Tagged: ETFs


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.


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.


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).


What did you say yesterday to your executive team, investor-relations officers, if you’d sent a note Monday about mounting Coronavirus fears?

The market zoomed back, cutting losses in the S&P 500 to about 2% since Jan 17.  We said here in the Market Structure Map Jan 22 that data on market hedges that expired Jan 17 suggested stocks could be down about 2% over the proceeding week.

It’s been a week and stocks were down 2%. (If you want to know what the data say now, you’ll have to use our analytics.)

The point is, data behind prices and volume are more predictive than headlines.

NIRI, the professional association for IR, last year convened a Think Tank to examine the road ahead, and the group offered what it called The Disruption Opportunity.

If we’re to become trusted advisors to executive teams and boards, it won’t be through setting more meetings with stock-pickers but by the strategic application of data.

For instance, if Passive investment powering your stock has fallen 30% over the past 200 trading days, your executive team should know and should understand the ramifications. How will IR respond? What’s controllable? What consequences should we expect?

At a minimum, every week the executive team should be receiving regular communication from IR disruptors, a nugget, a key conclusion, about core trends driving shareholder value that may have nothing to do with fundamentals.

Take AAPL, which reported solid results yesterday after the market closed.  AAPL is the second most widely held stock in Exchange Traded Funds (there’s a nugget).  It’s over 20% of the value of the Tech sector, which in turn is nearly 24% of the S&P 500, in turn 83% of market-capitalization.

AAPL is a big engine (which for you cyclists is American rider Tejay van Garderen’s nickname).  And it always mean-reverts.

It may take time. But it’s as reliable as Rocky Mountain seasons – because the market is powered today by money that reverts to the mean. Over 85% of S&P 500 volume is something other than stock-picking.

AAPL has the widest mean-reversion gap in a half-decade now, with Passive investment down a third in the last week.  AAPL trades over 30 million shares daily, about $10 billion of stock. And 55% of that – 17 million shares, $5.5 billion of dollar volume – is on borrowed shares.

Those factors don’t mean AAPL is entering a mean-reversion cycle. But should the executive team and the board know these facts?  Well, it sure seems so, right?

And investors, would it behoove you to know too?

The Russell 1000 is 95% of market cap, the Russell 3000, over 99.9%.  That means we all own the same stocks.  You won’t beat the market by owning stocks someone else doesn’t.

How then will you win?  I’m coming to that.

IR pros, you’re the liaison to Wall Street.  You need to know how the market works, not just what your company does that differs from another. If your story is as good as somebody else’s but your stock lags, rather than rooting through the financials for reasons, look at the money driving your equity value.

Take CRM. Salesforce is a great company but underperformed its industry and the S&P 500 much of the past year – till all at once in the new year it surged.

There’s no news.  But behaviors show what caused it.  ETF demand mushroomed. CRM is in over 200 ETFs, and the S&P 500.  For a period, ETFs could get cheap CRM stock to exchange into expensive SPY shares, an arbitrage trade.  The pattern is stark.

Now that trade is done. CRM market structure signals no imminent swoon but Passive demand is down over 20% because there’s no profit in the CRM-for-ETFs swap now.

That fact is more germane to CRM’s forward price-performance than its financials.

This, IR pros, is your disruption opportunity in the c-suite. If you’re interested in seeing your market structure, ask and we’ll give you a free report.

Investors, your disruption opportunity isn’t in what you own but when you buy or sell it. Supply and demand rule that nexus, and we can measure it.   If you’d like to know about Market Structure EDGE, ask us.

Hummingbird Wings

I recall reading in high school that the military’s then new jet, the FA-18 Hornet, would fall out of the sky if not for computers.

Could be that’s exaggerated but the jet’s designers pushed the wings forward, creating the probability of continual minute turbulence events too frequent for human responses.  Why do that? Because it made the plane vastly nimbler in supersonic flight.

You just had to keep the computers on or the craft would go cartwheeling to earth.

As we wrap a remarkable year for stocks in a market too fast for humans and full of trading wings whipping fleeting instances of turbulence, we’re in a curious state where the machines are keeping us all airborne.

I don’t mean the market should be lower.  Valuations are stretched but not perverse. The economy is humming and the job market is great guns. And while the industrial sector might be spongy, the winds in the main blow fair on the fruited plain.

So why any unease about stocks, a sense the market is like an FA-18 Hornet, where you hope the computers keep going (ironic, right)?

It’s not just a feeling.  We at ModernIR as you longtime readers know are not touchy-feely about data. We’re quantitative analysts. No emotion, just math.  Data show continual tweaking of ailerons abounds.

You see it in fund flows. The WSJ wrote over the weekend that $135 billion has been pulled from US equities this year. Against overall appreciation, it’s not a big number. But the point is the market rose on outflows.

And corporate earnings peaked in real terms in 2014, according to data compiled by quantitative fund manager Julex Capital. We’ve got standouts crushing it, sure.  But if earnings drive stocks, there’s a disconnect.

I’m reading the new book on Jim Simons, the “man who solved the market,” says author and WSJ reporter Greg Zuckerman. Simons founded Renaissance Technologies, which by Zuckerman’s calculations (there’s no public data) has made more than $100 billion the past three decades investing in stocks. Nobody touches that track record.

It’s a riveting book, and well-written, and rich with mathematical anecdotes and funny reflections on Simons’s intellectually peripatetic life.

Renaissance is not a stock-picking investment firm. It’s a quant shop. Its guys and gals good at solving equations with no acumen at business or income statements proved better at investing than the rest.

It’s then no baseless alchemy to propose that math lies at the heart of the stock market.

And son of a gun.

There’s just one kind of money that increased the past year.  Exchange Traded Funds (ETFs). This currency substituting for stocks is $224 billion higher than a year ago and about a trillion dollars greater the past three years.  As we learned from Milton Friedman and currency markets, more money chasing the same goods lifts prices.

Stocks declined in 2018, yet ETF shares increased by $311 billion, more than this year.  In 2017, ETF shares increased by $471 billion.

Behind those numbers is a phantasmagorical melee of ETF creations and redemptions, the ailerons keeping the market’s flight level through the turbulent minutia flying by.

I’ve explained it numerous times, so apologies to those tiring of redundancy. But ETFs are substitutes for stocks.  Brokers take a pile of stocks and give it to Blackrock, which authorizes the brokers to create and sell to the public a bunch of ETF shares valued the same as the pile of stocks.

If you sell ETF shares, the reverse happens – a broker buys the ETF shares and gives them to Blackrock in trade for some stocks of equal value.

This differential equation of continuous and variable motion doesn’t count as fund-turnover. But it’s massive – $3.2 trillion through October this year and $10.7 trillion, or a third of the market’s total value, the past three years.

Why the heck are there trillions of ETF transactions not counted as fund flows? Because our fly-by-wire stock market is dependent on this continuous thrum for stable harmonics.

That’s the hummingbird wings, the Butterfly Effect, for stocks.

We can see it.  In July a seismic ripple in behavioral patterns said the market could tumble. It did. Dec 3-5, a temblor passed through the movement of money behind prices. The market faltered.

If the ETF hive goes silent, we’ll cartwheel.  It won’t be recession, earnings, fundamentals, tariffs, Trump tweets, blah blah.  It will be whatever causes the computers to shut off for a moment.  It’s an infinitesimal thing.  But it’s why we watch with machines every day.  And one day, like a volcano in New Zealand, it’ll be there in the data.

Jim Simons proved the math is the money. It’s unstable. And that’s why, investor-relations pros and investors, market structure matters.

Boxed Yellow Pencils

“How do you think about ESG?” said my friend Moriah Shilton at a San Francisco NIRI summit some weeks back with hedge fund Citadel.

Silence. The four panelists shifted around.  A couple whispered to each other. Finally, somebody offered with a throat-clearing cough, “It doesn’t factor into our portfolio decisions.”

For those not fluent in Investor Relations (IR) Speak, ESG is “Environmental, Social, Governance.”  NIRI is the National Investor Relations Institute, professional association for the liaison between public companies and Wall Street.

ESG dominates the contemporary IR educational platform. NIRI has made a policy statement on ESG. There are at least two ESG sessions here at the NIRI Senior Round Table meeting (and NIRI national board meeting) this week in Santa Barbara.

The ESG heat isn’t coming from stock-picking investors, the “long-only” audience of public companies spending billions annually on communication through compliance-driven reports like 10Ks, 10Qs, press releases and proxies and via proactive outreach aimed at increasing share-ownership.

Nor is it, apparently, coming from hedge funds like Citadel, the other key audience – and I’d argue now the vital IR constituency because of its capacity to compete with the Great Passive Investment Wave – for public companies.

In fact, the Citadel team later said, “We vote with management on proxy matters, or we vote with our feet by selling shares.”

It’s passive money that’s obsessed with ESG. Passive investment to us is any form of capital allocation for a day or more (by contrast Fast Trading is an investment horizon of a day or less) driven by rules. That’s index investing, Exchange Traded Funds, or any variety of quantitative investment, from global macro to statistical arbitrage.

True, passives may oppose a proxy measure that doesn’t comport with an ESG platform. They will, however, continue owning the stock. Index funds pegged to a benchmark like the S&P 500 are required to own the securities comprising the benchmark.

It’s cognitively dissonant to own things you oppose.

But aren’t they trying to promote practices that make companies better stewards for stakeholders?

From my first exposure to it, good business has been sound financial management, the right people, products, markets, capital structure, the advancement of the best interests of your customers, employees, communities. These are essential strands of business DNA.

In fact, turning those into a checklist promotes the possibility that mediocre firms are treated the same as stellar ones by virtue of filling out a form.  Rules breed uniformity.

Nowhere is that more apparent than in the stock market, where rules push prices toward a mean. Track the midpoint – as Passive money does – and returns become superior by pegging the average.

The investor-relations profession, the pursuit of excellence, Warren-Buffett-style investment strategies, are about unique differentiation.  What makes a company better, superior?

Rules-based investing makes things the same. Passive money has boomed because shares of companies are increasingly products defined by shared criteria, like ESG. The more of that there is, the greater the probability the market will become homogeneous.

Without dismissing its merits, I’m perplexed by why public companies and stock-picking investors would promote shared criteria like ESG (why not differentiate with ESG if you’re so moved?).  We don’t want the stock market to become a bunch of yellow pencils in a box.

I think a form of guilt has gripped the passive-investment colossus like what manifests among the Silicon Valley nouveau riche who ofttimes with minimal effort realize vast wealth, and then feel compelled to browbeat the rest about the “greater good.”

How one favors the greater good should be individually chosen, not directed by rules.

So from atop vast heaps of assets gained through doing nothing more than tracking a benchmark, Massive Passives are compelled to berate the market over purpose.

If that purpose is an ESG checklist, the purpose is a dictated set of rules.  The very thing passive investment promotes.  Ironic, right? By subtly suggesting moral superiority, passive investment advances its own self-interest: rules-based investing.

Rather than mindlessly embracing ESG as good for all, a sentient species capable of staggering creativity and achievement through the individual pursuit of happiness that inures to the benefit of the masses owes itself moments of objective reflection.

And the question to ponder is whether a uniform ESG blanket tossed over the capital markets furthers the pursuit of the excellence the IR profession and stock-pickers seek.

The Fortress

Happy birthday to Karen Quast! My beloved treasure, the delight of my soul, turns an elegant calendar page today. It’s my greatest privilege to share life with her.

Not only because she tolerates my market-structure screeds.

Speaking of which, I’m discussing market structure today at noon ET with Joe Saluzzi of Themis Trading and Mett Kinak from T Rowe Price. In an hour you’ll mint a goldmine of knowledge.  Don’t miss it.

A citadel by definition is a fortress.  I think of the one in Salzburg, Austria, the Hohensalzburg castle perched on the Salzach, “Salt River” in German, for when salt mined in Austria moved by barge.  We rode bikes there and loved the citadel.

It’s a good name for a hedge fund, is Citadel. We were in San Francisco last week and joined investor-relations colleagues for candid interaction with Citadel. IR pros, hedge funds are stock-picking investors capable of competing in today’s market.

Blasphemy?  Alchemy?  I’ve gone daft?

No, it’s market structure. Exchange Traded Funds (ETFs) have proliferated at the expense of what we call in the IR profession “long-only” investors, conventional Active managers buying stocks but not shorting them.

Since 2007 when Regulation National Market System transformed the stock market into a sea of changing stock-prices around averages, assets have fled Active funds for Passive ones.  ETF assets since 2009 have quadrupled, an unmatched modern asset-class boom.

Underperformance has fueled the flight from the core IR audience of “long-onlys.” Returns minus management fees for pricey stock-pickers trails tracking a benchmark. So funds like SPY, the ETF mirroring the S&P 500 from State Street, win assets.

Why would a mindless model beat smart stock-pickers versed in financial results? As we’ve written, famous long-only manager Ron Baron said if you back out 15 stocks from the 2,500 he’s owned since the early 80s, his returns are pedestrian. Average.

That’s 1%. Smart stock-pickers can still win by finding them.

But. Why are 99% of stocks average? Data show no such uniformity in financial results. We come to why IR must embrace hedge funds in the 21st century.

Long-onlys are “40 Act” pooled investments with custodial assets spent on a thesis meant to beat the market.  Most of these funds must be fully invested. That is, 90% of the money raised from shareholders must be spent.  To buy, they most times must first sell.

Well, these funds have seen TRILLIONS OF DOLLARS the past decade leave for ETFs and indexes (and bonds, and target-date mixed funds). Most are net sellers, not buyers.

Let’s not blindly chase competitively disadvantaged and vanishing assets. That confuses busy with productive. And “action” isn’t getting more of the shrinking stock-picking pie.

First, understand WHY ETFs are winning:

  • ETFs don’t hold custodial assets for shareholders. No customer accounts, no costs associated with caring for customers like stock-pickers support.
  • They don’t pay commissions on trades. ETFs are created and redeemed in large off-market blocks (averaging $26 million a pop, as we explained).
  • They don’t pay taxes.  ETFs are created and redeemed tax-free through in-kind exchanges.
  • ETFs avoid the volatility characterizing the stock market, which averages about 3% daily in the Russell 3000, by creating and redeeming ETFs off-market.
  • And fifth, to me the biggest, stock-market rules force trades toward average prices. All stocks must trade between the best bid to buy and offer to sell. The average.

So.  Stocks are moved by rule toward their average prices. Some few buck it.  Stock-pickers must find that 1%. Money tracking benchmarks picks the 99% that are average. Who’s got the probability advantage?

Now add in the other four factors. Who wins?  ETFs. Boom! Drop the mic.

Except dropping the mic defies market rules prohibiting discrimination against any constituency – such as stock-pickers and issuers.

SEC, are you listening? Unless you want all stocks to become ETF collateral, and all prices to reflect short-term flipping, and all money to own substitutes for stocks, you should stop. What. You. Are. Doing.

Back to Citadel. The Fortress. They admit they’re market neutral – 50% long and short. They use leverage, yes. Real economic reach isn’t $32 billion. It’s $90 billion.

But they’re stock-pickers, with better genes. Every analyst is covering 25-55 stocks, each modeled meticulously by smart people. Whether long or short they meter every business in the portfolio. Even analysts have buy-sell authority (don’t poo-poo the analysts!). And they’re nimble. Dry powder. Agile in shifting market sand.

They can compete with the superiority modern market structure unfairly affords ETFs.

So. Understand market structure. Build relationships with hedge funds. This is the future for our profession. It’s not long-onlys, folks. They’re bleeding on the wall of the fortress. And don’t miss today’s panel.

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.

Wholesale Profits

CNBC’s Brian Sullivan invited me to discuss shrinking market liquidity last Friday. Riveting, huh!

Well, it is to me! Unraveling the mystery of the market has turned out to be a breathtaking quest. I had another aha! moment this weekend.

Jane Street, a big Exchange Traded Funds (ETF) Authorized Participant, commissioned a study by Risk.net on ETF liquidity.  As a reminder, APs, as they’re called, are essential to the ETF supply chain.  They’re independent contractors hired by ETF sponsors such as State Street to create and redeem ETF shares in exchange for collateral like stocks and cash.

Without them, ETFs can’t function. In fact, they’re the reason why ETFs have been blanket-exempted from the Investment Company Act of 1940 under SEC Rule 6c-11, recently approved.

Exempted from what? The law that all pooled investments be redeemable for a portion of the underlying assets. There is no underlying pool of assets for ETFs, as we’ve explained before.

If you’re thinking, “Oh, for Pete’s sake, Quast, can you move on?” stay with me. If we don’t understand how ETFs are affecting equities and what risks they present, it’s our own darned fault.  So, let’s learn together.

As I was saying, ETFs don’t pool assets. Instead, firms like Jane Street gather up baskets of stocks and trade them straight across at a set price to ETF sponsors, which in turn “authorize” APs, thus the term, to create an equal value of ETF shares wholesale in large blocks and sell them retail in small trades.

I explained to Brian Sullivan how the math of the stock market shows a collapse in stock-liquidity. That is, the amount of stock one can buy before the price changes is down to about 135 shares (per trade) in the S&P 500. Nearly half of trades are less than 100 shares.

Block trades have vanished. The Nasdaq’s data show blocks are about 0.06% of all trades – less than a tenth of a percent. Blocks are defined as trades of $200,000 in value and up. And with lots of high-priced stocks, a block isn’t what it was. For BRK.A, it’s 1.5 shares.  In AMZN, around 130 shares.

Yet somehow, trade-sizes in the ETF wholesale market have become gigantic. Risk.net says 52% of trades are $26 million or more.  A quarter of all ETF trades are over $100 million. Four percent are over $1 billion!

And almost $3 TRILLION of ETF shares have been created and redeemed so far in 2019.

Guess what the #1 ETF liquidity criterion is?  According to the Risk.net study, 31% of respondents said liquidity in the underlying stocks. Another 25% said the bid-offer ETF spread.

Well, if stock liquidity is in free-fall, how can ETF liquidity dependent on underlying stocks be so awesome that investors are doing billion-dollar trades with ETF APs?

We’re led to believe APs are going around buying up a billion dollars of stock in the market and turning around and trading it (tax-free, commission-free) to ETF sponsors.

For that to be true, it’s got to profitable to buy all the products retail and sell them wholesale. So to speak. My dad joked that the reason cattle-ranching was a lousy business is because you buy your services retail and sell the products wholesale.

Yet the biggest, booming business in the equity markets globally is ETFs.

We recently studied a stock repurchase program for a small-cap Tech-sector company.  It trades about 300,000 shares a day. When the buyback was consuming about 30,000 shares daily, behaviors heaved violently and Fast Traders front-ran the trades, creating inflation and deflation.

That’s less than a million dollars of stock per day.  And it was too much. Cutting the buyback down to about 10,000 shares ended the front-running.

I don’t believe billions in stocks can be gobbled up daily by ETF APs without disrupting prices. Indeed, starting in September we observed a spiking breakdown in the cohesion of ETF prices and underlying stock-prices and a surge in spreads (not at the tick level but over five-day periods).

But let’s say it’s possible. Or that big passive investors are trading stocks for ETF shares, back and forth, to profit on divergence. In either case it means a great deal of the market’s volume is about capturing the spreads between ETFs and underlying stocks – exactly the complaint we’ve made to the SEC.

Because that’s not investment.

And it’s driving stock-pickers out of business (WSJ subscription required) with its insurmountable competitive lead over long-term risk-taking on growth enterprises, which once was the heart of the market.

The alternative is worse, which is that ETF APs are borrowing stock or substituting cash and equivalents. We could examine the 13Fs for APs, if we knew who they were. A look at Jane Street’s shows its biggest positions are puts and calls.  Are they hedging? Or substituting derivatives for stocks?

Public companies and Active investors deserve answers to these questions. Market regulation prohibits discriminating against us – and this feels a lot like discrimination.

Meanwhile, your best defense is a good offense:  Market Structure Analytics. We have them. Ask us to see yours.  We see everything, including massive ETF create/redeem patterns.

Suppy Chain Trouble

If you go to the store for a shirt and they don’t have your size, you wait for the supply chain to find it.  There isn’t one to buy. Ever thought about that for stocks?

I just looked up a client’s trade data. It says the bid size is 2, the ask, 3.  That means there are buyers for 200 shares and sellers of 300.  Yet the average trade-size the past 20 days for this stock, with about $27 million of daily volume, is 96 shares.  Not enough to make a minimum round-lot quote.

That means, by the way, that the average trade doesn’t even show up in the quote data. Alex Osipovich at the Wall Street Journal wrote yesterday (subscription required) that the market is full of tiny trades. Indeed, nearly half are less than 100 shares (I raised a liquidity alarm with Marketwatch this past Monday).

Back to our sample stock, if it’s priced around $50, there are buyers for $10,000, sellers of $15,000. But it trades in 96-share increments so the buyer will fill less than half the order before the price changes. In fact, the average trade-size in dollars is $4,640.

The beginning economic principle is supply and demand. Prices should lie at their nexus. There’s an expectation in the stock market of endless supply – always a t-shirt on the rack.

Well, what if there’s not? What if shares for trades stop showing up at the bid and ask?  And what might cause that problem?

To the first question, it’s already happening. Regulations require brokers transacting in shares to post a minimum hundred-share bid to buy and offer to sell (or ask). Before Mr. Osipovich wrote on tiny trades, I’d sent data around internally from the SEC’s Midas system showing 48% of all trades were odd lots – less than 100 shares.

Do you see? Half the trades in the market can’t match the minimum. Trade-size has gone down, down, down as the market capitalization of stocks has gone up, up, up.  That’s a glaring supply-chain signal that prices of stocks are at risk during turbulence.

Let’s define “liquidity.”

I say it’s the amount of something you can buy before the price changes. Softbank is swallowing its previous $47 billion valuation on WeWork and taking the company over for $10 billion. That’s a single trade. One price. Bad, but stable.

The stock market is $30 trillion of capitalization and trades in 135-share increments across the S&P 500, or about $16,500 per trade.  Blackrock manages over $6.8 trillion of assets. Vanguard, $5.3 trillion. State Street. $2.5 trillion.

Relationship among those data?  Massive assets. Moving in miniscule snippets.

Getting to why trade-size keeps shriveling, the simple answer is prices are changing faster than ever.  Unstable prices are volatility.  That’s the definition.

I’ll tell you what I think is happening: Exchange Traded Funds (ETFs) are turning stocks from investments to collateral, which moves off-market. As a result, a growing percentage of stock-trades are aimed at setting different prices in stocks and ETFs. That combination is leading to a supply-chain shortage of stocks, and tiny stock-trades.

ETFs are substitutes dependent on stocks for prices. The ETF complex has mushroomed – dominated by the three investment managers I just mentioned (but everyone is in the ETF business now, it seems) – because shares are created in large blocks with stable prices. Like a WeWork deal.

A typical ETF creation unit is 50,000 shares.  Stocks or cash of the same value is exchanged in-kind. Off-market, one price.

The ETF shares are then shredded into the stock market amidst the mass pandemonium of Brownian Motion (random movement) afflicting the stocks of public companies, which across the whole market move nearly 3% from high to low every day, on average.

Because there are nearly 900 ETFs, reliant on the largest stocks for tracking, ever-rising amounts of stock-trading tie back to ETF spreads. That is, are stocks above or below ETF prices? Go long or short accordingly.

Through August 2019, ETF creations and redemptions in US stocks total $2.6 trillion.  From Jan 2017-Aug 2019, $10.1 trillion of ETF shares were created and redeemed.

ETFs are priced via an “arbitrage mechanism” derived from prices in underlying stocks. Machines are chopping trades into minute pieces because the smaller the trade, the lower the value at risk for the arbitragers trading ETFs versus stocks.

ETFs are the dominant investment vehicle now. Arbitrage is the dominant trading activity. What if we’re running out of ETF collateral – stocks?

It would explain much: shrinking trade-sizes because there is no supply to be had. Rising shorting as share-borrowing is needed to create supply. Price-instability because much of the trading is aimed at changing the prices of ETFs and underlying stocks.

Now, maybe it’s an aberration only. But we should consider whether the collateralization feature of ETFs is crippling the equity supply-chain. What if investors tried to leave both at the same time?

All public companies and investors should understand market liquidity – by stock, sector, industry, broad measure. We track and trend that data every. Data is the best defense in an uncertain time, because it’s preparation.