Tagged: Market Structure

Minnows

Softbank bet big on call-options and Technology stocks are sinking.

So goes the latest big story. Business-reporting wants a whale, a giant trade that went awry.  A cause for why Tech stocks just corrected (off 10%).

In reality the market today rarely works that way.  Rather than one big fish there are a thousand minnows, swimming schools occasionally bringing the market down.

We wrote about this last week, regarding short volume. You should read it. We highlighted a key risk right before the market fell.

The same things driving stocks up unassailably toward the heavens, which should first have gotten our attention, often return them to earth. But we humans see no flaws in rising stocks.

Back to Softbank. If you’ve not read the stories, we’ll summarize. CNBC, the Wall Street Journal and other sources have reported on unconfirmed speculation the big Japanese private equity firm bet the equivalent of $50 billion on higher prices for Tech stocks.

Maybe it’s true.  Softbank owned about $4 billion of Tech stocks in the last 13Fs for the quarter ended June 30 (the filings the SEC wants to make less useful, by the way).

Rumor is Softbank levered those holdings by buying call options, rights to own shares at below-market prices if they’re worth more than a threshold level later, on big Tech stocks like MSFT and AAPL.

Here’s where the story ends and market structure begins. The truth is the market neither requires a leviathan to destabilize it, nor turns on this colossus or that. It’s minnows.

It’s always thrumming and humming in the lines and cables and boxes of the data network called the stock market.  And everything is magnified.

A single trade for a single stock, coupled with an order to sell options or buy them, sets off a chain of events.  Machines send signals like radar – ping! – into the network to learn if someone might take the other side of this trade.

Simultaneously, lurking mechanical predators are listening for radar and hearing the pings hitting a stock – MSFT! Wait, there are trades hitting the options market.  Get over to both fast and raise the price!

Compound, compound, compound.

Prices rise.  Retail traders say to themselves, “Let’s buy tech stocks!  Wait, let’s buy options too!”

And the same lurking machines buy those trades from the pipelines of online brokerage firms, assessing the buy/sell imbalance. They rush to the options market to raise prices there too, because once the machines own the trades from retail investors, they are no longer customer orders.  And the machines calculate demand and run prices up.

And index futures contracts rise, and the options on those. Then index funds using options and futures to true up index-tracking lift demand for options and futures, magnifying their own upside.

Read prospectuses, folks. Most index funds can spend up to 10% of assets on substitutes for tracking purposes, and a giant futures contract expires the last trading day of each month that helps indexed money square its assets with the benchmark.

And then the arbitragers for Exchange Traded Funds drive up the prices of ETF shares to keep pace with rising stocks, options, futures.

And there are options on ETFs.

Every price move is magnified by machines.  Up and up and up go stocks and people wonder does the stock market reflect reality?

The thing about prices is you never know precisely when they hit a zenith, the top of the arc. The last pump of your childhood legs in the playground swing, and that fleeting weightlessness.

And then whoosh!  Down you come.

Did Softbank make money or lose it?  I don’t know and it makes no difference. What I just described is relentlessly occurring every fraction of every second in the stock and options markets and there comes a moment of harmonic convergence after long arcs up and down, up and down, like children on swing sets.

It’s a thousand cuts, not a sword. Schools of minnows, not a whale.  The problem isn’t Softbank. It’s a market that depends on the machine-driven electromagnification of every action and reaction.

The reason we know is we measure it. For public companies, and investors. You can wait for stories after the fact surmising sea monsters swam through. Or you can watch it on the screen and see all the minnows, as we do (read last week’s MSM).

What’s next? The same thing. Again.

The Little Short

In Michael Lewis’s The Big Short, a collection of eccentrics finds a flaw in real estate securities and shorts them.  The movie is great, the book even better.

Somebody will write a book about the 2020 stock market (anyone?) flaw.

The flaw? Depends who you ask. Writing for Barron’s, Ben Levisohn notes ZM is worth more in the market on $660 million of sales for the quarter than is IBM on $18 billion.

TSLA is up a thousand percent the last year, sales are up 3%. NVDA is trading at a hundred times quarterly revenue. AAPL is up 160% on 6% sales growth.

I know a lot about fundamental valuation after 25 years in investor relations. But 20 of those years were consumed with market structure, which our models show mechanically overwhelms fundamentals.

Why is market structure irrational?

Because most of the money in the market since Reg NMS isn’t rational. And still investor-relations professionals drag me to a whiteboard and sketch out how the performance of the stock – if it’s up – can be justified by prospects, or if it’s down is defying financials.

Market structure, rules governing how stocks trade, is agnostic about WHY stocks trade. The flaw is process has replaced purpose. Money inured to risk and reality can do anything. Just like government money from the Federal Reserve.

And yet that’s not what I’m talking about today.  The market is the Little Short.  Nobody is short stocks. I use the term “nobody” loosely.

Let me give you some history.

First, ignore short interest. It’s not a useful metric because it was created in 1975 before electronic markets, ETFs, Reg NMS, Fast Traders, exchange-traded derivatives, blah, blah. It’s like medieval costumes in Tom Cruise’s redux of Top Gun. It doesn’t fit.

After the financial crisis, rules for banks changed. The government figured out it could force banks to own its debt as “Tier 1 Capital,” and the Fed could drive down interest rates so they’d have to keep buying more.

Voila! Create a market for your own overspending. The Basel Accords do the same thing.

Anyway, so big banks stopped carrying equity inventories because they couldn’t do both.  Meanwhile the SEC gave market-makers exemptions from limitations on shorting.

Presto, Fast Traders started shorting to provide securities to the market. And that became the new “inventory.” Ten years later, short volume – borrowed stock – averages 45% of trading volume.

It was over 48% this spring.  And then it imploded in latter August, currently standing at 42.6%. The FAANGs, the giant stocks rocketing the major measures into the stratosphere, show even more short paucity at just 39%.

Realize that the market was trading $500 billion of stock before August, about 12 billion shares daily. So what’s the point? Short volume is inventory today, not mainly bets on declining stocks. It’s the supply that keeps demand from destabilizing prices, in effect. A drop from 48% to 43% is a 10% swoon, a cranial blow to inventory.

Higher short volume restrains prices because it increases the available supply. If demand slows, then excess supply weighs on prices, and stocks decline. We’ve been measuring this feature of market structure for a decade. It’s well over 80% correlated.

So the absence of inventory has the opposite impact on prices. They rise.  If the whole market lacks inventory, stocks soar. And the lowest inventory right now is in the FAANGs, which are leading the stampeding bulls.

Thinking about prices as rational things is wholly flawed. It’s not how the market works, from supply-chain, to routing, to quotes, prices, execution.

We thought temporal tumult in behaviors two weeks ago would derail this market. It didn’t. Or hasn’t yet. The big drop in shorting followed, suggesting those patterns included largescale short-covering by market-makers for ETFs.

When the market does finally reverse – and it will, and it’s going to be a freak show of a fall too, on market structure – low short volume will foster seismic volatility. Then shorting will explode, exacerbating the swoon as supply mushrooms and prices implode.

The good news is we can measure these data, and the behaviors responsible, and the impact on price. There’s no need to ever wonder if your stock, public companies, or your portfolio, traders, is about to step on a land mine.  We’re just waiting now to see how the Little Short plays out.

Mini Me

Minis abound.

You can trade fractions of shares.  Heck, the average trade-size is barely 100 shares, and 50% of trades are less than that.  Minis, as it were.

There are e-mini futures contracts on the S&P 500 index, and the newer micro e-mini futures product is the CME’s most successful, says the derivatives market operator.

Starting Aug 31 there will be micro options on e-mini futures for the S&P 500 and the Nasdaq 100. As of Aug 10, there are mini CBOE VIX volatility futures too, with a 10th of the face value of the conventional contract (expiring Aug 19).

One can spend less to have exposure to stocks and market-moves. The same notion animated a push toward decimalization before 2001 when it was implemented.

Decimals didn’t kill the stock market but they gutted analyst-coverage. Spreads – that is, the difference between the cost to buy and sell – funded research. In the 1990s there were on average 60 underwriters per IPO, and there were hundreds of those.

Today, there are five underwriters on average, the data show, and IPOs don’t keep pace with companies leaving markets through deals.  The Wilshire 5000, which in 1998 had 7,200 components, today has 2,495, factoring out micro-caps comprising just basis points of total market-capitalization.

Half the companies in the Wilshire 5000 have no analysts writing, while the top few hundred where trading supports it are festooned with quills – pens – like porcupines.

I think the inverse correlation between markets and the proliferation of minis bears some connection. It’s not the only thing, or perhaps even the biggest. But there’s a pattern.

And you should understand the market so you know what to expect from it. After all, who thought the March bear turn for stocks would be the shortest in history?

No one.  Including us.  Market structure, the way the ecosystem functions, explains it far better than fundamentals. But read to the end. We’ll say more.

Are the minis playing a role?

Look I’m not knocking fractional shares or tiny derivatives.  Rather, let’s think about the ramifications of growing layers separating trading from underlying assets.  Consider:

  • You can trade the stocks of the Nasdaq 100, the largest hundred at the exchange.
  • You can trade them in fractions without paying a commission.
  • You can trade the QQQ, the popular Exchange Traded Fund (ETF) that tracks the performance of the 100. ETFs as we’ve explained repeatedly are substitutes for stocks, not pooled interest in owning them.
  • You can trade e-mini futures contracts on the Nasdaq 100.
  • And now you can trade micro options on the e-mini Nasdaq 100 futures.
  • And you can trade options on the QQQ, and every component of the Nasdaq 100.
  • And you can trade the S&P 500 with exactly the same kinds of instruments, and SPY, the ETF.

It’s ingenious product-creation, and we’re not criticizing the innovators behind them.  It’s that I don’t think many people ask what effect the pursuit of mini increments of investment will have on market-behavior and prices, things that matter particularly to public companies depending on the market as a rational barometer.

And investors join public companies in caring how markets work.  Derivatives are becoming an ever-larger part of market volume. They’re layers of separation from underlying assets that become ends unto themselves, especially as increments shrink.

Why trade the stocks? Trade the rights on how they may behave – in tiny slices.

It disguises real supply and demand, which drives markets up relentlessly. Until that stops. Then markets collapse violently. These are chronic conditions in markets with too many derivatives.

Just saying.

Speaking of the market, it did as we wrote last week, with Market Structure Sentiment™ bottoming Aug 7, presaging gains a week out. Now options are expiring (including the VIX today), and Sentiment is topping, and behavioral volatility is massive, larger than we’ve measured at any point in the pandemic.

Maybe it’s nothing. Sometimes those data pass without a ripple. The FAANGs look good (low shorting, bottomed Sentiment). But we may be at the top of the Ferris Wheel after all those minis drove us this short, sharp way back up.

Dark Edges

The stock market’s glowing core can’t hide the dark edges – rather like this photo I snapped of the Yampa River in downtown Steamboat springs at twilight.

Speaking of which, summer tinkled its departure bell up high.  We saw the first yellowing aspen leaves last week, and the temperature before sunrise on the far side of Rabbit Ears Pass was 30 degrees, leaving a frosty sheen on the late-summer grass.

The last hour yesterday in stocks sent a chill too. Nothing shouts market structure like lost mojo in a snap.  I listened to pundits trying to figure out why.  Maybe a delay in stimulus.  Inflation. Blah blah.  I didn’t hear anyone blame Kamala Harris.

It’s not that we know everything.  Nobody does.  I do think our focus on the mechanics, the machinery, the rules, puts us closer to the engines running things than most observers.

And machines are running the market.  Machines shift from things that have risen to things that have fallen, taking care to choose chunks of both that have liquidity for movement. Then all the talking heads try to explain the moves in rational terms.

But it’s math. Ebbs and flows (Jim Simons, the man who solved the market at Renaissance Technologies, saw the market that way).

Passives have been out of Consumer Staples. Monday they rushed back and blue chips surged. The Nasdaq, laden with Tech, is struggling. It’s been up for a long time. Everybody is overweight and nobody has adjusted weightings in months. We can see it.

By the way, MSCI rebalances hit this week (tomorrow on the ModernIR Planning Calendar).

This is market structure. It’s morphed into a glowing core of central tendencies, such as 22% of all market capitalization now rests on FB, AAPL, AMZN, NFLX, GOOG, MSFT, AMD, TSLA and SHOP.

That’s the glowing core.  When they glow less, the dark edges grow.

Then there’s money.  Dough. Bucks. Specifically, the US dollar and its relationship to other global currencies. When the dollar falls, commodities surge. It’s tipped into the darkness the past month, marking one of its steepest modern dives.  Gold hit a record, silver surged, producer prices dependent on raw commodities exploded.

Then the dollar stopped diving. It’s up more than 1% in the last five days. And wham! Dark edges groped equities late yesterday. Gold plunged. Silver pirouetted off a 15% cliff.

August is traditionally when big currency-changes occur. Aug last year (massive move for the dollar versus the Chinese Renminbi Aug 5, 2019). Aug 2015. Aug 2018. Currencies rattle prices because currencies underpin, define, denominate, prices.

Back up to Feb 2020.  The dollar moved up sharply in late February, hitting the market Monday, Feb 24, as new options traded.  Pandemic!

Options expire next week.  The equivalent day is Aug 24, when new options will trade. Nobody knows when the dark edges will become cloying hands reaching for our investment returns or equity values.

In fact, Market Structure Sentiment™, our algorithm predictively metering the ebb and flow of different trading behaviors, peaked July 28 at 7.7 of 10.0, a strong read.  Strong reads create arcs but say roughly five trading days out, give or take, stocks fall.

They didn’t. Until yesterday anyway. They just arced.  The behavior giving equities lift since late July in patterns was Fast Trading, machines chasing relative prices in fractions of seconds – which are more than 53% of total volume.

Then Market Structure Sentiment bottomed Aug 7 at 5.3, which in turn suggests the dark edges will recede in something like five trading days.  Could be eight. Might be three.

Except we didn’t have dark edges until all at once at 3pm ET yesterday.

Maybe it lasts, maybe it doesn’t. But there’s a vital lesson for public companies and investors about the way the market works.  The shorter the timeframe of the money setting prices, the more statistically probable it becomes that the market suddenly and without warning dives into the dark.

It’s because prices for most stocks are predicated only on the most recent preceding prices.  Not some analyst’s expectation, not a multiple of future earnings, not hopes for an economic recovery in 2021.

Prices reflect preceding prices. If those stall, the whole market can dissolve into what traders call crumbling quotes.  The pandemic nature of short-term behavior hasn’t faded at the edges. It’s right there, looming.  We see it in patterns.

If something ripples here in August, it’ll be the dark edges, or the dollar. Not the 2021 economy.

Boxes and Lines

 

In the sense that high-speed transmission lines connecting computerized boxes are the stock market, it’s boxes and lines.

Also, stock exchange IEX, the investors exchange, hosts a podcast called Boxes and Lines that’s moderated by co-founder Ronan Ryan and John “JR” Ramsay, IEX’s chief market policy officer. I joined them for the most recent edition (about 30 mins of jocularity and market structure).

In case you forget, the stock market is not in New York City.  It’s in New Jersey housed in state-of-the-art colocation facilities at Mahwah, Carteret and Secaucus.  It’s bits and bytes, boxes and lines.

It’s superfast.

What’s not is the disclosure standard for institutional investors.  We wrote about the SEC’s sudden, bizarre move to exclude about 90% of them from disclosing holdings.

The current standard, which legitimizes the saying “good enough for government work,” is 45 days after the end of the quarter for everybody managing $100 million or more.

We filed our comment letter Monday.  It’ll post here at some point, where you can see all comments. You can read it here now.  Feel free to plagiarize any or all of it, investors and public companies. Issuers, read our final point about the Australian Standard of beneficial ownership-tracing, and include it with your comments.

Maybe if enough of us do it, the SEC will see its way toward this superior bar.

Without reading the letter or knowing the Australian Standard you can grasp a hyperbolic contradiction. The government’s job is to provide a transparent and fair playing field.  Yet the same SEC regulates the stock market located in New Jersey. Boxes and lines.

FB, AAPL, AMZN, NFLX, GOOG, GOOGL, MSFT, AMD, TSLA and SHOP alone trade over 2.5 MILLION times, over $80 billion worth of stock. Every day.

And the standard for measuring who owns the stock is 45 days past the end of each quarter.  A quarter has about 67 trading days, give or take.  Add another 30 trading days.  Do the math.  That’s 250 million trades, about $7.9 trillion of dollar-flow.  In 10 stocks.

Why should the market function at the speed of light while investors report shareholdings at the speed of smell? Slower, really.

Do we really need to know who owns stocks?  I noted last week here and in our SEC 13F Comment Letter both that online brokerage Robinhood reports what stocks its account holders own in realtime via API.

That’s a communication standard fitted to reality. True, it doesn’t tell us how many shares. But it’s a helluva better standard than 97 days later, four times a year.

Quast, you didn’t answer the question.  Why does anyone need to know who owns shares of which companies? Isn’t everybody entitled to an expectation of privacy?

It’s a public market we’re talking about.  The constituency deserving transparency most is the only other one in the market with large regulatory disclosure requirements: Public companies.

They have a fiduciary responsibility to their owners. The laws require billions of dollars of collective spending by public companies on financial performance and governance.

How incoherent would it be if regulations demand companies disgorge expensive data to unknown holders?

As to retail money, the Securities Act of 1933, the legislative basis for now decades of amendments and regulation, had its genesis in protecting Main Street from fraud and risk.  The principal weapon in that effort has long been transparency.

Now, the good news for both investors and public companies is that you can see what all the money is doing all the time, behaviorally. We’ve offered public companies that capability for 15 years at ModernIR.

Take TSLA, now the world’s most actively traded – we believe – individual stock. SPY trades more but it’s an ETF.  Active money has been selling it.  But shorting is down, Passive Investment is down 21% the past week.  TSLA won’t fall far if Passives stay put.

That’s market structure. It’s the most relevant measurement technique for modern markets. It turns boxes and lines into predictive behavioral signals.

And investors, you can use the same data at Market Structure EDGE to help you make better decisions.

Predictive analytics are superior to peering into the long past to see what people were doing eons ago in market-structure years. Still, that doesn’t mean the SEC should throw out ownership transparency.

Small investors and public companies are the least influential market constituents. Neither group is a lobbying powerhouse like Fast Traders.  That should warrant both higher priority – or at least fair treatment. Not empty boxes and wandering lines.

PS – Speaking of market structure, if you read last week’s edition of the Market Structure Map, we said Industrials would likely be down. They are. And Patterns say there’s more to come. In fact, the market signals coming modest weakness. The Big One is lurking again but it’s not at hand yet.

The Daytraders

 

A year ago, Karen and I were flying to Fiji, 24 hours of travel from Denver to LA, to Auckland, to Nadi.

We took a ferry out of Denarau Island into Nadi Bay and north toward the Mamanuca Islands, all the way past the castaway home for television’s Survivor Fiji to our South Pacific gem, Tokoriki.

It’s not that I wish now to be a world away.  We can ride bikes past this gem, Catamount Lake, any crisp Steamboat morning (while the fruited plain radiates, it’s 45 degrees most days at 630a in northern Colorado).

It’s the shocking difference a year makes. Everybody’s trading. Instead of going to Fiji or whatever.

Schwab and Ameritrade have a combined 26 million accounts. Fidelity has 13 million in its brokerage unit. E*Trade, over 5 million.  Robinhood, the newest, has 13 million users.

Public companies wonder what impact these traders have on stock prices.  The old guard, the professional investors, seem to be praying daily that retail daytraders fail.

In some sense, the Dave Portnoy era (if you don’t know Barstool Sports and Davey Daytrader – perhaps our generation’s most adroit marketer – you must be a hermetic) has pulled the veil off the industry. It appears the pros know less than they led us to believe.

The pros say just wait.  The wheels are going to come off the retail wagon in a cacophony of sproinging springs and snapping spokes.

Of course, as Hedgeye’s Keith McCullough notes, if the wagon splinters, we’re all in the smithereens because there’s just one stock market.

We wrote in our widely read June 10 post, Squid Ink, about what happens to the millions of online retail trades.  They’re sold to what we call Fast Traders, machines that trade everything, everywhere, at the same time and thus can see what to buy or sell, what to trade long or short.

How does this flow that Citadel Securities, the biggest buyer of retail trades, says is now about 25% of market volume, affect the stock market, public companies and investors?

Two vital points about market structure here.  First, market-makers like Citadel Securities enjoy an exemption from rules governing stock-shorting.  Second, Fast Traders run trading models that predict in fleeting spaces how prices will behave.

Put these two factors together and you have the reason why stocks like TSLA can double in two weeks without respect to business fundamentals – or even the limitations of share supply.

If three million accounts at Robinhood want fractional exposure to TSLA, the problem for Fast Traders to solve is merely price and supply.  If you go to the grocery store and they don’t have shishito peppers, you go home without shishitos.

If you’re a retail trader wanting TSLA, you will get TSLA, and the price will rise, whether any shares exist or not.  Fast Traders will simply manufacture them – the market-maker SEC exemption on shorting.

The market-maker will cover before the market closes in 99% of cases.  So the market-maker isn’t short the stock anymore.  But maybe TSLA will have 25% more shareholdings than shares outstanding permit.

Worse, it’s impossible to understand supply and demand. If market-makers could only sell existing shares – back to shishito peppers – TSLA would skyrocket to $5,000 and plunge to $500.  Frankly, so would much of the market.

Which is worse?  Fake shares or fake prices?  Ponder it.

And machines will continuously calculate the supply or demand of shares of a stock versus others, and versus the exchange-traded derivatives including puts, calls and index futures (oh, and now Exchange Traded Funds which like prestidigitated shares have no supply limitations), to determine whether to lift prices.

As we said in Squid Ink, we believe Fast Traders buying order flow from retail brokers can see the supply in the pipeline.

Combine these features. Fast Traders see supply and demand. They relentlessly calculate how prices are likely to rise or fall. They manufacture shares to smooth out imbalances under SEC market-making exemptions.

And the market becomes this mechanism.

Risks? We’ve declaimed them for years.  The market will show a relentless capacity to rise, until something goes wrong. And then there won’t be enough stock to sell to meet redemptions, and prices will collapse. We’ve had tastes of it.  There will be more.

But it’s not the fault of the daytraders.

Power of Two

We’re coming to the end of two Coronavirus quarters. What happens now?

In a word, July.  As to what July brings, it’s summer in the northern hemisphere, winter down under.

It’s also the end of a remarkable period in stocks. I don’t mean rising or falling, volatility, the invincible-Alexander-the-Great-Macedonian-phalanx of the stock market (your history tidbit…you can look it up).

By “end” we don’t mean demise.  Though a demise is probably coming. More on that later. We mean the end of epic patterns.

We wrote last week about index-rebalances delayed since December.  In patterns observable through ModernIR behavioral analytics, the effort to complete them stretched unremitting from May 28 to June 18.

Yes, June 19 was a muscular volume day with quad-witching and we saw BIG Exchange Traded Fund (ETF) price-setting that day in many stocks. (Note: ETFs are substitutes for stocks that are easily traded but entitle owners to no underlying assets save the ETF shares.)

But the patterns strapping May to June like a Livestrong bracelet (wait, are those out?) ended almost everywhere June 18.  The effort reflected work by about $30 trillion, adding up money marked to MSCI, FTSE Russell and S&P Dow Jones, to match underlying construction.

Funds moved before rebalances. And the biggest components, ETF data indicate – really, they dwarf everything else – are AAPL and MSFT. Patterns show money piled like a rugby scrum into AAPL call options in early June, and then plowed headlong into AAPL equity between June 12-18.

It’s good business if you can get it, knowing the stock will inevitably rise because of its mass exposure to indexes and how its price then when last money square-danced into an Allemande Left with indexers in December 2019 was about $280.

How many of you remember when AAPL was down to about 5% of the computing market, most of that in academia, and it looked like MSFT would steamroll it right out of business?  And then MSFT was yesterday’s news, washed up, a boomer in a Slack world.

Today both say, Ha! Suckers!

MSFT patterns are like AAPL’s but less leveraged, explaining the divergence in performance over the past year. AAPL is up 84%, MSFT about half that.  You can see here how both have performed versus the Tech-heavy QQQ (Nasdaq 100 from Invesco) and the SPY, State Street’s proxy for the S&P 500.

AAPL and MSFT have pulled the market along like Charles Atlas (and his doppelganger) towing a Pennsylvania railcar (more arcane and anachronistic history for you).

That ended, at least for now.  The Russell reconstitution continues through Friday but in patterns at this point it appears money has already changed mounts, shifted chairs.

The marvel is the magnitude of the effects of these events, and the power of two – AAPL and MSFT.

You’re thinking, “What about the rest of the FAANGs?”

MSFT isn’t one but we include it, and oftentimes now TSLA and AMD.  FB, AMZN, NFLX, GOOG – incisors dripping less saliva than AAPL – are massive, yes. But they don’t pack the ETF power of the two.

Let me give you some data. There are 500 Financials stocks, about 400 Healthcare, around 300 Consumer Discretionary.  Tech is around 200.  Most of these sectors are Oversold, and there’s a lot of shorting. The FAANGs are Overbought and more than 50% short, collectively.

The few outweigh the many.

And meanwhile, Market Structure Sentiment™ is both bottomed and lacking the maw it signaled. Either we skip across the chasm for now, or it trips us soon (stocks love to render fools of soothsayers).

The salient point is that the market can’t be trusted to reflect views on Covid19, or trade with China, or the election in November, or economic data, or actions of the Federal Reserve (curiously the Fed’s balance sheet is tightening at the moment). It’s right now defined by the power of two.

Two legs.

We humans stand fine on two. Can the market?  We’re about to find out.  And the degree to which your shares are at risk, public companies, to those two legs, and your portfolio, investors, is measurable and quantifiable. Ask us, and we’ll show you.

Seen and Unseen

The stock market is a story of the seen and the unseen.

Ethereal, hieratic, a walk by faith not by sight kind of thing?  No, not that.

And by the way, I’ve not forgotten about the rest of the story, as Paul Harvey (millennials, look him up) would say, the good developments for investors and public companies I mentioned some time back. I’ll come to it soon. This week there’s urgency.

A tug of war rages between bulls and bears. Some say stocks are wildly overpriced. There’s record bearishness on stocks in surveys of individual investors. Yet people are daytrading like it’s 1999.  And record stockpiles of cash like tumbleweeds on Kansas fences strain at the bounds, and the bulls say, “Just you wait and see when that money rolls into markets!”

All of this is seen stuff. Things we can observe.  As are promising clinical developments in steroids that might help severe coronavirus sufferers.  Rebounding retail sales. The Federal Reserve taking tickets at the market’s door.

None of those observable data points buy or sell stocks, though.  People and machines do.  In my Interactive Brokers account as I continue testing our new Market Structure EDGE decision-support platform for traders, I sold a thousand shares of AMRN yesterday.

It took me several hours, nine trades, all market orders, not limits. I’m cautious about limit orders because they’re in the pipeline for everyone intermediating flow to see.  Even so, only three matched at the best offer. The rest were mid-pointed in dark pools, and one on a midpoint algorithm priced worse, proof machines know the flow.

In a sense, 70% of the prices were unseen. Marketable trades have at least the advantage of surprise.  Heck, I’m convinced Fast Traders troll the quotes people look up.

Now, why should you care, public companies and investors?

Because the unseen is bigger than the seen. This cat-and-mouse game is suffusing hundreds of billions of dollars of volume daily.  It’s a battle over who knows what, and what is seen is always at a disadvantage to those with speed and data in the unseen.

There are fast and slow prices, and the investing public is always slow.  There are quotes in 100-share increments, yet well more than 50% of trades are odd lots less than that.

There are changes coming, thankfully. More on that in a couple weeks.  What’s coming this week is our bigger concern, and it’s a case of seen versus unseen.

Today VIX options expire (See ModernIR planning calendar).  There are three ways to win or lose: You can buy stocks in hopes they rise, short them on belief they’ll fall – or trade the spread. Volatility. It’s a Pandemic obsession. Inexperienced traders have discovered grand profits in chasing the implied volatility reflected in options.  I hope it doesn’t end badly.

Volatility bets will recalibrate today. The timer goes off, and the clock resets and the game begins again.

Thursday brings the expiration of a set of index options, substitutes for stocks in the benchmark.  Many option the index rather than buy its components.

Friday is quad-witching when broad stock and index options and futures expire (and derivatives tied to currencies, interest rates, Treasurys, which have been volatile).

The first quad-witch of 2020 Mar 20 marked the bottom (so far) of the Pandemic Correction. And wiped out some veteran derivatives traders.  We’re coming into this one like a fighter jet attempting a carrier landing, with the longest positive stretch we’ve ever recorded for Market Structure Sentiment™, our 10-point gauge of short-term tops and bottoms.

It’s at 8.2. Stocks most times trade between 4.0-6.0. It’s screaming on the ceiling, showering metal sparks like skyrockets.

And beneath lurks a leviathan, not unseen but uncertain, a shadowy and shifting monster of indefinite dimension.

Index rebalances.

IR Magazine’s Tim Human wrote on ramifications for public companies, an excellent treatise despite my appearance in it.

Big indexers S&P Dow Jones, Nasdaq and MSCI haven’t reconstituted benchmarks this year. The last one done was in December.  Staggering volatility was ripping markets in March when they were slated and so they were delayed, a historical first, till June.

Volatility is back as we approach resets affecting nearly $20 trillion tracking dollars.

And guess what?  The big FTSE Russell annual reconstitution impacting another $9 trillion is underway now in phases, with completion late this month.

It took me several hours of careful effort to get the same average price on a thousand shares of one stock.  How about trillions of dollars spanning 99.9% of US market cap?

It may go swimmingly.  It’s already underway in fact. We can track with market structure sonar the general shape of Passive patterns. They are large and dominant even now.  That also means they’re causing the volatility we’re experiencing.

The mechanics of the market affect its direction. The good news is the stock market is a remarkably durable construct.  The bad news is that as everyone fixates on the lights and noise of headlines, the market rolls inexorably toward the unseen. We’re shining a light on it (ask us how!).  Get ready.

Squid Ink

Is retail money creating a Pandemic Bubble? Sort of. Really, it’s Fast Traders turning those orders into clouds of squid ink.

There are 47 million customer accounts at Schwab, Fidelity, Ameritrade, E*Trade and Robinhood.  These big online brokers sell their flow to Citadel, Two Sigma, Susquehanna’s G1X options platform, Virtu, UBS, options trader Wolverine, and others.

Nearly all of the orders are “non-directed,” meaning the broker determines where to send them.  Also, more than three paragraphs of market structure goop and people grab a bottle of tequila and go back to day-trading.

So, let me explain.

Do you know CHK?  A shale-oil play, it’s on the ropes financially. In May it was below $8. Yesterday CHK was near $70 when it halted for news. Which never came, and trading resumed. (Note: A stock should never, ever be halted for news, without news.)

It closed down hard near $24. Rumors have flown for weeks it’ll file bankruptcy.  Why was it at $70? People don’t understand that public equity often becomes worthless if companies go bust. Debtholders convert to equity and wipe out the old shareholders.

Hertz (HTZ) went bankrupt May 26 and shares closed at $0.56.  Monday it was over $5.50, up about 900%. HTZ debt is trading at less than 40 cents on the dollar, meaning bondholders don’t think they’ll be made whole – and they’re senior to equity.

This is bubble behavior. And it abounds. Stocks trading under $1 are up on average 79% since March, according to a CNBC report.

ABIO, a Colorado biotech normally trading about 10,000 shares daily with 1.6 million shares out made inconsequential reference to a Covid preclinical project (translation: There’s nothing there). The stock exploded, trading 83 million shares on May 28, or roughly 50 times the shares outstanding.

Look at NKLA.  It’s been a top play for Robinhood clients and pandemic barstool sports day-trading. No products out yet, no revenue. DUO, an obscure Chinese tech stock trading on the Nasdaq yesterday jumped from about $10 to $129, closing above $47.

Heck, look at Macy’s.  M, many thought, was teetering near failure amidst total retail shutdown. From about $4.50 Apr 2, it closed over $9.50 by June 8.

W, the online retailer that’s got just what you need, is up 700% since its March low despite losing a billion dollars in 2019.

When day traders were partying like it was 1999, in 1999, stocks for businesses with no revenues and products boomed.  Then the Nasdaq lost 83% of its value.

About 95% of online-broker orders are sold to Fast Traders – the Citadels, the Two Sigmas, the Virtus.  They’re buying the tick data (all the prices) in fractions of seconds. They know what’s in the pipeline, and what’s not.

Big online brokers sell flow to guarantee execution to retail traders.  I shared my experience with GE trades. The problem is retail prices are the ammunition in the machine gun for Fast Traders. They know if clips are being loaded, or not. And since retail traders don’t direct their trades (they don’t tell the broker to send it to the NYSE, Nasdaq, Instinet, IEX, etc., to hide prices from Fast Traders), these are tracer rounds stitching market prices up and down wildly.

The Fast Traders buying it can freely splatter it all over the market in a frenzy of rapidly changing prices, the gun set on Full Automatic.

This is how Fast Traders use retail trades to cause Wayfair to rise 700%. The order flow bursts into the market like squid ink in the Caribbean (I’ve seen that happen snorkeling), and everyone is blinded until prices whoosh up 30%.

A money manager on CNBC yesterday was talking about the risk in HTZ. She said there were no HTZ shares to borrow. Even if you could, the cost was astronomical.

Being a market structure guy with cool market structure tools (you can use them too), I checked HTZ.  Nearly 56% of trading volume is short. Borrowed. And the pattern (see here) is a colossus of Fast Trading, a choreographed crescendo into gouting squid ink.

How? Two Sigma, Hudson River Trading, Quantlab, etc., Fast Trading firms, enjoy market-making exemptions. They don’t have to locate shares. As high-speed firms “providing liquidity,” regulators let them do with stocks what the Federal Reserve does with our money. Digitally manufacture it.

Because they buy the flow from 47 million accounts, they know how to push prices.

That’s how ABIO traded 83 million shares (60% of the volume – nearly 50 million shares – was borrowed May 28, the rest the same shares trading many times per second).

It’s how CHK exploded up and then imploded as the manufactured currency vanished. And when stocks are volatility halted – which happened about 40 times for CHK the past two trading days – machines can game their skidding stop versus continuing trades in the ETFs and options and peer-group stocks related to the industry or sector.

This squid ink is enveloping the market, amid Pandemic psychology, and the economic (and epic) collapse of fundamental stock-pricing.

Dangerous.

You gotta know market structure, public companies (ask us) and investors (try EDGE).

Unknowable

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

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

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

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

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

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

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

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

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

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

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

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

Cough, cough.

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

Yet we are.

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

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

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

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

How about corporate spending on box seats at big arenas?

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

An empty edifice?

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

Should stocks trade where they did before these things?

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

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

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

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

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

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

What’s your bet?

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

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