Tagged: Earnings

Supply and Demand

Happy Bastille Day!  Also, Goldman Sachs made $15 per share, 50% over expectations. The stock declined.

JP Morgan earned $12 billion on revenue of $31 billion, doubling views. Shares fell.

Why are banks making 36% margins when you can’t earn a dime of interest?

I digress.

Illustration 98288171 / Goldman Sachs © Alexey Novikov | Dreamstime.com

I told the Benzinga Premarket Prep show July 12 on Market Structure Monday (which we sponsor) that falling demand and rising supply in the shares of JPM and GS predicted the stocks would probably perform poorly despite widespread views both would batter consensus like Shohei Ohtani on both sides of the plate (baseball humor for you).

Sure, you could say everybody already knew so they sold the news. This is the kind of copout we get from people who want to tell us stocks are always expectations of future outcomes while simultaneously telling us “they were down because growth wasn’t quite good enough to get past the whisper number.”

That is BS.  Plain and simple. 

ModernIR can measure supply and demand in JPM and GS and observe that demand is falling and supply is rising.  Even amid the farcical characteristics of the modern stock market, that means prices will fall.

We can meter these conditions in your stock too, by the way.

The best thing about the stock market today is how well it reflects supply and demand.  Currency markets don’t. The Federal Reserve continuously jacks with currency supplies in such manipulative ways that almost no economic measure, from growth to inflation, can be believed.

But in the stock market, the math is so sacrosanct that it’s impervious to the ubiquitous interference by Congress and regulators with the mechanisms of a free, fair and open market. No matter how bureaucrats assail the battlements, nothing disguises the stark supply/demand fluctuations apparent in the data.

Wow, mouthful there, Quast.

I know it. I’m not kidding.

Look, regulators REQUIRE brokers to buy and sell stocks even when there are no buyers and sellers.  That’s called a “continuous auction market.”  That’s what the US stock market is.

Contrast that with an art auction.

Stay with me. I have a point.

The first requirement of an art auction is actual ART.  Even if its pedigree is suspicious, like Nonfungible Tokens (NFT).  There’s still art for sale, and an audience of bidders pre-qualified to buy it.  No shill bidders allowed.

Nothing so provincial impairs the stock market. While you can make stuff up such as always having 100 shares of everything to buy or sell, even if it doesn’t actually exist, you STILL HAVE TO REPORT THE MATH.

Think I’m joking about shares that don’t exist?  Educate yourself on the market-maker exemption to Reg SHO Rule 203(b)(2). Or just ask me. 

Anyway, everything is measurable. Thanks to rules dictating how trades must be executed. In GS trading the day before results, Short Volume (supply) was rising, Market Structure Sentiment (demand) was falling.

Unless stock-pickers become 300% greater as a price-setter than they’ve been in the trailing 200 days – a probability approaching zero – the stock will decline.

I don’t care how good your story is.  Story doesn’t change supply or demand. Only ACTIONS – to buy or sell or short or leverage – do.

This math should be the principal consideration for every public company. Were we all in the widget business, selling widgets, we wouldn’t say, “I hope the CEO’s speech will juice widget sales.”

Now maybe it will!  But that’s not how you run a widget business.  You look at the demand for widgets and your capacity to supply widgets to meet demand. That determines financial performance. Period.

The stock market is the same.  There is demand. There is supply. Both are measurable. Both change constantly because the motivation of consumers differs. Some want to own it for years, some want to own it for 2 milliseconds, or roughly 0.05% of the time it takes to blink your eyes.

Both forms of demand set price, but one is there a whole lot more than the other. If the only behavior you consider is the one wanting to own for years, you’re not only a buffoon in the midst of courtiers. You’re wrong.  And ill-informed.

Thankfully, we can solve that social foible. And sort the data for you.

The stock market is about supply and demand. Earnings season is upon us again.  The market will once more tell us not about the economy or earnings, but supply and demand.

Ask us, and we’ll show you what your data say comes next.

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.”

Message vs Messages

It’s earnings season. Across the market, companies beat expectations and lift guidance and stocks decline. 

Huh?

I can offer a broad array of cases.  Take TSLA.  Massive quarter, monstrous boost to forward views.  Stock declines.

And yes, I Tweeted before TSLA reported that its price would probably fall.

A Consumer Staples stock beat all the key metrics, lifted guidance. Stock fell 10%, another 10% in following days.

There’s a figure that explains what’s happening: 350 billion. 

That’s the number of order messages processed on a single March day this year by the NYSE, according to head of equities Hope Jarkowski in a TABB Forum interview.  It was a new highwater mark for the exchange, where the previous record in March 2020 was 330 billion.

What’s that got to do with reporting great numbers and seeing your stock swoon? Public companies and investors both deserve to know, and the answer is there in the mass pandemonium of message traffic.

When billions of messages for stock orders are flying around, that’s not rational behavior. That’s money moving near the speed of light.  That’s speculation.

The market is crammed with it.

And what are we doing, public companies (investors, I’ll come to you in a bit)?  We’re prepping our numbers and expecting the stock to reflect what those say, good or bad.

Too many of us are still leading our boards and executive teams to think the numbers drive the stock, even though it’s 2021 and we’ve had this high-speed chaff-winnowing market since 2007 when Regulation National Market System was implemented.

It’s part of the investor-relations job to know the ORDER MESSAGES, not the message, drive the stock. About 350 billion of them on high-traffic days at just the NYSE Group of five stock exchanges and two options markets.

And why does the NYSE operate seven stock and options markets if an exchange is supposed to AGGREGATE buy and sell interest?

Because they’re NOT aggregating buy and sell interest. They want message traffic, a lot of orders.  This is why you need firms like ModernIR, a check and balance on the exchanges, which don’t tell you what the money is doing.

The image here comes courtesy of IEX, the Investors Exchange, and shows how bursts of trades – which flow through messaging traffic – come from proprietary trading firms within two milliseconds of changes in price.

For comparison, hummingbirds flap their wings about 80 times per second, equivalent to about once every 12 milliseconds.  So in a fraction of the flap of hummingbird wings, your entire market structure could shift from positive to negative.  Rational? Nope.

Case in point.  I bought 200 shares of NCLH at the market and it executed at the NYSE RLP.

What’s that?  My broker, Interactive Brokers, is a Retail Member Organization.  It can execute the trade for a tenth of a penny higher than the offer at the NYSE’s Retail Liquidity Program, where a high-speed trader can earn three cents per hundred shares for filling my order.

And if the seller is a NYSE Designated Market Maker (see page 20 here), it’s 20 cents per hundred, 40 cents to sell me 200 shares at one-tenth of a penny better than the best displayed price.

Got that? Sure, I got $30.169 instead of $30.17.  Oh boy. But talk about convoluted.  Why the hell would an exchange do that?

For 350 billion reasons.  Traffic is data. The RLP and my broker set the best bid and offer. That’s money – literally.  Data is money. Best prices are data. We’ve all been buffaloed into believing a tenth of a penny matters. No it doesn’t. We’re being gamed, merchandised.

The more platforms, the more prices, the more data – and especially if five are stocks and two are options on those stocks.    

That’s why your shares implode on results.  Suppose a million of those messages are a bunch of parties shorting, and the market tips the other way in tenths of pennies on hummingbird beats?  In the case of the Staples stock above, over 72% of volume that day was short – borrowed. Not story. Just data. Bets exchanges fill.

So the whole food chain of order-flow messages and order types to take advantage of a retail trade or pay a high-speed trader to be the best bid or offer can cook the market.

Now, why is that all right with you, public companies?

Part of the answer is not knowing enough about the stock market.  We can help.

Investors, this is your market too. I looked at TSLA Market Structure Sentiment. Peaked and falling. Probability is the stock declines. Doesn’t matter what Elon Musk says.

You’re better to trade using Market Structure Sentiment. Stocks can’t be relied upon to behave rationally.  They DO follow supply and demand.

Other than that, everything’s fine.

Time Changes

Public companies, are you still reporting financial results like it’s 1995?

Back then, Tim Koogle and team at Yahoo! made it a mission to be first, showing acuity at closing the books for the quarter faster than the rest. Thousands turned out for the call and – a whiz-bang new thing – webcast.

Ah, yesteryear and its influence.  It’s still setting time for us all.  No, really.  Benjamin Franklin penned a 1784 letter to a Parisian periodical claiming his experiments showed sunlight was available the moment the sun rose and if only Parisians could get out of bed earlier instead of rising late and staying up, they could save immense sums on candles.

Some say his levity gave rise to the notion of Daylight Savings Time. A closer look suggests it was the Canadians.  Sure, scientist George Hudson of the Wellington Philosophical Society presented an 1895 paper saying New Zealand would improve its industry by turning clocks forward two hours in October, back two in March.

But the occupants of Thunder Bay in northern Ontario first shifted time forward in 1908.

What do Canada and New Zealand have in common besides language and erstwhile inclusion in a British empire upon which the sun never set?  They’re at extreme latitudes where light and dark swing mightily.

The push to yank clocks back and forth swept up much of the planet during World War I in an effort to reduce fuel-consumption.

Here in Denver we’re neither at war and hoarding tallow nor gripping a planetary light-bending polar cap in mittened hands.  So why do we cling to an anachronistic practice?

Speaking of which, in 1995 when the internet throngs hung on every analog and digital word from the Yahoo! executive fearsome foursome (at least threesome), most of the money in the market was Active Investment. That was 24 years ago.

Back then, investor-relations pros wanted to be sellside analysts making the big bucks like Mary Meeker and Henry Blodget. Now the sellsiders want to be IR pros because few hang on its words today like it was EF Hutton and the jobs and checks have gone away.

Volume is run by machines. The majority of assets under management are Passive, paying no attention to results. Three firms own nearly 30% of all equities. Thousands of Exchange Traded Funds have turned capital markets into arbitrage foot races that see earnings only as anomalies to exploit. Fast Traders set most of the bids and offers and don’t want to own anything. And derivatives bets are the top way to play earnings.

By the way, I’m moderating a panel on market structure for the NIRI Virtual Chapter Nov 20 with Joe Saluzzi and Mett Kinak. We’ll discuss what every IRO, board member and executive should understand about how the market works.

Today 50% of trades are less than 100 shares.  Over 85% of volume is a form of arbitrage (versus a benchmark, underlying stocks, derivatives, prices elsewhere).

Active Investment is the smallest slice of daily trading. Why would we do what we did in 1995 when it was the largest force?

Here are three 21st century Rules for Reporting:

Rule #1: Don’t report results during options-expirations.  In Feb 2019 Goldman Sachs put out a note saying the top trading strategy during earnings season was buying five-day out of the money calls. That is, buy the rights (it was 1996 when OMC offered that same advice in a song called How Bizarre.). Sell them before earnings. This technique, Goldman said, produced an average 88% return in the two preceding quarters.

How? If calls can be bought for $1.20 and sold for $2.25, that’s an 88% return.  But it’s got nothing to do with your results, or rational views of your price.

The closer to expirations, the cheaper and easier the arbitrage trade. Report AFTER expirations. Stop reporting in the middle of them. And don’t report at the ends of months. Passives are truing up tracking then. Here’s our IR Planning Calendar.

Rule #2: Be unpredictable, not predictable.  Arbitrage schemes depend on three factors: price, volatility, and time. Time equals WHEN you report. If you always publish dates at the same time in advance, you pitch a fastball straight down the middle over the plate, letting speculative sluggers slam it right over the fence.

Stop doing that. Vary it. Better, be vague. You can let your holders and analysts know via email, then put out an advisory the day of earnings pointing to your website.  Comply with the rules – but don’t serve speculators.

Rule #3: Know your market structure and measure it before and after results to shape message beforehand and internal feedback afterward. The bad news about mathematical markets is they’re full of arbitragers.  The good news is math is a perfect grid for us to measure with machines. We can see everything the money is doing.

If we can, you can (use our analytics!).  If you can know every day what sets your price, how it may move with results, whether there are massive synthetic short bets queued up and looming over your press release, well…why wouldn’t you want to know?

Let’s do 21st century IR. No need to burn tallow like cave dwellers. Go Modern. It’s time.

 

Hot Air

Balloons rise on hot air. Data suggest there’s some in stocks.

Lipper says about $25 billion left US equities in October, $15 billion if you weed out inflows to Exchange Traded Funds (ETFs). Bond flows by contrast were up $21 billion. So how did stocks rise 5%?

In September 2019 when the S&P 500 closed roughly unchanged for the month, the Investment Company Institute reported a net increase in ETF shares of over $48 billion, bringing total YTD ETF creations and redemptions to $2.96 trillion.

For what?  More money has gone than come in 2019, so why more ETF shares?

And should we be concerned that stocks are rising on outflows?

Drawing correct conclusions about stocks depends on a narrative buttressed by data.  If we stay “stocks are up on strong earnings,” and earnings are down, it’s incorrect.

With about 80% of S&P 500 components having reported, earnings are down (FactSet says) about 3% year-over-year, the third straight quarterly contraction. Analysts currently expect Q4 2019 earnings to also contract versus 2018.

I’m not bearish. We measure behavioral data to see WHY stocks act as they do, so we’re not surprised by what happens.  It was simpler when one could meter inflows and outflows to explain ups and downs. More buyers than sellers. Remember those good old days?

Some $70 billion has exited US equities in 2019 yet stocks are at records. If holdings are down while stocks are up, the simplest explanation left to us now is it’s hot air – balloons lifted on heated atmosphere.

What’s heating the air? Well, one form of inflow has risen in 2019: The amount of ETF shares circulating. It’s up $200 billion.

The industry will say it’s because more money is choosing ETFs.  Okay, but is a dollar spent on ETFs hotter than one spent on underlying stocks, or mutual funds? There shouldn’t be more ETF shares if there are less invested dollars.

And if ETFs are inflationary for equities, how and why?

The reason investors are withdrawing money from stocks is because the market cannot be trusted to behave according to what we’re told is driving it. Such as people withdraw money and stocks rise.

Now ahead in the fourth quarter, if indeed rational money is forward-looking, we may see rising active investment on an expected 2020 pickup in earnings.

But measuring the rate of behavioral change from Jan-Nov 2019, the biggest force is ETFs. It’s not even close.  That matches ETF-creation data.

The inflationary effect from ETFs is that the market is hitting new highs as earnings decline and money leaves stocks.

The bedrock of fundamental investment is that earnings drive the market. Apparently not now.  What’s changed? ETFs.

How do they create inflation? Arbitraging spreads between stocks and ETFs has become an end unto itself. The prices of both are thus relative, not moored to something other than each other. And with more ETF shares chasing the same goods, the underlying stocks, the goods inflate.

We see it in the data. Big spreads periodically develop between stocks and ETFs, and stocks rise, and spreads wane, and stocks fall. In the last six weeks, correlation between the movement of stocks and ETFs has collapsed to 39% from over 91% YTD.

That’s not happened since we’ve been tracking the data. If ETFs are substitutes, they should move together (with periodic gaps), not apart. That they are indicates a fever-pitch in the focus on profiting on stock-ETF spreads.

That’s hot air.  The chance to trade things that diverge in value.

The problem with inflation is deflation, and the problem with rising on hot air is falling when it cools. We’re not predicting a collapse. But the risk in a market levitating on hot air is real.

Knowing the risks and how they may affect your stock, investor-relations people, or your portfolio, investors, is pretty important. We have the data to demystify hot air.

Shell Game

The earnings-versus-expectations construct that fixates Wall Street and business journalism as companies report results fuels bets on which shell hides the pea.

In fact, the stock market is built now on hiding the pea and moving the shells, apparent in the Fee Pilot debate we’ve written about recently.

You know the shell game, right?  This cat is pretty good at it.

As to picking the shell that hides the pea, I’m surprised the investor-relations profession isn’t up in arms over claims like Google parent Alphabet’s good numbers reputedly “boosting earnings optimism,” as one headline read.

What stock picker following GOOG trends and drivers and listening to its IR team and executives providing color and guidance didn’t know the quarter would be good? Keen observers didn’t wake up shouting, “Shazzam! I’m shocked at the numbers!”

But yesterday was Counterparty Tuesday, the one day every month when banks backing directional bets – most very short term – square derivatives books. Every third month it falls amidst earnings. If your bets are right, you get paid. Wrong, you pay up.

Banks shuffle assets accordingly. Yesterday, blue chips were up (GOOG is one now), risky stocks were down.

Take the new Communications Services ETF, XLC (see here in sector ETFs), which presages a reshuffling of Consumer Discretionary and Technology stocks into a re-imagined and amalgamated General Industry Classification System (GICS) for everything from Twitter, to Disney, to Facebook, to Electronic Arts that officially hits markets Sep 21, 2018.

Just four companies accounted for XLC gains yesterday if you view Alphabet’s two stock classes as a single company. Alphabet is 24% of the ETF’s weighting. With Facebook, two stocks are 45% of purported assets (read our ETF White Paper for more on “assets”).

The others with gains were VZ and T, two of the spare coterie comprising the old Telecom GICS that’s going away.  Combined the five green elements of XLC yesterday are 54% of its weighting. The other 21 were all in the red.

If you bet on GOOG and you pile in regardless of numbers, your bet pays because GOOG is so massive that as counterparties cover, it drives the entire market up. No wonder betting abounds.

But it’s not fundamentals. It’s betting on the law of large numbers.

Coming back to the Fee Pilot proposed by the SEC to study whether trading incentives distort how orders are handled, we support it because Fast Traders turn the market into a shell game.

Take HRT Financial, a top high-speed trader. We’ve got nothing against the smart folks behind it. But look up its 13F reports. It trades many billions of shares of stocks every month yet owns almost nothing – a measly few hundred million dollars.

Public companies are led to believe that having a bunch of prices set by high-speed firms that don’t want to own anything is good. Well, where do they get shares to sell to investors?  They borrow most of them – from owners! If they didn’t, it would show up as ownership. Or they buy them elsewhere in the market, in tiny pieces, in fractions of seconds, and immediately sell them. They are moving the shells, not fostering a market with deep supply.

It all fits together.  The earnings-versus-expectations model shifts focus from long-term prospects to how something fluctuates.  What is betting on fluctuations? Arbitrage.

Next piece of the puzzle:  How are prices set in the stock market?  By the fastest order bidding to buy or offering to sell. Fast machines like those run by HRT Financial set prices in tiny increments.  Exchanges offer incentives to high-speed traders to set prices in tiny increments – to keep moving the shells, keep that pea in motion, keep fooling people about where the best price is.

And exchanges sell the data from this shell game because rules require everybody in pursuit of the pea to buy it to prove they’re not gaming their customers. It would be laughable if it weren’t true, and describing the stock market.

Three big lessons, investors and public companies. Number one, you’ve got to have better data than the operators of the shell game if you want to keep track of the pea.  And we’ve got it.  Number two, don’t trust a shell game to give you an accurate portrayal of either business fundamentals or future outcomes.

And number three, the best defense against any form of shell game is knowledge. Education. Knowing how the game works. I refer you to the cat above. If the cat can figure it out, so can we!  Market Structure knowledge is now essential for both investors and public companies.

The Matrix

FactSet says quarterly earnings are up 23% from a year ago. Why have stocks declined?

There’s an inclination to grasp at fundamental explanations. Yet stock pickers generally don’t reactively sell because most times they must be fully invested (meaning to sell, they must buy).

Blackrock, Vanguard and State Street claim for Exchange-Traded Funds tracking the S&P 500 or Russell 1000 that turnover is 3-5%. (Editorial note: Those figures exclude creations and redemptions of ETF shares totaling trillions annually – a story we’ve told exclusively in the Market Structure Map.)

If investors are not responsible, who or what is?  Machines. By market rule all trades wanting to set the best bid to buy or offer to sell are automated – running on an algorithm. Why? Because the best price can be anyplace at anytime in the market system, and trades must move fluidly to it.

Thus, machines have become hugely influential in determining how prices are calculated. An amalgam of broker algorithms, smart routers and exchange order types are continually calculating the probability of higher or lower prices and completing a trade.

By our measures, back on Apr 19 the probability of calculating higher prices dropped. Why? Perhaps risk calculations for asset managers ordered rotation from overweighted equities or a need to slough off capital gains from ETFs (stuff mathematical models routinely do).

We have a mathematical representation for it: The market was Overbought. It doesn’t mean people are overpaying for fundamentals. It says machines will lack data to arrive at higher prices.  What follows this condition is nearly always a flat or lower market.

We know then that math arising from market rules is more powerful than a 23% increase in earnings. That should disturb stock pickers and public companies. If the market is The Matrix (if you’re younger than the movie, watch it to understand the reference), what are we all doing straining so hard to be outliers?

And why do machines possess the capacity to trump value-creation?

Good question.

By the way, the math is now changing. It’s resolving toward a mean.  We measure these price-setting propensities with a 10-point scale, the ModernIR Behavioral Index. Most of the time the stock market trades between 4.0 and 6.0, mean-reverting to 5.0 or thereabouts.

It returns to the middle because rules propel it there. Stocks must trade between the best bid or offer. What lies there? The average price. What do indexes and ETFs hew to? Averages.  We’ve explained this before.

When the market slops beyond 6.0, a mean-reversion is coming.  When it drops below 4.0, it signals upward mean-reversion. The market has descended from about 6.5 a week ago to 5.2 yesterday. The market will soon level off or rise as it did microcosmically yesterday, a day of extremes that ended back near midway (but it’s not down to 4.0, notice).

If math is a more reliable indicator of the future than earnings, why is everybody fixated on earnings versus expectations? What if that model is obsolete? And is that a bad thing?

I don’t think so. The earnings-versus-expectations convention promotes arbitrage. Shouldn’t capital-formation power the market?

Big Movers

You can’t expect the stock market to reflect earnings. I’ll explain.

By week’s end, 20% of the S&P 500 will have reported, and earnings are up 17% over the same period last year so far (normalized to about 7% sans federal corporate tax reform legislation).

Yardeni Research, Inc. reports that price-to-earnings ratios in various categories of the market are not misaligned with history.  The S&P 500 trades just over 16 times forward expected earnings, about where it did in 2015, and in 2007 before the financial crisis, and well below levels before Sep 11, 2001.

Sure, by some measures valuations are extreme. Viewed via normative metrics, however, the market is as it’s been. From 1982-2000, PE ratios were generally rising.  From there to 2012, they were generally falling. Yet between we had multiple major market corrections.

Which returns us to my incendiary opening assertion that earnings today don’t drive stocks. What does? The money setting prices. Let me explain.

Buy-and-hold money tends to buy, and hold. Most conventional “long” equity funds must be fully invested, which means to buy something they must sell something else.  Buying and selling introduces tax, trading-commission, and volatility costs, which can cause stock-picking investors to underperform broad indexes.

The Investment Company Institute reported that 2016 turnover rates among equity funds averaged 34%, or about a third of positions annually. Passive index and exchange-traded funds tout low turnover. State Street, sponsor for the world’s largest ETF, SPY, claimed 2017 turnover was 3%.

We’ll come to the fallacy of low turnover in ETFs.

First, Big Reason #1 for the movement of stocks is arbitrage. Follow the money. Using our proprietary statistical measures of behavior in stock trades, nearly 46% of market volume (20-day ave.) in the Russell 1000 (which is over 90% of market cap) came from high-speed traders.

They are not investors. These machines trade tick data in baskets, aiming most times to own nothing at day’s end. The objective is to profit on intraday price-moves.  For instance, 52% of Facebook’s daily trading volume is high-speed machines. Less then 9% is Active investment by stock-pickers.

Viewed another way, there’s a 46% chance that the price of stocks reflects machines trading the tick. Since less than 12% of Russell 1000 volume was fundamental, there is but a one-in-eight chance that earnings set prices. High-speed trading is arbitrage – profiting on price-differences.

Don’t fundamentals price the market long-term? Again, that would be true if the majority of the money setting prices in the market was motivated by fundamentals. That hasn’t been true this century.

How about fund flows?  Assembling data from EPFR, Lipper and others and accounting for big outflows in February, about $40 billion has come into US stocks this year.

Using Investment Company Institute data and estimates for Mar and Apr this year, ETFs have by comparison created and redeemed some $1.5 TRILLION of shares. Fund flows are less than 3% of that figure.

These “in-kind” exchanges between ETF creators and big brokers that form the machinery of the ETF market are excluded from portfolio turnover. If they were counted, turnover rates in ETFs would dwarf those for conventional funds. And the objective behind creations and redemptions is not investment.

ETF creators make money by charging brokers fees for these transactions (which are tax-free to them) and investing the collateral. Brokers then trade ETFs and components and indexes to profit on the creations (new ETF shares sold to investors) and redemptions (returning ETF shares to ETF creators in exchange for collateral to sell and short).

Neither of these parties is trying to produce an investment return per se. They are profiting on how prices change – which is arbitrage (and if ETF creations are greater than redemptions, they permit more money to chase the same goods, lifting markets).

Summarizing: The biggest sources of movement of money and prices are machines trading the tick, and ETF creators and brokers shuttling tax-free collateral and shares back and forth by the hundreds of billions. If pundits describe the market in fundamental terms, they are not doing the math or following the money.

And when the market surges or plunges, it’s statistically probable that imbalances in these two behaviors are responsible.

Earning the Answers

It’s 8am Eastern Time and you’re in a conference room. Earnings season.

Executives around the table. The serious ones in suits and ties like usual. Others in shorts or jeans. Everybody reading the call script one more time. 

“You think we’ll get that question about inventory levels?” the COO says. 

“What’s the stock gonna do today?” says your CEO. 

All of us who’ve been in the investor-relations chair understand the quarterly grind. We practice, prepare, canvass probable questions, rehearse answers.  Try to get the execs to read the script aloud. We listen to competitors’ calls, seeking key queries.

Yet 85% of the volume in the market is driven by money paying no attention to calls.

“Not during earnings,” you say. “Active money is the lead then.” 

If it is, that’s a victory. It’s an anecdotal observation rather than hard statistical fact, but my experience with the data suggests less than 20% of public companies have Active money leading as price-setter on earnings days. 

I’m reminded of a classic example. One of our clients had screaming Sentiment – 10/10 on our index, slamming into the ceiling – and 68% short volume ahead of results. We warned that without the proverbial walk-off grand slam, nothing would stop a drop. 

Active money led, setting a new Rational Price, our measure of fair value, though shares closed down. In proceeding days the stock lost 8%. It wasn’t the story. It was the sector. Tech tanked. And shorting. And Sentiment.

Which leads us back to the carefully crafted earnings call. We’ve got a variety of clients with Activist investors, and I’ll give you two sharply contrasting outcomes that illustrate the importance of the answer to both your COO’s and CEO’s questions. 

One has been slashing and burning expenses (it’s what you do when somebody horns in with money and personality).  Still, heading into the call shorting was 69% and investors were wary. The company has a history of sharp pullbacks on results.

The only bull bets were from machines that leveraged hard into shares. No thought, just a calculated outcome.

Did you see the Wall Street Journal article yesterday on a massive VIX bet?  Some anonymous trader has wagered about $265 million that the VIX will be over 25 in October.  The trader could win big or lose big.

It’s the same thing. Traders, both humans and machines, bet on volatility, exacerbated by results.  Fast Traders wagered our client would jump about 8% (we could forecast it).  They were right. The buying that drove initial response came from quantitative money. Machines read the data and bought, and shorting dropped 20% in a day.

Rational investors have since been profit-takers.  Price moved so much on bets that buy-and-hold money turned seller.

In the other instance, price fell 15%. Risk Management was 15% of market capitalization ahead of the call because Activism tends to boost the value of the future – reflected in derivatives. But Activists have short attention spans. If you’re two quarters in without any meaningful catalyst, you’re asking for trouble.

Well, that was apparent in the data. They were 60% short every day for 50 days ahead of results, the equivalent of a tapping foot and a rolling eye. If you don’t give that audience a catalyst they’re going to take their futures and forwards and go home. 

Results missed and management guided down, and ALL of that 15% came out of market cap. Investors didn’t sell? No. How does it help long money to sell and slaughter price? They’d wreck months or years of commitment in a minute.

But the future was marked to zero because event-driven money dropped its rights to shares. And 15% of market cap held that way vanished.

The degree of uncertainty in all prices, not just ones at earnings season, are increasing because machines are betting on volatility, long and short, price-spreads.

It’s not rational. It’s gambling. Moral of the story? Prepare well, yes.  But prepare proportionally.  Keep it simple. A minority of the money listens now and cannot overcome the power of arbitrage (we need a better market. Another story.).

You might recoil at the idea. But if the market has changed, shouldn’t we too? Correlate outcomes to effort. Learn market structure. Measure the money. Set expectations. Prepare. But prepare wisely. Efficiently. Don’t confuse busy with productive.  

For your COO, the answer is yes, we’ll get that question, and for your CEO, the answer probably has no bearing on how shares will behave. Keep the answer short. (And yes, we can forecast how shares will behave and what will set price. Ask us.)