Tagged: Stocks

Watch the Machines

As dawn spreads across the fruited plain today, we’re plunging into Iceland’s Blue Lagoon.  If we learn market-structure secrets here, we’ll report back next week.

Meanwhile, stocks have been emitting the effervescence of a Sunday brunch mimosa bubbling a happy orange hue.  Market Structure Sentiment™ for stocks as measured daily has posted a record stretch at 6.0/10.0 or higher.

What’s that mean ahead?

Here’s back-story for those new to the Market Structure Map. We formalized what we first called MIRBI (merbee), the ModernIR Behavioral Index, in Jan 2012. Market Structure Analytics is the science of demographics in the money behind prices and volume. We can measure them in your stock, a sector, the whole market.

Correlated to prices, volatility and standard deviation, behaviors proved predictive. We built a ten-point quantitative scale from Oversold at 1 to Overbought at 10. Stocks mean-revert to 5.0 and trade most times between 4.0-6.0. Market Structure Sentiment™ has signaled nearly every short-term rise and fall in stocks since 2012, large and small.

In both late January 2018 and late Sep 2018 preceding market corrections, Market Sentiment topped weakly, signaling stocks were overbought and pressure loomed.

If corporate fundamentals consistently priced stocks, this math wouldn’t matter. Active Investment can only blunt market structure periodically. Just the way it is.

It reflects a truth about modern markets: Machines set prices more than humans. So, if you want to know what prices will do, watch the machines. Investor-relations professionals and investors must know market structure now. Otherwise we blame humans for things machines are doing.

Getting back to the future, we recorded a couple long 6.0+ stretches in 2012. They presaged plateaus for stocks but nothing else. It was a momentum market rich with Fed intervention, and European bond-buying to prop up the euro.  Scratch those as comparatives.

Same drill in two 2013 instances, May and July. We had a blip, but the rocket sled was burning central-bank nitrous oxide and barely hiccupped.

After the Federal Reserve hiked rates in December 2015 for the first time in ten years, the market nearly imploded in January. This would prove – till further notice – to be the last time the Fed overtly intervened.

After stocks showed gaping cracks to begin the year, by Mar 2016 excess reserves at the Fed had soared by $500 billion.  The dollar swooned.  Stocks surged. And Market Structure Sentiment™ marked the longest recorded stretch above 5.0.

By Nov 1, 2016, before Donald Trump’s election, however, stocks were back to Dec 2014 levels. I think the bull market was ending but Trump’s ascendency gave it new life.

Cycles have shortened because the bulk of behaviors changing prices every day are motivated by arbitrage – profiting on price-differences. True for Fast Traders, ETF market-makers, market-neutral strategies, global-macro allocations, counterparties.

The length of trading cycles, I believe, depends on the persistence of profits from arbitrage.  Volatility bets expire today, index options tomorrow, with full options expirations and index true-ups Feb 15th.

We may not yet mark a cycle terminus, but arbitrage profits are thinning. For the week ended Feb 2, spreads between sector ETFs and sector stocks totaled 10.5%. Last week it was down to 5.6%.

Further illustrating, Healthcare stocks were up 1.6% the five days end Feb 2, and down 1.6% the week of Feb 8 (and the sector is down the past five days). Real Estate and Utilities offered behavioral data saying they were market hedges – and they’re the two best performers the past five trading days.

I’m confident we’ll see this trading cycle end first in peaking Market Structure Sentiment™ (linked here for Sep 4-Feb 11). It faltered briefly but hasn’t fallen.

As to a big prediction? Past performance guarantees nothing, yet forgetting history condemns us to repeating mistakes. There’s a balance. Seen that way, this long positive run may be the earliest harbinger of the last bull run ending 6-9 months out. Machines will be sifting the data. We’ll watch them.

Now if you’ll excuse us, we’re going to slip into this wildly blue lagoon.

 

Flowing

The Investment Company Institute (ICI) says US equities saw net outflows of $5.1 billion Jan 2-23, the latest data. Add the week ended Dec 26 and a net $26.2 billion left.

So how can stocks be up?

Maybe flows reversed after the 23rd?  Okay, but the S&P 500 rose 12.2% from Dec 24-Jan 23.  It’s now up about 16%, meaning 75% of gains occurred during net outflows.

Is the ICI wrong?  In a way, yes.  It treats redeemed Exchange Traded Fund (ETF) shares as outflows – and that’s not correct.

Let me explain. The stock market is up because of whatever is setting prices. We measure that stuff. The two big behaviors driving stocks Dec 26-Feb 4 were Passive Investment, and Risk Mgmt, the latter counterparties for directional bets like index options.

That combination is ETFs.

ETF shares are redeemed when brokers buy or borrow them to return to ETF sponsors like Blackrock, which exchanges them for stocks or cash of equal value.

If ETF shares are removed from the market, prices of ETFs tighten – and market makers bet long on index and stock options. That’s how derivatives rally underlying assets.

See, ETFs depend on arbitrage – different prices for the same things. And boy do prices differ. We track that data too.  When ETFs rise more than underlying stocks, the spreads are small. Stocks are far less liquid than ETFs because share-supplies don’t continually expand and contract like ETFs.

As an example, Consumer Discretionary stocks were up 1.6% last week (we meter 197 components for composite data on behaviors, shorting, Sentiment, etc.).  But the State Street Sector SPDR (pronounced “spider,” an acronym for S&P Depository Receipts, an ETF) XLY was up just 0.2%.

XLY is comprised of 65 Consumer Discretionary stocks. As we’ve explained before, ETFs are not pooled investments.  They’re derivatives, substitutes predicated on underlying assets.

So it really means State Street will take these stocks or similar ones in exchange for letting brokers create ETF shares, and vice versa.

You can’t short a mutual fund because it’s a pooled investment.  You can short ETFs, because they’re not. In fact, they’re a way to short entire sectors.

Want to pull down a swath of the market? Borrow key components correlated to the ETF and supply them to a big broker authorized to create ETF shares, and receive off-market blocks of a sector ETF like XLY. Then sell all of it on the open market.

It happened in December.

Here’s how. A staggering $470 BILLION of ETF shares were created and redeemed in December as the market plunged, putting the Nasdaq into bear territory (down 20%) and correcting major indices (down 10% or more).

And guess what?  There were $49 billion more creations than redemptions, which means the supply of ETF shares expanded even as the market declined.

I doubt regulators intended to fuel mass shorting and supply/demand distortion when they exempted ETFs from key provisions of the Investment Company Act of 1940 (and how can they do that, one wonders?).

But it’s happening. More proof: shorting in stocks topped 48% of all volume in December.

Returning to spreads, we’ve since seen the reverse of that trade. Stocks are being arbitraged up in value to reflect the supply of ETF shares outstanding, in effect.

And shorting has come down, with 5-day levels now below 20- and 50-day averages.

We’ve showed you ETF patterns before. Here’s the Industrials sector, up 5% the past week. Those purple and green bars?  ETFs. Stocks, plus leverage.  The purple bars are bigger than the green ones, meaning there is more leverage than assets.

That was true Jan 8-15 too, ahead of expirations the 16th-18th, the only period during which the sector and the market showed proportionally flat or down prices (see linked image).  Traders used their leverage (options volumes in 2018 crushed past records – but the culprit is short-term ETF leverage, arbitrage. Not rational behavior).

Why should you care about this stuff, investor-relations professionals and investors? We should know how the market works and what the money is doing. With ETF-driven arbitrage pervasive, the market cannot be trusted as a barometer for fundamentals.

Your boards and executive teams deserve to know.

What can we do? Until we have a disaster and the SEC realizes it can’t permit a derivatives invasion in an asset market, we must adapt. Think ahead.

For companies reporting results next week or the week after, risk has compounded because this trade is going to reverse. We don’t know when, but options expire Feb 14-16. Will bets renew – or fold?

Whenever it happens, we’ll see it coming in the data, by sector, by stock, across the market, just as we did in late September last year before the tumult.

Down Maiden Lane

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

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

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

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

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

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

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

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

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

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

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

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

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

Wow, right? Whew!

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

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

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

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

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

Now we’re at the top of the arc.

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

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

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

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

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

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

 

A Credit Market

In the stock market the beatings have been consistent while we all wait for morale to improve. What’s causing it?

I’m surprised conservatives haven’t blamed midterm elections. Alert reader Pat Davidson in Wisconsin notes CNBC viewers say tariffs, global economic weakness and Fed rate-hikes are behind the stock swoon.

Is it a coincidence that these are what the media talk about most?

I think stocks are down because of market structure. Exchange Traded Funds infect them with characteristics of a credit market.

The big hand pelting backsides of stocks has been uneven. Broad measures have corrected off highs. I tallied the FAANGs (FB, AMZN, AAPL, NFLX, GOOG) and they’re down 20-40% from peaks. Same with small-caps.

We last week launched our Sector Insights reports that compile readings on composite stocks by sector. Surveying them, only one, Communications Services, showed recent Active buying. The rest were uniformly beset by ETFs. As was the broad market. ETFs were favoring Utilities and shedding everything else.

Two sectors had positive Sentiment, Real Estate and Utilities, but both were in retreat. Financials and Industrials were tied for worst Sentiment at 2.2/10.0.

Note that Monday, Real Estate and Utilities were the worst performers, down nearly 4%. Financials and Industrials were best, down less than the rest.

The point is that our measures are quantitative. They are not rational factors like tariffs, global economic weakness, or Fed rate-hikes. Yet they accurately and consistently predict what stocks, sectors and the market will do, short-term.

Therefore, the cause for much of the short-term behavior in stocks cannot be rational.

Sure, we’ve written about our expectation that a strong dollar would be deflationary for commodities and risk assets. Inflation is low interest rates. Excess availability of capital fostered by artificially depressed costs. It’s not rising prices. When excess availability vanishes, prices fall regardless of whether they first rose.

The Federal Reserve has removed nearly $1 trillion from its balance sheet and excess reserves through policies, which translates on a reserve-ratio basis to a reduction in capital of roughly $8-10 trillion. That will deflate prices.

But the problem isn’t deflation. It’s the inflation that preceded it. Fed, are you listening?  How about not creating inflation in response to crises? How about instead letting things that should fail do so by setting rates high and accepting only good collateral? Then human creativity can restore productivity, and economies can soar anew.

A financial instrument that extends reach to an asset class is a form of credit.  Credit creates bubbles that collapse when the extension of credit is curtailed.

Let’s use the Healthcare sector as an example. Year to date, Healthcare before Friday was the top-performing sector (now eclipsed by Utilities, up nearly 8%). From Nov 15-Dec 3, comparative performance for the sector was positive.

Suddenly in December the sector fell apart, with the red tide coming on green and purple bars, signaling ETFs.  It happened before JNJ plunged 14%. The credit bubble burst.

ETFs are a form of credit. Blackrock itself describes ETFs as a tool that equalizes supply with demand. ETFs are collateralized substitutes for buying and selling stocks. They offer artificially low costs. They permit elastic supplies of money to chase finite US shares.

The result on the way up is soaring equities. The consequence on the way down is collapsing stocks.

Here’s an analogy. Suppose you have a line of credit on your house and you buy something with it – say a vacation home.  Your capacity to borrow derives from the rising value of your house, which in turn is driven by demand for homes around you.

What if banks extending credit are out of lending capacity and lift rates?  Suddenly, demand for houses around yours declines. Home prices begin to fall. The value of your house drops.

And the bank that extended credit to you becomes concerned and wants more collateral.

Suppose that’s happening in the wholesale market where ETFs are created and redeemed. It far outstrips any other form of fund-flows — $4 trillion already this year through November (estimated), $400 billion per month.

If the value of the collateral used to create ETF shares – stocks – is of indefinite and unpredictable and falling value, the capacity to extend credit collapses. And prices start falling everywhere.  Those who borrowed must sell assets to cover obligations.

What if that’s the cause, not the economy or tariffs? That should matter to pundits, investors and investor-relations professionals (and CEOs by extension).

We have the data. Use it. We expect markets to jump Dec 19-21 through the final expirations period of 2018. But it’s a credit market subject to credit shocks.

Sector Insights

We take a moment to honor the passing of George Herbert Walker Bush, 41st President of the United States, who earned respect across aisles and left a legacy of dignity, achievement and service.

Markets are closed today in Presidential honor, perhaps fortuitously, though it won’t surprise us if stocks surge back, confounding pundits. A CNBC headline at 4:24pm ET yesterday said, “Dow plunges nearly 800 points on fears of cooling economy.”

The article said the slide steepened when Jeffrey Gundlach of Doubleline Capital told Reuters the yield-curve inversion (three-year Treasury notes now pay more than five-year notes) signals that the economy is “poised to weaken.” A drubbing in Financials (weren’t we told higher rates help banks?) and strength for Utilities were said to support that fear.

Yet Sector Insights (I’ll explain in a moment!) for Financials show the rally last week came on Active Investment – rational people buying Financials.  In a spate of schizophrenia, did Active money seize a truncheon and bludgeon away its gains in a day?  Possible, maybe. But improbable.

Utilities have been strong all year (see Figure 1). Market Structure Sentiment™ for Utilities from Jan 3-Dec 3, 2018 is 5.4/10.0 – solidly GARP (sectors trade between 4 and 7 generally). Utilities haven’t dipped below 4.0 since late June.

If strength in Utilities signals economic fear, did it commence in January (or March, when they soared after the market corrected)?

What if it’s market structure?  Did anyone ask?  Add up the week-over-week change in the two behaviors driving Utilities highe

Figure 1 – Market Structure Sentiment(TM) – Utilities Sector – 2018. Proprietary ModernIR data.

r the past week and what we call internally “behavioral volatility” was massive – 22%.  Daily behavioral change is routinely 2% total!

We’ve long said that behavioral volatility precedes price-volatility.  Last Friday, daily behavioral volatility in the entire market was a breathtaking 19.6% (5.4% jump in Active Investment, sizzling 14.2% skyhook from Fast Traders) at month-end window-dressing.  On Thu, Nov 29, it was 20%, driven by Passive Investment and Risk Mgmt, a behavioral combination signaling ETF creations and redemptions.

On Monday Dec 3, ETF basket-moves drove another 15% surge. Think about it: 20%, 20%, 15%. Picture a boat rocking as people rush from one side to the other, and the momentum builds until the boat tips over.

Economic fear exists. And the yield curve has predicted – what’s the economics joke? – five of the last three recessions.

But the curve could as well trace to selling by the Fed of $350 billion of Treasurys and mortgage securities while the Treasury gorges on short-term paper to fund deficits.

Most see the market as a ticking chronometer of rational thought.  It’s not, any more than your share-price is a daily reflection of investors’ views of your management’s credibility. It is sometimes. Data say about 12% of the time.

If pundits think it’s economics when it’s a structural flaw in the market, the advice and actions are wrong.  And we could be caught unprepared.

Don’t people move money into and out of index funds or ETFs too in reaction to economics?  Sure. But not daily.  We just had this discussion with our financial advisors and we like most allocating assets plan in long swaths on risk and exposure.

And I’ll say it till everyone gets it: ETFs do not form capital or buy or sell stocks. They are continually created and redeemed by parties swapping collateral (stocks and cash) back and forth to profit on spreads between that underlying collateral and the frenzy of arbitrage in ETF shares traded in the stock market.

It’s those people and machines in the market who rush back and forth and rock the boat, arbitragers trying to profit on different prices for the same thing.

Especially if they’ve borrowed collateral or leveraged into expected short-term moves. They’ve tipped the market over three times now just since early October.

You can see it in patterns. Speaking of which, wouldn’t it be nice to know what’s driving your sector the next time the CEO says, “Why is our stock down while our peers are up?”

To that end, we’re delighted to announce our latest innovation at ModernIR:  Sector Insights.  Now you can compare the trading and investment behaviors behind your stock and your sector.

We classify every company by GICS industry and sector.  Algorithms can then cluster a variety of data points from investment and trading behaviors, to shorting, and intraday volatility and Market Structure Sentiment™, providing unprecedented clarity into sector trends and drivers.

If you’re interested in seeing your Sector Insights alongside your Market Structure Report, send a note to Mike Machado here. (Clients, you can see a three-minute overview of how to use Sector Insights in concert with your Market Structure Reports here.)

Meanwhile, buckle up.  December could further provide a wild ride to investors – and you’ll see it in Sector Insights if it’s coming.  We’ll be here to help you help your executives and board directors understand what’s driving equity values.

When Oil Swoons

How is it that stocks and oil fall if no one is selling them? There’s an answer. Tim Tebow once famously sent a one-word tweet: “Motivation.”

For Tebow (Karen and I were downtown years ago when Tim was a Denver Broncos quarterback, and we passed a handsome youngster who offered a friendly hello and seemed familiar and had shoulders so wide they covered most of the sidewalk…and we realized seconds later we’d passed Tim Tebow.), the word meant a reason to try.

Motivation in markets is money.

Whatever your ticker, investor-relations professionals (or investors, whatever the composition of your portfolios), your price is often set by trading firms.

How do we know? Floor rules at the exchange prohibit using customer orders to price NYSE-listed stocks at the open. Designated Market Makers (DMMs) must trade their own capital to set a bid and offer for your shares. Now all DMMs are proprietary traders.

Investors:  If you don’t know how stock prices are set, you deserve to be outperformed by Exchange Traded Funds (ETFs). ETFs don’t even buy and sell stocks!  They are collateralized stock derivatives (let’s call them CSDs).

Don’t know what I mean? Stop, and listen:

If you’re in Dallas Fri Nov 16, hear my presentation on ETFs at The Clubs at Prestonwood.  Clients in Dallas: Ask your CFO and Treasurer and VP of Finance and Controller to learn what the money is doing behind price and volume, and why.

What if you’re Nasdaq-listed?  The first and fastest machines set all offers to sell (the primary price) and bids to buy (the secondary price) when stocks open for trading, and chances are traders (not IEX, the only exception) have been paid to set bids and offers.

It’s not your fundamentals. Machines set prices all day long.

And the price of oil most days is not determined by fundamentals either. It’s set by a currency. The US dollar.  Oil is denominated in dollars. Big dollar, smaller oil price. Small dollar – say 2007, or much of 2017 – big oil price.

Back to stocks. Under Regulation National Market System, there is a spread between the best bid to buy and offer to sell for your shares.  They can’t be the same ($15.01 buy, $15.01 to sell). That’s a locked market. Against the law.

The Bid cannot be higher than the Offer (e.g. Bid, $15.02, Offer $15.01). That’s a crossed market. Can’t happen. Why? So there’s an audit trail, a way to trace which firms set every bid, every offer, in the market. And a crossed market cannot be controlled by limit-up/limit-down girders that govern stocks now. (You can bid more than what’s asked for art, houses, cars, companies, etc. But not stocks.)

If demand from money wanting to buy shares exactly matched supply, stocks would decline. Brokers, required by rule to set every bid and offer, have to be paid.

That means stocks can rise only if demand exceeds supply, a condition we measure every day for you, and the market. Do you think your board and executive team might like to know?  (Note: If you want to know if supply exceeds demand in your stock, or your sector, ask us. We’ll give you a look gratis.)

Knowing if or when supply exceeds demand is not determined by whether your stock goes up or down. Were it so, 100% of trades would be front-run by Fast Traders. So how can it be that no money leaves stocks and they fall, and no money sells oil and it falls?

Do you own a house? Suppose you put it up as collateral for a loan to start a business you believed would be more valuable than your house. This is the bet ETF traders make daily. Put up collateral, create ETF shares, bet that ETF shares can be sold for more ($12.1 million) than the cost of the collateral offered for the right to create them ($12.0 million).

Then suppose you can sit between buyers and sellers and make 10 basis points on every trade in the ETF, the index futures the ETF tracks, and the stocks comprising the index.  Another $120,000 (a 20% margin over collateral). Do that every day and it’s meaningful even to Goldman Sachs for whom this business is now 90% of equity trading.

Reverse it. When stock-supply exceeds demand, ETF creators and market-makers lose money. So they sell and short, and the whole market convulses.  Spreads jump. Nobody can make heads or tails of it – until you consider the motivation. Price-spreads.

Oil? Remember our time-tested theme (you veteran readers). If the dollar rises, oil falls. It happened in Sep 2014 when the Federal Reserve stopped expanding its balance sheet.

Now it’s worse. The Fed is shrinking its balance sheet. Oil is denominated in dollars no matter what Saudi Arabia does. If the dollar gets bigger – stronger – oil prices shrink. Look at the chart here for the Energy sector. ETFs? Devalued collateral?

ETFs, the greatest investment phenomenon of the modern era, behave like currencies. We’ve not yet had a BIG imbalance. It’s coming. We’ll see it.  Subscribe. It’s motivating.

Pricing Everything

As the colors of political persuasion in the USA ripple today, what matters in the equity market is what the money is doing.

We measure Sentiment by company and sector and across the whole market daily. It’s not mass psychology. Rational thought sets a small minority of prices (your board and execs should know, investor-relations professionals, or they will expect you to move mountains when the power at IR fingertips now is demographics – just as in politics).

We’re measuring ebbs and flows of money and the propensity of the machines executing the mass of trades now to lift or lower prices.

When the market is Oversold by our measures, it means Passive money is likely to be underweight relative to its models and benchmarks, and probability increases that machines will lift prices for stocks because relative value – the price now versus sometime in the past 20 days – is attractive. We call it Market Structure Sentiment.

In Oct 2016, before the Presidential election, Market Structure Sentiment saw its worst stretch since Sep-Oct 2014 when the Federal Reserve stopped buying debt, sending the dollar soaring and the energy industry into a bear market.

We at ModernIR thought then that after pervasive monetary intervention the next bear market would be two years out. On the eve of the Presidential election two years ago, and two years out, the Dow 30 traded at Dec 2014 levels.

We figured we’d called it.

We were wrong (the market makes fools of most who propose to prophesy).  Donald Trump won, and stocks surged until October this year.

As I write Nov 6, Market Structure Sentiment has bottomed at 3.5/10.0 on our 10-point scale. In 2016 it bottomed Nov 9, the day of the election (and stocks surged thereafter).

Conclusions?  Maybe rational thought means little.

Consider: The SEC has approved Rule 606(b)(3) (if rules need parentheses it means there are too many – but I digress) for brokers, requiring that they disclose (thank you, alert and longtime reader Walt Schuplak) when they’re paid by venues for trades and trade for their own accounts.

Public companies and investors, why do we need rules requiring brokers to tell us if they’re getting paid for orders or trading ahead? Because they’re doing it. And it’s legal.

If we want to suppress both things, why not outlaw them?

Because the market now depends on both to price everything.

Let me explain. When the SEC exempted Exchange Traded Funds from the Investment Company Act’s requirement that fund-shares be redeemable for underlying assets, they did so because ETFs had an “arbitrage mechanism,” a built-in way for brokers to profit if ETFs deviated from its underpinning index.  (NOTE: If you don’t know how ETFs work, catch the panel at NIRI Chicago next week.)

Those exemptions preceded Regulation National Market System, which capped trading fees – but left open what could be PAID for trades. I bet the SEC never saw this coming.

Rule 606(b)(3) forces brokers to tell customers when they get paid for trades and if they are trading for themselves at the same time.

In ETFs, the two dovetail. Brokers can earn trading incentives legitimately because they’re fueling the SEC-sanctioned arbitrage mechanism, which requires changing prices. Rules let you get paid for it!

Second, since ETFs are created and redeemed by brokers (not Blackrock), much ETF market-making is principal trading – for a broker’s own account.

So ETFs create opportunity for brokers to get paid for setting price, and to put their own trades ahead of customer orders – the things 606(b)(3) wants to highlight.

Now ETFs are the largest investment vehicle in markets, and Fast Trading prices stocks more often than anything else. Suppose you’re the SEC. What would you do?

Let’s put it in mathematical terms. Our analytics show 88% of trading volume is something besides rational investment. We blame rules that focus on price. Whatever the cause, there’s a 12% chance rational thinking is why Sentiment is bottomed at midterms.

I think the SEC knows. Can they fix it? Well, the SEC created it to begin.

For now, public companies, every time you look at stock-price, there’s a 12% chance it’s rational. Does your board know? If not, why not? Boards have fiduciary responsibility.

And investors, are you factoring market structure into your decisions? You’d best do so. Odds favor it.

Blocking Volatility

Boo!

As the market raged high and low, so did Karen and I this week, from high in the Rockies where we saw John Denver’s fire in the sky over the Gore Range, down to Scottsdale and the Arizona desert’s 80-degree Oct 30 sunset over the Phoenician (a respite as my birthday is…wait for it…Oct 31).

Markets rise and fall.  We’re overdue for setbacks.  It doesn’t mean we’ll have them, but it’s vital that we understand market mechanics behind gyrations. Sure, there’s human nature. Fear and greed. But whose fear or greed?

Regulators and exchanges are tussling over fees on data and trades.  There’s a proposed SEC study that’ll examine transaction fees, costs imposed by exchanges for trading. Regulation National Market System caps them at $0.30/100 shares, or a third of a penny per share, which traders call “30 mils.”

The NYSE has proposed lowering the cap to $0.10/100, or a tenth of a penny per share, or 10 mils. Did you know there’s a booming market where brokers routinely pay eight cents per share or $8.00/100 shares?

What market? Exchange-Traded Funds (ETFs).

We’re told that one day the market is plunging on trade fears, poor earnings, geopolitics, whatever. And the next, it surges 430 points on…the reversal of fears. If you find these explanations irrational, you’re not alone, and you have reason for skepticism.

There’s a better explanation.

Let’s tie fees and market volatility together. At right is an image from the iShares Core MSCI EAFE ETF (CBOE:IEFA) prospectus showing the size of a standard creation Unit and the cost to brokers for creating one.  Divide the standard Unit of 200,000 shares by the usual cost to create one Unit, $15,000, and it’s $0.08/share (rounded up). Mathematically, that’s 2,600% higher than the Reg NMS fee cap.

Understand: brokers provide collateral – in this case $12.5 million of stocks, cash, or a combination – for the right to create 200,000 ETF shares to sell to the public.

Why are brokers willing to pay $8.00/100 to create ETF shares when they rail at paying $0.30/100 – or a lot less – in the stock market?

Because ETF shares are created in massive blocks off-market without competition. Picture buying a giant roll of paper privately, turning it into confetti via a shredder, and selling each scrap for a proportionate penny more than you paid for the whole roll.

The average trade-size for brokers creating IEFA shares is 200,000 shares.  The average trade-size in the stock market where you and I buy IEFA or any other stock is 167 shares (50-day average, ModernIR data).  Do the math on that ratio.

ETF market-makers are pursuing a realtime, high-speed version of the corporate-raider model. Buy something big and split it into pieces worth more than the sum of the parts.

In a rising market, it’s awesome.  These creations in 200,000-share blocks I’ve just described are running at nearly $400 billion every MONTH. Create in blocks, shred, mark up. ETF demand drives up all stocks. Everybody wins.

What happens in a DOWN market?

Big brokers are exchanging your stocks, public companies, as collateral for the right to create and sell ETF shares.  Suppose nobody shows up to buy ETF shares.  What brokers swapped to create ETF shares is suddenly worth less, not more, than the shredded value of the sum of the parts. So to speak.

Without ETF flows to drive up it up, the collateral – shares of stocks – plunges in value.

The market devolves into desperate tactical trading warfare to offset losses. Brokers dump other securities, short stocks, buy hedges. Stocks gyrate, and the blame goes to trade, Trump, earnings, pick your poison.

How do I know what I’ve described is correct?  Follow the money. The leviathan in the US equity market today is creating and redeeming ETF shares. It’s hundreds of billions of dollars monthly, versus smatterings of actual fund-flows. You don’t see it because it’s not counted as fund turnover.

But it fits once you grasp the weird way the market’s last big block market is fostering volatility.

What’s ahead? If losses have been sorted, we’ll settle down in this transition from Halloween to November. Our data are still scary.  We may have more ghouls to flush out.

Counterparty Tuesday

Anybody hear yesterday’s volatility blamed on Counterparty Tuesday?

Most pointed to earnings fears for why blue chips fell 500 points before clawing back.  Yet last week the Dow Jones Industrial Average zoomed 540 points on earnings, we were told.  We wrote about it.

Counterparty Tuesday is the day each month following expiration of the previous month’s derivatives contracts like puts, calls, swaps, forwards (usually the preceding Friday), and the start of new marketwide derivatives contracts the following Monday.

When grocery stores overstock the shelves, things go on sale.  When counterparties expect a volume of business that doesn’t materialize, they shed the inventory held to back contracts, which can be equities.

Counterparty Tuesday is a gauge indicating whether the massive derivatives market – the Bank for International Settlements tracks over $530 trillion, ten times the global economy – is overstocked or understocked. It’s much larger than the underlying volume of Active Investment behavior in the US stock market.

Let me use a sports analogy. Suppose your favorite NFL team is beating everyone (like the LA Rams are).  “They are killing everybody through the air,” crow the pundits.

You look at the data. The quarterback is averaging five passes per game and zero touchdowns.  But on the ground, the team is carrying 40 times per game and averaging four rushing touchdowns.

These statistics to my knowledge are fake and apply to no NFL team right now. The point is the data don’t support the proffered explanation. The team is winning on the ground, not through the air.

In the same vein, what if market volatility in October ties back to causes having no direct link to corporate earnings?

What difference does it make if the stock market is down on earnings fears or something else?  Because investor-relations professionals message in support of fundamental performance, including earnings.  Boards and management teams are incentivized via performance. Active stock-picking investors key off financial performance.

If the market isn’t swooning over performance, that’s important to know!

Returning to our football analogy, what data would help us understand what’s hurting markets?  Follow the money.

We wrote last week about the colossal shift from active to passive funds in equities the past decade.  That trend has pushed Exchange-Traded Funds toward 50% of market volume. When passive money rebalanced all over the market to end September, the impact tipped equities over.

Now step forward to options expirations, which occurred last week, new ones trading Monday, and Counterparty Tuesday for truing up books yesterday. Money leveraged into equities had to mark derivatives to market. Counterparties sold associated inventory.

Collateral has likely devalued, so the swaps market gets hit. Counterparties were shedding collateral. The cost of insuring portfolios has likely risen because counterparties may have taken blows to their own balance sheets. As costs rise, demand falters.

Because Counterparty Tuesday in October falls during quarterly reporting, it’s convenient to blame earnings. But it doesn’t match measurable statistics, including the size of the derivatives market, the size and movement of collateral for ETFs (a topic we will return to until it makes sense), or the way prices are set in stocks today.

The good news?  Counterparty Tuesday is a one-day event. Once it’s done, it’s done. And our Market Structure Sentiment index bottomed Oct 22. We won’t be surprised if the market surges – on earnings enthusiasm? – for a few days.

The capital markets have yet to broadly adapt to the age of machines, derivatives and substitutes for stocks, like ETFs, where earnings may pale next to Counterparty Tuesday, which can rock the globe.

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.