Tagged: Federal Reserve

Money Highway

Is Jay Powell the new Investor Relations Officer for all public companies? 

Before we answer, the tranquil image at right free of the Federal Reserve and all the travails of modern economics and politics (and investor relations) is Catamount Lake near Steamboat Springs.  I love this time of year, the way the mountains glow verdant and lakes lie full among the meadows.

Back to the Fed and IR, the gaping deficit in investor-relations today is an application of quantitative and behavioral analytics. We have them. You can use them.  They tell us just about everything one would want to know about the equity market.

For the hermitic amongst us, the Fed chair takes the mic today to end a two-day policy meeting. Some have asked about the impact of monetary policy on Market Structure Sentiment, our ten-point gauge for share supply and demand in your stock, peers, industry, sector, and the whole market, so we’ll address it briefly.

For those not reading the Fed’s balance sheet, you should know it’s $7.993 trillion currently, and includes commitments to buy mortgage-backed securities running north of $200 billion continuously (no wonder mortgage rates are low despite a dearth of homes), reverse repurchases are a record-shattering $720 billion, and excess reserves are nearing $4 trillion.

In 2007, excess reserves averaged $10 billion. It’s 400 times more now, money with no place to go save begging for 10-12 basis points of interest from the Fed, which gave it to banks to begin.

Yeah, weird, right?  Why would you create money and then pay interest on it? Because your models have convinced you this is “good for the economy.”

The Fed’s yearly calendar typically includes four meetings with policy statements in March, June, September and December. The Fed doesn’t convene in May or October and calls an abbreviated November conclave ahead of the US election cycle.

Central banks were considered lenders of last resort under the Thornton-Bagehot (badge-it) model from the UK. They took only good collateral for monetary support (limited by gold and silver) and charged high interest rates.  Central banks were not seen as the fiscal pantheon but a lifeline for only those capable of surviving.

Thus, economies washed out failure.  Economic crises throughout history always trace to the overextension of credit. They are normal parts of the tension between human fear and greed.

Today, central banks take bad collateral and offer low rates. They prevent failure. That truncates the market mechanisms wanting to remove excess capacity when credit is overextended. It obviates competition and promotes monopolism (then government decries business practices).

Failure transfers from economies to the public balance sheet (and citizens bemoan these bailouts that are only possible through the central bank). I’m sure it’ll all work out.  Cough, cough.

Market Structure Sentiment is a constant meter of human fear and greed, through stock-picking, macroeconomic musings, quantitative models and speculation.  We don’t need to make monetary policy a separate input. The behavior of money already tells us what people think.

Money is the drug. The Fed is the dealer. 

Broad Market Sentiment told us in April the monetary party was over. That’s when money stopped flooding to equities and Broad Market Sentiment stopped rising toward 7.0 and stalled near 6.0.  Broad Market Sentiment is falling at an accelerating rate now.

We like to track daily behavioral change in the S&P 500.  Most times it runs from basis points to a few percentages. June 14, with Sentiment accelerating down, behavioral change mushroomed to 14%.

Not good.

We’re all on the Money Highway, public companies. You can have the best strategy for driving 55 (Sammy Hagar notwithstanding! Musical humor for you oldsters like me.). But if the Fed governs the freeway to 30mph, you’ll be stuck in the traffic, no way out.

And you should be measuring the behavior of money because it will tell you what everyone is doing. It’ll tell you what your stock pickers think. It’ll tell you if Passive money is coming or going. If you’re in deals, it’ll tell you if that deal gets done or gets competition.

So, is the Money Highway crumbling? The dollar is rising despite the Fed’s best efforts.  It gets hoarded into assets, and then prices stop rising. I don’t know if we’re about to tip over. I do know that every market correction in the modern era has been preceded by the same data we see now.

I wish we could all get off the Money Highway and take the backroads.

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.

Deal Art

The Federal Reserve’s balance sheet is 185 times leveraged, and DoorDash’s market cap is $50 billion.  I’m sure it’ll all work out.

Image courtesy Amazon and Showtime.

In some ways the Fed is easier to understand than DoorDash. It’s got $7.2 trillion of liabilities and $39 billion of capital.  Who needs capital when you can create money? The Fed is the intermediary between our insatiable consumption and the finite time we all offer in trade for money.

Speaking of money, DoorDash raised over $2.4 billion of private equity before becoming (NYSE:DASH).  For grins, recall that INTC’s 1971 IPO raised $6.8 million.  Thanks to the Fed’s approach to money, it would be worth at least seven times more today.

Really, it says the 1971 dollar is about $0.14 now.  I suspect it’s less still, because humans find ingenious ways to offset the hourglass erosion of buying power running out like sand.  (And INTC’s split-adjusted IPO price would be $0.02 per share rather than the $23.50 at which they then were offered.)

I’m delighted for those Palo Alto entrepreneurs at DASH who early on both wrote the code and delivered the food. And the movie Layer Cake declared that the art of the deal is being a good middleman.  DASH is a whale of a fine intermediary.

As is Airbnb.  The rental impresario is worth $75 billion. Not bad for sitting in the middle.  ABNB is already in six Exchange Traded Funds despite debuting publicly just Dec 10.

Funny, both these intermediary plays are most heavily traded by…intermediaries.  Both in early trading show 70% of volume from Fast Traders, machines intermediating market prices.  More than 50% of daily volume in each thus far is borrowed too.  That is, it’s not owned, but loaned.

ABNB is trading over 22 million shares daily, over 330,000 daily trades, and 54% of volume is borrowed. DASH is averaging 110,000 trades, 9.4 million shares of volume.  And through yesterday, 57% of those shares, about 5.4 million daily, were a bit like the money the Fed creates – electronically borrowed from nowhere.

How? High-speed traders constructing the market’s digital trusses and girders daily like Legos get leeway as so-called market-makers to trade things that might not exist in the moment, if the moment demands it for the sake of stability.

Do you follow?  When the Fed buys our mortgages, it manufactures money. It’s an accounting entry.  Trade banks $200 billion of electronic bucks residing in excess reserves for the mortgages the banks want to sell, which in turn become digital assets on the Fed’s balance sheet. The country didn’t raise that cash by borrowing or taxing.

Pretty cool huh?  Wish you could do that?  Don’t try. It’s fraud for the rest of us.

Anyway, traders can do the same thing, earning latitude to make liquidity from stock marked “borrowed,” so long as the books are squared in 35 days.

And here’s the kicker.  ETFs are intermediary vehicles too.  Man, this art of the deal thing – being a good middle…person – is everywhere.

ETFs take in assets like ABNB shares, and issue an equal value of, say, BUYZ, the Franklin Disruptive Opportunities ETF.  They manage the ABNB shares for themselves (tax-free too). And you buy BUYZ in your brokerage account instead.

Got that?  ETFs don’t manage any money for you. Unlike index funds.  They sell you a substitute, an intermediary vehicle, called ETFs.

Franklin used to be an Active manager. Key folks there told me a couple years ago that unremitting redemptions from active funds had forced them into the ETF business.

One of them told me, paraphrasing, it’s a lot easier running ETFs. We don’t have to keep customer accounts or pick stocks.

You need to understand the machinery of the markets, folks. And the Grand Unified Theory of Intermediation that’s everywhere in our financial markets nowadays.

It’s the art of the deal.  And reason not to expect rational things from the stock market.

If 70% of the volume in ABNB and DASH is resulting thus far from machines borrowing and trading it, and not wanting to own it, valuations reflect the art of the deal, intermediation. Not prospects (which may be great, but the market isn’t the barometer).

Same thing with ETFs.  The art of the deal is exchanging them for stocks.

The Fed? The more it buys, the more valuable debt becomes (and the less our money is worth). So that’s working too.  Cough, cough.

Here’s your lesson, investors and investor-relations folks. You cannot control these things. But ignore them at your peril (we always know the facts I shared about DASH and ABNB). All deals with intermediaries need three parties to be happy, not two.  And one always wants to leave.

Money for Nothing

How much does free money cost?

Everything, apparently.

The play Hamilton by Lin Manuel Miranda has grossed over $620 million, seventh all-time on Broadway but still a long way from Phantom of the Opera, Wicked, and Lion King, theater’s billion-dollar trio.

Hamilton is about Alexander, our first Treasury Secretary and the man behind the first bank of the United States, now the Federal Reserve Bank, which concludes its Open Market Committee meeting today.

Hamilton’s generous pen proliferates in the Federalist Papers, required reading for any serious defender of the republic.

In Federalist 78, Hamilton wrote that while it’s a republican axiom that the people may alter or abolish the Constitution if it’s inconsistent with their happiness, no momentary inclination laying hold of a majority of constituents justifies departure from it unless or until the people have by solemn act approved it.

My governor here in CO issued an order shutting down the economy, citing the emergency powers in Article IV Section 2 of the CO Constitution. I read it.  There are no emergency powers. It says the governor is the chief executive.

I sent a note to his chief of staff, Eve Lieberman, saying that not only had the governor construed meaning from the Constitution that it doesn’t contain, but that he also had overlooked Article II, which among other things says that all political power derives from the people, and that all persons have certain natural, essential and inalienable rights, among which may be reckoned the right of enjoying and defending their lives and liberties; of acquiring, possessing and protecting property; and of seeking and obtaining their safety and happiness.

If the governor suspends these by decree and uses the power of the police to enforce it, is he suspending the Constitution and imposing martial law?

I didn’t get an answer.

I’ve got a point about markets, the Fed and this country post-Pandemic. Stay with me.  You may disagree, but I’ll say it anyway.

People with political power and the best intentions reasoned that we could not have sick and dying people. Maybe that’s the ultimate ideal. It’s not in the US Constitution or any of the 50 state Constitutions.

It should not evade the collective conscience of this free people that the rule of law was suspended.  What should we do next time?  The political power, if not the will, is ours.

Let’s get to The Fed. The only reason we could realize the high self-actualized ideal of switching off the economy was because of the promise of free money.  If the Fed couldn’t write the checks, the economy couldn’t shut down.  Period.

I’ve told this story before: When we visited her hometown of Lake Jackson, TX for a school reunion, the fathers of two of Karen’s high-school classmates related vignettes to me about their grandfathers from the 19th century.

The grandfathers were about 12 years old each when their sharecropper parents told them, “We can’t afford you.  Here’s a lunch and our last silver dollar. Seek your fortune.”

Both went west. One become a big West Texas rancher, the other a wealthy Galveston mercantilist. Both sent their kids to school, and they in turn sent theirs to college.

And those kids were these fathers, now in their 70s, both college-educated, wealthy retired Dow Chemical executives.

The Fed’s balance sheet is now $6.6 trillion, laden with government debt, private mortgages, and soon high-yield-debt-backed Exchange Traded Funds, even facilities buying municipal debts, underwriting direct-lending to businesses and consumers.

The cost of free money is bigger than you think.  It’s the lost spirit of a 12-year-old on his own.  It’s liberty and the rule of law.

And free money is worth less than you suppose. My grandparents and parents never had mortgages or car payments and they concluded life with wealth as blue-collar farmers and ranchers. My grandfather bought his first house for $500.  Built his next on two acres for $5,500, sold that one in 1980 for $55,000.

I bought my first house for $370,000.  Sold that first house for $800,000.

Inflation. If we keep creating money to solve problems, it buys less and less, so you need more and more until there isn’t enough to retire on and we need unemployment of 3% instead of 10-12% just to keep it all going. And checks from the Fed for any crisis.

We are bleeding ourselves dry, ostensibly for our financial health, just like doctors once bled patients to make them well.

The stock market will buy free money – until suddenly it doesn’t. Japan stopped believing (despite rock band Journey’s anthemic counterargument).  The stock market there, the Nikkei, was nearly twice as high in 1990 than it is now.

It takes almost unimaginable character today to hand somebody a lunch and a dollar and say you’re on your own.  Yet it’s the strait and narrow way to wealth.

It’s never too late to change what we’re doing.  Can we give up free money and become rich again?

Nothing

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

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

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

Nothing.

I’ll explain.

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

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

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

And do they even matter?

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

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

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

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

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

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

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

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

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

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

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

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

Viral Market

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

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

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

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

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

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

The Fed cut rates yesterday instead.

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

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

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

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

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

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

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

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

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

Time and Sentiment

Time matters.

We’ve gone 42 trading days with the ten-point Market Structure Sentiment index, our proprietary measure of the propensity of algorithms to lift or lower prices, over 5.0. That’s a growth-at-a-reasonable-price (GARP) market since Oct 17.

It’s by no means the longest. More on that in a moment.

The market seems impervious to fault lines as we move into year-ending options-expirations tomorrow through Friday, and index rebalances, and portfolio window-dressing.

It’s nothing like either 2010, the Year of the Flash Crash, or 2012, the Year of the Glitch. I wrote an editorial for IR Magazine on those, a retrospective ahead of 2020 on the last decade of market structure.

The market’s capacity to relentlessly rise through a corporate earnings recession (we’ve had three quarters of falling comparative profits), trade disputes, Presidential impeachment, on it goes, shows how both the IR profession and investors need different data in the arsenal to understand how stocks are valued.

Two other terrific IR Magazine pieces highlight the value of data to IR. We’re not alone! Reporter Tim Human describes how AI Alpha Labs uses deep-learning to help investors understand how to achieve better returns – something IR must know.

Oliver Schutzmann of Iridium Advisors says future IR will be data science – because that’s how the market works.

Speaking of data, ours for the S&P 500 show Active money the past year was the lead buying behavior 7% of the time. The worst day was Dec 19, 2018, with just one company earning what we call a new “Rational Price” from Active Investment. The best day came a month later on Jan 18, 2019, when 26% of the index had new Rational Prices.

Add selling, and Active money leads the S&P 500 behaviorally about 14% of the time.

Back to Sentiment, over the 42 days where the market has gone up, up, up on positive Sentiment, Active money led buying just 6% of the time. Exchange Traded Funds have led, our data indicate, 67% of the time, directly or indirectly.

Data points like these are requisites of the IR job the next decade. And measuring changing behavioral trends will be essential to understanding stock prices. Case in point, I saw a client’s data yesterday where Fast Traders, automated machines creating price-changes, were responsible for a 40% 2019 decline in equity value.

Machines don’t know what you do. But they can trigger negative and positive chains of events divergent from fundamentals.

In this case, trading machines blistered shares on consecutive earnings reports, which in turn pushed Passive money to leave because volatility created tracking errors, which caused market cap to fall out of the Russell 1000 – which is 95% of market value today.

Active money was incapable of overcoming the overwhelming force of Passive behavior.

Back to Sentiment and Time, before the market tipped over in the fourth quarter of 2018 Sentiment stayed around 5.0 or higher for 66 days. When it finally dipped below 4.0, a Sentiment bottom, the market was cast into tumult.

Part of the trouble was delayed portfolio rebalances. When markets go up, investors put off aligning positions to models. When the turn comes, there’s a scramble that compounds the consequence.

We’re hitting one of those crucial points this week, delayed rebalances colliding with options-expirations, index-rebalances and year-end.

We may see nothing. After all, it’s only been 42 days. Sentiment went 45 days at 5.0 or better this spring on the great January rally. There were 42 positive days from June 11 to Aug 8, too.

My final thought in the final fresh blog for 2019 (we’ll do retrospectives to finish out the year) is a monetary one. Karen reminds me that monetary policy clears a room like a fart – so you can’t talk about it often.

But it’s another data point driving market behavior. As the Federal Reserve has turned accommodative again – that is, it’s shifted from shrinking its balance sheet and raising rates to expanding assets and lowering rates – we’ve seen a corresponding fall in shorting and derivatives-leverage in stock-trading.

In fact, a steep drop for shorting coincided with a sudden spike in what’s called the Fed Funds overnight rate. Remember that? Happened in September. The rate the Fed had set near 1.5% exploded to 10% as the market ran out of cash.

Ever since it’s been troubled, the Fed Funds market. The Fed keeps injecting tens of billions of dollars into it. That market is meant to provide banks with temporary liquidity to process payrolls, taxes, credit-card payments, transaction-settlements and so on.

What if ETFs are using cash to collateralize transactions (rather than actual stocks) at the same time rising consumer debt is beginning to weigh on bank receipts and liquidity?

If that’s at all the case, time matters. We’re not worried about it – just watchful. But with so vast a part of market volume tracing to ETFs, and Sentiment getting long in the tooth, we’re cautiously wary as this fantastic trading year ends.

Down Maiden Lane

For the Federal Reserve, 2018 was the end of the lane. For us, 2019 is fresh and new, and we’re hitting it running.

The market comes stumbling in (anybody remember Suzy Quatro?). The Dow Jones dropped 6% as it did in 2000. The index fell 7% in 2001 and 17% in 2002. The last year blue chips were red was 2015, down 2%.

Everybody wants to know as the new year begins what’s coming.  Why has the market been so volatile? Is a recession at hand? Is the bull market over?

We only know behavior – what’s behind prices. That’s market structure.

Take volatility. In Q4 2018, daily intraday volatility marketwide (average high-low spread) averaged 3.7%, a staggering 61% increase from Q3.  Cause? Exchange-Traded Funds. It’s not the economy, tariffs, China, geopolitics, or Trump.

Bold assertion?  Nope, math.  When an index mutual fund buys or sells stocks, it’s simple: The order goes to the market and gets filled or doesn’t.

ETFs do not buy or sell stocks. They move collateral manually back and forth wholesale to support an electronic retail market where everything, both ETF shares and stocks serving as collateral for them, prices in fractions of seconds. The motivation isn’t investment but profiting on the difference between manual prices and electronic ones.

When the market goes haywire, that process ruptures. Brokers lose collateral exchanged for ETF shares, so they trade desperately to recoup it. There were over $4.1 trillion of ETF wholesale transactions through Nov 2018.

The other $4.1 trillion that matters is the Fed’s balance sheet. If the bull market is over, it’ll be due to the money, not the economy. We have been saying for years that a reckoning looms, and its size is so vast that it’s hard to grasp the girth (rather like my midsection during the holidays).

On Dec 18, 2008, the Federal Reserve said its balance sheet had been “modified to include information related to Maiden Lane II LLC, a limited liability company formed to purchase residential mortgage-backed securities (RMBS) from…American International Group, Inc. (AIG).”

The biggest Fed bank sits between Liberty Street and Maiden Lane in New York. Maiden Lane made the Fed over the next six years owner of seas of failed debts.

Ten year later, on Dec 27, 2018, The Fed said its balance sheet had been “modified to reflect the removal of table 4 ‘Information on Principal Accounts of Maiden Lane LLC.’ The table has been removed because the remaining assets in the portfolio holdings of Maiden Lane LLC have been reduced to a de minimis balance.”

There were at least three Maiden Lane companies created by the Fed to absorb bad debts. At Dec 2018, what remains of these bailouts is too small to note.

Wow, right? Whew!

Not exactly. We used the colossal balance sheet of US taxpayers – every Federal Reserve Note in your wallet pledges your resources to cover government promises – to save us.  We were able to bail ourselves out using our own future money in the present.

We’ve been led to believe by everyone except Ron Paul that it’s all worked out, and now everything is awesome.  No inflation, no $5,000/oz gold.  Except that’s incorrect.  Inflation is not $5,000/oz gold.  It’s cheap money.  We’ve had inflation for ten straight years, and now inflation has stopped.

Picture a swing set on the elementary-school playground. Two chains, a sling seat, pumping legs (or a hand pushing from behind). Higher and higher you go, reaching the apex, and falling back.

Inflation is the strain, the pull, feet shoved forward reaching for the sky.  What follows is the stomach-lurching descent back down.

We were all dragged down Maiden Lane with Tim Geithner and Hank Paulson and Ben Bernanke. They gave that sling seat, the American economy, the biggest shove in human history. Then they left. Up we went, hair back, laughing, feet out, reaching for the sky.

Now we’re at the top of the arc.

The vastness of the economic swing is hard to comprehend. We spent ten years like expended cartridges in the longest firefight ever to get here. We won’t give it up in a single stomach-clenching free-fall.

But the reality is and has always been that when the long walk to the end of Maiden Lane was done, there would be a reckoning, a return to reality, to earth.

How ironic that the Fed’s balance sheet and the size of the ETF wholesale market are now roughly equal – about $4.1 trillion.

It’s never been more important for public companies and investors to understand market structure – behavior. Why? Because money trumps everything, and arbitraging the price-differences it creates dominates, and is measurable, and predictable.

The trick is juxtaposing continual gyrations with the expanse of Maiden Lane, now ended. I don’t know when this bull market ends. I do know where we are slung into the sling of the swing set.

It’s going to be an interesting year. We relish the chance to help you navigate it. And we hope the Fed never returns to Maiden Lane. Let the arc play out. We’ll be all right.

 

Bucking the Mighty

Federal Reserve Chairman Jerome Powell, keeper of the buck, speaks today. Should we care, investors and investor-relations folks?

There’s been less worshipfulness in the Powell Fed era than during the Yellen and Bernanke regimes. Out of sight, out of mind.  We tend in the absence of devotion to monetarists to forget that the mighty buck is the world’s only reserve currency.

Yet the buck remains the most predictive – besides ModernIR Market Structure Sentiment™ – signal for market-direction. So we have to know what it’s signaling.

When we say the dollar is the reserve currency, we mean it’s proportionate underpinning for other currencies. Effectively, collateral. The European Central Bank owns bucks and will sell them to weaken the dollar and strengthen the euro, and vice versa.

The USA alone holds no foreign currency reserves as ballast to balance out the buck. Instead, if the Fed wants to hike rates, dollars have to become a little rarer, harder to find.

The Federal Reserve as we noted when oil dove has been selling securities off its balance sheet.  It receives Federal Reserve Notes, bucks, in return, and that money comes out of circulation, and dollars nudge higher (forcing other central banks to sell dollars).

Combine what the Fed has sold and what banks are no longer leaving idle at the Fed as excess reserves (at the height $2.6 trillion but now below $1.8 trillion) and the supply of bucks has shrunk $1 trillion, and since banks can loan out about nine dollars for every one held in reserve, that’s a big decline out there – effectively, trillions.

So the dollar rises, and markets falter, and oil plunges.  We wrote about this back in January and said to watch for a rising dollar (even as others were predicting $100 oil).

Now why do stocks and oil react to relative dollar-value?  Because they are substitutes for each other.  As famous value investor Ron Baron says, investors trade depreciating assets called dollars for appreciating ones called stocks.

If the dollar becomes stronger, you trade fewer of them for stocks. Or oil. That means lower prices for both. Conversely, when interest rates are as low as a doormat, credit creates surging quantities of dollars, and the prices of substitutes like stocks and oil rise.

It raises a point I hope future economics textbooks will recognize: The definition of inflation should be “low interest rates,” not higher prices. Low rates surge the supply of dollars via credit, so even if prices don’t rise everywhere, inflation exists, which we find out when rates rise and prices of things used as substitutes for dollars fall.

Those people saying “see, there’s no inflation” do not understand inflation. By the way, Exchange Traded Funds have exactly the same condition, and risk. They are substitutes for stocks that expand and contract to equalize supply and demand.

Presuming Chairman Powell wants interest rates higher so we can lower them furiously – and wrongly – in the next crisis, we can expect more deflation for things that substitute for dollars.

It won’t be linear.  ModernIR Market Structure Sentiment™ signals a short-term bottom is near. There may be a rush to the upside for a bit. Credit will go to “strong sales expectations for the holiday season” when it’s likely market-makers for ETFs trading depreciated stocks for the right to create ETF shares.  Like the buck, the stocks come out of circulation – causing stocks to rise – which in turn boosts ETF shares tracking those prices.

The problem as with currencies is that we can’t get a good view of supply or demand when the medium of exchange – money, ETF shares – keeps expanding and contracting to balance out supply and demand.

The market loses its capacity to serve as an economic or valuation barometer, just as money loses its capacity to store value.

I’ve said before to picture a teeter-totter. One side is supply, the other, demand. When currencies have fixed value, we know which thing is out of balance. When the fulcrum moves, we have no idea.

That distortion exists in stocks via ETFs and economies via the mighty buck, which both must buck mightily to equalize supply and demand. Who thought it was a good idea to equalize supply and demand?  I hope Jerome Powell bucks the mighty.

Looking Back: Dec 2015

In New York City, it’s beginning to look a lot like Christmas around Rockefeller Center and it feels more like it here than in Denver where we hear yesterday it was 66 degrees (on Dec 12!).

In the weather forecast today is a probable Federal Reserve rate hike, followed by index-options expirations Thursday, quad-witching Friday along with quarterly index rebalances, and volatility expirations next Wednesday.

The market’s Teflon character the past year means we have to go back to Dec 2015 to recall risk. Remember when the Fed lifted rates for the first time since 2006?  We went to sea to avoid the fallout. Read on. -TQ

 

Dec 9, 2015: The Vacuum

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how they’re priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.