Search Results for: ETFs

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.

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.

Nothing

I rest my case, and it only took 15 years.

On Dec 29, 2009, we wrote in this very blog we’d then been clattering off the keyboard since 2006: “Now, why would you care about Iron Condors, IROs and execs? Because once again something besides fundamentals affected market prices.

Has the market ever offered more proof than now of the absence of fundamentals?  SPY, the S&P 500 Exchange Traded Fund (ETF), is up 27.3% since Mar 23 after falling 34.1% from a Feb 19 peak.  It’s still 19% down but, boy.  That’s like a Patriots Super Bowl comeback.  And what happened?

Nothing.

I’ll explain.

Note: We’re going to discuss what’s happened to the market in the age of the virus at 2p ET today, and it’s free and open to anyone. Join us for an hour: https://www.niri.org/events/understanding-wild-markets-age-of-virus

What I mean by nothing is that the virus is still here, the economy is still shut down.  Quarterly earnings began with the big banks yesterday and they were bad and Financials fell.  The banks are the frontlines of the Viral Response (double entendre intended).

Many say the market’s expectations are improving. But we have NO IDEA what sort of destruction lies beyond the smoky wisps floating up from quarterly reporting. Future expectations are aspirational. Financial outcomes are rational facts.

And do they even matter?

Consider the Federal Reserve. Or as people are calling it on Twitter, the Freasury (Fed merged with Treasury).  The Fed is all-in, signaling that it’ll create plenty of money to replace shrunken consumption (why is that good if your money buys less?). It’s even buying bond-backed ETFs, which are equities (we’re Japan now).

The market’s reaction to Fed intervention cannot be said to reflect business fundamentals but rather the probability of asset-price inflation – or perhaps the analogous equivalent of enough poker chips for all the players including the losers to stay in the game.

It’s a reason for a 27% rally in equities. But it’s confusing to Main Street, as it should be.  We’ll have 20 million unemployed people (it’s coming) and capital destruction in the trillions of dollars when we sort out the mess in our consumption-driven society.

Yet the market doesn’t seem to depend on anything. That’s what I mean by nothing.  The market does its thing, rises and falls, shifts money from Real Estate to Tech and back, without respect to the virus or fundamentals. As investors flail to describe the unexpected.

Stocks dependent on consumption like Consumer Discretionary, Energy, Materials, led sector gainers the last month.  These include energy companies like Chevron, Exxon and Valero that sell gasoline to commuters. Chipotle, Starbuck’s, Royal Caribbean, selling stuff to people with discretionary income. Dow, Dupont and Sherwin-Williams selling paint, chemicals, paper.

They’ve soared, after getting demolished. And nothing has changed. Sure, Amazon, Zoom, Netflix, the chip companies powering systems behind all our stay-at-home video-use are up, and should be.

But the central tendency is that the market plunged down and bucked up, without data to support either move.  That’s what I’ve been talking about so long. The market is not a barometer for rational thought.

It IS a barometer for behaviors, one of which is rational.  And we’ll explain what this image means when you tune to the webcast. (Click here for larger version.)Active Investment - Mar 2020 Correction

Think of the risk in a market motivated by nothing.  In Dec 2019 when we described the market as surly furious, the steep decline had no basis. During it, pundits tried to explain the swoon as expectation of a recession. Stocks roared to epic gains after Christmas 2018.

Nothing motivated either move.  That was a stark illustration of market structure form trumping capital-formation function.

Now stocks have zoomed back up 27% off lows, and everything is still wrong, and the wrongness doesn’t yet have defined parameters.

I don’t know which instance is most stark. Maybe it doesn’t matter. Come ask questions today at 2p ET at our webcast on market structure during the age of the virus.  I would love nothing more!

Epiphany

DoubleLine’s famed Jeff Gundlach says we’ll take out March lows in stocks because the market is dysfunctional.

Karen and I have money at DoubleLine through managed accounts with advisors.  Mr. Gundlach is a smart man. Maybe it’s splitting hairs if I say the stock market isn’t dysfunctional but reflecting its inherent structural risks.

We know as much as anyone including Mr. Gundlach about market mechanics. And I still learn new stuff daily.  Matter of fact, I had an epiphany over the weekend. I compared market behaviors during the Great 2020 Market Correction.

Wow is that something to see.  We might host a webcast and share it.  If you’re interested, let us know.

Over the past decade, the effort to produce returns with lower risk has spread virally in the US stock market.  Call it alpha if you like, getting more than you’re risking.  Hedge funds say it’s risk-adjusted return.

The aim is to protect, or insure, everything against risk, as we everyday people do. We protect our homes, cars, lives, appliances, even our entertainment expenditures, against risk by paying someone to replace them (save for our lives, where beneficiaries win at our loss).

Stock traders try to offset the cost of insurance by profitably transacting in insured assets. That’s the holy grail.  No flesh wounds, no farts in our general direction (for you Monty Python fans).

It works this way. Suppose your favorite stock trades for $20 and you’re a thousand shares long – you own 1,000 shares. For protection, you buy 20 puts, each for 50 shares. You’re now long and short a thousand shares.

If the stock rises, the value of your puts shrinks but you’re up. If the stock declines, your long position diminishes but your puts are worth more.  Say the stock rises to $23. The value of your puts declines, making you effectively long 1,300 shares, short 700.

To generate alpha (I’m simplifying, leaving out how options may decrease in value near expiration, the insurance-renewal date, so to speak), you need to offset the cost of insurance. With a good model built on intraday volatility, you can trade the underlying stock for 20 days, buying high and selling low, going long or short, to mitigate costs.

Everybody wins. Your counterparty who sold you the puts makes money.  You make money trading your favorite stock. You have no fear of risk. And because more money keeps coming into stocks via 401ks and so on, even the losers get lucky (thank you Tom Petty, rest in peace, for that one).

One big reason this strategy works is the rules.  Regulation National Market System requires all stocks to trade at a single daily average price in effect. Calculating averages in a generally rising market is so easy even the losers can do it.

Now, what would jack this model all to hell?

A virus (frankly the virus is an excuse but time fails me for that thesis today).

Understand this:  About 80% of all market volume was using this technique. Quants did it. Active hedge funds. Fast Traders. Exchange-Traded Funds (ETF) market-makers.

Big volatility doesn’t kill this strategy. It slaughters the parties selling insurance. Observers are missing this crucial point. Most active money didn’t sell this bear turn.  We can see it.  Again, a story for later via webcast if you’re interested.

What died in the great 2020 Coronavirus Correction was the insurance business.

Casualties litter the field. The biggest bond ETFs on the planet swung wildly in price. Big banks like Dutch giant ABN Amro took major hits. Twenty-six ETFs backed by derivatives failed. The list of ETFs ceasing the creation of new units keeps growing and it’s spilling into mainstream instruments. Going long or short ETFs is a fave hedge now.

The Chicago Mercantile Exchange auctioned the assets of a major high-speed trader that sold insurance, Ronin Capital (around since 2006. If its balance sheet and leverage can be believed, it may have imputed a loss of $500 billion to markets.

Just one firm. How many others, vastly bigger, might be at risk?

Forget stock-losses. Think about how funds mitigate volatility. How they generate alpha. We’ve been saying for years that if the market tips over, what’s at risk is whatever has been extended through derivatives. ETFs are derivatives. That’s 60% of volume.

And now key market-makers for stocks, bonds, ETFs, derivatives, commodities, currencies, are tied up helping the Federal Reserve. Including Blackrock. They can’t be all things to all people at once.

The market isn’t dysfunctional.  It’s just designed to function in ways that don’t work if insurance fails. And yes, I guess that that’s dysfunctional. That was my epiphany.

I’ll conclude with an observation. We shouldn’t shut down our economy. Sweden didn’t. This is their curve. Using a population multiplier, their curve is 27% better than ours – without shutting down the economy, schools, restaurants. We are the land of the free, the home of the brave. Not the land of those home, devoid of the brave. I think it’s time to put property rights, inalienable rights, above the government’s presumption of statist power.

The End

In crises I think of Winston Churchill who said, “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Let’s start now with lessons from a health crisis that became a market crisis and proceeded to an economic crisis.

This last leg is yet murky but with hotels at 15% occupancy and the great American service industry at a standstill in an economy 70% dependent on consumption, it’s big.

First, the stock market. Intraday volatility in the S&P 500 averaged 10% the past week – a daily market correction between mean high and low prices by component.

Volatility is unstable prices, and big money needs stability to move. If the market exists for public companies and investors, it has served them poorly. Short-term machines have dominated. Investors were unable to get in or out without convulsing the whole construct of a $30 trillion edifice now smashed a third smaller.

Energy companies should be the first ones knocking at the SEC because the sector was 22% volatile the past week amid losing vast value. Sure, oil prices fell. Should it be the worst month ever for oil? The sector was battered more than in the maw of 2008.

Market structure is the hubris of equities. We’ve said it for years. We warned that Exchange Traded Funds, derivatives, had pervaded it, spreading the viral threat of severe inflation and deflation if stocks and ETFs move in unison.

There’s another basic problem. I’ll give you an analogy. The local grocery store down the street in Steamboat was denuded of wares as though some biblical horde of incisor-infested critters had chewed through it. I guess in a sense it was.

If there’s no lettuce, you can’t buy it. The price of lettuce doesn’t carom though. Demand ceases until supply arrives.

And it did. We later found lettuce, carrots, onions, eggs in abundance, but no limes (drat! A vital gin-and-tonic component).

We bought what they had.

In the stock market as with groceries there is no limitless supply of XOM or AAPL or whatever. But rules permit machines to behave as though lettuce and carrots always exist on the shelves when they don’t (a majority of volume was shorting and Fast Trading the past week – phantom products).

It’s why prices bucked and seized like a blender hucked into a bathtub. Investors would reach a hand for the proverbial lettuce and it would vanish and lettuce prices would scream smoking off like bottle rockets on July 4.

We don’t do that with groceries. Why in stocks? Energy companies, are you happy that machines can manufacture a crisis in your prices (that rhymes) and destroy the bulk of your value in days?

Look at Utilities. Producing energy to heat and cool American homes is vulnerable to tornadoes. Not viruses. Why did a preponderance of Utilities lose half their market capitalization in days – and then get 20% back yesterday?

These are questions every public company, every investor, should ask.

(Here’s what happened: Utilities were overweight – we warned of it! – in “low volatility” investments. Those blew up, taking Utilities with them.)

And they jumped on options bets. Volatility as an asset class lapses today around VIX expirations, and resets. Tomorrow index options expire, Friday is the first quad-witch of 2020. Derivatives have demolished swaths of equity capital like a runaway Transformer in one of those boom-boom superhero movies trampling through a trailer park.

It should be evident to the last market-structure skeptic – whoever you are – that market structure overwhelms reason, fundamentals, financials. If you’re in stocks, you need to get your head around it (we have, removing that burden for you).

If you want to be prepared and informed, ask us. We have a product that will fit your budget and put you in with the – socially distanced – cool kids who make market structure part of the investor-relations and investing processes.

Speaking of social distancing, there are 71 million American millennials (meaningful numbers living paycheck-to-paycheck). Viral mortality rate for them globally: 0%. There are two million hoary heads over 90. Covid-19 mortality is 19% (and most over 80 have chronic medical conditions).

I’m a data guy. How about keeping oldsters out of bars and youngsters out of nursing homes? I don’t mean to be insensitive and I know the concern is healthcare facilities. But destroying the finances of millennials over sequestering the vulnerable is troubling.

Last, central banks once were lenders of LAST resort taking good collateral at high cost. I would be pulling out all stops too, were I leading. I’m casting no aspersions. But governments are funded by people, not the other way around, and cannot carry the freight by idling productive output. That’s cognitively dissonant, intellectually incongruous.

This may be the last time we get away with it. Let’s stop that before it ends us. Find a new plan.

And investors and IR people, understand market structure. This is a beginning. It’ll again roar in our faces with slavering fangs.

SPECIAL CORONAVIRUS EDITION: Halting

My email inbox took such a fusillade of stock volatility halts yesterday that I set two rules to sort them automatically. Emails rained in well after the close, girders triggered hours before and stuck in an overwhelmed system.

As I write, volatility halts Mon-Thu this week total 2,512.  Smashing all records.

You need to understand these mechanisms, public companies and investors, because high-speed trading machines do.

On May 6, 2010 the market collapsed and then surged suddenly, and systems designed then to interdict volatility failed.  They were revamped. Finalized and implemented in 2013, new brackets sat dormant until Mar 9, 2020.

Wham!

They were triggered again yesterday, the 12th. At Level 1, the market in all its forms across 15 exchanges and roughly 31 Alternative Trading Systems stops trading stocks when benchmarks fall 7% from the reference price in the previous day’s closing auction.

To see exchanges, visit the CTA plan and exclude Finra and CBOE (17 members becomes 15 exchanges). You can track ATS’s (dark pools) here.

The Level 1 pause lasts 15 minutes and trading then resumes.  Say the reference price was 2,400 for the S&P500 the day before. At 2,242, it stops for 15 minutes.  Down 13% to 2,123, it halts again for 15 minutes. At 20% down, the markets close till the next day (that would be SPX 2,000 in our example).

Here’s the kicker: Levels 1-2 apply only till 3:25p ET. If the market has been off 5% all day till 3:25p ET and then it swoons, it won’t stop falling till it’s down 20% – SPX 2,000.  Girders apply only down, not up. Stocks could soar 30% in a day but couldn’t fall 21%.

Then there are single-stock guards called Limit Up/Limit Down (LULD) halts (the stuff inundating my inbox). When a Russell 1000 stock (95% of market cap), or an ETF or closed-end fund, moves 5% away from the preceding day’s reference price in a five-minute span, the security will be halted.

Russell 2000 stocks (add the two and it’s 99.9% of market cap) halt on a 10% move from the reference price in five minutes, applicable all the way to the close. Prices for all securities must be in the LULD range for 15 seconds to trigger halts.

For perspective, high-speed machines can trade in microseconds, millionths of a second (if machines can find securities to trade). Machines can game all these girders.

Boeing (BA) was volatility-halted three times yesterday (market cap $87 billion, over $220 billion of market cap in April last year) and still declined 18%, 80% more than the DJIA (and it’s a component).

Our friends at IEX, the Investors Exchange (the best market, structurally, for trading) tracked the data. Full-service broker-dealers handle customer orders, as do agency brokers (like our blood brothers at Themis Trading). Proprietary traders are racing their own capital around markets.  Look at this.

It matches what we see with behavioral analytics, where machines outrace any indication that rational money is coming or going. It’s why real money struggles to buy or sell.

How have stocks lost 25% of value in two weeks with no material change to shareholdings (widely true)? This is how. Machines are so vastly faster than real money that it’s like shooting fish in a barrel.

A word on futures:  The Chicago Mercantile Exchange triggers halts overnight if futures move 5%. But that tells machines to bet big on the direction prices were last moving.

Let’s bring in Exchange Traded Funds (ETFs). They depend on predictable value in ETF shares and the underlying stocks. If ETFs have risen above the value of underlying stocks, market-makers short ETF shares (borrow them) and return them to ETF sponsors to get stocks worth less than ETF shares. And vice versa.

With a low VIX, this trade is easy to calculate. When volatility soars and ETFs and stocks move the same direction, market-makers quit. They can’t tabulate a directional gain. The market loses roughly 67% of its prices, which come from ETF market-makers. Machines then yank markets up and down thousands of points without meaningful real buying or selling.

Which leads us to next week.  Options expire. This pandemonium began with Feb options-expirations, where demand plunged.  If the market puts together two solid days, there will be an epochal rush to out-of-the-money call options before Mar 20. Stocks will soar 15%.

I’m not saying that’ll happen. It’s remotely possible. But we’re on precarious ground where ETFs subtracted from stocks suggest another 35% of potential downside.

Last, here’s my philosophical thought, apolitical and in the vein of Will Rogers or Oscar Wilde on human nature. A primitive society ignorant of the Coronavirus would blithely pursue food, clothing and shelter. Life going on.

Now our global self-actualized culture in one breath proposes we change the climate, and in the next paralyzes over a tiny virus.  I think Will and Oscar would suggest we learn to live (with viruses and the climate).

Whether we lose 35% or gain 15%, market structure is crushing human thought and shareholder behavior, and that fact deserves redress after this crisis.

Canary Prices

We’ve written of risks in stocks from proliferating Exchange Traded Funds (ETFs).

We’ve talked long about liquidity risks, here last October with CNBC’s Brian Sullivan.

So what, right?

The market has functioned well in this Coronavirus Pandemonium, argue regulators and reporters (WSJ subscription required).

What’s the definition of functioning?  Volume?  You longtime users of Market Structure Analytics rely on them so as not to confuse busy – volume – with productive – liquidity (and to know when story drives price, and doesn’t, and much more).

Refinitiv Lipper says some $20 billion left US equities the week ended Mar 6. Sounds big but it’s 1% of volume.

Add up shorting (borrowed stock) at 45.2% of daily S&P 500 trading the past week, and Fast Trading (machines hyper-trading intraday and ending flat), 53.3% of volume, and it’s 98.5% of market volume but not liquidity.

There’s your 99% (the difference is a rounding error).

This is why you should care about market structure, if you haven’t yet.

Volatility Monday triggered a marketwide stock circuit-breaker halting trading when stocks drop 7%. First time since the rule was implemented in 2013.

Volatility halts also stopped futures trading Monday. Both events derailed reads of VIX volatility, which depend on futures contracts and put/call pricing for freely trading S&P 500 components.

Maybe the VIX was over 100 Monday. We don’t know, as components stopped trading.

What’s more, volatility halts for stocks and ETFs cascaded to more than a thousand Monday and Tuesday, including pauses in large caps like OXY, stopped eight times. I think we surpassed the record-setting currency-driven (as is this) frenzy of Aug 24, 2015.

Many directional ETFs in energy, commodities, market vectors, bonds, leveraged instruments, were halted too.  Volatility halts are coal-mine canaries.

And we’re led to believe investors are panicking over the Coronavirus, and getting out, because markets are working. Anybody but ModernIR writing about volatility halts, paucity of liquidity? Do tell.

Market Structure Analytics exist, public companies and investors, to know what headlines don’t say.

It’s egregious disservice to tell everyone “the market is working great!” when volatility halts explode, most volume is transient trading, and nobody can get in or out.

Canaries falling in waves.

Active Investment declined in the S&P 500 from early Feb until Mar 6 and Mar 9, then ticked up 3% on selling – less than the 5.4% daily intraday volatility (spread between highest and lowest average prices) in components of the S&P 500.

Responding, the market suffered one of its greatest collapses.

People don’t care about insurance – a canary in the coal mine – until it’s needed. And then it’s too late.

Investors and public companies, if you’re lulled by quiescence like last autumn, you’ll be shocked by its departure regardless of the Coronavirus. You shouldn’t be.

ETFs are a principal cause for both market volatility and vanishing liquidity. Investors can sit on stocks – meaning they don’t circulate – and trade ETFs.  When the market lurched, ETF market-makers withdrew, as we’d reasoned from data.

Then investors wanted to sell.

Without the ETFs driving some 67% of trading volume normally, nobody was there to calculate prices. Markets spun crazily like a fighter jet hit by a missile.

And regulators tell us the market is working fine. What about these dying canaries everywhere?

Here is liquidity simply. Trade-size is down to 132 shares in the S&P 500. If you’re an investor trying to sell 100,000 shares, you fill 1% of it and the price gyrates away from you as Fast Traders jump ahead.

Now your pre-trade analytics are wrong. You can pull your trade. Or try to blitzkrieg it in a thousand 100-share trades “at the market,” the best bid.

Wham!

The market implodes a thousand points. Try to buy 10,000 shares and the market skyrockets, rising a thousand points.

Investor-relations people for Energy companies, how do your executives feel about this market?

Technology IR people, what if you’re next?  Tech is the biggest sector. Shorting rose 12% last week in the FAANGs (FB, AAPL, AMZN, GOOG/GOOGL, NFLX) and Active money was selling. FAANGs lead the market up and down. They topped Feb 14, bottomed Mar 3. And now?

(We have the answer. Ask us.)

Investors, is a market that can’t accommodate 1% of the audience into and out of the exits without shuddering the whole stadium and threatening its foundations okay?

Sentiment by our measures is the lowest we’ve ever recorded. Yesterday it was still falling but a day or two from bottom. Uncharted territory, yes. But ModernIR is continuously mapping behaviors, trends, spreads, more.  We have that data, right here.

What if markets zoom? Or don’t?

What’s it worth, public companies and investors, to know what the headlines don’t tell you?  What’s the price of a canary? Ask us. You’ll be surprised.

Viral Market

I fear the Coronavirus may cause us to miss the real clanging claxon the past two weeks: The stock market cannot handle any form of truth.  The viral threat is market structure.

That the market plummeted on yesterday’s surprise (shocking) Federal Reserve rate-cut, the first non-meeting central-bank move since 2008, is to be expected in context of the continuum that created pressure in the first place.  Let’s review:

1.      Week of Feb 16. Options expired, Market Structure Sentiment topped, demand for derivatives bets fell 5% rather than rose, on a fast-appreciating US dollar.

2.      Feb 24.  New options for March expiration began trading. March brings the first “quad-witching” period of 2020, with rafts of derivatives tied to currencies and interest rates recalibrating.  Against a soaring dollar and plunging interest rates, uncertainty flared and implied derivatives demand vanished, tanking stocks.

3.      Intraday volatility (spreads between high and low prices) zoomed in the S&P 500 to the highest level we’ve recorded, averaging a searing 4.9% daily. Market-makers for Exchange-Traded Funds could not calculate successful trades between stocks and ETFs and withdrew.  Fast Trading rose to 53% of volume. Markets corrected by Feb 28 at the fastest pace ever.

4.      Bets jumped to 100% that the Fed would cut rates at its Mar 17 meeting in response to mounting economic concern over the Coronavirus.  On Mar 2, with a new month beginning, traders bet big with swaps (swap volumes crushed records) paying on a rate cut.

The Fed cut rates yesterday instead.

They might as well have trafficked in infectious diseases. The change rendered Monday’s bets void by pulling forward all implied returns. It’s effectively the same thing that happened Feb 24 when bets never materialized. The market imploded.

Somebody should be on TV and in the newspapers explaining these mechanics, so the public stops incorrectly supposing the market is a barometer for virus fears.

It’s worse in fact. During the whole period of tumult in the market from Feb 24 to present, Active money at no point was a big seller.  Patterns show a collapse for passive investment – especially ETFs – that didn’t change till Monday on rate-cut bets (that were chop-blocked yesterday).

There’s more. Trade-size in the S&P 500 plummeted to a record-low 132 shares. While volume exploded, it was repeated movement of the same shares by Fast Trading machines, which were 53% of volume. Daily trades per S&P 500 component exploded from a 200-day average of 27,000 to over 58,000.

What does it all mean?  Without any real buying or selling, the market gyrated in ways we’ve never seen before. That’s the shriek of metal, the scream of inefficiency. Rightly, it should raise hair.

We wrote about this looming liquidity threat last year (more than once but we’ll spare you).

Regulators should prepare now for the actual Big One yet to come.  Because the next time there will be real selling. It could make February’s fantasia look like a warmup act.  I’m not mongering fear here. I’m saying public companies and investors should demand a careful assessment from regulators about recent market turmoil.

My suggestion:  If the market moves more than 5% in a day, we should suspend the trade-through rule, the requirement that trades occur at the best national price. Let buyers and sellers find each other, cutting out the Fast Trading middlemen fragmenting markets into a frenzy of tiny trades and volatile prices.

And we’d better develop a clear-eyed perspective on the market’s role as a barometer for rational thought.  The truth is, market structure is  the real viral threat to the big money exposed to stocks.

The Mock

Does it matter where stock-trades occur, investors and public companies?

It does to the stock exchanges.  The explosion in passive investing has driven trades toward the last price of the day, found in stock-exchanges’ closing auctions.

Why?

Index and Exchange-Traded Funds need to track a benchmark in most cases. The bane of passive investing is skewing from the mean, called a tracking-error. The last price of the day is the reference price, the official one.  Money pegging a benchmark wants it.

It’s been profitable business for the big exchanges because they charge the same price to buy or sell into the close. Often at other times there’s a fee to buy but a credit to sell (they say “adding and removing” but don’t get lost in the jargon).

Orders to buy or sell may be “market-on-close,” (we’ll call it “the mock”) meaning at the best bid to buy or offer to sell as determined by matching up supply and demand, or “limit-on-close,” orders buying or selling at a specific price or better to end the day.

If you’re nodding off now or looking for the latest news on who might’ve won the Iowa Caucus, stay with me. There’s an important market-structure lesson coming.

Cboe (the erstwhile Chicago Board Options Exchange) operates four stock markets and just received SEC approval to be part of the closing auction, formerly controlled by the NYSE for stocks listed there, and the Nasdaq for stocks listed there.

The auction will occur at Cboe’s BZX market, likely at a set fee per share. It’s important to know that BZX encourages orders to sell, paying $0.30 per hundred shares, or even $0.32 if the shares first came from retail traders.  That means firms like Two Sigma might buy trades for $0.15 from Schwab and sell them at BZX for $0.32.

Why would an exchange pay so much for a trade?  Because it sets the price – and that’s valuable data to sell, worth more than the cost of paying for the trade.

But I digress.

So the Cboe will now use prices from the NYSE and the Nasdaq to match trades market-on-close for reference purposes.  No short trades, no limit orders. Only what the market giveth or taketh away.

Naturally, the NYSE and the Nasdaq opposed the Cboe plan. We wrote about it all the way back in Aug 2017, describing the cash at stake then.  The biggies argued expanding access to the closing auction would fragment liquidity.

Anyone can use order types from all the exchanges to fill trades. What difference does it make where trades occur if the rules from the SEC say the behavior must be uniform?

It’s like those heist movies where the robbers huddle beforehand and say “synchronize watches.” The market is a collection of synchronized watches at the close.

But overlooked amid the market mumbo-jumbo are the effects on trading the rest of the time – and we need to understand, investors and public companies.

Phil Mackintosh, now chief economist at the Nasdaq and always an interesting read, says, “The data show there are a lot of other investors, traders and hedgers who are also using the close because it’s a cheap way to get sizable liquidity with minimal market impact.”

True enough, it’s not all passive. By the way, MSCI indexes rebalance for the quarter today. The issue to us is the way that much of the trading throughout the rest of the day is an effort to change the prices of big measures into the close.

Traders know money chases reference prices.  So they change prices the rest of the day by running stocks up or down, and trading index futures, options, options on futures, or baskets of ETFs, creating divergences to exploit.

This becomes the market’s chief purpose – skewing prices and bringing them back to the mean (the hubris here is a story for next time).  Everyone thinks it’s fundamentals when the behavioral data show how pervasive this short-term pursuit has become.

How to solve it? Disconnect markets. That alone would halve the arbitrage opportunity.

Since that won’t happen, the best defense is a good offense. Know what all the money is doing, all the time (we can help), and you won’t be fooled. Or mocked.

The Truth

You know it’s after Groundhog Day?  We passed Feb 2 and I don’t recall hearing the name Punxsutawney Phil (no shadow, so that means a reputed early spring).

Reminds one of the stock market. Things change so fast there’s no time for tradition.

We have important topics to cover, including the implications of the SEC’s recent decision to approve closing-auction trading at the CBOE, which doesn’t list stocks (save BATS).  Circumstances keep pushing the calendar back.

We said last week that the Coronavirus wasn’t driving stocks. It was market structure – measurable, behavioral change behind prices.

The Coronavirus is mushrooming still, and news services are full of dire warnings of global economic consequence.  Some said the plunge last Friday, the Dow Industrials diving 600 points, reflected shrinking economic expectations for 2020.

Now the market is essentially back to level in two days. The Nasdaq closed yesterday at a new record.  Did expectations of Coronavirus-driven economic sclerosis reverse course over the weekend?

It’s apparent in the Iowa caucuses that accurate outcomes matter.  The Impeachment odyssey, slipping last night into the curtains of the State of the Union address, is at root about interpretations of truth, the reliability of information, no matter the result.

We seem to live in an age where what can be known with certainty has diminished. Nowhere is it manifesting more starkly than in stocks.  Most of what we’re told drives them is unsupported by data.

A business news anchor could reasonably say, “Stocks surged today on a 10% jump in Fast Trading and a 5% decline in short volume, reflecting the pursuit of short-term arbitrage around sudden stock-volatility that created a broad array of cheap buying opportunity in derivatives.”

That would be a data-backed answer. Instead we hear, “Coronavirus fears eased.”

Inaccurate explanations are dangerous because they foster incorrect expectations.

The truth is, behavioral volatility exploded to 30% Feb 3, the most since Aug 2019. To understand behavioral volatility, picture a crowd leaving a stadium that stampedes.

Notice what Sentiment showed Feb 3. Sentiment is the capacity of the market to absorb higher and lower prices. It trades most times between 4.0-6.0, with tops over 7.0  The volatile daily read dropped below 4.0 Feb 3.

Cycles have shortened. Volatility in decline/recovery cycles is unstable.

Here’s the kicker. It was Exchange Traded Funds stampeding into stocks. Not people putting money to work in ETFs.  No, market makers for ETFs bought options in a wild orgy Monday, then caterwauled into the underlying stocks and ETFs yesterday, igniting a searing arc of market-recovery as prices for both options and ETFs ignited like fuel and raced through stocks.

That’s how TSLA screamed like a Ford GT40 (Carroll Shelby might say stocks were faster than Ferraris yesterday).  Same with a cross-section of stocks up hundreds of basis points (UNH up 7%, AMP up 6%, VMW up 4%, CAT up 4%, on it goes).

These are not rational moves. They are potentially bankrupting events for the parties selling volatility. That’s not to say the stock market’s gains are invalid.  We have the best economy in the world.

But.

Everyone – investors, investor-relations professionals, board directors, public-company executives – deserves basic accuracy around what’s driving stocks.  We expect it everywhere else (save politics!).

We’ll have to search out the truth ourselves, and it’s in the data (and we’ve got that data).