Search Results for: ETFs

Something Wicked

When I was a kid I read Ray Bradbury’s novel, Something Wicked this Way Comes, which plays on our latent fear of caricature. It takes the entertaining thing, a traveling carnival, and turns it into 1962-style horror.

Not 2021-style of course. There’s decorum. It stars a couple 13-year-olds after all.

The stock market also plays on our latent fear of caricature.  It’s a carnival at times.  Clowns abound.  As I said last week, companies can blow away expectations and stocks fall 20%.  That’s a horror show.

Courtesy The Guardian

Devilish winds have been teasing the corners of the tent for a time.  We told our Insights Reports recipients Monday about some of those.

The Consolidated Tape Association, responsible for the data used by retail brokers and internet websites like Yahoo! Finance and many others last week lost two hours of market data.  Gone.  Poof.

Fortunately, about 24 hours later they were able to restore from a backup.  But suppose you were using GPS navigation and for two hours Google lost all the maps.

So that was one sideshow, one little shop of horrors.  I don’t recall it happening before.

Twice last week and six times this year so far, exchanges have “declared self-help” against other markets.

It’s something you should understand, investor-relations professionals and traders.  It’s a provision under Regulation National Market System that permits stock exchanges to stop routing trades to a market that’s behaving anomalously, becoming a clown show.

Rules require all “marketable” trades — those wanting to be the best bid to buy or offer to sell — to be automated so they can zip over to wherever the best price resides. And exchanges must accept trades from other exchanges. No exceptions.  It’s like being forced to share your prices, customers, and even your office space with your competitors.

The regulators call this “promoting competition.” Sounds to me like a carnival.

But I digress. Exchanges must by law be connected at high-speed, unless declaring self-help.

An aside, I’ll grant you it’s a strange name for a regulatory term.  Self-help?  Couldn’t they have come up with something else?  Why not Regulatory Reroute? Data Detour?

Anyway, last week the trouble occurred in options markets.  First the BOX options market went down. It’s primarily owned by TMX Group, which runs the Toronto Stock Exchange.

Then last Friday CBOE — Chicago Board Options Exchange, it used to be called — failed and the NYSE American and Arca options markets and the Nasdaq options markets (the Nasdaq is the largest options-market operator) declared self-help. They stopped routing trades there until the issue was fixed.

Now maybe it’s no big deal.  But think about the effect on the algorithms designed to be everywhere at once.  Could it introduce pricing anomalies?

I don’t know.  But Monday the Nasdaq split the proverbial crotch of its jeans and yesterday the so-called “Value Trade” blew a gasket.

I’m not saying they’re related. The market is a complex ecosystem and becoming more so. Errors aren’t necessarily indicative of systemic trouble but they do reflect increasing volumes of data (we get it; we’re in the data business and it happens to us sometimes).

And we’d already been watching wickedness setting up in our index of short-term supply and demand, the ten-point Broad Market Sentiment gauge.  It’s been mired between 5.8-6.1 for two weeks.

When supply and demand are stuck in the straddle, things start, to borrow a line from a great Band of Horses song, splitting at the seams and now the whole thing’s tumbling down.

And here’s a last one:  Exchange Traded Funds (ETFs) have been more volatile than the underlying stocks for five straight weeks, during which time stocks had risen about 5% through last Friday. Since we’ve been measuring that data, it’s never happened before.

Doesn’t mean it’s a signal. It’s just another traveling freak show. Clowns and carnivals. ETFs are elastic and meant to absorb volatility. Stocks are generally of fixed supply while the supply of ETFs fluctuates constantly.  You’d expect stocks most times to thus move more, not less.

I think this feature, and the trouble in options markets, speaks to the mounting concentration of money in SUBSTITUTES for stocks.  It’s like mortgage-backed securities — substitutes for mortgages.  Not saying the same trouble looms.  We’re merely observing the possibility that something wicked this way is coming.

Our exact line Monday at five o’clock a.m. Mountain Time was: “There’s a lot of chaos in the data.”

Son of a gun.

I don’t know if we’re about to see a disaster amongst the trapezes, so to speak, a Flying Wallendas event under the Big Top of our high-flying equity market.  The data tell me the probability still lies some weeks out, because the data show us historically what’s happened when Sentiment hits stasis like it’s done.

But. Something is lurking there in the shadows, shuffling and grunting.

And none of us should be caught out. We have data to keep you ahead of wickedness, public companies and traders. Don’t get stuck at the carnival.

Roped Together

This Cinco de Mayo we’re grateful for tequila.

Especially if you’re a Tech investor. Why are companies crushing earnings and revenue being pulverized by an imperious market?

It’s easiest to say expectations for the future have diminished and so market capitalization will too.  That doesn’t reflect how the market works.

In fact, there’s inherent contradiction between that orthodox view of equities and the way money now behaves.  Morningstar shows that more than a third of all institutional assets are in large-cap blend Passive funds.  Total domestic ETF assets have increased by $1.5 trillion in the past year, says the Investment Company Institute.

Well, what’s that money do?  We all understand the idea of following the money.  That is, if you want to understand what’s driving behavior, track where the money goes.

For instance, prices of things consumers buy for both daily and discretionary reasons have risen.  Personal income is up 21%.  That’s following the money. The more there is, the more stuff costs.

Until everything resets.

See the image here.  The Tech sector dwarfs other parts of the S&P 500 at 28%.  Data we track show Passive and Active Investment – combined indexes and ETFs and stock-picking flows – were up about 5% in the sector last week as stocks fell 5%.

That means investors were selling Tech.

No mystery there, you might think. But stocks can fall on the absence of buying as much as the presence of selling. And Tech has come down further since, though the pattern of selling by investment behaviors is receding.

Here’s the point.  The stock market’s value nears $50 trillion.  Tech is about $15 trillion. And it’s even more when you consider that the largest companies – Google, Apple, Amazon, Facebook, Tesla, Microsoft – are spread over three sectors, not one, the big green box on the left of the image.

If 5% of that money leaves during month-end window-dressing it’s destabilizing not just to a handful of stocks but to the sector, the whole market.  The big green box is about $24 trillion.  All of that can oscillate if money shifts to say, Financials (up 2% last week) or Energy (up 5%).

I’ll give you another observation from the data.  This one requires understanding something. ETFs – Exchange Trade Funds – are not fiduciaries. They don’t manage your money.  If you buy Blackrock ETFs, you don’t have an account at Blackrock.

And Blackrock can do what you can’t.  Blackrock can dump its Tech stocks all at once via the “redemption basket” – the garbage to take out – while simultaneously asking for only appreciating stocks in the “creation basket,” the grocery cart from brokers.

So Blackrock could shed its falling Tech stocks for ETF shares and then trade the ETF shares for Financials, Homebuilders, Energy stocks, Real Estate stocks.  It thus avoids the falling stocks and rides the rising ones. 

But that’s a very short-term trade.  There’s not enough stock in those sectors and industries to remotely account for the 52% in the giant swaths of the market populated by Big Tech.

So either the whole market tips over. Or suddenly Tech will look good again. There’s no way to meet the demands of large-cap Passive target-date funds with heavy weightings in equities without Tech.

We told clients this in the Friday Market Desk note out Apr 23:

You recall when those two Bear Stearns mortgage-backed securities funds went under in 2007?  We all went, “Huh. Wonder what happened there.”  Then we followed the Dave Barry Car Mechanic Manual:  When your car starts knocking, turn up the radio.

We didn’t understand that those funds and Bear Stearns and Lehman and the whole housing industry were roped together and pulling each other off El Capitan. I’m not saying we’re roped here.  But it’s possible.  

We’re all roped to Tech.  Tied to its weight.

I also trotted out an old theology term from my college days studying that discipline: Laodicea. I said the market was neither cold nor hot, and it was the kind that could spew us out.  You can look it up in the last book of the bible, Revelation, chapter 3.

I think there’s too much commitment to equities by large-cap diversified Passive target-date (that’s a mouthful) funds for us to fall from El Capitan.  Yet.  There will be a day when the flows stop, and Blackrock can’t trade anything for Tech shares.

That’s when, as the head of campus security back in my collegiate days in tornado country would say, “You go grab little brother Willie off the porch.”

Swapping Volatility

Google chose as motto “don’t be evil.” “Beware derivatives” isn’t a bad motto either.

If you’ve read the MSM long, you know we’ve beaten the drum like Boneshaker (when you hear the sound of the drum, here we come) over the risk in derivatives.

Oh please, Quast.  Can’t we talk about something more interesting, like the molecular structure of Molybdenum?

Do you want to know what’s coming, public companies and investors?  We’ve now been warned twice.  I’ll explain.

Before that, this: Recall that we said the market could take a beating this week because of derivatives. A raft of major banks have reported combined damage in the billions from bad derivatives bets by one hedge fund, Archegos Capital.

And VIX bets hit today.  Volatility bets blew up another fund.  Warning Signal No. 2.

Gunjan Banerji wrote about it yesterday in the WSJ (subscription required), admirably explicating the complexities of variance swaps.  The Infinity Q Diversified Alpha Fund shut down.

Diversified Alpha, a mutual fund marketed as a hedge fund for the masses, had roughly $1.75 billion of assets at last word.  The fund aimed in part at volatility strategies.  It said:

“The Volatility Strategy seeks to profit from the mispricing of volatility related instruments across equities, currencies, bonds, interest rates, and commodities markets. These instruments include options, variance swaps, correlation swaps, and total return swaps. The Strategy invests across a wide range of time horizons and takes long and short positions in the underlying volatility instruments.”

The fund went broke betting on volatility – mispricings.  That’s two in short succession.  Diversified Alpha filed its plea with the SEC Feb 21 to halt redemptions. Right after February expirations. Archegos Capital went belly-up with March expirations.

Much of the money in equities trades mispricings. That’s what ETFs do (ETF vs a basket). It’s what Fast Traders do (one price vs another). It’s what derivatives traders do (stocks vs options).  Those behaviors are roughly 80% of US equity volume.

These disasters you describe, Tim, are isolated to leveraged outfits.

Nope.

Here’s the SAI for the Blackrock Technology Opportunities Fund. I have read a great many SAIs, a reason I’ve in the past highlighted risks, especially for Exchange Traded Funds.

On page 3 is this: Only information that is clearly identified as applicable to the Fund is considered to form a part of the Fund’s SAI.

Then follows a table, with X’s by what applies.  See page 4, the derivatives section. Derivatives for hedges and speculation apply.  Credit default swaps, interest-rate swaps, total return swaps, options on swaps, on it goes.

I’m sure it’s a small part of this fund’s assets, used within rules to true up tracking or remediate some of the unremitting volatility that’s been seeded in all financial instruments by vast artificial quantities of money and low interest rates. But read the SAI on your favorite fund. What’s it say?

By the way, volatility in stocks has plunged by 50% the past couple weeks. Almost like a tide going out ahead of a tsunami. Behind it in other data we track are vast swings in standard deviation between the prices of sector stocks and the ETFs tracking them.

That is, if we compile moves of all sector stocks and the average is a 1.8% decline and the composite average for sector ETFs is 0.1%, standard deviation is 625%.

It suggests to me that ETFs are substituting stuff that moves less than stocks – like swaps or IOUs of some sort, or cash – to get away from the error-inducing volatility in stocks.

But that could blow up derivatives predicated on a statistical equity basket. What the hell is going on?  Exactly.  That’s what I want to know. Something is wrong, and we’re seeing little fissures, seeping steam, wisps of ash.

We’ve long been concerned about these risks. But they’re like the way Ernest Hemingway described how one goes broke (a line I’ve used often): very slowly then all at once.

I’m not wringing my hands. Forewarned is forearmed. Investors and traders, it’s wise to get out of the pool around these things, which we observe in the data, and report.

And for public companies, it’s high time to make sure your executive teams realize risk resides beyond “alternative investments.” It’s everywhere. All around us. 

How central are Morgan Stanley, JP Morgan, Credit Suisse, Deutsche Bank, banks losing on Archegos, to financial markets from IPOs to Treasury Open Market operations?  Derivatives to equity and ETF trading?

It may be the cost of paying ourselves to sit out a Pandemic is the stability of our financial markets. We’re inflating everything including derivatives.  We can survive it.  In fact, it would do us good to roll around in the dirt and develop some resilience.

Whatever happens, we’ve got the data.  We warned EDGE users to be out by last Friday. We can tell you, public companies, if these instruments are large in your price. 

Everybody is swapping volatility. Beware.

Which Way

In Lake Jackson, TX, you can take This Way or That Way.

No, really.  I snapped that shot Friday at the corner of This Way and That Way in LJ.  And yes, that rhymes.  And yes, it’s a metaphor for the stock market.  It goes this way and that way.

So the market goes this way and that.  So what?

Every time I hear that refrain, and I do hear it routinely from investor-relations professionals, I know how Copernicus felt. You tell people nothing is what it seems and the response is, yeah so what?

The single most important principle for life, business, investing, trading, pick your thing, is to exist in reality.  Everything rests on it.  Otherwise, we’re living in a fantasy, as Leo Sayer sang (okay, that was a love song but you get the point).

Traders never say, “Why should I care about that?” One EDGE subscriber sent me a note yesterday saying, “Thank you for your Monday morning briefings on Benzinga – we are learning things we have never learned before so it’s important!”

Investors by contrast sometimes say they don’t care because “our horizons are longer.”

That’s ironic to me because long horizons in the stock market are frankly abysmal, a reason why companies are growing privately and exiting publicly. Yes, the Nasdaq is up 40% over the past year, more from the depths of the Pandemic correction.  Even so it’s a 9% annualized return, minus taxes, commissions, inflation, the past 20 years.

Take out the trailing 12 months and you’re negative on your Nasdaq investment those two decades. I wrote last week about the effects of volatility. This is it.  Reality.

You probably feel like the people Copernicus told: “Do you want us to kill you now or kill you later?  Pick one.” 

Because what good is reality to me if it harms my interests?  That is, the IR profession would seem to depend on a) returns from equity investments, and b) the superiority of what you DO in the IR chair.

It used to be phone calls we made depended on what somebody was doing in the operator’s chair.  Travel used to depend on somebody who could drive a team of horses.  Streetlights used to depend on somebody coming by and lighting them.

Pick your comparative.

Do we think we’re telephone operators in this profession?  We better shut up about how the market works and hope nobody figures it out, because we might be obsolete?

Engineers aren’t obsolete, though we’ve had them through technological epochs. Same with mathematicians, chemists, physicians, scientists, accountants.  The rules and the technology and the application of skills change, but the centrality of value doesn’t.

You can’t cling to operating the switchboard like that’s the future.  

The IR profession exists to ground public companies in the reality of the equity market. 

I’ll repeat it.  Our profession exists to ground executives in financial reality.

That includes understanding how long-only money evaluates your financials.  But it also includes why Gamestop goes up 1,000% on nothing rational.

It includes why Direct Listings are cutting out investment banks.  It includes knowing why the Buyside widely pans the Sellside today, and why sellsiders want IR jobs.

It includes understanding how ETFs work.  When Passives rebalance and why. How derivatives are used.  What fosters volatility.  What liquidity means.  How characteristics drive quantitative investing. Behavioral factors that should shape equity offerings and buybacks.

How to position your company in front of “The Money,” whatever The Money is doing, because you understand what The Money does.

Like engineers and accountants and scientists, that kind of value never fades no matter which way the money is going – this way, or that.

Speaking of which, Broad Market Sentiment is peaking.  Options for April begin expiring Thursday.  The cycle stretches through next Wednesday with VIX expirations and new ones trading in between.

Big prime brokers have taken a beating.  Hedge funds are going to pay more to borrow money and take risk, and banks will be more reticent on the other side of trades after Archegos Capital.

What might happen?  Well, the market will go this way, or that.  But we have a pretty good read on the risk and probabilities, because we know what The Money is doing.

And we can help you know which way it’s going.  This way, or that way.

Fama Market

Eugene Fama, Booth School, Univ of Chicago

 

Do you know traders could have made 580% in the S&P 500 the past 200 days?

Public companies, your stock need not rise.  I’ll explain.

The S&P 500 is up almost 20% the last six months. The math says 454 of the 500 are up. That also means 46 stocks are down. Including some big ones like Verizon, Lockheed Martin, Procter & Gamble, Kellogg, Zoetis.

But up isn’t the point. It’s up and down. Traders could have made all the returns in the S&P 500 from October 1995 to present – about 600% – in just 200 days on volatility.

By capturing all of it perfectly, which is next to mathematically impossible. But follow me here.

Across the 500 components, average intraday volatility the past 200 days is 2.9%. That is, the typical S&P 500 stock will gyrate almost 3% from lowest to highest intraday prices.

Add that up.  Over 200 days it’s 580%.

And it bugs the bejesus out of Chief Financial Officers. As it should.  The Wall Street Journal highlighted the investor-relations profession and our own Laura Kiernan in a piece (subscription required) last week called CFOs Zero in on Shareholders as Stock Volatility Soars.

But holders aren’t behind volatility.

The University of Chicago’s Eugene Fama won a Nobel Prize on efficient markets and the effects of volatility.  He famously said, “If active managers win, it has to be at the expense of other active managers. And when you add them all up, the returns of active managers have to be literally zero, before costs. Then after costs, it’s a big negative sign.”

Why?  I’m oversimplifying but he showed that volatility risk, size risk and value risk make stock-picking inefficient and ineffectual.

The data prove it.  Most stock-pickers can’t beat the market because they don’t understand why volatility exists.

What is volatility? Changing prices. We’ve written often about it over the years as this search on the word “volatility” at the ModernIR blog shows.  Stock prices constantly change.

Why?

Regulations require it.  Think I’m overstating it? Rules for stocks require trades to occur between the best bid and offer. And regulators mandated penny spreads for stocks 20 years ago.  Thus trades can only occur at the best current price, which changes often.

The best price for stocks cannot be established by a single principle. That idea earned a Nobel Prize.  Other factors matter including volatility, size and value.  And I’d argue convenience, time-horizon, purpose. You can probably add more.

The market is only efficient for parties benefiting from constantly changing prices. Who’s that? Traders and stock exchanges. 

Profiting on price-changes is arbitrage. We have the perfect arbitrage market. How? There are almost 50 different places where trades can occur in the National Market System, a cornucopia for changing the price if you’re fast and algorithmic.

And now the market is chock full of things that look like stocks but aren’t stocks. ETFs, options, futures.  They all converge and diverge in price.  The parties feasting on this environment need prices to change all the time.

Enter the exchanges. They sell data. The data is comprised of quotes and trades. The more the price changes, the more data there is.  Heck, they lose money on trades to make it selling data.

Only trades involving different owners will settle. About 95% of my trades – I understand market mechanics and I become my own algorithm to take advantage of how it works – match at my broker’s internalizer.  No measurable ownership-change.

And Fast Traders are 54% of market volume. No ownership-change. And trades tied to derivatives are 18% of volume. Little to no ownership-change. And half the market’s volume reflects borrowed stock. No ownership-change.

Let’s review.  Shareholders don’t create volatility. They try to avoid it.  Most trades don’t result in ownership-change because the market is stuffed with efforts to profit on changing prices. And that is the definition of volatility, which exists because of rules that promote constantly changing prices.

There’s a simple fix.  Put the focus back on stable prices, by emphasizing factors other than price, such as size and value.  Call it the Fama Market.  When my dad sold cattle from our ranch, we wanted an average price for a herd, not a price per steer.

If public companies want to fix volatility, we need a different market. You can’t fix it by telling the story. And that can’t be the heart of the investor-relations job. It’s now understanding the market for shares – just as my dad knew the cattle market.

If we lack the collective verve to lobby for better markets, then we have to adapt to this one, by understanding it. We have the tools and data for both companies and investors.

Suez on Wall

The stuff Archegos used expires today. Sound like Greek?

Courtesy SEC.gov

Let me explain. A hedge fund blew up. Its counterparties are taking huge hits. There are ramifications. What happens?  Maybe nothing. Maybe everything.

First, let’s understand “counterparty.”  A counterparty accepts the risk of the opposite of your desired trade. That is, if you want to bet something rises, somebody else will necessarily have to bet it falls by selling a put – a right to sell a stock.

Do you follow? It’s why winning trades are hard.  Somebody is always taking a countermanding risk (as ever, market structure matters because you can see the ODDS on which way things go).

And public companies, bets are pervasive.  One of these lately punctured the time-space continuum of the market.  Hedge fund Archegos (“guiding light” in Greek) gambled on derivatives tied to stocks and lost.

I won’t recapitulate details. Stories abound. What matters is WHY NOW, and what does this event mean to you as public companies and investors?

We wrote about CFDs – Contracts for Difference – in 2012.  Total return swaps are a type of CFD. These contracts give funds – I don’t say “hedge funds,” because, reading prospectuses for Blackrock and others, they too can use them – a way to put money on Red 34, but where Red 34 is half the spots on the Roulette wheel.

Why would a counterparty take that bet?  Because they too – Goldman Sachs, Morgan Stanley – make bets on the outcomes to offset the risk that Red 34 comes up.  Remember, Lloyd Blankfein, erstwhile Goldman Sachs CEO, said in the aftermath of the 2008 debacle, “We’re in the risk-transfer business.”

I think it’s the HOPE of the markets biggest participants that nobody understands this stuff – because everybody would be outraged.  I’m not a cynic. I’m looking at the data. Trading unrelated to how your business performs, public companies, pops eyeballs from sockets. Investors, if you don’t know, you’ll be a popped eyeball.

Remember the mortgage-backed securities pandemic?  The movie and book The Big Short? Why would banks sell credit default swaps and then bet against the outcome they just sold?

Because you can always offload your risk.

Until you can’t.

Friday was an “until you can’t” moment for the market.  I’m surmising based on the available data that hedge funds bet certain stocks in a limited period of time expiring today – Mar 31 – would outperform some benchmark by a defined percentage.

Banks took that bet.  Other banks unaware of the size of the bet lent money to the firm making the bet, making it massively larger than anyone comprehended.

To offset risk, banks require collateral. The hedge fund in question put up its portfolio, which the banks shorted – which raised cash and hedged exposure.

I suspect the fund first pledged the SAME collateral to the banks lending money, but then actually assigned it to GS and MS, firms backing swaps.

Here’s the WHY NOW answer. As expirations drew nigh – Mar 31 – it became apparent to the banks selling the swap to the hedge fund and to the hedge fund itself that it was going to fail.  Banks holding collateral sold it.

Those with just a pledge held only the bag they’d been left holding. This is why Credit Suisse and Nomura face big losses, it seems to me (it could be some variation on this theme of course).

But that’s not the heart of the problem here.

This is the Suez Canal converging with Wall Street.

If you’ve somehow missed it, a cargo ship longer than the Empire State Building got stuck in the Suez, blocking everything. God freed it. That is, engineers used a combination of the Worm Moon, a super moon and its incumbent high tides, and a lot of tugging. It’s free now. But the damage is done.

In the stock market, as in the Suez Canal, there’s not much liquidity – not much floating things. And a handful of banks serve the bulk of transactions in Treasurys, currencies, bonds, derivatives (like swaps), commodities, equities, ETFs.

Indexes need to true up tracking right now for the quarter. They depend on these banks. Investors want to lock quarterly results. Massive futures obligations are expiring that the same banks back, to true up index-tracking.

What if something just can’t get done? Which thing do they pick to let go?

Maybe they can juggle it all.  The Suez couldn’t. Maybe Wall Street can. If not, there’s a CHANCE of severe dislocation for markets between today and Apr 6, when books will be all square.

Cash in Lieu

Public companies and investors, is the Federal Reserve using cash to hurt you?

What?  Quast, don’t you mean they’re inflating stocks?

To a point, yes. And then history kicks in. There’s no such thing as “multiple expansion,” the explanation offered for why stocks with no increase in earnings cost more.  If you’re paying more for the same thing, it’s inflation.

But that’s not what matters here. The Fed’s balance sheet is now over $7.7 trillion. “Excess reserves” held by member banks are $3.7 trillion, up $89 billion in just a week. In March 2007 excess reserves were about $5 billion.  I kid you not.

What’s this got to do with stocks?

The banks behind about 85% of customer orders for stocks, about 95% of derivatives notional value, and the bulk of the Exchange Traded Fund (ETF) shares trading in the market are the same.  And they’re Fed members.

Cash is fungible – meaning it can be used in place of other things.  Same with ETF shares. About $500 billion of ETF shares are created or redeemed every month.  ETF shares are swapped for stocks of equal value when money flows out of ETFs,  and when it flows in, stocks of equal value are provided by brokers to sponsors like Blackrock so the brokers can sell ETF shares to the public.

Follow? Except it can be cash instead.  Cash in lieu.

I mean, what is more abundant than cash now? There is so much excess money in the system thanks to the Fed’s issuance of currency that banks can find little better to do with it than leave it at the Fed for seven basis points of interest.

Or use it in place of stocks.

Buying and selling them is hard. They’re not liquid like $3.7 trillion of cash. There are transaction costs.  Suppose a bank needs to bring $10 billion of S&P 500 stocks as a prime broker to Blackrock to get it back in line with asset-allocations?  That’s a lot of work.

But what if Blackrock would be happy with $10 billion of cash, plus a few basis points of over-collateralization?  That’s cash in lieu. 

I’m not suggesting it happens all the time. But as the President would say, Come on man.  Imagine the temptation when creating and redeeming ETF shares for both parties to prefer cash.  It’s piled in drifts.

And you don’t have to settle any shares.  You don’t have to pay trading commissions.  And it’s an in-kind exchange of things of equal value. Cash for ETFs, or stocks for ETFs, either way. Tax-free.

Oh, and you won’t see any ownership-change, public companies.  

Don’t you wonder why stock-pickers – who enjoy none of these advantages – accept this disparity? Rules are supposed to level the playing field, not tilt it like a pinball machine.

Anyway, here’s the problem for public companies and investors.  These transactions aren’t recorded in cash. They’re in lieu, meaning the cash represents a basket of stocks. On the books, it’s as though Blackrock got stocks.

So, we investors and public companies think Blackrock owns a bunch of stocks – or needs to buy them. But it’s instead swapping cash in lieu.

The real market for stocks is not at all what it seems. Stocks start doing wonky things like diverging wildly.

Investors, I think you should complain about cash in lieu. It distorts our understanding of supply and demand for stocks.

And public companies, you wonder why you’re not trading with your peers? If you’re “in lieu,” you’re out.  There are more reasons, sure. But nearly all times it’s not your story. It’s this.

And it’s not fraudulent. It’s within the rules. But excess reserves of $5 billion would make substituting cash for stocks all but impossible. The more money there is, the more it will be substituted for other things of value.

It’s Gresham’s Law – bad money chases out good. Copernicus came up with that. Apparently he was known as Gresham (just kidding –Englishman Thomas Gresham, financial advisor to Queen Elizabeth I, lent his name to the rule later).  But it says people will hoard the good stuff – stocks – and spend the bad stuff.

Cash.

And so it is.

The Fed is distorting markets in ways it never considered when it dipped all assets in vast vats of dollars and left them there to soak. 

The good news is we can see it. We meter the ebb and flow of equities with Market Structure Sentiment and Short Volume (for both companies and investors). Broad Market Sentiment peaked right into expirations – telling us demand was about to fall.

It’s one more reason why market structure matters.

Reg Efdy and Thee

The Securities and Exchange Commission is in danger of becoming the Dept of Silly Walks.

Let me explain why I’m calling the SEC Monty Python. And it matters to you, public companies and investors.

Speaking of disclosure: I’m on the NIRI National Ethics Council, and we’re debating this matter.  What I’m saying here is, as usual, my own view.

So back in the go-go late 1990s, “sellside” analysts like Henr

Courtesy Monty Python’s Flying Circus, 1970.

y Blodget and Mary Meeker were the superstars of research. Public companies could be seen groveling at sellside thrones.

And simultaneously, sometimes tens of thousands of retail investors would join a new-fangled communication tool public companies were using, the earnings-call webcast.

And insider-trading was the hottest of buttons for regulators.  They were concerned companies were telling sellside analysts and big institutional investors things before the little guys would hear them.  The disturbing spectacle of the Big Guys getting an edge over the Little Guys.

Nothing smokes the cigar of regulators faster than that.

So in August 2000, the SEC passed Regulation Fair Disclosure requiring public companies not to tell some people stuff that could alter valuation or stock-performance without telling everybody else.

In enacting the rule, the SEC said:  

As reflected in recent publicized reports, many issuers are disclosing important nonpublic information, such as advance warnings of earnings results, to securities analysts or selected institutional investors or both, before making full disclosure of the same information to the general public. Where this has happened, those who were privy to the information beforehand were able to make a profit or avoid a loss at the expense of those kept in the dark.

Step forward to 2021.  The SEC last week brought a Reg FD enforcement against members of the investor-relations team at AT&T for supposed material nonpublic disclosures to analysts and big investors five years ago.

AT&T is contesting these findings in a tartly worded missive.

So now we get to the Ministry of Silly Walks and how it’s dragging its gangly limbs about in comic fashion.  First, if it takes you five years to figure out enforcement is needed, you’ve already made a mockery of the process.

Now, consider the stock market in 2000.  Almost 90% of investment assets were actively managed – overseen by people finding what would set one company apart from another and lead to better investment returns.  And 80% of volume was Active. And market intermediaries like Citadel Securities barely existed.

And in 2000, stocks were not decimalized.  Markets were not connected electronically and forced to share prices and customers and stock-listings so that everything trades everywhere, all the time.

In 2021, about 65% of investment assets are now passively managed using models.  Over $5 trillion in the US alone resides in Exchange Traded Funds (ETFs), stock substitutes backed by cash and securities that trade in place of actual stocks.

And trading machines using lightning-quick techniques from collocating servers right next to the exchanges’ to microwaves and fiberoptics drive over 50% of volume.

And guess where selective disclosures and informational advantages reside now?  You got it.  ETFs.  And Fast Traders.  ETFs know which direction the supply and demand for shares is moving, and they transact off-market with a handful of Authorized Participants in giant blocks called Creation Units.

Imagine if big investors gathered with big companies and traded information in smoky backrooms.  It would at minimum violate Reg FD.  It would no doubt prompt outrage.

So, why is it okay for ETFs and their brokers to do this at the rate of $500 billion per month?  It’s an insurmountable advantage harming non-ETF fund managers.

Second, Fast Traders buy retail stock orders so us little guys can trade for free and in fractional shares.  But Fast Traders can see the limit-order pipeline. Nobody else can.  That’s material nonpublic information, and it permits them to profit at others’ expense.

Why is it okay for the quickest firms to have a first look?  Notice how the operators of big traders own sports teams and $100 million houses?  There’s a reason.  It’s called Informational Advantage.

Third, as I’ve said repeatedly, automated market-makers, a fancy name for parties between buyers and sellers, can short shares without locating them, and they don’t have to square books for more than 30 days.  As we described, it’s how GME went up 1,000%.

Finally, next week indexes and ETFs will have to rebalance, and a raft of options and futures expire. And about ten big banks handle all that stuff – and know which direction it’s going.

A handful have a massive advantage over everybody else – the very thing regulations are meant to prevent. Sure, we get free trading, cheap ETFs and the appearance of liquidity.

But it’s not a fair market – and that’s why this AT&T case is silly.  It’s cognitively dissonant and hypocritical to permit rampant market exploitation while culling a five-year old file from the last regime to score political points.

Reg FD is a quaint relic from a time that no longer exists.  Maybe the SEC should regulate to how the market works now?

IS REPORTING NOW JUST A SIDESHOW?

“Looking good, Valentine!” “Feeling good, Louis!” A gentleman’s bet. But maybe not so fast.

Farce met Street last week with good reason distracting many in the Finance and public company arenas. Far better chronicled elsewhere (here a good one on Benzinga’s Monday Pre-Market Prep – pls skip the clunky ad), but this weekend I couldn’t resist the parallels to 1983’s Trading Places – I’ll leave you to Twitter, your browser or favorite streaming service and bring the focus to Market Structure.

With all rights to Messrs. Russo, Landis, Harris, Weingrod, Aykroyd, Murphy, Ms. Curtis and Paramount, et al.

We start February with a significant percentage of our clients yet to report quarterly and year-end results and to confirm their forward-looking expectations. Tough challenge in a Market seemingly growing more disinterested.

No question your IR team is working long hours with counselors and non-public facing finance, accounting and marketing coworkers to develop a cogent, clear message, to tie-out results and craft outlook statements and public disclosures; all too often, a thankless job.

It doesn’t help that the Market and the trading in individual equities are seemingly chaotic and unpredictable. But are they? As a subscriber you’re likely conversant in Market Structure – our view of the Market here at ModernIR (if no, read on and please reach out to our Zach Yeager to set up a demo). So like the polar bear swimmers here in Minnesota let’s dive in – we’ll be quick.

Here’s how the Market has evolved in the first month of 2021 – changes in the demographics of trading:

Note the Passive Investment retreat – would have been fair to expect the opposite with all the month-end true-ups for ETFs, Index and Quant Funds – but it’s a repeating month-end behavior recently followed by buying. The surge of volatility arose from increased Fast Trading – machine-driven High Frequency trading, and yes, some Retail day trading.

Both categories are largely populated by algorithmically driven trading platforms; “Passive” (a largely  anachronistic designation – and far from it or the buy and hold strategies the name conjures) today constantly recalibrate collateral holdings with dominate behaviors suggesting little long-term primary focus. “Fast Trading” – pure execution speed, volume-based trading; its goal beyond vast incremental profits – no overnight balance sheet exposure.

Short Volume trading rather than building, declined and Sentiment remained persistently positive (5.0 = Neutral) and never negative. Does this sound disorganized? For forces dominating early Q1/21 equity trading this was a strong, dynamic and likely very profitable period.

The cruel truth – machine trading is no gentlemen’s bet. Brilliant in execution, these efforts have one goal – to game inherent trading advantages over slower moving Market participants – folks that demand conference calls, executive time, build and tie-out spreadsheet models and trade in non-Market-disruptive fashion – the traditional IR audience. The system rewards this – topic for another time.

From a pure trading standpoint, traders behind 9 out 10 trades in the final day of January trading placed minimal value on traditional IR efforts as their bots rocket through Short Seller reports and quarterly management call transcripts, scan real-time news feeds and playbacks for tradable intonation in your executives’ delivery and make mathematical judgments about the first 100 words of each press release.

As IR professionals its incumbent that we, rather than be demoralized by the evolution and dominance of short-term trading, engage, and become intimately versed in these data and these Market realities. The competitive advantage is in understanding and minimizing false conclusions in decision-making. Management and the constituents of long-term investors – yes, they are still legion – and expect no less.

Let us show you how.

Perry Grueber filling in for Tim Quast

  

 

Sailing Away

Sailing takes me away to where I’ve always heard it could be just a dream and the wind to carry me.

Christopher Cross said it (youngsters look it up). In this pandemic we said, “That boy might have it figured out.”

TQ and KQ sailing

So, with two negative Covid tests in hand, we’re currently near 17 degrees North, 62 degrees West readying our 70-foot catamaran for a float with friends.  Chef, bar, crew, trade winds blowing our hair around, azure waters, sunrise, sunset. We’ll catch you after, Feb 8.

And in between, let’s have a look at the market.  The big buzz is GME, Reddit now dominating chatter with WallStreetBets (y’all can look that up too), the stock streaking, a push-pull among longs and shorts, and Andrew Left from Citron cannonballing into the discourse and an pool empty.

It may be a sideshow.  GME is up because Fast Trading, the parties changing bids and offers – shill bids, I call it – and buying retail volume surged from 38% of GME trading to over 57%.

At the same time, Short Volume, daily trading that’s borrowed, plunged from 47% to 34%. The funny thing is it happened AFTER the news, not before it.

The Reddit WSB crew has the sort of solidarity I wish we’d direct at being free. Nobody says to them the words “allow,” or “mandate,” and I love that.

But.

In a free stock market, your actions as traders are known before you make them.

That is, plow millions of limit orders into the market from retail brokerage accounts, and the firms like Citadel Securities buying them know before they hit the market.  They will feed the fire, blowing on the conflagration until it runs out of fuel.

And BBBY is up 50% in two weeks.  But it’s not the same, looking at market structure (the behavior of money behind price and volume in context of rules). Quantitative money plowing into BBBY to begin the year ignited the surge.

Could the actions of machines be misunderstood by humans?  Of course. Already the pattern powering GME has reverted to the mean.  In BBBY, Short Volume is up already on surging Fast Trading, the same machines we just talked about.

All but impossible is beating trading machines. They know more, move faster.

However, they are, paradoxically, unaware of market structure beyond fractions of seconds into the future.

Humans have the advantage of knowing what’s days out.  And on Fri Jan 29, the largest futures contract in the market comes due.  It’s designed to erase tracking errors. This is a much bigger deal than GME and BBBY but not as much fun.

Tracking errors are the trouble for Passive investors, not whether they’re “beating the benchmark,” the goal for Active stock-pickers.

A tracking error occurs when the performance of a fund veers from its benchmark.  The aim is generally less than 2%.  Yet S&P 500 components are 2.5% volatile daily, the difference between highest and lowest average daily prices. For those counting, daily average exceeds monthly target).

It’s why Passives try to get the reference price at market-close. But the market would destabilize if all the money wanting that last price jammed into so fleeting a time.  It would be like all the fans in Raymond James Stadium pre-pandemic – capacity 65,618 – trying to exit at the same time.

Congrats, Tom Brady. We old folks relish your indomitable way.

Like Brady’s achievements, everybody leaving RJ Stadium at once is impossible in the real world.

So funds use accounting entries in the form of baskets of futures and options.  ModernIR sees the effects.  The standard deviation between stocks and ETFs in 2019 was about 31%.  The difference reflects the BASKET used by the ETF versus ALL the stocks. To track that ETF, investors need the same mix.

Well, it’s not possible for everyone in the market to have the same quantity of shares of the components. So investors pay banks for options and futures to compensate for those tracking errors.  The more errors, the higher the demand for true-up derivatives.

In 2020, the average weekly spread rose to 71%, effectively doubling.  In the last eight weeks since the election it’s up to 126%.

The paradoxical consequence is that increasing volatility in benchmark-tracking is creating the illusion of higher demand for stocks, because options and futures are implied DEMAND. 

And so we’re

sailing away. You guys hold the fort. Keep your heads down.  We’ll catch you after the last Antigua sunset.