Tagged: shorting

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.

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.

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.

The Long and Short

In the timeless 1987 movie The Princess Bride, Vizzini the Sicilian, played riotously with a lisp by Wallace Shawn, keeps declaring things “inconceivable!”

Swordsman Inigo Montoya, portrayed then by Homeland’s Mandy Patinkin, finally says, “You keep using that word. I do not think it means what you think it means.”

You could say the same for short interest. It’s not what you think it means. Stay with me to the end, and you’ll see.

On August 2, 2012, Knight Capital Group’s algorithms failed. Monday at TABB Forum, Anthony Masso, CEO at trading risk-analytics provider Succession Systems, described how the SEC’s recent settlement with Knight successor KCG Holdings clarified a risk standard called the Market Access Rule. It requires brokers to have systems that forestall actions that may imperil themselves or others in the market. I’d paraphrase the law this way: “We order you to take whatever actions are necessary to prevent bad stuff. Thank you.”

That’s not what got my attention. The settlement reveals details about Knight’s errant trades. The broker bought, or went long, $3.5 billion of stocks; and shorted, or sold, about $3.2 billion. In less than an hour, its systems executed four million trades in 174 different stocks to create these positions.

This one tidbit is a tumbler unlocking vast secrets about market behavior. Knight’s algorithms were observably designed to build long and short positions of similar size principally to supply the storefronts of the stock market. When these positions failed to modulate, markets rushed into the vacuum, crushing Knight’s balance sheet.

Here’s the delicate balance in proprietary high-speed trading. Get it wrong by less than 10% and you’re done. Knight got it wrong. This same fragile trestle trains markets over the chasm each day. We’re all riding the rail.

ModernIR tracks short volume using algorithms. The daily average the past 50 days marketwide is 41%, not far off long/short equilibrium. Combined volumes on exchanges and dark pools total about 6.3 billion shares daily, meaning 2.5 billion shares each day are short.

Short interest in the S&P 500 is nearer 5% on average, though components can reach levels that roughly match daily short volume. The difference between interest and volume is that volume is just borrowed, while interest remains sold and outstanding.

Our data show that 11% of public companies have short volume above 50% of total volume. The highest in our client base the last five days was 61%. We’ve seen levels reach 85%, meaning nearly nine of every ten trades involved short shares – rented trading inventory. The lowest we saw was in a series of Class B shares trading just a few thousand per day where still 15% were short.

Elevated short interest can mean speculators are betting on a downturn. But it could as well be searing daytime demand for trading “inventory” – bowling shoes to put on for the day, for the game, traders and intermediaries finding renting cheaper than owning.

What concerns me is that short volume by definition in Regulation T is credit. So the market is heavily dependent on borrowing, just like the entire global financial system.

You have to see volume differently. Half of it is borrowed. Rented. Bowling shoes. High short interest is a product of frenetic demand on short horizons – not a certificate guaranteeing imminent pressure.

But realize that a hiccup in long/short balances can move your shares sharply – and it’s got nothing to do with ownership, or even shorting in the conventional sense. Inconceivable? No. And you know now what I mean.

Stopping Shorts

We’re in Paris.

After last week’s pelting Hollywood, FL schedule at NIRI National 2013, we’re sight-seeing along the Seine and then wheels-down southward through Provence on bikes. Tell you about it in two weeks.

Back to NIRI. The Westin Diplomat taunts with beckoning views of surf and sand mere yards away while you ride chilly escalators through its immense conference center. One early walk Wednesday up the strand, home to bargain venues like the Manta Ray Hotel and dining establishments where breakfast still goes for $3.90, cured our longing for the outdoors, however. We soaked fast in the sultry air where but degrees of atomization separate sea and sky. We don’t know humid in Denver.

Observations? NIRI ran a solid show, tightening panel-times and offering innovative material to spice up the same stuff you’ve always seen if you’ve gone to fifteen of these like I have. Audience? Seemed light to me, perhaps some under the 1,200-ish we heard. But it’s FL. Maybe a chunk hit boats and links rather than booths and panels.

ModernIR pumped up its presence with a new booth, a bag insert, and a full page in the conference program. And I was on a panel about short-selling (we track short volume with algorithms). In all my NIRI years, I can’t recall one on shorting that featured the head of securities-lending for Franklin Templeton and a real short-selling hedge fund.

The gregarious Kevin Tuttle, CEO of short fund Tesseract Management, entertained us with wide-ranging views interspersed with gems that could slip by if you weren’t paying close attention. (more…)

Equity Supply Chain

Dollar General (NYSE:DG) dropped 9% yesterday, offering a lesson to investor-relations professionals.

Before that, a plug: At NIRI National next week I’m paneling with the CEO of short-seller Tesseract Management and the head of securities-lending for Franklin Templeton on short-selling strategy and practices. Longtime NIRI fixture Theresa Molloy has organized a great discussion and will moderate. And please visit ModernIR at booth 719, our eighth straight year in the exhibit hall.

For Dollar General, revenues were light and guidance lighter, margins weakened due to the products folks were buying last quarter, and inventories rose 21%. Investors and traders can examine facts about the structure of Dollar General’s market, from margins to supply-chain, and make value judgments (which will be distorted by other market behaviors, however).

Have you considered that your equity market is also affected by logistics, supply-chain and who’s consuming the product? We perhaps never imagine that the stock market has the same characteristics and limitations of other markets. Have you gone to the shoe store and they didn’t have your size in the brand you wanted? How come that doesn’t happen in the stock market? (more…)