Tagged: Short Volume

In Control

What can you control?

Courtesy IEX

It’s a question largely abandoned in the modern era under the assumption humans can control everything.  Arrogance often precedes experience-induced humility.

But we’re talking specifically about the stock market.  Public companies. Share-performance.  Investor relations. What’s within your sphere of influence?

There’s a big difference between your capacity to drive shareholder value rationally in a quantitative market – and the value you provide internally to your board and executive team about what depends on story, and what turns on the product, your shares.

I’ll talk in practical terms about it Thursday at the NIRI Chicago 2020 IR Workshop, the first virtual edition. Join us for the event! I’m on about 1:30pm ET Thursday the 24th.

Market structure plays a key role.  Supply and demand affect stocks the same way they do products in any market. Yet the supply of product – shares – is almost never a consideration for public companies and investor-relations professionals, who suppose that telling the story to more investors will create volume and drive the price up.

Our friends at IEX here explain the difference between volume and liquidity (and we described liquidity and volatility last week). The more parties between the sources of supply and demand, the more volume compounds (especially with derivatives, leverage via borrowing, Exchange Traded Funds).

But volume doesn’t create more supply of the product.  This by the way is how stocks soar and lurch today (we touched on it last week).

SHOP, the big Canadian e-commerce company, saw shares plummet about 30% in a week on a share-offering. The stock then skyrocketed yesterday.  Shares were trading near $1,140 to start September, fell to $850 after the news, and were near $960 yesterday.

Rational thought?

No, supply and demand. SHOP is the 7th most liquid stock in the US market (a reason why we cluster it with close cousins the FAANGs). In fact, supply is so tight in SHOP that it depends on borrowed stock.

Most times stocks with high short volume – borrowed shares – underperform the market.  Shorting adds supply to the market.  If demand falls, short volume weighs on price.

Short volume is at a basic level rented inventory. Traders who deal shares in fractions of seconds rent stocks to sell to others, profiting on the differences in price.  At some point before the close they buy it back and return it, aiming to make more getting between buyers and sellers – see the IEX video – than they spend renting stocks and covering that borrowing.

In SHOP, the demand has been so great that even high shorting isn’t dragging the price down. They’re an outlier, and edge case (and that data clearly indicate they can afford to continue issuing stock, by the way). There’s more to be made trading SHOP every day than the cost of constantly covering borrowed shares.

Disrupt that supply chain with a stock offering and the whole SHOP market for shares shudders.

That’s why it’s essential for investor-relations professionals to help executives and boards understand what’s controllable.  If your market capitalization is less than roughly $4 billion, you’re outside where 95% of the money plays, which is in the Russell 1000.

You can either get bigger and get into the top thousand, come up with something that makes you a screaming growth play that’ll compound your trading and limited liquidity into $4 billion of market cap – or set realistic internal expectations for your team.

Data can help you make a difference with your liquidity. Use it to time your outreach to investors. Aiming to attract buyers when it’s 62% short – unless you’re SHOP – is wasting time. Wait till liquidity improves.

I’ll use a great example to kick off the Chicago discussion tomorrow. And if you’re on hand live and we have the data, I’ll tell you your liquidity ranking.

Bottom line, IR should be captaining liquidity. You’re the chief intelligence officer. Supply and demand determine your price. Know your liquidity.  Ask us, and we’ll help.

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.

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.

 

Short-Term Borrowing

Half the volume in the stock market is short – borrowed. Why?

It’s the more remarkable because stocks since late December have delivered an epic momentum rebound. A 15% gain is a good year. Half the sectors in the market were up 15% in just the last 25 trading days.

Yet amid the stampede from the depths of the December correction, short volume, the amount of daily trading on borrowed shares, rose rather than fell, and remains 48%.  That means if daily dollar-volume is $250 billion, $120 billion is borrowed stock.

What difference does it make? We’ve written before that the stock market now has characteristics of a credit market.  That is, if lending is responsible for half the volume, the market depends on short-term loans rather than long-term investment.

And share-borrowing, credit, will give the market a false appearance of liquidity.

Think about the sudden and massive December declines that included the worst-ever points-loss for the Dow Jones Industrial Average.  Was that a liquidity problem? Does a V-shaped recovery signal a liquidity problem?

Before the Dodd-Frank financial legislation, large banks might carry a supply of shares to meet the needs of customers, especially stocks covered by equity research.

With rigid value-at-risk regulations now, banks don’t hold inventory.  The supply chain for the stock market has shifted to proprietary fast traders, which don’t carry inventory either. They borrow it.

We define liquidity as the number of shares that can be traded before the price changes.  Prior to electronic markets, trade-sizes were ten times larger than today.  The mean trade-size the last five days was 181 shares, or about $13,500 against an average market price of $74.61.

But a few liquid stocks skew the average.  AAPL’s liquidity is over $23,000, its average trade-size. WMT is the average, about $13,000. GIS is half that, about $6,800.

AAPL is also 57% short – over half its liquidity is borrowed.  And AAPL is used as collateral by 270 Exchange-Traded Funds (ETFs). Related?

(Side note: Why would AAPL be used more than other stocks in an index if ETFs are tracking an index? Because ETFs only use a sample, often the biggest stocks that are liquid and easy to borrow.)

These three elements – fast traders, high borrowing levels, ETFs – are intertwined and they create risks of inflation and deflation in stocks that bear no correlation to fundamentals.

The market, as we’ve said before, always reflects its primary purposes. If the parties supplying the market with shares are borrowing them, they have an economic interest that will compete with the objectives of those buying shares as an equity investment.

Second, borrowing is a back-office brokerage function. With massive short-term securities lending, the back office becomes as important as the cash equities desk. And it’s a loan business, a credit market (a point made by the insightful academics comprising the Bogan family).

And ETFs? If you want to know how they work, read our white paper. ETFs are not pooled investments. They are collateralized stock substitutes. Derivatives.

Collateral is something you find in a credit market. ETF collateralization, the wholesale market where ETF shares are created and redeemed, is a staggering $400 billion per month in US equities, says the Investment Company Institute.

It’s cheap and easy for brokers to borrow the shares of a basket of stocks and supply them as collateral to the Blackrocks of the world (does Blackrock then loan them out, perpetuating the cycle?) for the right to create and sell ETF shares (or provide them to a hedge-fund customer wanting to short the whole Technology sector).

And how about the reverse? Brokers can borrow ETF shares and return them to Blackrock to receive collateral – stocks and/or cash that Blackrock puts in the redemption basket to offer in-kind for ETF shares.

These are the mechanics of the stock market.  It works well if there’s little volatility – much like the short-term commercial paper market that froze catastrophically during the financial crisis.

We are not predicting doom. We are highlighting structural risks investors and public companies should understand. The stock market depends for prices and liquidity on short-term borrowing. In periods of volatility, that dependency will amplify moves.

In extreme cases, it’s possible the stock market could seize up not through investor panic but because short-term borrowing may freeze.

How might we see that risk? Behavioral volatility. When the movement of money becomes frantic behind prices and volume where only a few firms like ours can see it, market volatility tends to follow (as Sept 2018 behaviors presaged October declines).

Currently, behavioral volatility is muted ahead of the Fed meeting concluding today, loads of earnings, and jobs data Friday. It can change on a dime.

Borrowed Time

“If a stock trades 500,000 shares daily,” said panelist Mark Flannery from hedge fund Point72 last Thursday on my market-structure panel, “and you’ve got 200,000 to buy or sell, you’d think ‘well that should work.’ It won’t. Those 500,000 shares aren’t all real.”

If you weren’t in Austin last week, you missed a great NIRI Southwest conference.  Mr. Flannery and IEX’s John Longobardi were talking about how the market works today.  Because a stock trades 500,000 shares doesn’t mean 500,000 shares of real buying and selling occur.  Some of it – probably 43% – is borrowed.

Borrowing leads to inflation in stocks as it does in economies.  When consumers borrow money to buy everything, economies reflect unrealistic economic wherewithal. Supply and demand are supposed to set prices but when demand is powered by borrowing, prices inevitably rise to unsustainable levels.  It’s an economic fact.

All borrowing is not bad. Borrowing money against assets permits one to spend and invest simultaneously.  But borrowing is the root of crises so watching it is wise.

Short interest – stock borrowed and sold and not yet covered and returned to owners as a percentage of total shares outstanding – isn’t unseemly. But it’s not a predictive indicator, nor does it describe risk. The great majority of shares don’t trade, yet what sets price is whoever buys or sells.

It’s far better to track shares borrowed as a percentage of total traded shares, as we described last week. It’s currently 43%, down one percentage point, or about 2.3%, as stocks have zoomed in latter August.

But almost 30% of stocks (excluding ETFs, routinely higher and by math on a handful of big ones averaging close to 60%) have short volume of 50% or more, meaning half of what appears to be buying and selling is coming from something that’s been borrowed and sold.

In an up market, that’s not a problem. A high degree of short-term borrowing, much of it from high-speed firms fostering that illusory 500,000 shares we discussed on the panel, means lots of intraday price-movement but a way in which short-term borrowing, and covering, and borrowing, and covering (wash, rinse, repeat), may propel a bull market.

In the Wall Street Journal Aug 25, Alex Osipovich wrote about how Goldman Sachs and other banks are trying to get a piece of the trading day’s biggest event: The closing auction (the article quotes one of the great market-structure experts, Mehmet Kinak from T Rowe Price). Let’s dovetail it with pervasive short-term borrowing.

We’ve mapped sector shorting versus sector ETF shorting, and the figures inversely correlate, suggesting stocks are borrowed as collateral to create ETFs, and ETFs are borrowed and returned to ETF sponsors for stocks.

A handful of big banks like Goldman Sachs are primary market-makers, called Authorized Participants (as opposed to secondary market-makers trading ETFs), which create and redeem ETF shares by moving stock collateral back and forth.

The banks give those using their versions of closing auctions the guaranteed closing price from the exchanges.  But it’s probably a great time to cover short-term ETF-related borrowings because trades will occur at an average price in effect.

The confluence of offsetting economic incentives (selling, covering borrowings) contribute to a stable, rising market. In the past week average intraday volatility dropped to 1.9% from a 200-day average of 2.5% at the same time shorting declined – anecdotal proof of the point.

What’s the flip side?  As with all borrowing, the bill hurts when growth stalls. When the market tips over at some future inevitable point, shorting will meet shorting. It happened in January 2016 when shorting reached 52% of total volume. In February this year during the correction it was 46%. Before the November election, short volume was 49%.

The point for both investors and public companies is that you can’t look at trading volume for a given stock and conclude that it’s equal and offsetting buying and selling. I guarantee you it’s not.

You don’t have to worry about it, but imbalances, however they may occur, become a much bigger deal in markets dependent on largescale short-term borrowing. It’s another market-structure lesson.

Going Naked

Today this bull market became the longest in modern history, stretching 3,453 days, nosing out the 3,452 that concluded with the bursting of the dot-com bubble.

Some argue runs have been longer before several times. Whatever the case, the bull is hoary and yet striding strongly.

Regulators are riding herd. Finra this week fined Interactive Brokers an eyebrow-raising $5.5 million for short-selling missteps. The SEC could follow suit.

Interactive Brokers, regulators say, failed to enforce market rules around “naked shorting,” permitting customers to short stocks without ensuring that borrowed shares could be readily located.

Naked shorting isn’t by itself a violation. With the lightning pace at which trades occur now, regulators give brokers leeway to borrow and sell to investors and traders to ensure orderly markets without first assuring shares exist to cover borrowing.  I’m unconvinced that’s a good idea – but it’s the rule.

Interactive Brokers earned penalties for 28,000 trades over three years that failed to conform to rules. For perspective, the typical Russell 1000 stock trades 15,000 times every day.

What’s more, shorting – borrowed shares – accounts for 44% of all market volume, a consistent measure over the past year.  Shorting peaked at 52% of daily trading in January 2016, the worst start to January for stocks in modern history.

In context of market data then, the violations here are infinitesimal. What the enforcement action proves is that naked shorting is not widespread and regulators watch it closely to ensure rules are followed. Fail, and you’ll be fined.

“Wait a minute,” you say.  “Are you suggesting, Quast, that nearly half the market’s volume comes from borrowed shares?”

I’m not suggesting it. I’m asserting it.  Think about the conditions. Since 2001 when regulations forced decimalization of stock-trading, there has been a relentless war on the economics of secondary market-making. That is, where brokers used to carry supplies of shares and support trading in those stocks with capital and research, now few do.

So where do shares come from?  For one, SEC rules make it clear that market makers get a “bona fide” exemption from short rules because there may be no actual buyers or sellers. That means supply for bids and offers must be borrowed.

Now consider investment behaviors.  Long-term money tends to buy and hold. Passive investors too will sit on positions in proportion to indexes they’re tracking (if you’re skewing performance you’ll be jettisoned though).

Meanwhile, companies are gobbling their own shares up via buybacks, and the number of public companies keeps falling (now just 3,475 in the Wilshire 5000) because mergers outpace IPOs.

So how can the shelves of the stock market be stocked, so to speak? For one, passive investors as a rule can loan around a third of holdings. Blackrock generates hundreds of millions of dollars annually from loaning securities.

Do you see what’s happening?  The real supply of shares continues to shrink, yet market rules encourage the APPEARANCE of continuous liquidity.  Regulators give brokers leeway – even permitting naked shorting – so the appearance of liquidity can persist.

But nearly half the volume is borrowed. AAPL is 55% short. AMZN is 54% short.

Who’s borrowing? There are long/short hedge funds of course, and I’ll be moderating a panel tomorrow (Aug 23) in Austin at NIRISWRC with John Longobardi from IEX and Mark Flannery from Point72, who runs that famous hedge fund’s US equities long/short strategy.  Hedge funds are meaningful but by no means the bulk of shorting.

We at ModernIR compare behavioral data to shorting. The biggest borrowers are high-frequency traders wanting to profit on price-changes, which exceed borrowing costs, and ETF market-makers.  ETF brokers borrow stocks to supply to ETF sponsors for the right to create ETF shares, and they reverse that trade, borrowing ETF shares to exchange for stocks to cover borrowings or to sell to make money.

This last process is behind about 50% of market volume, and hundreds of billions of dollars of monthly ETF share creations and redemptions.

We’re led to a conclusion: The stock market depends on short-term borrowing to perpetuate the appearance of liquidity.

Short-term borrowing presents limited risk to a rising market because with borrowing costs low and markets averaging about 2.5% intraday volatility, it’s easy for traders to make more on price-changes (arbitrage) than it costs to borrow.

But when the market turns, rampant short-term borrowing as money tries to leave will, as Warren Buffett said about crises, reveal who’s been swimming naked.

When? We’d all like to know when the naked market arrives. Short-term, it could happen this week despite big gains for broad measures. Sentiment – how machines set prices – signals risk of a sudden swoon.

Longer term, who knows? But the prudent are watching short volume for signs of who’s going naked.

Three Ways

Jakob Dylan (he of Pulitzer lineage) claimed on the Red Letter Days album by the Wallflowers that there are three ways out of every box.  Warning: Listen to the song at your own risk. It will get in your head and stay there.

Something else that should get in the heads of every investor, every executive and investor-relations professional for public companies, is that there are three ways to make money in the stock market (which implies three ways to lose it too).

Most of us default to the idea that the way you make money is buying stuff that’s worth more later. Thus, when companies report results that miss by a penny and the stock plunges, everybody concludes investors are selling because expectations for profits were misplaced so the stock is worth less.

Really? Does long-term money care if you’re off a penny? Most of the time when that happens, it’s one of the other two ways to make money at work.

Take Facebook (FB) the past two days.

“It’s this Cambridge Analytica thing. People are reconsidering what it means to share information via social media.”

Maybe it is.  But that conclusion supposes investors want a Tyrion Lannister from Game of Thrones, a mutilated nose that spites the face. Why would investors who’ve risked capital since New Year’s for a 4% return mangle it in two days with a 9% loss?

You can buy stocks that rise in value.  You can short stocks that decline in value. And you can trade the spreads between things. Three ways to make money.

The biggest? We suppose buying things that rise dominates and the other two are sideshows.  But currently, 45% of all market trading volume of about $300 billion daily is borrowed. Short.  In January 2016, shorting hit 52% of trading volume, so selling things that decline in value became bigger than buying things that rise.  That’s mostly Fast Trading betting on price-change over fractions of seconds but the principle applies.

Facebook Monday as the stock plunged was 52% short. Nearly $3 billion of trading volume was making money, not losing it.  FB was 49% short on Friday the 16th before the news, and Overbought and overweight in Passive funds ahead of the Tech selloff.

The headline was a tripwire but the cause wasn’t investors that had bought appreciation.

But wait, there’s a third item. Patterns in FB showed dominating ETF market-making the past four days around quad-witching and quarterly index-rebalances. I say “market-making” loosely because it’s a euphemism for arbitrage – the third way to make money.

Buying the gaps between things is investing in volatility. Trading gaps is arbitrage, or profiting on price-differences (which is volatility).  ETFs foster arbitrage because they are a substitute for something that’s the same: a set of underlying securities.

Profiting on price-differences in the same thing is the most reliable arbitrage scheme. ETF trading is now 50% of market volume, some from big brokers, some from Fast Traders, nearly all of it arbitrage.

FB was hit by ETF redemptions.  Unlike any other investment vehicle, ETFs use an “in-kind exchange” model. Blackrock doesn’t manage your money in ETFs. It manages collateral from the broker who sold you ETF shares.

To create shares for an S&P 500 ETF like IVV, brokers gather a statistical sampling of S&P stocks worth the cost of a creation basket of 50,000 shares, which is about $12 million. That basket need be only a smattering of the S&P 500 or things substantially similar. It could be all FB shares if Blackrock permits it.

FB is widely held so its 4% rise means the collateral brokers provided is worth more than IVV shares exchanged in-kind. Blackrock could in theory make the “redemption basket” of assets that it will trade back for returned IVV shares all FB in order to eliminate the capital gains associated with FB.

So brokers short FB, buy puts on FB, buy a redemption basket of $12 million of IVV, and return it to Blackrock, receive FB shares, and sell them. And FB goes down 9%.  The key is the motivation. It’s not investment but arbitrage profit opportunity. Who benefited? Blackrock by reducing taxes, and brokers profiting on the trade. Who was harmed? Core FB holders.

This is 50% of market volume. And it’s the pattern in FB (which is not a client but we track the Russell 1000 and are building sector reports).

The next time your stock moves, think of Jakob Dylan and ask yourself which of the three ways out of the equity box might be hitting you today. It’s probably not investors (and if you want to talk about it, we’ll be at NIRI Boston Thursday).

Volume and Interest

In the five trading days ended Oct 17, 49.1% of average daily stock volume was short.

“Wait, what?” you say.  “Half the stock market is short?”

Yes, that’s right.  Short volume last topped 49% marketwide in mid-April. The market glided gently downward from there to May options-expirations. Speaking of expirations, we’re in them for October this week, so it’s a good time to talk about shorting.

Short volume hit a last marketwide low July 12 at 43%, which roughly corresponded to the high point of the Brexit Bounce.  At Nov 30 last year short volume was 42.9% and December and January were horrific for markets.  And on Jan 7, 2016, short volume was 52%. A month later the market bottomed and soared till April.

If short-volume history is a guide, the market is nearing a temporary bottom. It’s unwise to use a single data point, and we don’t (we use six key measures, plus a small supporting cast, as you clients know). The flow and behavior of money count, and we track both.

“Back up,” you say.  “You lost me at ‘short volume.’ What do you mean by that?”

Short volume is trading derived from borrowed shares.

“I read back in August on Zero Hedge that nobody’s short stocks. Trading from borrowed shares is 2% of the S&P 500, near a three-year low.”

You’re talking about short interest, the long-in-the-tooth risk-assessment tool derived from a 1975 Federal Reserve rule called Regulation T. Shorting and derivatives exploded after the US scrapped the gold standard and the Feds wanted to track margin accounts.

“Are we talking about the same short interest? The amount of total shares outstanding or float that’s borrowed and sold and not yet covered?”

Yes. Forty-one years later it’s still a standard market-risk measure. Yet it’s largely useless predictively. It didn’t shoot up until well after Bear Stearns foundered. In late 2007 it was 1.6%.

“So you’re saying it’s a crappy measure. What’s short volume then?”

Short volume is the amount of daily trading volume that’s borrowed. If a stock trades a million shares a day and short volume is 53%, then 530,000 shares of it were borrowed.  With over 40% of all market volume coming from Fast Traders wanting to own nothing, a great deal of this is short-term trading.

“Okay, I’m following. But what’s it tell me?”

Short volume signals several things but in sum it’s what you think: High short volume, lower price.  Why? Shorting is at root the continual adding of supply to the market. So if demand doesn’t keep up, price falls.

Here’s more:

High short volume means weak expectation for gains. No matter what company fundamentals are, if more volume comes from borrowed shares than owned shares, Fast Traders weighing tick data with high performance machines predict investors would rather lend shares for a return than spend money buying and holding them.

High short volume points to rotation. If the machines want to be short, they’re betting holders are selling and trying to hide it by passing shares through multiple brokers. The converse is true too: If you’ve been short and shorting falls, rotation is probably done.

Persistent high shorting reflects uncertainty about corporate strategy.  Not to pick on Tesla (because it’s not alone by any stretch) but its 200-day average short volume is 55%. Investors say it’s a trading vehicle, not an investment opportunity.  By contrast Qualcomm’s 200-day average is 42%. The two have inverse performance the past year.

Tangentially, high short volume CAN mean ETFs are seeing outflows. Exchange Traded Funds don’t directly buy or sell stocks but they create big volume because ETFs track other measures, such as indexes, that are in turn composed of other issues, such as stocks.

Traders measure deviation between ETFs and these other things and arbitrage (profit on price-differences) the spreads.  When investors sell ETF shares, ETF market makers or authorized participants (parties designated to create and redeem ETF shares) might short components to raise cash in order to buy ETF shares and retire them to rebalance supply.

In sum, short volume is a sensor situated near the beating heart of the money behind price and volume. And while algorithms driving trades today are designed to deceive, they can often be unmasked through short volume (with a couple other key measures).

For the rest of this week though, don’t be surprised if the market shows us not a beating heart but expirations-related palpitations.

Feedback

You’ve got to know what to measure.

Every time I interact with anybody from an airline to my company’s communications providers, I get a survey. “How’d we do?”

It drives me crazy. It’s like Claymation customer service:  Move something, take a picture.  Move something, take a picture. You’ve seen clay animation?  Wallace & Gromit popularized cartoonish clay caricature (and cheese!). Each picture contributed to forming movement and emotion. Every snapshot is feedback that when viewed together become the story. It works in cartoons but isn’t a good customer-service model.

We’re inundated with market information in the investor-relations profession.  The feedback loop is so intensive that it can somewhere morph from meaningful to white noise. You don’t know what you’re measuring or hearing. The sequence of snapshots doesn’t translate to meaningful film. There’s no narrative in the data.

Back when I was in the IR chair, I’d hear all the time that we’d broken through moving averages.  Initially, I exclaimed, “Oh!” and added, “Thank you!” It was only later that I realized moving averages told me little and certainly weren’t entertaining like Claymation. What should I tell management?  “Unfortunately, there’s been a breakdown in our moving averages, prompting a sharp shift in perception.”

Really?

Here’s another metric that confuses busy with productive. We have clients with high short interest. The measure derives from a 1974 regulation from The Federal Reserve to track borrowing in marginable securities accounts as part of aggregate money supply.

Borrowing is a good measure of risk. To that end, if you’re interested in a riotous three-minute explanation of what’s wrong in Europe, click here (it’s a video clip so be appropriately prepared).

But what if we’re not measuring borrowing correctly? Short volume, or trading with borrowed shares instead of owned shares, is roughly 43% of the total market. This measure wasn’t created by the Fed in 1974. It’s current. It’s Claymation. We’ve studied short interest and short volume and found that the former often is inversely correlated with price-movements, suggesting that it’s a lagging indicator of risk (and thus a lousy one). Not so with short volume.

The ownership measure extant today, 13Fs, was created in 1974 as well. It’s deplorable as feedback on institutional behavior, coming 90 trading days after it might have occurred. Today, over $1.7 trillion of assets are held by Exchange-Traded Funds that post ownership positions daily, yet trades clear “T+3,” or potentially four days out.

Do you think about these things in the IR chair? Perception is, “Our price continuously reflects rational thought.” Reality is something else, demonstrably and statistically.  Speaking of which, I’m hoping to take the NIRI Arizona chapter on a rollicking safari through market structure today. Process is more influential than purpose.

What you don’t want to do with your IR forensics is confuse busy with productive. You can track vast seas of data that neither offer narrative nor animate it.  What’s the right feedback mechanism? Reality! What is money doing right now and what’s the likely impact in the future, and what’s that mean to actions in my IR program and what I communicate to management? (more…)

Autocallable

It’s time we had The Talk.

Candid discussions can be uncomfortable. They broach subjects we prefer to avoid. But we can’t ignore the facts of life.

One such fact is Contingent Absolute Return Autocallable Optimization Securities. We’re more comfortable talking about diarrhea, right? Bring them up at a party and the crowd disperses. Try talking to your teenager about them and she’ll roll her eyes and turn up One Direction in her ear buds.

Why the public disdain? Look at the name. Need we say more? They’re wildly popular though with issuing banks including JP Morgan, UBS, Barclays, Morgan Stanley, RBC and others – just about anyone who offers “structured products.”

This particular version of structured product (“a financial instrument crafted by a brokerage to achieve a particular investment objective for clients ranging from short-term yield to long-term risk-mitigation” is how we’d describe them) achieved both infamy and scrutiny after Apple shares slumped in latter 2012. Big banks had sold hundreds of millions of dollars of Contingent Autocallable Securities paying a yield of about 10% and tied to the performance of Apple shares. Buyers got stuck with shares that had dropped 30% in value and lost principal to boot.

I’ll give you my simplest understanding of how these instruments work and why you should care from the IR chair. It’s a debt instrument and it’s unsecured. It tends to pay high interest, like 10% annualized in a basis-points world. Whether it pays out turns on two things: How long you hold it, and whether the underlying equity to which it’s paired declines below a trigger price.

There are two problems for IROs. First, because regulators consider it debt, if it “converts” there’s no equity trade. These things are not responsible for big percentages of volume so there’s no vortex looming in your share-counts. But still, decisions and strategies impacting shares are resulting from instruments you can’t track. (more…)