Power of Two

We’re coming to the end of two Coronavirus quarters. What happens now?

In a word, July.  As to what July brings, it’s summer in the northern hemisphere, winter down under.

It’s also the end of a remarkable period in stocks. I don’t mean rising or falling, volatility, the invincible-Alexander-the-Great-Macedonian-phalanx of the stock market (your history tidbit…you can look it up).

By “end” we don’t mean demise.  Though a demise is probably coming. More on that later. We mean the end of epic patterns.

We wrote last week about index-rebalances delayed since December.  In patterns observable through ModernIR behavioral analytics, the effort to complete them stretched unremitting from May 28 to June 18.

Yes, June 19 was a muscular volume day with quad-witching and we saw BIG Exchange Traded Fund (ETF) price-setting that day in many stocks. (Note: ETFs are substitutes for stocks that are easily traded but entitle owners to no underlying assets save the ETF shares.)

But the patterns strapping May to June like a Livestrong bracelet (wait, are those out?) ended almost everywhere June 18.  The effort reflected work by about $30 trillion, adding up money marked to MSCI, FTSE Russell and S&P Dow Jones, to match underlying construction.

Funds moved before rebalances. And the biggest components, ETF data indicate – really, they dwarf everything else – are AAPL and MSFT. Patterns show money piled like a rugby scrum into AAPL call options in early June, and then plowed headlong into AAPL equity between June 12-18.

It’s good business if you can get it, knowing the stock will inevitably rise because of its mass exposure to indexes and how its price then when last money square-danced into an Allemande Left with indexers in December 2019 was about $280.

How many of you remember when AAPL was down to about 5% of the computing market, most of that in academia, and it looked like MSFT would steamroll it right out of business?  And then MSFT was yesterday’s news, washed up, a boomer in a Slack world.

Today both say, Ha! Suckers!

MSFT patterns are like AAPL’s but less leveraged, explaining the divergence in performance over the past year. AAPL is up 84%, MSFT about half that.  You can see here how both have performed versus the Tech-heavy QQQ (Nasdaq 100 from Invesco) and the SPY, State Street’s proxy for the S&P 500.

AAPL and MSFT have pulled the market along like Charles Atlas (and his doppelganger) towing a Pennsylvania railcar (more arcane and anachronistic history for you).

That ended, at least for now.  The Russell reconstitution continues through Friday but in patterns at this point it appears money has already changed mounts, shifted chairs.

The marvel is the magnitude of the effects of these events, and the power of two – AAPL and MSFT.

You’re thinking, “What about the rest of the FAANGs?”

MSFT isn’t one but we include it, and oftentimes now TSLA and AMD.  FB, AMZN, NFLX, GOOG – incisors dripping less saliva than AAPL – are massive, yes. But they don’t pack the ETF power of the two.

Let me give you some data. There are 500 Financials stocks, about 400 Healthcare, around 300 Consumer Discretionary.  Tech is around 200.  Most of these sectors are Oversold, and there’s a lot of shorting. The FAANGs are Overbought and more than 50% short, collectively.

The few outweigh the many.

And meanwhile, Market Structure Sentiment™ is both bottomed and lacking the maw it signaled. Either we skip across the chasm for now, or it trips us soon (stocks love to render fools of soothsayers).

The salient point is that the market can’t be trusted to reflect views on Covid19, or trade with China, or the election in November, or economic data, or actions of the Federal Reserve (curiously the Fed’s balance sheet is tightening at the moment). It’s right now defined by the power of two.

Two legs.

We humans stand fine on two. Can the market?  We’re about to find out.  And the degree to which your shares are at risk, public companies, to those two legs, and your portfolio, investors, is measurable and quantifiable. Ask us, and we’ll show you.

Seen and Unseen

The stock market is a story of the seen and the unseen.

Ethereal, hieratic, a walk by faith not by sight kind of thing?  No, not that.

And by the way, I’ve not forgotten about the rest of the story, as Paul Harvey (millennials, look him up) would say, the good developments for investors and public companies I mentioned some time back. I’ll come to it soon. This week there’s urgency.

A tug of war rages between bulls and bears. Some say stocks are wildly overpriced. There’s record bearishness on stocks in surveys of individual investors. Yet people are daytrading like it’s 1999.  And record stockpiles of cash like tumbleweeds on Kansas fences strain at the bounds, and the bulls say, “Just you wait and see when that money rolls into markets!”

All of this is seen stuff. Things we can observe.  As are promising clinical developments in steroids that might help severe coronavirus sufferers.  Rebounding retail sales. The Federal Reserve taking tickets at the market’s door.

None of those observable data points buy or sell stocks, though.  People and machines do.  In my Interactive Brokers account as I continue testing our new Market Structure EDGE decision-support platform for traders, I sold a thousand shares of AMRN yesterday.

It took me several hours, nine trades, all market orders, not limits. I’m cautious about limit orders because they’re in the pipeline for everyone intermediating flow to see.  Even so, only three matched at the best offer. The rest were mid-pointed in dark pools, and one on a midpoint algorithm priced worse, proof machines know the flow.

In a sense, 70% of the prices were unseen. Marketable trades have at least the advantage of surprise.  Heck, I’m convinced Fast Traders troll the quotes people look up.

Now, why should you care, public companies and investors?

Because the unseen is bigger than the seen. This cat-and-mouse game is suffusing hundreds of billions of dollars of volume daily.  It’s a battle over who knows what, and what is seen is always at a disadvantage to those with speed and data in the unseen.

There are fast and slow prices, and the investing public is always slow.  There are quotes in 100-share increments, yet well more than 50% of trades are odd lots less than that.

There are changes coming, thankfully. More on that in a couple weeks.  What’s coming this week is our bigger concern, and it’s a case of seen versus unseen.

Today VIX options expire (See ModernIR planning calendar).  There are three ways to win or lose: You can buy stocks in hopes they rise, short them on belief they’ll fall – or trade the spread. Volatility. It’s a Pandemic obsession. Inexperienced traders have discovered grand profits in chasing the implied volatility reflected in options.  I hope it doesn’t end badly.

Volatility bets will recalibrate today. The timer goes off, and the clock resets and the game begins again.

Thursday brings the expiration of a set of index options, substitutes for stocks in the benchmark.  Many option the index rather than buy its components.

Friday is quad-witching when broad stock and index options and futures expire (and derivatives tied to currencies, interest rates, Treasurys, which have been volatile).

The first quad-witch of 2020 Mar 20 marked the bottom (so far) of the Pandemic Correction. And wiped out some veteran derivatives traders.  We’re coming into this one like a fighter jet attempting a carrier landing, with the longest positive stretch we’ve ever recorded for Market Structure Sentiment™, our 10-point gauge of short-term tops and bottoms.

It’s at 8.2. Stocks most times trade between 4.0-6.0. It’s screaming on the ceiling, showering metal sparks like skyrockets.

And beneath lurks a leviathan, not unseen but uncertain, a shadowy and shifting monster of indefinite dimension.

Index rebalances.

IR Magazine’s Tim Human wrote on ramifications for public companies, an excellent treatise despite my appearance in it.

Big indexers S&P Dow Jones, Nasdaq and MSCI haven’t reconstituted benchmarks this year. The last one done was in December.  Staggering volatility was ripping markets in March when they were slated and so they were delayed, a historical first, till June.

Volatility is back as we approach resets affecting nearly $20 trillion tracking dollars.

And guess what?  The big FTSE Russell annual reconstitution impacting another $9 trillion is underway now in phases, with completion late this month.

It took me several hours of careful effort to get the same average price on a thousand shares of one stock.  How about trillions of dollars spanning 99.9% of US market cap?

It may go swimmingly.  It’s already underway in fact. We can track with market structure sonar the general shape of Passive patterns. They are large and dominant even now.  That also means they’re causing the volatility we’re experiencing.

The mechanics of the market affect its direction. The good news is the stock market is a remarkably durable construct.  The bad news is that as everyone fixates on the lights and noise of headlines, the market rolls inexorably toward the unseen. We’re shining a light on it (ask us how!).  Get ready.

Squid Ink

Is retail money creating a Pandemic Bubble? Sort of. Really, it’s Fast Traders turning those orders into clouds of squid ink.

There are 47 million customer accounts at Schwab, Fidelity, Ameritrade, E*Trade and Robinhood.  These big online brokers sell their flow to Citadel, Two Sigma, Susquehanna’s G1X options platform, Virtu, UBS, options trader Wolverine, and others.

Nearly all of the orders are “non-directed,” meaning the broker determines where to send them.  Also, more than three paragraphs of market structure goop and people grab a bottle of tequila and go back to day-trading.

So, let me explain.

Do you know CHK?  A shale-oil play, it’s on the ropes financially. In May it was below $8. Yesterday CHK was near $70 when it halted for news. Which never came, and trading resumed. (Note: A stock should never, ever be halted for news, without news.)

It closed down hard near $24. Rumors have flown for weeks it’ll file bankruptcy.  Why was it at $70? People don’t understand that public equity often becomes worthless if companies go bust. Debtholders convert to equity and wipe out the old shareholders.

Hertz (HTZ) went bankrupt May 26 and shares closed at $0.56.  Monday it was over $5.50, up about 900%. HTZ debt is trading at less than 40 cents on the dollar, meaning bondholders don’t think they’ll be made whole – and they’re senior to equity.

This is bubble behavior. And it abounds. Stocks trading under $1 are up on average 79% since March, according to a CNBC report.

ABIO, a Colorado biotech normally trading about 10,000 shares daily with 1.6 million shares out made inconsequential reference to a Covid preclinical project (translation: There’s nothing there). The stock exploded, trading 83 million shares on May 28, or roughly 50 times the shares outstanding.

Look at NKLA.  It’s been a top play for Robinhood clients and pandemic barstool sports day-trading. No products out yet, no revenue. DUO, an obscure Chinese tech stock trading on the Nasdaq yesterday jumped from about $10 to $129, closing above $47.

Heck, look at Macy’s.  M, many thought, was teetering near failure amidst total retail shutdown. From about $4.50 Apr 2, it closed over $9.50 by June 8.

W, the online retailer that’s got just what you need, is up 700% since its March low despite losing a billion dollars in 2019.

When day traders were partying like it was 1999, in 1999, stocks for businesses with no revenues and products boomed.  Then the Nasdaq lost 83% of its value.

About 95% of online-broker orders are sold to Fast Traders – the Citadels, the Two Sigmas, the Virtus.  They’re buying the tick data (all the prices) in fractions of seconds. They know what’s in the pipeline, and what’s not.

Big online brokers sell flow to guarantee execution to retail traders.  I shared my experience with GE trades. The problem is retail prices are the ammunition in the machine gun for Fast Traders. They know if clips are being loaded, or not. And since retail traders don’t direct their trades (they don’t tell the broker to send it to the NYSE, Nasdaq, Instinet, IEX, etc., to hide prices from Fast Traders), these are tracer rounds stitching market prices up and down wildly.

The Fast Traders buying it can freely splatter it all over the market in a frenzy of rapidly changing prices, the gun set on Full Automatic.

This is how Fast Traders use retail trades to cause Wayfair to rise 700%. The order flow bursts into the market like squid ink in the Caribbean (I’ve seen that happen snorkeling), and everyone is blinded until prices whoosh up 30%.

A money manager on CNBC yesterday was talking about the risk in HTZ. She said there were no HTZ shares to borrow. Even if you could, the cost was astronomical.

Being a market structure guy with cool market structure tools (you can use them too), I checked HTZ.  Nearly 56% of trading volume is short. Borrowed. And the pattern (see here) is a colossus of Fast Trading, a choreographed crescendo into gouting squid ink.

How? Two Sigma, Hudson River Trading, Quantlab, etc., Fast Trading firms, enjoy market-making exemptions. They don’t have to locate shares. As high-speed firms “providing liquidity,” regulators let them do with stocks what the Federal Reserve does with our money. Digitally manufacture it.

Because they buy the flow from 47 million accounts, they know how to push prices.

That’s how ABIO traded 83 million shares (60% of the volume – nearly 50 million shares – was borrowed May 28, the rest the same shares trading many times per second).

It’s how CHK exploded up and then imploded as the manufactured currency vanished. And when stocks are volatility halted – which happened about 40 times for CHK the past two trading days – machines can game their skidding stop versus continuing trades in the ETFs and options and peer-group stocks related to the industry or sector.

This squid ink is enveloping the market, amid Pandemic psychology, and the economic (and epic) collapse of fundamental stock-pricing.

Dangerous.

You gotta know market structure, public companies (ask us) and investors (try EDGE).

Unknowable

The question vexing Uber and Grubhub as they wrestle over a merger is which firm’s losses are worth more?

And for investors considering opportunities among stocks, a larger question: What companies or industries deserve better multiples on the Federal Reserve’s backstopping balance sheet and Congress’s operating loans?

Sure, I’m being cheeky, as the Brits would say.  The point is the market isn’t trading on fundamentals. Undeniable now to even the most ardent skeptics is that something is going on with stocks that wears an air of unreality.

And there is no higher impertinence than the somber assertion of the absurd. It deserves a smart retort.

We’ve been writing on market structure for over a decade. Market structure is to the stock market what the Periodic Table is to chemistry. Building blocks.

We’ve argued that the building blocks of the market, the rules governing how stock prices are set, have triumphed over the conventions of stock-valuation.

SPY, the S&P 500 Exchange Traded Fund (ETF), yesterday closed above $308. It last traded near these levels Mar 2.

What’s happened since? Well, we had a global pandemic that shut down the entire planetary economic machinery save what’s in Sweden, North Dakota and Africa. Over 40 million people in the United States alone took unemployment. Perhaps another 50 million got a paycheck courtesy of the US Congress’s Paycheck Protection Program.

Which means more than half the 160 million Americans working on Mar 2 when stocks last traded at current levels have been idled (though yes, some are returning).

At Feb 27, the Federal Reserve’s balance sheet was $4.2 trillion, of which $2.6 trillion sat in excess-reserve accounts earning interest of about 1.6% (why banks could pay some basis points on your savings account – arbitrage, really, that you, the taxpayer, footed).

By May 28 the Fed’s obligations on your behalf (all that money the Fed doles out has your name on it – “full faith and credit of the United States”) were $7.1 trillion, with $3.3 trillion in excess reserves now earning ten cents and wiping out meager savings-account returns but freeing taxpayers of interest expense.

The nearest facsimile I can arrive at for this great workforce idling, casting about in my history-obsessed mind, is the American Indians.  They were told, stop hunting and gathering and go on the government’s payroll.

Cough, cough.

You cannot idle the industrious and value their output the same as you did before.

Yet we are.

While I’m a pessimist about liberal democracy (classical meaning of “freedom”) because it persisted through a pandemic by the barest thread, I’m an inveterate optimist about American business.  I’ve obsessed on it my adult life. It affords a fulsome lifestyle.

The goal of good fiction is suspense of disbelief. That is, do I buy the thesis of the story? (News of the World is by the way brilliant fiction from Paulette Jiles with a high disbelief-suspension quotient).

Well, the stock market is supposed to be a barometer for truth. Not a litmus test for suspension of disbelief.

Sure, the pandemic cut some costs, like business travel. But contending a benefit for bottom lines ignores the long consequential food chain of ramifications rippling through airlines, hotels, restaurants, auto rentals, Uber, Lyft, on it goes.

How about corporate spending on box seats at big arenas?

Marc Benioff is still building his version of Larry Ellison’s Altar to Self in downtown San Francisco (no slight intended, just humor) for salesforce.  Yet he said to CNBC that some meaningful part of the workforce may never return to the office.

An empty edifice?

And nationwide riots now around racial injustice will leave at this point unknown physical and psychological imprints on the nerve cluster of the great American economic noggin.

Should stocks trade where they did before these things?

The answer is unknowable. Despite the claims of so many, from Leuthold’s Jim Paulson to Wharton’s Jeremy Siegel, that stocks reflect the verve of future expectations, it’s not possible to answer something unknowable.

So. The market is up on its structure. Its building blocks. The way it works.

Yes, Active investors have dollar-cost-averaged into stocks since late March. But that was money expecting a bumpy ride through The Unknowable.

Instead the market rocketed up on its other chock-full things.

Quants chased up prices out of whack with trailing data. ETF arbitragers and high-speed traders feasted on spreads between the papery substance of ETF shares and the wobbly movement of underlying stocks.  Counterparties to derivatives were repeatedly forced to cover unexpected moves. The combination lofted valuations.

None of these behaviors considers The Unknowable.  So, as the Unknowable becomes known, will it be better or worse than it was Mar 2?

What’s your bet?

Daily Market Structure Sentiment™ has peaked over 8.0/10.0 for the third time in two months, something we’ve not seen before. The causes are known.  The effects are unknowable save that stocks have always paused at eights but never plunged.

The unknowable is never boring, sometimes rewarding, sometimes harsh. We’ll see.

Medium Frequency Trading

Liquidity is driving the stock market.  And I don’t mean the Federal Reserve.

I saw it firsthand in my Interactive Brokers account.  I bought 600 shares of GE at the market.  Limit orders are like turn signals in LA:  For sissies.  The average trade-size in GE is a little over 600 shares, or about $3,700.

Ergo, 600 shares should fill without issue. Well, pfffttth on that.

A hundred shares went to Island – which doesn’t exist anymore but the name lives on at Instinet, owned by Nomura. It’s an Alternative Trading System, a dark pool.

Island, for you market structure geeks (you know who you are!), invented the market as it exists today.  Look up Josh Levine and Jeff Citron (the guy behind phone company Vonage now).  And read Scott Patterson’s “Dark Pools.” 

Back to our saga. Another hundred shares filled at the NYSE’s Retail Liquidity Program, meaning I bought them from a high-frequency trader paid by the NYSE to improve the price a half-penny (price was $6.445).

If you’re suffering from insomnia, read this latest update on NYSE Arca fees. I’ll give you something to keep you awake:  a $50 American Express gift card to the first three people to tell me CORRECTLY what selling retail orders pays at NYSE Arca.

Oh, and this is why online retail brokers sell order flow and why high-speed traders buy it.  Read – or try to – the fee schedule. Think about all that complexity filtering through how algorithms route orders around the marketplace.

And think about how it might set the price for things while the good folks on CNBC are divining economic signals from what stocks do.

The exchanges are going to gush about how great this is for me.  You’re getting a better price, see!

Continuing:  Then a hundred shares executed at the very same price and time at CBOE EDGA, a stock exchange that pays traders about $0.18/100 to buy shares (to “remove,” the exchanges like to say, but adding and removing is selling and buying).  If you sell there, you pay.

Then 200 shares matched at $6.448 at a place simply labeled “DARK,” followed by another hundred in the same place, at the same price.

By breaking up my single order into five pieces (IBKR’s algo did it), the price went up.  GE’s market cap is $60 billion. It trades 130 million shares daily. Revenues are $120 billion. Should 20% of my 600-share order price it?

All these trades occurred at 9:25:52 AM MT.  I know the sequence only because the trades are ranked by succession.

This…process, or whatever you want to call it, is pricing the whole stock market.  It’s the Twister – remember that suggestive board game? – version of liquidity.

Our friends Joe Saluzzi, Sal Arnuk and team at Themis Trading are chuckling. This is daily life for them (read their book!).

But do you understand, readers?  GE’s business prospects didn’t do it.

I bought it because Market Structure Sentiment ticked up, signaling gains.  The vast bulk of trades are driven by the same motivation.  For me, it’s Medium Frequency Trading, or what probability for gains exists over a few days.

For most orders it’s far less, and for ten parties – no doubt some of them the same but there is a broker on each side of every trade – my MFT, my medium-frequency trade, was an HFT, a high-frequency trade.

Our collective acts set prices.  Trading heuristics – what do I get for this action versus that one?  Who will pay me to be ahead or behind this trade?

Exchanges and brokers say it bears little on the weight of the money in the market. Oh, really?  Try trading 600 shares of GE at the market. And why is the NYSE’s fee-schedule update 49 pages long?

Get takeout via DoorDash (a restaurant HFT, we could call them) and the price is in the cart. It’s not dependent on volume of food or whether you’re routing the meal to somebody else.

The restaurant pays for the service (or you pay delivery), but the cost is clear, and fixed. It appears to me traders made nearly three cents intermediating my fragmented order, and were paid an additional $0.51-$0.54 for setting prices.

What difference does it make? Motivation. During the placid, halcyon days of Nov 2019, stock prices still moved 2% up and down every day. In March it was over 12%. Right now it’s 3.3%. Every party to a trade gets paid. Price? Volatility.

Try reading the Nasdaq’s response to what we call Reg Nemesis II. No, seriously. Read it. Make sense?  Why is the market so fricking complicated?  Why are we told it’s good?

It lacks credulity. As do most of the daily links drawn to stock prices and headlines.

But I’ve got good news, public companies and investors. If we understand what’s happening, we can turn it to our advantage and influence it, both. I’ve got more to say on both counts soon. It’s happening.  Stay tuned.

Meanwhile, Market Sentiment bottomed last week but we’ve been moving at dog years in equities, so watch out. Things can change on a dime – especially either side of month-end window-dressing.

What’s Changed

We’ve been pandemicking across the fruited plain and through the stock market for better than two months. Now what?

I still rue my decision Friday Mar 13 to delay skiing in Steamboat till the next day (it was Fri the 13th after all). The next day the slopes closed for the season.

It’s a reminder not to put off till tomorrow what you can do today. And it raises this question:  What’s changed in the stock market since fear drove us to ground?

Let me wrest your eyes from the headlines over to what the money is doing, demographically. Under Regulation National Market System, exchanges can’t have a “no shirt, no shoes, no service” rule for who buys and sells stocks in the store. Reg NMS requires fair access for all.

We can debate whether giving the public a cheap, slow look at stock prices and volume – the consolidated tape – while selling the pros with fat wallets better, faster and deeper data is fair access. And exchanges handle only about 60% of volume.

But I digress.

On Jan 20, 2020, about 13% of trading volume came from Active Investment, your Benjamin Grahamers, your stock-pickers.

About 16% tied to managing risk and leveraging returns. This is who’s on the other side when there is buying or selling of puts and calls. Or, say, a bank selling a swap for the returns in Financials, then offsetting the risk by shorting Consumer Staples.

Around 24% was Passive investment like quants and index funds.

Nearly 47% was Fast Trading, machines with a horizon of a day or less modeling the math of changing prices.

By Mar 30, coming off the current market bottom, boy had behaviors changed.  Active Investment was up 8% even as volume had exploded to record levels.  That means Active money was buying the bottom, value-style.

Passive Investment tracking the mean, or following global macro factors, or parrying volatility risk was rocked off the balance beam. It plunged 29% as a share of volume.

Moving in opposite fashion, Fast Trading exploded to 57% of trading volume, up 21%. This is what was driving record trading.  WMT, Sam Walton’s globe-crushing consumer staples empire, was averaging 45,000 trades daily Jan 20.  On Mar 30 as stocks were boomeranging out of pandemic hell, it was averaging 146,000 trades daily – an astonishing 224% increase.  Blame Fast Traders.

And finally, Risk Mgmt, the counterparties to derivatives and borrowing for leverage that depend on future prices, dropped 25%.

These behavioral changes describe what happened better than all the headlines, all the Daily Pandemic Updates with Dr. Fauci and team, the Death Clock ticking on the right side of the TV screen, all the Federal Reserve actions, the 40 million people out of work, the 50 million getting paid by loans from the Fed instead of revenue from the job.

Really, 50% of the market’s value vanished as the engine of today’s equities, Passive Investment and the implied leverage in Risk Mgmt, imploded like an unused football stadium where demolition charges change it in seconds from the Roman Coliseum to a pile of steaming dust.

But the market didn’t lose 50% of its value.

Exactly.  You’re catching on.

About 21% of the market’s rebound is speculation on the tick data.  Another 8% is Active investment, stock-pickers putting in a bottom on Fed action, American resilience.

Maybe only 8% of the bounce is real.  Regardless, the combination gives us a 30% (close to it) recovery for the S&P 500.

What about now? At May 20?

Active Investment remains the same. Zero percent change. Risk Mgmt is unchanged too, 0% difference from Mar 30 to May 20. Passive is up 12%, Fast Trading down 4%.

Apply these data to what’s ahead.  Active money is content, committed to a “bottom is in” posture. Risk Mgmt is expensive and uncertain.  Passive money is trying to get its mojo back but it’s half what it was.  And Fast Traders gaming those moving parts, the prices of stocks, are retreating, uncertain.

You’d be hard-pressed to see how these data take us to new highs. You’d also say they don’t smack of another smackdown.

But the pandemic data are still here. They’ve not changed much the past six weeks. Market structure is like water. Disturbances roil it.  When those events pass, it reverts to stillness.

The data are still sloshing.

If the waters are troubled, then even as commuter traffic picks up, gas prices tick up, the city stirs again, keep one eye on the deep. What’s changed at this point is bigger than what’s returned to normal.  Keep your hands inside the gunwales.

Reg Nemesis II

In the Colorado mountains at Steamboat Springs, the pixie dust florescence of greening aspen leaves paints spring onto the high country.

In the bowels of equity markets there gurgles an emergent leviathan (maybe I should choose different imagery – but we’ll talk about what stinks and what doesn’t in this…movement).  The Securities Exchange Commission (SEC) in January asked stock exchanges to rethink Reg NMS.

Everybody who trades stocks, every investor-relations officer for a public company, should know some key facts about this regulation.

Yes. Of course it’s a pain in the butt (I need a new motif).  Who wants to read regulations?

Reg NMS is Regulation National Market System. In one of our all-time most frequented posts, called Reg Nemesis, we described the effects this law has had on the stock market.

We also explained in our recent NIRI webcast on market structure that its four components regulate stock data, stock quotes, stock prices, and access to all three.

Now the SEC wants to modernize it. I think that’s not a stinker at all. Rules should reflect how the market works, and Reg NMS hatched in the contemporary minds of members of Congress in 1975.

Then, amid caroming inflation and screaming currency volatility of the post-gold, bell-bottomed pandemic-haired hippie era, the legislative halls of Columbia echoed with calls to protect the vital “system” of our stock market.

So Congress added the 11A national market system amendments to the Securities Act.  And thirty years later, the SEC got around to regulating Congress’s will upon free markets, and in 524 sweepingly droll pages that one cannot help but read in the same soporific nasal tone as Ben Stein in Ferris Bueller’s Day Off, the stock market became the national market system.

You cannot bear imagining the cacophony with which the stock exchanges met this plan, back then.  There was shrieking and gnashing of legal teeth, the rending of garments and the donning of sack cloth. Ashes were poured on heads. Hieratic beseeching, a great priestly tumult, roared over capital markets.  It was like a pandemic.

Reg NMS was approved in 2005, about four years after the drumbeat began, and implemented in 2007.

Thirteen years on now, nobody loves Reg NMS like stock exchanges love Reg NMS. They’ve even sued the SEC to stop the regulator from questioning its own rules.

As Dave Barry, one of my favorite humorists (if your car is making a knocking noise, turn the radio up) of all time, used to say, “We are not making this up.”

So the SEC basically said, to quote Jerry Stiller (RIP, Ben Stiller’s dad), “Do you want a piece of me!!!!????”

And they’ve instructed exchanges and other market participants to help redraw Reg NMS.  And somehow the sequel is even longer than the original, at 595 pages.

And once again, even though the Securities Act of 1933 and 1934 as amended (oh so very many times amended) specifically includes issuers as constituents not to be discriminated against, we’re omitted from this re-imagining.

That’s a major reason to me why more than 55% of all trading volume currently comes from firms that don’t know what you do or who you are, public companies. They care only that your price profitably changes in fractions of seconds at your investors’ expense.

But I digress.

The Festivus for the rest of us that’s thus far been as elusive as holiday aluminum poles and feats of strength is a market that really works for our profession.

What would that be?  For one, a market that produced more IR jobs rather than fewer (we continue to lose more stocks each year than we gain and there are less than half what there were when I started in this profession in 1995).

And a market where stock pickers favoring your story have the same chance to make money as ETF market-makers and Fast Traders (so blissfully optimistic you want to start humming Fred Rogers, and, were we not socially distanced, hugging your neighbor).

Hey, maybe this is our chance. We can form opinions, speak up.  We’ll have that opportunity as this process, likely to take years as it did the first time around, unfolds.

So, what’s the SEC wanting to put in Nemesis II?  It wants competition for consolidated market data.  The Securities Information Processor (SIP) is a monopoly run by one firm (currently the Nasdaq).  It’s the official source of price and quote information – but it’s slower than all the proprietary data feeds. So everybody sells access even though the law says access must be uniform.

That needs fixing and the SEC is right.

And they want to redefine a “round lot” to reflect an Amazon market. Right now, stocks quote in 100-share increments.  The problem is AMZN, BKNG, GOOG and other stocks trade for well more than $1,000.  The average trade-size in these is about 30 shares.

In fact, almost 60% of trades now are for less than 100 shares, so stocks are trading at prices differing from quotes. It merits analysis, we agree. But do we further “yellow pencil” the market? Should we force all stocks to be $25-50? Is the round lot dead?

I haven’t finished reading all 595 pages yet. We’ll have more to say. We need rules that reflect reality. But we also need simple, comprehensible markets that work for all of us, and not just for speedy machines and stock exchanges.

Maybe we should all yell at them, “Do you want a piece of me!!!!????”

Benjamin Graham

A decade ago today, stocks flash-crashed.  I’m reminded that there are points of conventional market wisdom needing reconsideration.

It’s not because wisdom has diminished. It’s because the market always reflects what the money is doing, and it’s not Ben Graham’s market now. I’ll explain.

There are sayings like “sell in May and go away.”  Stocks fell last May. You’ll find bad Mays through the years. But to say it’s an axiom is to assert false precision.

Mind you, I’m not saying stocks will rise this month. They could plunge. The month isn’t the reason.

Graham protégé Warren Buffett told investors last weekend that he could find little value and had done the unthinkable: Reversed course on an investment. He dumped airlines. Buffett owned 10% of AAL, 11% of DAL, 11% of LUV and 9% of UAL.

Buffett and Berkshire Hathaway, sitting on $137 billion, believe in what Buffett termed “American Magic.” But they’ve sold, and gone away in May.

There are lots of those sayings. As January goes, so goes the market.  Santa Claus rallies come in December.  August is sleepy because the traders are at the Cape, the Hamptons.

These expectations for markets aren’t grounded in financial results or market structure.

Blackrock, Vanguard and State Street own 15-20% of the airlines, all of which are in 150-200 Exchange Traded Funds (ETF).  Passive money holds roughly half their shares.

Passives don’t care about the Hamptons, January, or May.  Or what Warren Buffett does.

In JBLU, which Buffett didn’t own, the Big Three own 20%, and Renaissance Technologies and Dimensional Fund Advisors, quants with track records well better than Buffett’s in the modern era, invest in the main without respect to fundamentals.

Unlike Buffett, RenTech and DFA continually wax and wane.

It’s what the money is doing now.  Its models, analysis, motivation, allocations, are not Benjamin Graham’s (he wrote Security Analysis, The Intelligent Investor, seminal tomes on sound stock-picking from the 1930s and 1940s).

And that’s only part of it.  New 13fs, regulatory details on share-ownership, will be out mid-May. Current data from the Sep-Dec 2019 quarters for DAL show net institutional ownership down 17m shares, or 3%.

But DAL trades over 70 million shares every day. Rewinding to the 200-day average before the market correction exploded volumes, DAL still traded over 16m shares daily.  The total net ownership change quarter-over-quarter was one day’s trading volume.

Since there are about 64 trading days in a quarter, and 13fs span two quarters, we could say DAL’s ownership data account for about 1/128th of trading volume. Even if we’re generous and measure a quarter, terribly little ownership data tie to volume.

Owners aren’t setting prices.

Benjamin Graham was right in the 1930s and 1940s.  He’s got relevance still for sound assessment of fundamental value.  But you can’t expect the market to behave like Benjamin Graham in 2020.

The bedrock principle in the stock market now is knowing what motivates the money that’s coming and going, because that’s what sets prices.  Fundamentals can’t be counted on to predict outcomes.

In DAL, Active Investment – call it Benjamin Graham – was about 12% of daily volume over the trailing 200 days, but that’s down to 8% now. Passive money is 19%, Fast Traders chasing the price long and short are 62% of the 73m shares trading daily. Another 11% ties to derivatives.

Those are all different motivations, reasons for prices to rise or fall.  The 11% related to derivatives are hoping for an outcome opposite that of investors. Fast Traders don’t care for more than the next price in fractions of seconds. They’re the majority of volume and will own zero shares at day’s end. You’ll see little of them in 13fs.

The airline showing the most love from Benjamin Graham – so to speak – is Southwest.  Yet it’s currently trading down the most relative to long-term performance. Why? Biggest market cap, biggest exposure to ETFs.  It’s not fundamental.

If you’re heading investor-relations for a public company or trying to invest in stocks, what I’ve just described is more important than Benjamin Graham now.

The disconnect between rational thought and market behavior has never been laid so bare as in the age of the pandemic.  It calls to mind that famous Warren Buffett line:  Only when the tide goes out do you discover who’s been swimming naked.

Might that be rational thought?

How airlines perform near-term depends on bets, trading, leverage. Not balance sheets.  It’s like oil, Energy stocks – screaming up without any fundamental reason.  And market structure, the infinite repeating arc from oversold to overbought, will price stocks. Not Ben Graham.  Though he was wise.

Money for Nothing

How much does free money cost?

Everything, apparently.

The play Hamilton by Lin Manuel Miranda has grossed over $620 million, seventh all-time on Broadway but still a long way from Phantom of the Opera, Wicked, and Lion King, theater’s billion-dollar trio.

Hamilton is about Alexander, our first Treasury Secretary and the man behind the first bank of the United States, now the Federal Reserve Bank, which concludes its Open Market Committee meeting today.

Hamilton’s generous pen proliferates in the Federalist Papers, required reading for any serious defender of the republic.

In Federalist 78, Hamilton wrote that while it’s a republican axiom that the people may alter or abolish the Constitution if it’s inconsistent with their happiness, no momentary inclination laying hold of a majority of constituents justifies departure from it unless or until the people have by solemn act approved it.

My governor here in CO issued an order shutting down the economy, citing the emergency powers in Article IV Section 2 of the CO Constitution. I read it.  There are no emergency powers. It says the governor is the chief executive.

I sent a note to his chief of staff, Eve Lieberman, saying that not only had the governor construed meaning from the Constitution that it doesn’t contain, but that he also had overlooked Article II, which among other things says that all political power derives from the people, and that all persons have certain natural, essential and inalienable rights, among which may be reckoned the right of enjoying and defending their lives and liberties; of acquiring, possessing and protecting property; and of seeking and obtaining their safety and happiness.

If the governor suspends these by decree and uses the power of the police to enforce it, is he suspending the Constitution and imposing martial law?

I didn’t get an answer.

I’ve got a point about markets, the Fed and this country post-Pandemic. Stay with me.  You may disagree, but I’ll say it anyway.

People with political power and the best intentions reasoned that we could not have sick and dying people. Maybe that’s the ultimate ideal. It’s not in the US Constitution or any of the 50 state Constitutions.

It should not evade the collective conscience of this free people that the rule of law was suspended.  What should we do next time?  The political power, if not the will, is ours.

Let’s get to The Fed. The only reason we could realize the high self-actualized ideal of switching off the economy was because of the promise of free money.  If the Fed couldn’t write the checks, the economy couldn’t shut down.  Period.

I’ve told this story before: When we visited her hometown of Lake Jackson, TX for a school reunion, the fathers of two of Karen’s high-school classmates related vignettes to me about their grandfathers from the 19th century.

The grandfathers were about 12 years old each when their sharecropper parents told them, “We can’t afford you.  Here’s a lunch and our last silver dollar. Seek your fortune.”

Both went west. One become a big West Texas rancher, the other a wealthy Galveston mercantilist. Both sent their kids to school, and they in turn sent theirs to college.

And those kids were these fathers, now in their 70s, both college-educated, wealthy retired Dow Chemical executives.

The Fed’s balance sheet is now $6.6 trillion, laden with government debt, private mortgages, and soon high-yield-debt-backed Exchange Traded Funds, even facilities buying municipal debts, underwriting direct-lending to businesses and consumers.

The cost of free money is bigger than you think.  It’s the lost spirit of a 12-year-old on his own.  It’s liberty and the rule of law.

And free money is worth less than you suppose. My grandparents and parents never had mortgages or car payments and they concluded life with wealth as blue-collar farmers and ranchers. My grandfather bought his first house for $500.  Built his next on two acres for $5,500, sold that one in 1980 for $55,000.

I bought my first house for $370,000.  Sold that first house for $800,000.

Inflation. If we keep creating money to solve problems, it buys less and less, so you need more and more until there isn’t enough to retire on and we need unemployment of 3% instead of 10-12% just to keep it all going. And checks from the Fed for any crisis.

We are bleeding ourselves dry, ostensibly for our financial health, just like doctors once bled patients to make them well.

The stock market will buy free money – until suddenly it doesn’t. Japan stopped believing (despite rock band Journey’s anthemic counterargument).  The stock market there, the Nikkei, was nearly twice as high in 1990 than it is now.

It takes almost unimaginable character today to hand somebody a lunch and a dollar and say you’re on your own.  Yet it’s the strait and narrow way to wealth.

It’s never too late to change what we’re doing.  Can we give up free money and become rich again?

Roll Call

Apr 21, yesterday, is Texas A&M Aggie Muster.  Aggies everywhere gather to say “here” for Aggies lost in the past year, a roll call. It’s more poignant this time for my Aggie, Karen, and the many friends and family hailing from College Station.  Gig’em, Aggies.

Speaking of Texas, let’s talk oil.  We’ve been saying for years that volatility during the next crisis, whenever it came, would be exacerbated by Exchange Traded Funds (ETFs) and lead to large failures.  It’s now happened in oil, which freakishly settled Monday at $37 below zero.

Oil prices are predicated in the USA on futures contracts for West Texas Intermediate (WTI). Overflowing storage facilities mean few parties want to take delivery of oil. That pressures prices.

But oil isn’t worth nothing. It’s not worth less than nothing. That futures went south of zero is a product of the supply/demand distortions ETFs introduce.

Futures are themselves derivatives that obligate one to action only if held to settlement. ETF investors are not buying barrels of oil. They’re buying the PRICE of oil.

But they’re really buying derivatives that represent derivatives that represent the price of oil.  The massive oil ETF, USO (always among the most active stocks, it yesterday traded a billion shares, one of every twelve, leading the market), currently claims assets of $3 billion comprised heavily of June and July WTI contracts.  It’s down 80% in a year.

We’ve explained before that ETFs work similarly to, say, buying poker chips.  You pay cash to the house and receive chips of equal value. The chips represent the cash.  The difference with ETFs is there’s an intermediary between you and the house.

So the intermediary, the broker, pays the house for the chips and sells them to you.  Suppose the intermediary, the broker, gave energy futures as payment for the chips, rather than cash.

Then the value of the futures plunged. ETFs compound the damage. The broker is out the value of it collateral, futures, and you’re out the value of your chips, which also collapse.

The broker may stop transacting in the ETF because it’s out a lot of money. Now you can’t find a buyer – and you suffer even more damage.

This happened.  Interactive Brokers said it lost $88 million, its portion of the excess losses by its customers, some of whom lost everything in their accounts. The firm’s CEO said in a CNBC interview yesterday it had exposure to about 15% of the May WTI futures contracts behind the damage, meaning some $500 million more exists.

And the damage yesterday to the June WTI contract, the next in the series, was as impactful.  Massive Singapore futures broker Hin Leong, which moves physical commodities, filed for bankruptcy. It had been in business since 1963.

Banks most exposed to Hin Leong’s billions in obligations:  HSBC and ABN Amro.  We’ve long said we thought HSBC was a counterparty at risk in a financial crisis, on exposure to derivatives.  ABN Amro lost big already, on Ronin Capital’s March failure.

The biggest derivatives counterparties though are all names you know: JP Morgan, Goldman Sachs, Morgan Stanley, BofA, Citi (which has vastly more derivatives exposure via swaps than anyone).  They may be fine – but the world relies on these firms to make every meaningful market, from helping the Fed, to trading ETFs.

We’re leaving out a key piece of the story. The big way ETFs cause trouble is by distorting the market’s perception of supply and demand. In 2008, securitized mortgage derivatives bloated the appearance of demand for real estate.

USO owned some 25% of the subject oil futures contract. Yes, we’ve got too much oil (remember peak oil? Cough, cough.) because travel died. Sure, we know supply exceeds demand.

But.

Demand from derivatives of derivatives is extended reach to an asset class – which inflates its price.  I submit:  WTI May futures traded to -$37 Apr 20 because ETFs grossly inflated the price despite its apparent weakness. When books were squared and inflationary “financial” demand from ETFs removed, oil was worth 200% less than zero.

Said another way, when money in ETFs not wanting to take delivery of oil didn’t even want its price, we discovered that demand implied in futures misrepresented reality.

Thank you, ETFs.

Barclays shuttered two oil instruments. A dozen more are at risk.  USO is at risk. The roll call of the threatened is lengthening.

Where else are ETFs inflating prices relative to underlying demand? Well, the greatest instance of asset-class extension is in US equities. Especially the FAANGs – FB, AAPL, AMZN, NFLX, GOOG (and the pluses are MSFT, AMD, TSLA, a handful of others).

These bellwethers have weathered better than the rest in a global shutdown.  But they all depend on consumer-discretionary income. People have to be working to pay for subscriptions, and businesses must be operating to spend advertising dollars.

The drums are drumming. I expect we’ll see some even more surprising ETF failures before the roll call is done.  The sooner we’re back to work, the quicker the drumbeat ends.