price-weighted DJIA. To offset that effect, Dow Jones is rejiggering.

You still with me?

AAPL’s coming stock-split whacks the DJIA from 27% Tech to 20%, so CRM joins, getting the index back to 23% (thanks to CNBC’s good take for that insight).

CRM instantly becomes #6 in the DJIA, AMGN #3 (is it now overexposed to Healthcare, with UNH #1 after the AAPL split?), HON #11.

In a sense, these moves are risk-management for the index creator. Depend too much on one stock and your index can get shellacked. Out over the skis in a sector? Pick somebody who gets you lined up with gravity.  CRM is in because it puts Tech in a reasonable range again in the index.

It’s a profound point, frankly. The index is less about the economy, more about the collective. Not that there’s anything wrong with that – unless you think the index is about the economy.

Now, what should we conclude about getting indexed, or not? It matters little if you’re big. All six of these issues will continue to be ETF fodder. None has an Engagement score over 75% though. It means the story struggles to stand clear from the collective in each case.

For public companies, it shifts the IR job from only the story, to measuring and reporting on the demographic effects of the money. It’s powerful. We have that data.

And investors should use market structure, not just fundamentals. If you want to know more, tune to Benzinga Premarket Prep today (Aug 26) at 835a ET (there’s a replay).  I’ll be talking about our sister company, Market Structure EDGE.

Mini Me

Minis abound.

You can trade fractions of shares.  Heck, the average trade-size is barely 100 shares, and 50% of trades are less than that.  Minis, as it were.

There are e-mini futures contracts on the S&P 500 index, and the newer micro e-mini futures product is the CME’s most successful, says the derivatives market operator.

Starting Aug 31 there will be micro options on e-mini futures for the S&P 500 and the Nasdaq 100. As of Aug 10, there are mini CBOE VIX volatility futures too, with a 10th of the face value of the conventional contract (expiring Aug 19).

One can spend less to have exposure to stocks and market-moves. The same notion animated a push toward decimalization before 2001 when it was implemented.

Decimals didn’t kill the stock market but they gutted analyst-coverage. Spreads – that is, the difference between the cost to buy and sell – funded research. In the 1990s there were on average 60 underwriters per IPO, and there were hundreds of those.

Today, there are five underwriters on average, the data show, and IPOs don’t keep pace with companies leaving markets through deals.  The Wilshire 5000, which in 1998 had 7,200 components, today has 2,495, factoring out micro-caps comprising just basis points of total market-capitalization.

Half the companies in the Wilshire 5000 have no analysts writing, while the top few hundred where trading supports it are festooned with quills – pens – like porcupines.

I think the inverse correlation between markets and the proliferation of minis bears some connection. It’s not the only thing, or perhaps even the biggest. But there’s a pattern.

And you should understand the market so you know what to expect from it. After all, who thought the March bear turn for stocks would be the shortest in history?

No one.  Including us.  Market structure, the way the ecosystem functions, explains it far better than fundamentals. But read to the end. We’ll say more.

Are the minis playing a role?

Look I’m not knocking fractional shares or tiny derivatives.  Rather, let’s think about the ramifications of growing layers separating trading from underlying assets.  Consider:

  • You can trade the stocks of the Nasdaq 100, the largest hundred at the exchange.
  • You can trade them in fractions without paying a commission.
  • You can trade the QQQ, the popular Exchange Traded Fund (ETF) that tracks the performance of the 100. ETFs as we’ve explained repeatedly are substitutes for stocks, not pooled interest in owning them.
  • You can trade e-mini futures contracts on the Nasdaq 100.
  • And now you can trade micro options on the e-mini Nasdaq 100 futures.
  • And you can trade options on the QQQ, and every component of the Nasdaq 100.
  • And you can trade the S&P 500 with exactly the same kinds of instruments, and SPY, the ETF.

It’s ingenious product-creation, and we’re not criticizing the innovators behind them.  It’s that I don’t think many people ask what effect the pursuit of mini increments of investment will have on market-behavior and prices, things that matter particularly to public companies depending on the market as a rational barometer.

And investors join public companies in caring how markets work.  Derivatives are becoming an ever-larger part of market volume. They’re layers of separation from underlying assets that become ends unto themselves, especially as increments shrink.

Why trade the stocks? Trade the rights on how they may behave – in tiny slices.

It disguises real supply and demand, which drives markets up relentlessly. Until that stops. Then markets collapse violently. These are chronic conditions in markets with too many derivatives.

Just saying.

Speaking of the market, it did as we wrote last week, with Market Structure Sentiment™ bottoming Aug 7, presaging gains a week out. Now options are expiring (including the VIX today), and Sentiment is topping, and behavioral volatility is massive, larger than we’ve measured at any point in the pandemic.

Maybe it’s nothing. Sometimes those data pass without a ripple. The FAANGs look good (low shorting, bottomed Sentiment). But we may be at the top of the Ferris Wheel after all those minis drove us this short, sharp way back up.

Dark Edges

The stock market’s glowing core can’t hide the dark edges – rather like this photo I snapped of the Yampa River in downtown Steamboat springs at twilight.

Speaking of which, summer tinkled its departure bell up high.  We saw the first yellowing aspen leaves last week, and the temperature before sunrise on the far side of Rabbit Ears Pass was 30 degrees, leaving a frosty sheen on the late-summer grass.

The last hour yesterday in stocks sent a chill too. Nothing shouts market structure like lost mojo in a snap.  I listened to pundits trying to figure out why.  Maybe a delay in stimulus.  Inflation. Blah blah.  I didn’t hear anyone blame Kamala Harris.

It’s not that we know everything.  Nobody does.  I do think our focus on the mechanics, the machinery, the rules, puts us closer to the engines running things than most observers.

And machines are running the market.  Machines shift from things that have risen to things that have fallen, taking care to choose chunks of both that have liquidity for movement. Then all the talking heads try to explain the moves in rational terms.

But it’s math. Ebbs and flows (Jim Simons, the man who solved the market at Renaissance Technologies, saw the market that way).

Passives have been out of Consumer Staples. Monday they rushed back and blue chips surged. The Nasdaq, laden with Tech, is struggling. It’s been up for a long time. Everybody is overweight and nobody has adjusted weightings in months. We can see it.

By the way, MSCI rebalances hit this week (tomorrow on the ModernIR Planning Calendar).

This is market structure. It’s morphed into a glowing core of central tendencies, such as 22% of all market capitalization now rests on FB, AAPL, AMZN, NFLX, GOOG, MSFT, AMD, TSLA and SHOP.

That’s the glowing core.  When they glow less, the dark edges grow.

Then there’s money.  Dough. Bucks. Specifically, the US dollar and its relationship to other global currencies. When the dollar falls, commodities surge. It’s tipped into the darkness the past month, marking one of its steepest modern dives.  Gold hit a record, silver surged, producer prices dependent on raw commodities exploded.

Then the dollar stopped diving. It’s up more than 1% in the last five days. And wham! Dark edges groped equities late yesterday. Gold plunged. Silver pirouetted off a 15% cliff.

August is traditionally when big currency-changes occur. Aug last year (massive move for the dollar versus the Chinese Renminbi Aug 5, 2019). Aug 2015. Aug 2018. Currencies rattle prices because currencies underpin, define, denominate, prices.

Back up to Feb 2020.  The dollar moved up sharply in late February, hitting the market Monday, Feb 24, as new options traded.  Pandemic!

Options expire next week.  The equivalent day is Aug 24, when new options will trade. Nobody knows when the dark edges will become cloying hands reaching for our investment returns or equity values.

In fact, Market Structure Sentiment™, our algorithm predictively metering the ebb and flow of different trading behaviors, peaked July 28 at 7.7 of 10.0, a strong read.  Strong reads create arcs but say roughly five trading days out, give or take, stocks fall.

They didn’t. Until yesterday anyway. They just arced.  The behavior giving equities lift since late July in patterns was Fast Trading, machines chasing relative prices in fractions of seconds – which are more than 53% of total volume.

Then Market Structure Sentiment bottomed Aug 7 at 5.3, which in turn suggests the dark edges will recede in something like five trading days.  Could be eight. Might be three.

Except we didn’t have dark edges until all at once at 3pm ET yesterday.

Maybe it lasts, maybe it doesn’t. But there’s a vital lesson for public companies and investors about the way the market works.  The shorter the timeframe of the money setting prices, the more statistically probable it becomes that the market suddenly and without warning dives into the dark.

It’s because prices for most stocks are predicated only on the most recent preceding prices.  Not some analyst’s expectation, not a multiple of future earnings, not hopes for an economic recovery in 2021.

Prices reflect preceding prices. If those stall, the whole market can dissolve into what traders call crumbling quotes.  The pandemic nature of short-term behavior hasn’t faded at the edges. It’s right there, looming.  We see it in patterns.

If something ripples here in August, it’ll be the dark edges, or the dollar. Not the 2021 economy.

Boxes and Lines

 

In the sense that high-speed transmission lines connecting computerized boxes are the stock market, it’s boxes and lines.

Also, stock exchange IEX, the investors exchange, hosts a podcast called Boxes and Lines that’s moderated by co-founder Ronan Ryan and John “JR” Ramsay, IEX’s chief market policy officer. I joined them for the most recent edition (about 30 mins of jocularity and market structure).

In case you forget, the stock market is not in New York City.  It’s in New Jersey housed in state-of-the-art colocation facilities at Mahwah, Carteret and Secaucus.  It’s bits and bytes, boxes and lines.

It’s superfast.

What’s not is the disclosure standard for institutional investors.  We wrote about the SEC’s sudden, bizarre move to exclude about 90% of them from disclosing holdings.

The current standard, which legitimizes the saying “good enough for government work,” is 45 days after the end of the quarter for everybody managing $100 million or more.

We filed our comment letter Monday.  It’ll post here at some point, where you can see all comments. You can read it here now.  Feel free to plagiarize any or all of it, investors and public companies. Issuers, read our final point about the Australian Standard of beneficial ownership-tracing, and include it with your comments.

Maybe if enough of us do it, the SEC will see its way toward this superior bar.

Without reading the letter or knowing the Australian Standard you can grasp a hyperbolic contradiction. The government’s job is to provide a transparent and fair playing field.  Yet the same SEC regulates the stock market located in New Jersey. Boxes and lines.

FB, AAPL, AMZN, NFLX, GOOG, GOOGL, MSFT, AMD, TSLA and SHOP alone trade over 2.5 MILLION times, over $80 billion worth of stock. Every day.

And the standard for measuring who owns the stock is 45 days past the end of each quarter.  A quarter has about 67 trading days, give or take.  Add another 30 trading days.  Do the math.  That’s 250 million trades, about $7.9 trillion of dollar-flow.  In 10 stocks.

Why should the market function at the speed of light while investors report shareholdings at the speed of smell? Slower, really.

Do we really need to know who owns stocks?  I noted last week here and in our SEC 13F Comment Letter both that online brokerage Robinhood reports what stocks its account holders own in realtime via API.

That’s a communication standard fitted to reality. True, it doesn’t tell us how many shares. But it’s a helluva better standard than 97 days later, four times a year.

Quast, you didn’t answer the question.  Why does anyone need to know who owns shares of which companies? Isn’t everybody entitled to an expectation of privacy?

It’s a public market we’re talking about.  The constituency deserving transparency most is the only other one in the market with large regulatory disclosure requirements: Public companies.

They have a fiduciary responsibility to their owners. The laws require billions of dollars of collective spending by public companies on financial performance and governance.

How incoherent would it be if regulations demand companies disgorge expensive data to unknown holders?

As to retail money, the Securities Act of 1933, the legislative basis for now decades of amendments and regulation, had its genesis in protecting Main Street from fraud and risk.  The principal weapon in that effort has long been transparency.

Now, the good news for both investors and public companies is that you can see what all the money is doing all the time, behaviorally. We’ve offered public companies that capability for 15 years at ModernIR.

Take TSLA, now the world’s most actively traded – we believe – individual stock. SPY trades more but it’s an ETF.  Active money has been selling it.  But shorting is down, Passive Investment is down 21% the past week.  TSLA won’t fall far if Passives stay put.

That’s market structure. It’s the most relevant measurement technique for modern markets. It turns boxes and lines into predictive behavioral signals.

And investors, you can use the same data at Market Structure EDGE to help you make better decisions.

Predictive analytics are superior to peering into the long past to see what people were doing eons ago in market-structure years. Still, that doesn’t mean the SEC should throw out ownership transparency.

Small investors and public companies are the least influential market constituents. Neither group is a lobbying powerhouse like Fast Traders.  That should warrant both higher priority – or at least fair treatment. Not empty boxes and wandering lines.

PS – Speaking of market structure, if you read last week’s edition of the Market Structure Map, we said Industrials would likely be down. They are. And Patterns say there’s more to come. In fact, the market signals coming modest weakness. The Big One is lurking again but it’s not at hand yet.

Plains Crossings

The Comanches ruled the Llano Estacado once.

We crossed it twice this week, driving in a day to Austin from Denver, and the next day back to Denver.  South of Lubbock you plunge off the Llano into Abilene and Sweetwater, and it looks like this.  You see why Quanah Parker was lord of the Plains.

The Texans call it the “LAN-oh.” I prefer the Spanish pronunciation, the YAH-no Esta-CAH-do.  Larry McMurtry’s Lonesome Dove, an unforgettable western if you’re looking for something to do in the Pandemic, immortalized its expanse.

What’s the Llano got to do with market structure?

It’s a math problem today, crossing the Llano.  You can calculate speed, fuel, stops, food, rest. Things can go wrong of course. Weather is a deterrent.  We’ve had to shelter the car under hotel awnings, trees, scrub mesquites outside the Boys Ranch, during hailstorms and downpours on our many jaunts betwixt Texline and Lampasas.

I love the open space. There’s peace in floating clouds and volcanic vistas, the row crops, the long ribbon of tarmac, the rain at the horizon. But geography is reduced to math, albeit in majestic fashion.

It’s a way to understand both investing and investor-relations in the modern era.  Crossing the Staked Plains for Larry McMurtry’s rugged characters in Lonesome Dove wasn’t math but art, in the same way that picking stocks was a matter of understanding what others missed, or how investor-relations was relationships and wordsmithing.

Now investing is like driving I-27 from Amarillo to Lubbock, IR is market intelligence. It’s a schedule and a map.

It’s not that art doesn’t matter.  What I love about the run from Amarillo to Raton, NM is how the cowboys must’ve seen it in 1880.  You can feel what they felt, hearts full of the infinite, nobody telling you what to do or where to go.

You’re also aware that at 75 mph you should be in Raton by 2:45p.

I can tell you we see it in stock-trading patterns behind price and volume.  The patterns of Active money vary – like chasing Blue Duck across the Llano (read Lonesome Dove).

The patterns of Passive money are a schedule proceeding from the beginning of the month when the inflows or outflows from 401ks come or go, to mid-month options-expirations where derivatives are leveraged directionally or used as substitutes, to month-end when the path across the month is adjusted to the plan.

It’s cruise-control on the Llano.

For Active investors and public companies, one thought should rise like Mount Capulin in New Mexico: You mean, I can check the SCHEDULE to see where the money is?

Exactly.

All analogies break down, sure. Sometimes the schedule fails.  We’re talking here about central tendencies, guideposts.

For instance, say you’re buying Industrials stocks.  If you’re using EDGE, you’ll see that Industrials are more Overbought than at any time over the past year.  The odds of more big gains have diminished. Shorting is low – they’re not about to fall apart. But why risk your capital?

Sure, there are outliers, exceptions. The latter always come with risk – like speeding down the straightaway.

Now suppose you’re the investor-relations officer for an Industrial component reporting results this week along with about 35% of all public companies.  Two weeks ago the sector rose almost 5% on derivatives into options-expirations. Last week the group added another 2% on Passive flows. (They’re related, you know. Passives knew and bought options and futures, which ETF market-makers can legally do, before the money came.)

But the sector is 8.5/10.0 Overbought into window-dressing, the third and last phase of Passive money crossing the monthly Llano.

Money is likely to rebalance away from Industrials. So it won’t matter how good your results are.  Focus on value messages, value money.  Stock-pickers wanting entry points should be your target. You can’t control Passives. You can only surf them.

This is the stock market now. You can do it the hard way, play Lonesome Dove from your trading turret, your IR chair. Or you can plot a course. Either way you’re crossing the plains.

The Daytraders

 

A year ago, Karen and I were flying to Fiji, 24 hours of travel from Denver to LA, to Auckland, to Nadi.

We took a ferry out of Denarau Island into Nadi Bay and north toward the Mamanuca Islands, all the way past the castaway home for television’s Survivor Fiji to our South Pacific gem, Tokoriki.

It’s not that I wish now to be a world away.  We can ride bikes past this gem, Catamount Lake, any crisp Steamboat morning (while the fruited plain radiates, it’s 45 degrees most days at 630a in northern Colorado).

It’s the shocking difference a year makes. Everybody’s trading. Instead of going to Fiji or whatever.

Schwab and Ameritrade have a combined 26 million accounts. Fidelity has 13 million in its brokerage unit. E*Trade, over 5 million.  Robinhood, the newest, has 13 million users.

Public companies wonder what impact these traders have on stock prices.  The old guard, the professional investors, seem to be praying daily that retail daytraders fail.

In some sense, the Dave Portnoy era (if you don’t know Barstool Sports and Davey Daytrader – perhaps our generation’s most adroit marketer – you must be a hermetic) has pulled the veil off the industry. It appears the pros know less than they led us to believe.

The pros say just wait.  The wheels are going to come off the retail wagon in a cacophony of sproinging springs and snapping spokes.

Of course, as Hedgeye’s Keith McCullough notes, if the wagon splinters, we’re all in the smithereens because there’s just one stock market.

We wrote in our widely read June 10 post, Squid Ink, about what happens to the millions of online retail trades.  They’re sold to what we call Fast Traders, machines that trade everything, everywhere, at the same time and thus can see what to buy or sell, what to trade long or short.

How does this flow that Citadel Securities, the biggest buyer of retail trades, says is now about 25% of market volume, affect the stock market, public companies and investors?

Two vital points about market structure here.  First, market-makers like Citadel Securities enjoy an exemption from rules governing stock-shorting.  Second, Fast Traders run trading models that predict in fleeting spaces how prices will behave.

Put these two factors together and you have the reason why stocks like TSLA can double in two weeks without respect to business fundamentals – or even the limitations of share supply.

If three million accounts at Robinhood want fractional exposure to TSLA, the problem for Fast Traders to solve is merely price and supply.  If you go to the grocery store and they don’t have shishito peppers, you go home without shishitos.

If you’re a retail trader wanting TSLA, you will get TSLA, and the price will rise, whether any shares exist or not.  Fast Traders will simply manufacture them – the market-maker SEC exemption on shorting.

The market-maker will cover before the market closes in 99% of cases.  So the market-maker isn’t short the stock anymore.  But maybe TSLA will have 25% more shareholdings than shares outstanding permit.

Worse, it’s impossible to understand supply and demand. If market-makers could only sell existing shares – back to shishito peppers – TSLA would skyrocket to $5,000 and plunge to $500.  Frankly, so would much of the market.

Which is worse?  Fake shares or fake prices?  Ponder it.

And machines will continuously calculate the supply or demand of shares of a stock versus others, and versus the exchange-traded derivatives including puts, calls and index futures (oh, and now Exchange Traded Funds which like prestidigitated shares have no supply limitations), to determine whether to lift prices.

As we said in Squid Ink, we believe Fast Traders buying order flow from retail brokers can see the supply in the pipeline.

Combine these features. Fast Traders see supply and demand. They relentlessly calculate how prices are likely to rise or fall. They manufacture shares to smooth out imbalances under SEC market-making exemptions.

And the market becomes this mechanism.

Risks? We’ve declaimed them for years.  The market will show a relentless capacity to rise, until something goes wrong. And then there won’t be enough stock to sell to meet redemptions, and prices will collapse. We’ve had tastes of it.  There will be more.

But it’s not the fault of the daytraders.

Big Blanket

The US stock market trades about $500 billion of stock daily, the great majority of it driven by machines turning it into trading aerosol, a fine mist sprayed everywhere. So tracking ownership-changes is hard. And unless we speak up it’s about to get a lot harder.

In 1975 when the government was reeling like a balloon in the wind after cutting the dollar loose from its anchoring gold, Congress decided to grant itself a bunch of authority over the free stock market, turning into the system that it now is.

How?  Congress added Section 11A to the Securities Act, which in 2005 became Regulation National Market System governing stock-trading today – the reason why Market Structure Analytics, which we offer to both public companies and investors, are accurately predictive about short-term price-changes.

And Congress decided to create a disclosure standard for investors, amending the Securities Act with section 13F. That’s what gave rise to the quarterly reports, 13Fs, that both investors and public companies rely on to know who owns shares.

I use the phrase “rely on” loosely as the reports are filed 45 days after the end of each quarter, which means the positions could be totally different by the time data is released. It’s a standard fit for the post office. Mail was the means of mass communication in 1975.

Currently, the standard applies to funds with $100 million or more in assets. Many managers divide assets into sub-funds to stay below that threshold.  So most companies have shareholders that show up in no reports. But at least they have some idea.

Well, out of the blue the Securities and Exchange Commission (SEC) has decided to lift the threshold to $3.5 billion to reflect, I guess, the collapse of dollar purchasing power.

But nothing else changes!  What would possess a regulatory body ostensibly responsible for promoting fairness and transparency to blanket the market in opacity while keeping in place time periods for reporting that have existed since 1975?

I’m reminded of a great line from the most quotable movie in modern history, Thank You For Smoking: I cannot imagine a way in which you could have $#!!@ up more.

Public companies have been asking the SEC for decades to modernize 13F reporting. Dodd Frank legislation passed in 2010 included a mandate for monthly short-position reporting. It’s not happened because the law put no timeframe on implementation.

But how stupid would it be to require monthly short-position reporting while letting long positions remain undisclosed till 45 days after the end of each quarter?

Much of the world has stricter standards of shareholder disclosure.  Australian markets empower companies and stock exchanges to require of investors full disclosure of their economic interest, on demand.

Our regulators appear to be going the opposite direction.

Australia offers an idea, SEC. If you’re going darken the capital markets with a new (non) disclosure standard, then how about empowering companies to demand from holders at any time a full picture of what they own and how they own it?

Investors, I get it. You don’t want anyone knowing what you have.  Well, it seems to work just fine in Australia, home to a vibrant capital market.

And let’s bring it around to market structure.  There is a woefully tilted playing field around ETFs.  A big investor, let’s say Vanguard, could give a billion-dollar basket of stocks to an Authorized Participant like Morgan Stanley off-market with no trading commissions and no taxes, in exchange for a billion dollars of ETF shares.

None of that counts as fund-turnover.

It could happen by 4p ET and be done the next day.  No trading volume. And then Vanguard could come right back with the ETF shares – again, off-market, doesn’t count as fund-turnover – and receive the stocks back.

Why would investors do that? To wash out capital gains. To profit on the changing prices of stocks and ETFs. This is a massive market – over $500 billion every month in US stocks alone.  It’s already over $3 TRILLION in total this year.

What’s wrong with it?  All other investors have to actually buy and sell securities, and compete with other forces, and with volatility, and pay commissions, pay taxes, alter outcomes by tromping through supply and demand.  Oh, and every single trade is handled by an intermediary (even if it’s a direct-access machine).

So how is that fair?

Well, couldn’t all investors do what Vanguard did?  No. Retail investors cannot.  Yes, big investors could take their stock-holdings to Morgan Stanley and do the same thing. But trading stocks and ETF shares back and forth to profit on price-changes while avoiding taxes and commissions isn’t long-term investment.

That the ETF market enjoys such a radical advantage over everything else is a massive disservice to public companies and stock-pickers.

And after approving the ETF market, you now, SEC, want to yank a blanket over shareholdings to boot?  Really?  Leave us in 1975 but 35 times worse?

Market Structure Analytics will show you what’s happening anyway. And nearly in real time. But that’s not the point. The point is fairness and transparency. Every one of us should comment on this rule.

Mr. Smith’s Money

The price-to-earnings ratio in the S&P 500 is about 23.  Is it even meaningful?

Some say a zero-interest-rate environment justifies paying more for stocks. That’s compounding the error. If we behaved rationally, we’d see both asset classes as mispriced, both overpriced.

All investors and all public companies want risk assets to be well-valued rather than poorly valued, sure. But Warren Buffett wasn’t the first to say you shouldn’t pay more for something than it’s worth.

What’s happening now is we don’t know what anything is worth.

Which reminds me of Modern Monetary Theory (MMT).  The words “money” and “theory” shouldn’t be used in conjunction, because they imply a troubling uncertainty about the worth of the thing everyone relies on to meter their lives.

That is, we all, in some form or another, trade time, which is finite, for money, which is also finite but less so than time, thanks to central banks, which create more of it than God gave us time.

Every one of us trading time of fixed value for money of floating value is getting hosed, and it’s showing up in the stock and bond markets.

Let me explain.  Current monetary thinking sees money as debits and credits.  If gross domestic product is debited by a pandemic because people lose their jobs and can’t buy stuff, the solution is for the government to credit the economy with an equal and offsetting amount of money, balancing the books again.

This is effectively MMT.  You MMTers, don’t send me long dissertations, please. I’m being obtuse for effect.

The problem in the equation is the omission of time, which is the true denominator of all valuable things (how much times goes into the making of diamonds, for instance? Oil?). Monetarists treat time as immaterial next to money.

If it takes John Smith 35 years to accumulate enough money to retire on, and the Federal Reserve needs the blink of an eye to manufacture the same quantity and distribute it via a lending facility, John Smith has been robbed.

How? Mr. Smith’s money will now be insufficient (increasing his dependency on government) because the increase in the availability of money will reduce the return Mr. Smith can generate from lending it to someone else to produce an income stream.

Mispriced bonds.  They don’t yield enough and they cost too much.

So by extension the cost of everything else must go up.  Why? Because every good, every service, will need just a little more capital to produce them, as its value has been diminished.  To offset that effect, prices must rise.

And prices can’t rise enough to offset this effect, so you pay 23 times for the earnings of the companies behind the goods and services when before you would only pay 15 times.

And this is how it becomes impossible to know the worth of anything.

And then it gets complicated.  Read a balance sheet of the Federal Reserve from 2007.  The Fed makes up its own accounting rules that don’t jive with the Generally Accepted Accounting Principles that all public companies must follow.

But it was pretty straightforward.  And there were about $10 billion of excess bank reserves on a monthly average, give or take.

Try reading that balance sheet today with all its footnotes.  It’s a game of financial Twister, and the reason isn’t time or money, but theory.  A theory of money that omits its time-value leads people to write things like:

The Board’s H.4.1 statistical release, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has been modified to include information related to TALF II LLC. The TALF II LLC was introduced on the H.4.1 cover note on June 18, 2020 https://www.federalreserve.gov/releases/h41/current/.

The theory is that if you just keep footnoting the balance sheet to describe increasingly tangled assets and offsetting liabilities, so long as it zeroes out at the end, everything will be fine.

Except it leaves out Mr. Smith and his limited time on the earth.

Oh, and excess bank reserves are now nearly $3 trillion instead of $10 billion, proof money isn’t worth what it was.

This then breaks down fundamental constructs of valuation.  And it’s why we offer Market Structure Analytics.  While fundamentals can no longer in any consistently reliable way be used to discern what the stock market is doing, Market Structure Analytics lays reasons bare.

For instance, Market Structure Sentiment™ ticked up for TSLA July 2. Good time to buy. It’s got nothing to do with fundamentals.  FB Market Structure Sentiment™ ticked up June 23. Good time to buy. In fact, it’s a 1.0/10.0 right now, but it’s 57% short, so it’s got just limited upside.  Heard all the negative stuff that would tank FB? Fat chance. Market structure rules this Mad Max world.

Public companies, if you want to understand your stock, you have to use tools that take into account today’s madness. Ours do.  Same for you, traders. Sign up for a free 14-day trial at www.marketstructureedge.com and see what drives stocks.

How does it all end? At some point Mr. Smith will lose faith, and the currency will too.  We should stop the madness before then.

Trading Fast and Slow

 

Happy 2nd Half of 2020!  I bet we’re all glad we’re halfway there. Karen and I would’ve been in Greece now sailing the Ionian islands, luxury catamaran, sunset off starboard, Hurricane in hand.

Instead my checklist leaving the house has expanded from wallet, phone, keys, to wallet, phone, keys, mask.  No vacation for you. Just a Pandemic and executive orders.

A CEO of a public company said, “Why does my stock trade only 60 shares at a time, and how do I fix it?”

I was happy the team at ModernIR had highlighted shares-per-trade (one of several liquidity metrics we track).  Every public-company CEO should understand it.

After all, your success, investor-relations folks selling the story to The Street (and investors, whether you can buy or sell shares before the price changes), depends on availability of stock. Not how great your story is.

Because there’s a mistaken idea loose in the stock market. We understand supply is limited in every market from homes for sale to shishito peppers at the grocery store. Yet we’re led to believe stocks are infinitely supplied.

This CEO I mentioned asked, “So how do I fix it?”

This isn’t AMZN we’re talking about, which trades less than 30 shares at a time, but that’s over $70,000 per trade.  AMZN is among the most liquid stocks trading today. The amount you can buy before the price changes is almost eight times the average in the whole market.

AAPL is liquid too, not because it trades almost $16 billion of stock daily but because you can ostensibly buy $35,000 at a pop, and it trades more than 400,000 times.

Back to our CEO, above. The company trades about 3,000 times per day, roughly $3,000 per trade.  Liquidity isn’t how much volume you’ve got. It’s how much of your stock trades before the price changes.

That matters to both the IR people as storytellers and the investors trying to buy it.

I’ve shared several vignettes as I experiment with our new decision-support platform democratizing market structure for investors, called Market Structure EDGE. I couldn’t buy more than 10 shares of AAPL efficiently. My marketable order for JPM split in two (96 shares, 4 shares), and high-speed traders took the same half-penny off each.

The CEO we’re talking about meant, “What can we do differently to make it easier for investors to buy our shares?”

The beginning point, at which he’d arrived, which is great news, is realizing the constraints on liquidity.

But. If you have the choice to buy something $3,000 at a time – oh, by the way, it’s also more than 4% volatile every day – or buying it $70,000 at a time with half the volatility, which “risk-adjusted return” will you choose?

And there’s the problem for our valiant CEO of a midlevel public company in the US stock market today. Fundamentals don’t determine liquidity.

To wit, TSLA is more liquid than AAPL, over $42,000 per trade.

Forget fundamentals. TSLA offers lower risk.

Ford and GM trade around $4,000 per transaction, a tenth as liquid as TSLA.  Heck, NKLA the maker of hydrogen trucks with no products and public via reverse merger is twice as liquid as our blue-chip carmakers of the 20th century.

Prospects, story, don’t determine these conditions. These vast disparities in liquidity invisible to the market unless somebody like us points them out are driven by DATA.

The reason liquidity is paltry in most stocks is because a small group of market participants with deep pockets can buy better data from exchanges than what’s seen publicly.  I’ll explain as we wrap the edition of the MSM in a moment.

The good news is the SEC wants to change it.  In a proposal to revamp what are called the data plans, the SEC is aiming to shake up the status quo by among other things, putting an issuer and a couple investors on the committee governing them.

I’ve been trying for 15 years to achieve something like this, and so has NIRI, the IR professional association (they longer than me!). I should retire! Mission accomplished.

Heretofore, the exchanges and Finra, called “Self-Regulatory Organizations (SROs),” have been able to create their own rules. In a perfect world full of character, we’d all be self-regulatory. No laws, just truth.

Alas, no.  The exchanges provide slow regulatory data to the public and sell fast data for way more money to traders who can afford it.

By comparing the slow data to the fast data, traders can jump in at whatever point and split up orders and a take a penny from both parties.

This happens to popular brokerage Robinhood’s order flow by the way.  Those retail customers get slow data, and the traders buying the trades use fast data.

That’s not the problem. The problem is that by buying Robinhood’s order flow at slow-data prices, and selling it at fast-data prices, T Rowe Price’s trades get cut out, front-run, jumped past.

Your big investors can’t buy your stock efficiently (passive money doesn’t care as it’s just tracking a benchmark).

That’s why our CEO’s company trades 60 shares at a time.

For stocks like AMZN the difference between fast and slow is small because they’re the cool kids. And size grows. For the rest, it’s the crows in the cornfield.

You can talk to investors till you turn blue. It won’t solve this problem. The only thing that will is when investors join with public companies and get behind eliminating Fast Data and Slow Data and making it just Data.

We’ve got a shot, thanks to this SEC, and the head of the division of Trading and Markets, Brett Redfearn.  We should all – public companies and investors – get behind it. If you want to know how, send me a note.