Tagged: Market Structure

Infected Stocks

Coronaviruses are common throughout the world. So says the US Centers for Disease Control and Prevention.

The market didn’t treat news of spreading cases in China and the first in the USA (from a Chinese visitor) that way though. Airline and gaming stocks convulsed yesterday.

There’s as ever a lesson for investor-relations practitioners and investors about how the stock market works now. News compounds conditions but is infrequently causal. Investors, there are opportunities in divergences. IR pros, you need to know what’s real and what’s ripple-effect, because moves in stocks may not reflect rational sentiment.

Airline and leisure stocks demonstrate it. Active Investment pushed airlines up 2.4% last week, industry data we track (with proprietary analytics) show.

But.

Shorting rose, and demand for derivatives used to protect or leverage airline investments fell 7% into last week’s options-expirations (know the calendar, folks). That’s a signal that with new options trading yesterday, counterparties would shed inventory in those stocks because demand for options was down.

Both facts – Active buying last week, weak demand for leverage – run counter to the narrative of investor-fear. The data say these stocks would have been down anyway and news is simply compounding what preceded it.

No doubt some investors knee-jerked to headlines saying investors were selling, and sold. But it’s not the cause. It’s effect.

We can’t isolate gaming in GICS data but leisure stocks shared behavioral characteristics with airlines. Investment was up last week, led by Passive money rather than Active funds (Active rose 2% too). But Risk Management, the use of leverage, declined 3%. And the pattern of demand changed.

What if the real cause for declines in these industries is the rising cost of leverage?

I’ll make my last plug for the book The Man Who Solved the Market. Near the end, one of Jim Simons’s early collaborators at Renaissance Technologies observes, “I don’t deny that earnings reports and other business news surely move markets. The problem is that so many investors focus so much on these types of news that nearly all of the results cluster very near the average.”

He added that he believed the narratives that most investors latch onto to explain price-moves were quaint, even dangerous, because they breed misplaced confidence that an investment can be adequately understood and its future divined.

I’ll give you two more examples of the hubris of using headlines to understand stocks. The S&P 500, like airline and leisure stocks, experienced a 2% decline in demand for derivatives into expirations last week. Patterns changed. Ten of eleven sectors had net selling Friday even as broad measures finished up.

If the market is down 2% this week – and I’m not saying it will fall – what’ll be blamed? Impeachment? Gloomy views from Davos? The coronavirus?

One more: Utilities. These staid stocks zoomed 4% last week, leading all sectors. They were the sole group to show five straight days of buying. We were told the market galloped on growth prospects from two big trade agreements.

So, people bought Utilities for growth?

No, not the reason. Wrapped around the growth headlines was a chorus of voices about how the market keeps going up for no apparent reason. Caution pushes investors to look for things with low volatility.

Utilities move about 1.4% daily between intraday high and low average prices. Tech stocks comprising about 24% of the S&P 500 are 2.6% volatile – 86% more!

Communication Services, the sector for Alphabet, Facebook, Twitter and Netflix, is 2.8% volatile every day, exactly 100% more volatile than Utilities.

The Healthcare sector, stuffed with biotechnology names, is 4.8% volatile, a staggering 243% greater than Utilities.

These data say low-volatility strategies from quantitative techniques, to portfolio-weightings, to Exchange-Traded Funds are disproportionately – and simultaneously – reliant on Utilities. If volatility spikes, damage will thus magnify.

IR people, you’ve got to get a handle on behaviors behind price and volume (we can show you yours!). Headlines are quaint, even dangerous, said the folks at Renaissance Technologies, who earned 39% after-fee returns every year for more than three decades.

Investors, you must, too (try our Market Structure EDGE platform). None of us will diagnose market maladies by reading headlines. The signs of pathology will be deeper and earlier. In the data.

What Matters

Happy New Year!

I hope you enjoyed our gift:  A two-week break from my bloviating!  We’d planned to run best-of columns and thought better, because everybody deserves a respite.

We relished the season in the Colorado mountains, as this album shows (see world-class ski-race video too).  If the album eludes you, this is Steamboat Springs 2020, and us on snowshoes, and the view up high where it’s always 3 o’clock (a superb ski run).

I’m thinking about 2020.  And I’m reading “The Man Who Solved the Market,” about quant hedge fund Renaissance Technologies, by Wall Street Journal reporter Greg Zuckerman.  You should read it, too.

About 47% in, my Kindle says, Zuckerman writes, “One day, a data-entry error caused the fund to purchase five times as many wheat-futures contracts as it intended, pushing prices higher.

“Picking up the next day’s Wall Street Journal, sheepish staffers read that analysts were attributing the price surge to fears of a poor wheat harvest.”

There’s so much going on behind stock-prices that’s something other than we think. The point for IR people and investors is why do we do what we do?

In fact, it’s a human question. We do things on the belief they count.

For instance, the quarterly “Q&A bible,” the compendium of earnings-call questions, dominated holiday discussion in NIRI eGroups.

Discourse is great.  But does all that preparatory effort matter?

If we’re spending the same time and effort in 2020 on earnings-call Q&A that we did in 2000, well, why?  In 2000, more than 70% of the money was rational. Today it’s 14%.

Tesla is up 42% the past year, which included an earnings call where CEO Elon Musk trashed an analyst during Q&A.  The Twittersphere blew up.

The stock didn’t.

You should have your executive team prepared for questions, investor-relations professionals. But you don’t need a bible in 2020 because rational behavior is a paltry part of why stocks move.

Equal to preparation for questions should be the time directed to educating your executives and board on what can move price with results, and why, and what historical data indicate are risks, and why risk exists in the first place – and if you can mitigate it by changing WHEN you report and how you notify investors.

And if you’re 10/10 Overbought and 60% short before you report, put your best VALUE foot forward. Data, not Q&A, should driver call-prep.

Human beings do things because they ostensibly matter and produce returns.  If we’re going through motions because it’s tradition, then 2020 should be the year you change tradition.

And investors. What matters to you?  Returns, right?

The average S&P 500 component moves 36% every month, intraday (1.6% each day between highest and lowest prices), change often lost in closing prices.  In a perfectly modulated, utterly quantitative Shangri-La, you’d capture ALL of that by buying low and selling high.  You could make 432% per year.

That’ll never happen. Eugene Fama, legendary University of Chicago economics professor, who’s 80 years old and still teaching, won a Nobel Prize for demonstrating the return-diminishing pugnacity of volatility.

But if there’s so much volatility, why expend immense effort finding great companies when the odds are roughly 1% that doing so will produce market-beating returns?

Wouldn’t it be smarter – wouldn’t it matter more – to surf volatility waves in today’s market?

I find in traveling around the country – we’re headed to Austin Thursday – talking to IR people and investors that they’re depressed by these things.

If what we learned doesn’t matter, should we rend garments, gnash teeth and weep?

No.

That’s like being depressed by passing time.  Time is a fact.  We can make the most of it, or we can rue its passage.  What’s it gonna be?

So what, IR people, if you don’t need a 400-page Q&A document that requires a software package to manage?  A single Word page, stored to the cloud so you can cross-reference in future quarters, is proportionate.  You’ve saved TIME to do things that MATTER.

What matters?  If you want to be in the US equity markets in 2020 as a public company, an investor-relations professional, an investor, what matters is knowing what money is doing.

It’s a law of success.  It’s not what you know about YOU that matters.  It’s what you know about life, the environment you’re in, the job you’re doing, about how to build relationships.

Right?

We should stop spending all our time understanding our businesses, and none understanding the market that assigns value to them.  That’s the flaw of IR.  Nothing more.  Let’s change it in 2020.

And you investors, why all the Sisyphean work finding great businesses without first understanding how the market transforms those businesses into products with fleeting and ever-evolving value?

If you could capture just 10% of the daily volatility of the S&P 500 by buying stuff low and selling it high, you’d win. It’s provable, useful math. That matters.

Resolve to make 2020 the year you learn what the money is doing.  It matters. We at ModernIR figured out the road map. Ask us how to start on the journey.

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.

Blurry

As Thanksgiving nears, we’re giving thanks for a rock-star stock market since last December, when it fell 20%. Can it hold?

In the simplest sense, whatever has been driving it must continue. Thanksgiving is to me the best holiday because it’s introspective. So let’s reflect on what’s behind stocks.

Everyone says corporate earnings, the economy, monetary policy.  The US economy is strong.  Earnings though are weaker the past three quarters than comparable earlier periods, so it’s not that. Monetary policy is easy, which helps by fueling leverage.

Buybacks?  Sure, a contributor. Geopolitics, trade deals, tariffs?  You’d think those might be headwinds. So far, no. Remember, news doesn’t buy or sell stocks. People and machines do.

Fund-flows? Research from Ed Yardeni says bonds have benefited while stocks have suffered. Domestic trends are disturbing – steep declines for years (See Figure 5) as money steadily shifts toward bonds and foreign equities.

Along our path of reflection we come to market structure – and why both companies and investors should learn it. Between Jul 1, 2015 and present there are 1,097 trading days. Of those, 589 are between 4.5-6.0 on ModernIR’s 10-point Market Structure Sentiment buy/sell scale.

Do the math. The ratio (589/1097) is 5.4/10.0. Reads over 5.0 mean machines will lift prices.  It’s a GARP market – growth at a reasonable price.

Now let’s add in the time the market has spent in “Overbought” territory, above 6.0. It’s 301 days, or 27% of the time. It’s been Oversold (below 4.5) 207 days, 19%.

There’s our answer. It’s GARP 54% of the time, momentum 27% of the time, value 19% of the time. It’s more growth than value, more buying than selling.  Whether money comes or goes, if what comes is disposed to pay up, stocks rise.

Contrast with Sep-Dec 2018. During that period when stocks fell about 20%, they were Oversold 44% of the time and Overbought just 16% of the time.

Narrow the data to 2019 and stocks are GARP just 44% of the time, Overbought 39% of the time. It’s become momentum almost as much as growth.

Zoom on Aug 1-present. GARP behavior is down to 41% of trading, Overbought, 36% of the time, Oversold 23% of the time.

Shouldn’t we be measuring that? By sector, industry, stock? Well. We do, at ModernIR.

Shifting our lens, in the past three weeks across the eleven market sectors, selling has outpaced buying 61% to 39%.

How does money leave stocks while the market sustains GARP or momentum (more Overbought than Oversold) characteristics?

The money behind prices is increasingly short-term, and leveraged. Add up everything that’s not long-only investing and it’s 86% of trading. The AMOUNT of money chasing stocks can shrink and stocks will still rise because the TIME dedicated to buying or selling is increasingly up-or-down, not buy-and hold.

Lesson? Public companies and investors, you cannot count on fundamentals, macroeconomics, central banks, to predict what the market will do. It moves in response to its temporal behavioral biases.

Or put another way, direction hinges on the short-term propensity of money to plow back into stocks tomorrow or to stop doing that.  It shifts to GARP, to growth, to value, and back. When the bias in the data blurs, money falters.

Data are getting blurry (as rock band Puddle of Mudd would say). It’s not a GARP market anymore.

For that reason, I’ll go out on a limb and say it’s too early to call this a record year (like Eric Church, for you country fans).  What got us here has begun eroding. We’re only 1% above the GARP levels for stocks in Q4 2018.

Wrapping up, it’s a great season, this one of Thanksgiving.  Give thanks!  And be alert to changing behaviors.  When lines blur – in your stock, your peers, your sector, industry – you should know. It’s a weather report on what’s coming. We want to stay clear-eyed.

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.

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.

Bad News

Markets swoon and again comes a hunt for why, because news offered no warning. The news has bad data, which makes for bad news. ModernIR warned. More shortly.

Meanwhile in Steamboat Springs the slopes are painted the palette of Thanksgiving, and a road leads to paradise.

We were in New York with the United Nations last week. Well, not with them. Navigating around them. On foot. We walked fifteen miles over two days of meetings. Trump Tower looked like a siege camp, loaded dump trucks lining the front and frantic 5th Avenue closed to traffic and so quiet you could stroll to the middle and snap a photo.

Wednesday we railed with Amtrak into Washington DC’s Union Station, and Thursday and Friday we trooped with the NIRI contingent up Capitol Hill. Strange time. The halls of congressional buildings Longworth and Rayburn vibrated in partisan division.

NIRI is flexing muscle, however. We had 50 people scattered through more than 30 legislative visits, and the SEC told us, “You’ve brought an impressive number!”

Numbers matter.  We keep that up and we might change the world. So next year, come along! NIRI CEO Gary LaBranche and team deserve all credit for ratcheting up our reach to regulators and legislators.

Now to the data that makes the news look bad. Last week in our piece called Curtains, we explained how market structure leads headlines around by the nose. Yes, news may be the feather that tilts a domino. But it’s not The Big Why.

Structural conditions must first permit daily chatter to move markets. Thus news one day is “stocks are down on trade fears,” and when they rebound as quickly, they’re “up on easing trade fears.”

We’re told the Dow Industrials dropped 340 points yesterday because the ISM Manufacturing Index dipped to a decade low. That index has been falling for months and slipped to contraction in late August. Yet the S&P 500 rose last month.

Anyone can check historical data. The ISM Index routinely bounced from negative (more than now) to positive during the go-go manufacturing days of the 1950s when the USA was over 50% of global output. It was lower routinely in the booming 1980s and 1990s. It was lower in the post-Internet-bubble economic high.

Lesson? Manufacturing moves in cycles. Maybe the data mean the cycle is shortening, as it did in past boom periods. You can see the long-range data here, courtesy of Quandl.

There’s rising and worrisome repetition of news that’s wrong about what’s behind market-moves. Many trust it for reasons, policy, direction. Decisions thus lack footing.

A year ago, ModernIR warned clients about collapsing ETF data in latter September related to the creation of the new Communication Services sector. The market rolled over. Headlines blamed sudden slowing global growth.

Since that headline splashed over the globe, US stocks have posted the best three quarters since 1997. But not before pundits blamed the 20% drop last December on impending recession and monetary policy.

Stocks surged in January 2019, regaining all the media blamed on what never happened.

Why don’t we expect more from the people informing capital markets? Shouldn’t they know market structure? If you get our Sector Insights reports (ask us how), you know what the data said could happen.

For the week ended September 27, selling outpaced buying across all eleven sectors two-to-one. Not a single sector had net buying. Staples, the best performer with gains of 2.7%, got them on outliers only. The sector had one buying day, four selling days, last week.

We asked: Could all that selling land with a splat in early October?

Remember, liquidity is so paltry – now 20% worse than in Sep 2018 – that what got on the elevator (so to speak) last week got off this week, leading the news, which watches the wrong data, to incorrect conclusions.

We saw a bigger behavioral change for ETFs last week than in late Sep 2018. I’ll ask again: If the data signal selling, or buying, and the data predicts where news reacts, why isn’t everyone, especially pundits, watching that data?

Are you?

If you’ve never seen market structure analytics, ask us. It’s the vital predictive signal now. That’s good news rather than bad.

Reality Disconnect

In 1975, there were no electronic exchanges in the United States.  Now the average S&P 500 component trades electronically 17,000 times daily in 134-share increments totaling a mean of $500 million of stock.

Yet public companies still have a 1975 standard of shareholder disclosure from the SEC, called 13F filings, referencing the section of the Securities Act with instructions for investment advisors of specified size to report positions 45 days after each quarter-end.

It’s a reality disconnect. Retaining this standard says to executive teams and boards for public companies that “regulators and legislators want you to believe this is what’s driving your share-value.”

You can’t believe what the market is telling you on a given day, let alone over a quarter. We’ll come to that.

In 1975, there were no Exchange Traded Funds, no Fast Traders.  The first index fund open to the public launched Dec 31, 1975, from Vanguard, with $11 million of assets.

Today, index investing has surpassed active stock-picking in the US for assets under management. ETFs are the phenomenon of the era, with growth surpassing anything modern markets have ever seen. There is one ETF for each Russell 1000 stock now.

Total US market capitalization is more than $30 trillion, and 1% of it trades every day – over $300 billion of stock. By our measures, ETFs are responsible for roughly 60% directly or indirectly. ETFs are priced by arbitrage. Arbitrage blurs delineation between Fast Traders and ETF “market-makers.” Both make trade decisions in 10 nanoseconds.

None of this money we’ve just highlighted pays attention to earnings calls or reads 10-Ks and 10-Qs or press releases.  It’s rules-based investing. Asset allocation. Trading.

As money has shifted tectonically from Active to Passive, regulatory and disclosure costs for public companies – to serve Active investors – have gone the opposite direction.

We estimate costs related to quarterly and annual reporting, associated public reviews and audits, and Sarbanes-Oxley and Dodd-Frank and other regulations total $5-6 billion annually. For the roughly 3,400 companies traded nationally, investor-relations budgets consumed by communications tools, travel, reports and services are $3-4 billion.

Unless the point of regulation is busywork, the rules are confusing busy with productive. As the money ceases to listen – there’s been a diaspora of sellside analysts from Wall Street to the IR chair because the buyside has gone passive – the chatter from companies has exponentiated.

The Securities Act says no constituency of the national market system including issuers is to be discriminated against. Failing to modernize data to reflect reality is a disconnect.

Summing up, public companies, beset by a leviathan load of regulatory costs for investors, which are moving in math-driven waves and microseconds, wait to see what funds file 13F records of shareholdings 45 days after the end of each quarter.

There’s more.  The average stock has four distinct trading patterns per month, meaning traders unwind and return, funds rebalance, derivatives bets wax and wane, in 20 trading days. Not over a quarter.

About 45% of all trading volume is borrowed. Another 45% comes from Fast Trading machines (with heavy overlap as machines are automated borrowers) that close out 99% of positions before the trading day ends.

All told, 87% of market volume comes from something other than stock-picking. The disclosure standard supposes – because it dates to 1975 – that all volume is rational.

The reality disconnect is so bad now that machines look like humans. As we wrote last week, the whole of financial punditry has been caught up in a vast reputed momentum-to-value shift.

Except it didn’t happen.

Sure, momentum stocks plunged while value stocks surged.  Yet as this story from Marketwatch yesterday notes (I’m a source here too), AAPL is a core component of flying value indices.  Isn’t AAPL a growth stock?

Here’s the kicker.  The principal reason for swooning momentum and soaring value was a rush by Fast Trading machines that spread through markets, and a corresponding short-squeeze for ETF market-makers, which routinely borrow everything but were caught out in ripping spreads between ETFs and component stocks.

What if today’s Federal Reserve monetary policy decisions reflect belief money has shifted to value?  What if investment decisions are incorrectly recalibrated?  What if observers falsely suppose growth is slowing and crow anew about impending recession?

The market is disconnected from 13Fs. How about modernizing them, regulators? I’ll be going to Capitol Hill and the SEC with the NIRI delegation next week to make this case.

Meanwhile, be wary of markets. The Fed was intervening yesterday and likely cuts rates today by 25-50 basis points, just as volatility expirations hit now, and before a raft of stock, index, ETF, currency, Treasury and interest-rate derivatives expire through Friday. And Market Sentiment is topped.

Maybe it’s nothing. But if the market rolls, there are data-driven reasons.  And it’s about time disclosures took a leap forward past the reality disconnect for public companies.

Liquidity

Want a big ranch out west?

Apparently you don’t. The Wall Street Journal last month ran a feature (subscription required) on the mushrooming supply of leviathan cattle operations from Colorado to Idaho, legacy assets of the rich left to heirs from the era of Ted Turner and John Malone.

A dearth of demand is saddling inheritors with big operating expenses and falling prices.  Cross Mountain Ranch near Steamboat Springs, CO is 220,000 acres with an 11,000 square-foot house that costs a million dollars annually to run. It can be yours for a paltry $70 million, $320 an acre (I wonder if that price holds for a thousand?).

What have cattle ranches got to do with the stock market?  Look at your holders, public companies.  What’s the concentration among the largest?

The same thing that happened to ranches is occurring in stocks.  The vast wealth reflected in share-ownership came considerably from generations now passing on inheritance or taking required minimum distributions. The youngsters, at least so far, aren’t stockowners. They’re buying coffee, cannabis and café food.

Juxtapose that with what we’ve been saying about liquidity in stocks, and as the WSJ wrote today.

Liquidity to us is how much of something can be bought or sold before the price changes.  Those landed dynasties of western dirt are discovering people eschew large land masses and monolithic homesteads.

In stocks, the same is true.  Back up five years to Sep 4, 2014. The 200-day (all measures 200-day averages) trade size was 248 shares and dollars/trade was $17,140. Short volume was about 42%, the average Russell 1000 stock traded about $230 million of stock daily. And intraday volatility, the difference between highest and lowest daily prices, was about 2.2%.

Five years later? Average trade-size is 167 shares, down 33%.  Dollars/trade is down 26% to $12,760. Shorting is nearly 47% daily. Dollars/day is down 17% to $170 million. Volatility is up 32% to 2.9% daily.

But market-capitalization has increased by some 40%.  It’s as though the stock market has become a giant ranch in Colorado teetering over millennials loitering in a coffee shop. No offense, millennials.

Every investor and public company should understand these liquidity characteristics because they increase risk for raising capital or making stock investments.

Why is liquidity evaporating like perspiration out of an Under Armor shirt?

Rules and behaviors. Rules force brokers – every dollar in and out of stocks passes through at least one – into uniform behavior, which decreases the number capable of complying. Picture a grocery store near dinnertime with just three checkout lanes open.

In turn, concentration means more machination by brokers to hide orders. They break them into smaller pieces to hide footsteps – and machines become more sophisticated at interrupting trades in ever smaller increments to reveal what’s behind them.

And all the liquidity measures shrink. We see it in the data. A blue bar of Active Investment rarely manifests without an array of orange bars swarming to change prices, Fast Traders who have detected the difference in the data where human influence drives machine behavior.

What can you do, public companies and investors?  Prepare for bigger and unexpected gyrations (volatility erodes investment returns and increases equity cost of capital).

Examples: HRB reported results before Labor Day. The quarter is fundamentally inconsequential for a company in the tax-preparation business. Yet the stock plunged. Drivers?  Shares were 71% short and dominated by machines setting prices and over 21% of trading tied to short derivatives bets.

Those structural facts cost holders 10% of market cap.

Same with ULTA. While business conditions might warrant caution, they didn’t promote a 30% reduction in equity value.  Market structure did it – 58% short, 55% of total volume from machines knowing nothing about ULTA and paying no heed to the call.

We have the data. Market structure is our sole focus. No public company or investor should be unaware of liquidity factors in stocks and what they predict.

Put another way, all of us on the acreage of equities better understand now that vast tracts of value are tied up by large holders who don’t determine the price of your stocks anymore than your grandfather’s capacity to buy 100,000 acres will price your big Wyoming ranch now.

What does is supply and demand. And liquidity is thin all over.  Data can guard against missteps.

 

Unstoppable

Any of you Denzel Washington fans?

He starred in a 2010 movie loosely based on real events called Unstoppable, about a runaway freight train (I have Tom Petty’s “Runaway Train” going through my head).

In a way, the market has the appearance of an unstoppable force, a runaway train.  On it goes, unexpectedly, and so pundits, chuckling uncomfortably, try to explain why.

Tellingly, however, in the past month, JP Morgan said 80% of market volume is on autopilot, driven by passive and systematic flows.  Goldman Sachs held a conference call for issuers on what’s driving stock-prices – focusing on market structure. Jefferies issued a white paper called When the Market Moves the Market (thank you, alert readers, for those!).

We’ve been talking about market structure for almost 15 years (writing here on it since 2006). We’re glad some big names are joining us. You skeptics, if you don’t believe us, will you believe these banks?

Market structure has seized control. Stock pickers say the market always reflects expectations.  Well, stocks are at records even as expectations for corporate earnings predict a recession – back-to-back quarterly profit-declines.

There’s more. Last week the S&P 500 rose 0.8%, pushing index gains to 9.3% total since the end of May. But something that may be lost on most: The S&P 500 is up less than 2.5% since last September. The bane of stock-investing is volatility – changing prices.

Hedge funds call that uncompensated risk. The market has given us three straight quarters of stomach-lurching roller coasters of risk. For a 2.5% gain?

We all want stocks to rise!  Save shorts and volatility traders.  The point is that we should understand WHY the market does what it does. When it’s behaving unexpectedly, we shouldn’t shrug and say, “Huh. Wonder what that’s about?”

It’s akin to what humorist Dave Barry said you can do when your car starts making a funny noise:  Turn the radio up.

Let me give you another weird market outtake.  We track composite quantitative data on stocks clustered by sector (and soon by industry, and even down to selected peers).  That is, we run central tendencies, averages, for stocks comprising industries.

Last week, Consumer Discretionary stocks were best, up 1.5%. The sector SPDR (XLY, the State Street ETF) was up 2% (a spread of 33% by the way). Yet sector stocks had more selling than buying every day but Friday last week.

You know the old investor-relations joke:  “Why is our stock down today?”

“Because we had more sellers than buyers.”

Now stocks are UP on more selling than buying.

An aside before I get to the punchline:  ETF flows are measured in share creations and redemptions. More money into ETFs? More ETF shares are created.  Except there were $50 billion more ETF shares created than redeemed in December last year when the market fell 20%.

The market increasingly cannot be trusted to tell us what’s occurring, because the mechanics of it – market structure – are poorly understood by observers. ETFs act more like currencies than stocks because they replace stocks. They don’t invest in stocks (and they can be created and shorted en masse).

With the rise of ETFs, Fast Trading machines, shorting, derivatives, the way the market runs cannot be seen through the eyes of Benjamin Graham.

Last week as the S&P 500 rose, across the eleven industry groups into which it’s divided there were 28 net selling days, and 27 net buying days (11 sectors, five days each).

How can Consumer Discretionary stocks rise on net selling? How can the market rise on net selling? Statistical samples. ETFs and indexes don’t trade everything. They buy or sell a representative group – say 10 out of a hundred.

(Editorial note: listen to five minutes of commentary on Sector Insights, and if you’re interested in receiving them, let us know.)

So, 90 stocks could be experiencing outflows while the ten on which this benchmark or that index rests for prices today have inflows, and major measures, sector ETFs, say the market is up when it’s the opposite.

Market Structure Sentiment™, our behavioral index, topped on July 12, right into option-expirations today through Friday.  On Monday in a flat market belying dyspepsia below the surface, we saw massive behavioral change suggesting ETFs are leaving.

Stay with me. We’re headed unstoppably toward a conclusion.

From Jan 1-May 31 this year, ETFs were less volatile than stocks every week save one. ETFs are elastic, and so should be less volatile. Suddenly in the last six weeks, ETFs are more volatile than stocks, a head-scratcher.

Mechanics would see these as symptoms of failing vehicle-performance. Dave Barry would turn the radio up.  None of us wants an Unstoppable train derailing into the depot.  We can avoid trouble by measuring data and recognizing when it’s telling us things aren’t working right.

Investors and public companies, do you want to know when you’re on a runaway train?