Tagged: ETFs

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

  

 

Gaffes and Spoofs

You all remember the Fat Finger?

It’s a gaffe, trading-style.  In one 2014 instance, if the record can be believed, somebody in Japan accidentally tried to buy $700 billion of stocks including more than half the total outstanding shares of Toyota.

The trades occurred outside hours and were cancelled but the embarrassment lingers.

Do you know of Harouna Traoré?  A French day trader learning the ropes, Mr. Traoré plunked down twenty thousand euros at online platform Valbury Capital and, thinking he was in simulation mode, began trading futures contracts.

Racking up a billion euros of exposure and about a million euros of losses before he realized his error, the horrified trader said, according to CNBC, “I could only think of my family.”  But the intrepid gaffer – so to speak – soldiered on, turning one billion and losses into five billion and profits of about twelve million euros.

I don’t know how it turned out but not well, it appears. The Chicago Mercantile Exchange sanctioned Mr. Traoré in June 2020 for exceeding credit thresholds, and banned him from trading for two years.

The Fat Finger has become reliably rare in US markets, thanks to security protocols.  It’s improbable we’ll again see a Knight Securities buy $4 billion of stock in 45 minutes and be forced to liquidate to Getco as happened in 2012 (Getco is now Virtu).

That’s the good news. The bad news is bizarre moves in equities such as we’ve seen in 2020 are therefore not due to gaffes.

But they could be spoofs, legal or otherwise.  JP Morgan yesterday agreed to a $920 million fine related to spoofing in futures contracts for metals and US Treasurys.  I can’t recall a larger trading fine.

Spoofing is the deliberate act of entering orders to trade securities and then cancelling them, creating, at least momentarily, the artificial appearance of supply or demand.  Dodd-Frank outlawed spoofing after tumult in the 2008 crisis, and regulations for commodities and stocks have subsequently articulated guidelines.

Investors and public companies alike don’t want fake liquidity in markets. As gaffes do, it’s what causes unexpected lurches in prices – but on purpose.

We can all sleep well, then?

Nope.

Turns out there is illegal spoofing, and legal spoofing.  The SEC’s Midas data platform shows trade-to-cancel ratios for stocks in various volume and market-cap tranches.  Generally, there are about 15 cancellations for every executed trade in stocks.

In Exchange Traded Funds (ETFs), the ratio explodes. The gaps or so severe between quartiles and deciles that an average is difficult to find. But the rate ranges from about 100 to nearly 2,000 cancellations for every completed trade.

Well, how is that not spoofing?

Answer: If you use order types it’s legal. It means – broad definitions here – that Fill or Kill (do it at once or don’t do it at all), Limit/Stop-Loss, All or None (no partial fills, the whole thing or nothing), Iceberg (just a little showing and more as the order fills) or Passive (sitting outside the best prices) orders are sanctioned by the government.

Tons are cancelled. Layer your trades with a machine instead, and it’s illegal.  Spoofing.

Wait a minute.

Order types through a broker are trades in the pipeline. Systems know they’re there. Risk-management protocols require it.  If the orders are at retail firms that sell their trades, then the high-speed buyer sees every layer before it reaches the market.

See the issue?

The market is stuffed with legal cancelled orders – that somebody else can see before the trades execute and who will therefore clearly know what the supply/demand balance is, and what gets cancelled.

I’m not sure which is worse, a fat finger, or this.  The one is just an accident.

Now, why should you care?  Because stocks are awash in compliant spoofs.  Regulators are trying to sort, one from the other, the same kind of activity, except one lets somebody else know ahead of time that it’s there. And that’s fine.  Sanctioned.

If you trade on inside information, data you obtained that others don’t know, in exchange for value, it’s illegal. Well, trades sold to high-speed firms are exactly that, if only for a fraction of a second.

If ETFs are peppered with cancellations at rates dwarfing trades, and money is piling into ETFs, would it be good for the public to know? And why mass cancellations?

Because ETFs are legally sanctioned arbitrage vehicles. That’s another story.

The good news is we track the behavior driving arbitrage.  Fast Trading.  We know when it’s waxing and waning. It imploded into today’s futures expirations – where much spoofing occurs, legally – and just as Market Sentiment turned dour.

I hope there are no gaffes.  Spoofs will abound.  Authorities will pat themselves on the back.  It’s a weird market.

***

By – Tim Quast, President and Founder, ModernIR

Big Blanket

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

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

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

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

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

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

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

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

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

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

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

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

Our regulators appear to be going the opposite direction.

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

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

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

None of that counts as fund-turnover.

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

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

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

So how is that fair?

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

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

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

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

Unknowable

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

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

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

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

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

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

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

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

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

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

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

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

Cough, cough.

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

Yet we are.

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

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

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

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

How about corporate spending on box seats at big arenas?

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

An empty edifice?

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

Should stocks trade where they did before these things?

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

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

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

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

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

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

What’s your bet?

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

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

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.

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.

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).