Tagged: Stocks

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.

August Currents

“Treasury yields rise as Turkey worries fade,” declaimed a headline at Dow Jones Marketwatch yesterday.

This one day after the New York Times bleated, “Plunge in Lira, Turkey’s Currency, Fuels Fears of Financial Contagion.”

Why are stocks, ostensibly propelled by fundamentals (earnings and revenue growth this reporting cycle were strong), instead wracked by the machinations of a minor monetary unit for an economy that ranks 19th, behind the Netherlands and Indonesia and just ahead of Saudi Arabia?

They’re not.  It’s the dollar. Every investor and investor-relations professional should understand currency valuation, just as we all must grasp how the market works and what the money is doing (we wrote about that last week).

(To Turkey, for a prescient economic perspective, read this piece by Jim Rickards – whose gold views fuel skepticism but who always writes thoughtfully.)

The dollar is the world’s reserve currency. Simplistically, instead of holding gold, countries own dollars, and sell or buy them to adjust the value of their own currencies.

The USA by contrast only mints the buck and the Federal Reserve uses interest rates to regulate its value. In effect, higher interest rates mean a stronger dollar, lower interest rates a weaker buck, all other things being equal. (In fact, some economics ingenue somewhere should write a thesis establishing that the definition of inflation is low rates.)

Anyway, stocks are risk assets that reflect fluctuations in currencies every bit as much as they are supposed to offer a barometer of economic activity.

Take Turkish stocks.  The lira has been falling in value for years while Istanbul’s stocks shined, especially last year. Yet the economy has slipped a couple notches in global rankings.

The US economy is booming, and yet markets have stalled in 2018. The dollar is at a 52-wk high, spiking lately. In 2017, the dollar devalued 12% and stocks soared. There’s consistent inverse correlation between broad US equity measures and the dollar’s value.

We’ve described Teeter Totter Monetary Theory before. The nexus of the Teeter of supply meeting the Totter of demand should determine prices.

But under the modern floating-rate currency construct, central bankers move the fulcrum, which is money, to balance out the teeter totter. To encourage investment (supply) increase the value of the dollar (also lifting productivity, something few in orthodox economics recognize). To fuel consumption, depress interest rates so people borrow more and save less.

The problem is these policies over time erode the veracity of stock prices – and the value of everything from debt to art to homes to money.

Yes, many economists will disagree. But the evidence is stark, as is the math. Goods are the numerator, dollars, the denominator. If the dollar depreciates, things like stocks and beer cost more. Increase its value – more purchasing power – and prices fall.

August has had a recent history of currency volatility.  August 2010 and August 2011 were rocked by the euro, which nearly failed. August 2015 brought a sudden Chinese currency devaluation and on the 24th a thousand Exchange Traded Funds were volatility halted. Stocks didn’t recover until October.

As August 2018 fades like summer grass, there are currents.  The dollar is strong and market-structure Sentiment is sluggish, positive now but without a vital mean-reversion. Options expire the 16th-17th and 22nd, a split cycle for derivatives. (NOTE: Speaking of August, don’t miss NIRI SWRC next week — I’ll be there.)

If stocks top into expirations with a rising dollar, we could have a hard mean-reversion to finish the summer. It’s no prediction, just a higher probability. And it’s not fundamental – yet another reminder that the stock market cannot be seen merely as an economic gauge.

 

Rules and Money

There are two pillars to market intelligence: The Rules, and The Money.

By market intelligence, I mean information about what’s pricing a stock. So, translating, information about what’s pricing a stock must derive from the rules that govern stock-trading, and how money conforms to those rules.

Wouldn’t that be supply and demand?  Would that it were! There are instead four big rules for stocks now, tenets of Regulation National Market System about which every investor and investor-relations officer should have a basic grasp.

“Quast,” you say. “This sounds about as exciting as cleaning a tennis court with a tooth brush. In Houston. In the summer.”

It can be very exciting, but the point isn’t excitement.  If you don’t know the rules (always expect your market intelligence provider to know the rules for stocks), your conclusions will be wrong.  You’ll be guessing.

For instance, if you report strong results and your stock jumps on a series of rapid trades, can a human being do that?  Refer to the rules. What do they require?  That all marketable trades – an order to buy or sell stock – be automated.

No manual stock order can be marketable. Manual orders are nonmarketable, meaning prices for the stock must come to them instead. Picture a block of cheese and a grater passing by it and shaving some off.

The rule creating this reality in stocks is the Order Protection Rule, or the Trade-Through Rule. Same thing. It says traders cannot trade at $21.00 if the same stock is available for $20.99 somewhere else. To ensure compliance, regulators have mandated that orders wanting to be the best bid to buy or offer to sell must be automated.

And the bid to buy will always be lower than the offer to sell. Stocks may only trade at them, or between them.  There can only be one best price (though it may exist in several places).

Now start thinking about what money will do in response.  Orders will be broken into pieces. Sure enough, trade size has come down by factors, and block trades (we wrote about it) are a tiny part of the market.

Big Commandment #2 for stocks is the Access Rule. It goes hand-in-glove with the first rule because it’s really what turned the stock market into a data network.

The Access Rule says all market centers including stock markets like the five platforms operated by the NYSE, the three owned by the Nasdaq, the four owned by CBOE, the newest entrant IEX, and the 32 broker markets that match stock trades must be connected so they can fluidly share prices and customers.

It also capped what exchanges could charge for trades at $0.30/100 shares – paid by brokers trading in the stock market for themselves or customers (the SEC Fee Pilot Program aims to examine if these fees, and their inverse, incentive payments, cause brokers to execute trades in ways they would not otherwise choose).

The third big rule outlaws Sub-Penny Pricing, or quoting in increments so small they add no economic value.  You may still see your stock trading at $21.9999 because of certain exceptions for matching at midpoints of quotes.

Reg NMS lastly imposed new Market Data Rules. Since everyone is sharing prices and customers on this network called the stock market, plans had to be refined for pooling data-revenue (prohibiting sub-penny trading was meant to prevent a proliferation of tiny meaningless prices).

Yet, data is a byproduct of prices. There are hundreds of millions of dollars of revenue governed by the Consolidated Tape Association, which divides proceeds according to how various platforms and brokers quote and trade in accordance with best prices. Outside the CTA, there may be billions of dollars now in proprietary data feeds.

These rules drive how money behaves. The fastest machines will price your stock to start the day no matter where you trade, because they have the quickest bids and offers. But their purpose is to profit on changing prices, not to own stocks.

Passive investment dominating the market is aided by rules. What lies between the bid and the offer? The average price. Those tracking benchmarks like index mutual and exchanged-traded funds get a boost toward their objective.  Prices become uniform (our data show very tight Poisson distribution in the stock market – which helps securities tracking benchmarks).

And because stock prices are highly unstable – average intraday spread in the Russell 1000 the past five trading days is 2.6%, and the typical stock trades over 16,000 times daily in 167-share increments – investors turn to substitutes like derivatives. Even Warren Buffett who once famously skewered them as instruments of mass financial destruction has large derivatives positions.

Let’s finish where we started. Why doesn’t supply and demand drive stock prices? Because rules governing trades don’t let supply and demand manifest naturally. The greatest proportion of trades are now driven by machines wanting to own nothing, the opposite of a market animated by supply and demand.

When you look at your stock or stocks in your portfolio, remind yourself: What’s driving them up and down are rules, and money racing around a course in compliance with those rules.  Some part is rational. A bunch of it isn’t.  We all – investors and public companies – can and should know what’s going on. The first rule, after all, is to be informed.

Welcome to the 21st century stock market.

Lab Knowledge

We are finally watching Breaking Bad five years after the most successful basic cable series in television history ended.

It’s symbolic of the era that we’re viewing it via Netflix. And NFLX Market Structure Sentiment is bottomed, and shorts have covered. We’ll come to market structure in a moment because it intersects with Breaking Bad.

Launched in 2008, Breaking Bad is about high school chemistry teacher Walter White, who turns to cooking methamphetamine to cover medical bills. He becomes Heisenberg, king of blue meth.

I won’t give the story away but what sets Walter White apart from the rest of the meth manufacturers is his knowledge of molecular structure. Let’s call it Lab Knowledge.  With lab knowledge, Walter White concocts a narcotic compound that stuns competitors and the Drug Enforcement Agency alike. He produces it in a vastly superior lab.

In the stock market there’s widespread belief that the recipe for a superior investment compound is the right set of ingredients comprised of financial and operating metrics of businesses.

Same goes for the investor-relations profession, liaison to Wall Street. We’re taught that the key to success is building buyside and sellside relationships around those very same financial and operating metrics.

There’s a recipe. You follow it, and you succeed.

Is anyone paying attention to the laboratory?

The stock market is the lab. Thanks to a total rewriting of the rules of its chemistry, the laboratory has utterly transformed, and the ingredients that underpin the product it churns out now are not the same ones from before.

I don’t mean to toot the ModernIR horn, but we did the one thing nobody else bothered to do.  We inspected the lab.  We studied the compounds it was using to manufacture the products circulating in the market (ETFs, high-speed trading, etc.).

And we saw that stock pickers were failing because they didn’t understand what the lab was producing. It was not that they’d stopped finding the historically correct chemical elements –financial and operating metrics defining great companies of the past.

It’s that these ingredients by themselves can no longer be counted on to create the expected chemical reaction because the laboratory is compounding differently.

And the difference is massive. The lab determines the outcomes. Write that down somewhere. The lab determines the outcomes. Not the ingredients that exist outside it.

So investors and public companies have two choices.  Start a lab that works in the old way.  Or learn how the current lab works. The latter is far easier – especially since ModernIR has done the work. We can spit out every manner of scientific report on the ingredients.

Back to market structure, before NFLX reported results it was 10/10 Overbought, over 60% short and Passive money – the primary chemical compound for investments now – was selling.  The concoction was destined to blow up.

Everyone blamed ingredients like weaker growth and selling by stock pickers, when those components were not part of the recipe creating the explosion in NFLX. Now, NFLX will be a core ETF manufacturing ingredient, and it will rise.

Investors, what’s in your portfolio?  Have you considered the simmering presence of the laboratory in how your holdings are priced?  And public companies, do you have any idea what the recipe is behind your price and volume?

If you want to be in the capital markets, you need lab knowledge. Every day, remind yourself that the ingredients you’re focused on may not be the ones the lab is using – and the lab determines the outcome. The lab manufactures what the market consumes.

One of the things we’ll be talking about at the NIRI Southwest Regional Conference is the laboratory, so sign up and join us Aug 22-24 in Austin.  Hope to see you there!

 

 

Moon Rules

We spent last week in Summit County, famous for Breckenridge and Keystone. With windows open and the sun set, the temperature at 9,000 feet drops fast, great for sleeping.

It’s not great for staying awake reading a Kindle but I worked through some exciting pages of Artemis, the new novel by Andy Weir, who wrote The Martian, made into a Ridley Scott movie starring Matt Damon.

And yes, Artemis got me thinking about market structure. Not because of the profanity, the ripping pace, the clever characters, the exotic settings.  It’s a book set on the moon, where scientific rules matter.

Weir’s genius is the application of science to clever storylines. On the moon, if you want to commit a crime to save the community, you better understand how to blend acetylene and oxygen in zero atmosphere. Fail to follow or understand the rules, you die.

It’s not life and death in the stock market but rules play the same supreme role in dictating outcomes. If as public companies you think your story will determine the outcome for your stock, the rules will humble you.  How much of your trading volume comes from Active Investment? You can and should know – and it’s not what you’d think. But that’s not the point of being public, is it.  So don’t be afraid.

If you’re an investor and you think fundamentals will pace you to superior results, think again. The amount of money choosing company financials has plunged, while funds indexing to markets has mushroomed. Rules helping models will eat your lunch.

What rules? Start with Regulation National Market System. It creates a marketplace that forces revenue-sharing among intermediaries. Professional sports like basketball in the USA also operate with rules that shift focus from playing the sport to managing salary cap (Denver just traded three Nuggets for that reason).

If you don’t know this, you’ll have a false understanding of what drives the sport. The “haves” must distribute funds to the “have nots.” Some owners in money-losing markets might choose to skimp on salary to scrape mandated distributions from teams making bank (I wonder what the NBA Cavaliers will do now?).

Right now, stock market sentiment reflecting not the opinions of humans but the ebb and flow of money and the way machines price stocks (the rules, in other words) is topping again as it did about June 12. Options expire today through Friday.  So, no matter what you expect as earnings commence, the market will have a propensity to decline ahead.

It’s like the rules on the moon.  In one-sixth of earth’s gravity, harsh sun, no atmosphere, success depends on knowing how stuff works. Investors and public companies, welcome to the moon. You can’t treat it like earth. Rules determine outcomes. If your actions don’t account for the rules that govern how markets function, outcomes will reflect it.

But it’s fun on the moon once you know what you’re doing. It’s fun knowing when the market is topped, and bottomed, on rules. It’s fun doing investor-relations when you know what all the money is doing.  So, come on up to zero atmosphere! It’s not scary.

Piloting Fees

What do these pension funds below have in common?

All (over $1.3 trillion of assets), according to Pensions & Investments, periodical for retirement plans, endorse the SEC’s Fee Pilot program on stock-trading in US equities.

The California State Teachers’ Retirement System
The California Public Employees Retirement System (CalPERS)
The Ontario Teachers Pension Plan (Canada)
The New York City Retirement Systems
The State of Wisconsin Investment Board
The Alberta Investment Management Corp. (Canada)
The Healthcare of Ontario Pension Plan (Canada)
The Alaska Permanent Fund Corp.
The Arizona State Retirement System
The San Francisco City & County Employees’ Retirement System
The Wyoming Retirement System
The San Diego City Employees’ Retirement System

In case you missed the news, we’ll explain the study in a moment. It will affect how stocks trade and could reverse what we believe are flaws in the structure of the US stock market impeding capital formation. But first, we perused comment letters from other supportive investors and found:

Capital Group (parent of American Funds) $1.7 trillion
Wellington Management, $1 trillion
State Street Global Advisors, $2.7 trillion (but State Street wants Exchange Traded Products, ETPs, its primary business, excluded)
Invesco, $970 billion
Fidelity Investments, $2.4 trillion
Vanguard, $5.1 trillion
Blackrock, $6.3 trillion (with the proviso that equal ETPs be clustered in the same test groups)
Assorted smaller investment advisors

By contrast, big exchange operators and a collection of trading intermediaries are either opposed to the study or to eliminating trading incentives called rebates.  We’ll explain “rebates” in a bit.

That the views of investors and exchanges contrast starkly speaks volumes about how the market works today.  None of us wants to pick a fight with the NYSE or the Nasdaq. They’re pillars of the capital markets where we’re friends, colleagues and fellow constituents. And to be fair, it’s not their fault. They’re trying to compete under rules created by the SEC. But once upon a time exchanges matched investors and issuers.

Let’s survey the study. The program aims to assess the impact of trading fees, costs for buying and selling shares, and rebates, or payments for buying or selling, on how trading in stocks behaves.  There’s widespread belief fees distort how stock orders are handled.

The market today is an interconnected data network of 13 stock exchanges (four and soon five by the NYSE, three from the Nasdaq, and four from CBOE, plus new entrant IEX, the only one paying no trading rebates), and 32 Alternative Trading Systems (says Finra).

The bedrock of Regulation National Market System governing this market is that all trades in any individual stock must occur at a single best price:  The National Best Bid to buy, or Offer to sell – the NBBO.  Since exchanges cannot give preference and must share prices and customers, how to attract orders to a market?  Pay traders.

All three big exchange groups pay traders to set the best Bid to buy at one platform and the best Offer to sell at another, so trades will flow to them (between the NBBO).  Then they sell feeds with this price-setting data to brokers, which must by rule buy it to prove to customers they’re giving “best execution.” High-volume traders buy it too, to inform smart order routers.  Exchanges also sell technology services to speed interaction.

It’s a huge business, this data and services segment.  Under Reg NMS, the number of public companies has fallen by 50% while the exchanges have become massive multibillion-dollar organizations.  No wonder they like the status quo.

The vast majority of letters favoring the study point to how incentive payments from exchanges that attract order flow to a market may mean investors overpay.

One example: Linda Giordano and Jeff Alexander at BabelFish Analytics are two of the smartest market structure people I know. They deal in “execution quality,” the overall cost to investors to buy and sell stocks. Read their letter. It explains how trading incentives increase costs.

Our concern is that incentives foster false prices. When exchanges pay traders not wanting to own shares to set prices, the prices do not reflect supply and demand. What’s more, the continuous changing of prices to profit on differences is arbitrage. The stock market is riven with it thanks to incentives and rules.

The more arbitrage, the harder to buy and sell for big investors. Arbitrage is the exact opposite motivation from investment. Why would we want a market full of it?

The three constituents opposing eliminating trading payments are the parties selling data, and the two principal arbitrage forces in the market:  High-frequency traders, and ETFs.

What should matter to public companies is if the stock market is a good place for the kind of money you spend your time targeting and informing. Look at the list above. We’ve written for 12 years now about how the market has evolved from a place for risk-taking capital to find innovative companies, to one best suited to fast machines with short horizons and the intermediaries selling data and services for navigating it.

Today, less than 13% of trading volume comes from money that commits for years to your investment thesis and strategy. All the rest is something else ranging from machines speculating on ticks, to passive money tracking benchmarks, to pairing tactics involving derivatives.

So public companies, if your exchange urges you for the sake of market integrity to oppose the study, ask them why $22 trillion of investment assets favor it? When will public companies and investors take back their own market? The SEC is offering that opportunity via this study.

Are there risks? Yes. The market has become utterly dependent for prices on arbitrage. But to persist with a hollow market where supply and demand are distorted because we fear the consequences of change is the coward’s path.

Substitutes

Substitutes were responsible for yesterday’s market selloff.

Remember back in school when you had substitute teachers? They were standing in for the real deal, no offense to substitutes.  But did you maybe take them a little less seriously than the home room teacher?

The market is saturated with substitutes. The difference between stocks and the home room back in grammar school is nobody knows the difference.

If shares are borrowed they look the same to the market as shares that are not borrowed.  If you use a credit card, the money is the same to the merchant from whom you just bought dinner or a summer outfit. But it’s a substitute for cash you may or may not have (a key statistic on consumption trends).

Apply to borrowed stock. The average Russell 1000 stock trades $235 million of stock daily, and in the past 50 trading days 46%, or $108 million, came from borrowed shares. The Russell 1000 represents over 90% of market capitalization and volume. Almost half of it is a substitute.

Why does it matter?  Suppose half the fans in the stands at an athletic event were proxies, cardboard cutouts that bought an option to attend a game but were there only in the form of a Fathead, a simulacrum.

The stadium would appear to be full but think of the distortions in player salaries, costs of advertisement, ticket prices.  If all the stand-ins vanished and we saw the bleachers were half-empty, what effect would it have on market behavior?

Shorting is the biggest substitute in the stock market but hardly the only one.  Options – rights to buy shares – are substitutes. When you buy call options you pay a fee for the right to become future demand for shares of stock.  Your demand becomes part of the audience, part of the way the market is priced.

But your demand is a Fathead, a representation that may not take on greater dimension. Picture this:  Suppose you were able to buy a chit – a coupon – that would increase in value if kitchen remodels were on the rise.

Your Kitchen Chit would appreciate if people were buying stoves, fridges, countertops, custom cabinets.  Now imagine that so many people wanted to invest in the growth of kitchen remodels that Kitchen Chits were created in exchange for other things, such as cash or stocks.

What’s the problem here?  People believe Kitchen Chits reflect growth in kitchen remodels. If they’re backed instead by something else, there’s distortion.  And buying and selling Kitchen Chits becomes an end unto itself as investors lose sight of what’s real and focus on the substitute.

It happens with stocks. Every month options expire that reflect substitutes. This kitchen-chit business is so big that by our measures it was over 19% of market volume in the Russell 1000 the past five days during April options-expirations.

It distorts the market.  Take CAT.  Caterpillar had big earnings. The stock was way up pre-market, the whole market too, trading up on futures – SUBSTITUTES – 150 points as measured by the Dow Jones Industrial Average.

But yesterday was Counterparty Tuesday, the day each month when those underwriting substitutes like options, futures, swaps, balance their books.  Suppose they had CAT shares to back new options on CAT, and they bid up rights in the premarket in anticipation of strong demand.

The market opened and nobody showed up at the cash register. All the parties expecting to square books in CAT by selling future rights to shares at a profit instead cut prices on substitutes and then dumped what real product they had.  CAT plunged.

Extrapolate across stocks. It’s the problem with a market stuffed full of substitutes. Yesterday the substitutes didn’t show up to teach the class. The market discovered on a single day that when substitutes are backed out, there’s not nearly so much real demand as substitutes imply.

Substitution distorts realistic expectations about risk and reward. It’s too late to change the calculus. The next best thing is measuring substitutes so as not to confuse the fans of stocks with the Fatheads.

Vapor Risk

One definition of “volatile” is “passing off readily in the form of vapor.”

Through yesterday, XIV, the exchange-traded security representing a one-day swap from Credit Suisse and offered by VelocityShares, had seen 94% of its value vaporized. It triggered a technical provision in the fund’s prospectus that says Credit Suisse may redeem the backing notes if the fund loses more than 80% of its value. It’s shutting down.

By mixing exposure to futures and other derivatives of varying lengths tied to the S&P 500, XIV aims to let investors capture not the appreciation of stocks or their decline if one shorted them, but instead the difference between current and future prices. Volatility.

The fund says in sternly worded and repeating fashion things like: The ETNs are riskier than securities that have intermediate or long-term investment objectives, and may not be suitable for investors who plan to hold them for longer than one day.

The idea for investors is hitting the trifecta – long rising stocks, short falling stocks, and with things like XIV, capturing the difference between prices to boot.

The problem for “synthetic” exchange-traded notes (ETNs) like XIV backed by a Credit Suisse promissory note is they hold no assets save commitment to replicate an outcome. They are for all intents and purposes vapor.

They have proved wildly popular, with several volatility ETNs routinely in the top 25 most actively traded stocks. In a low-volatility environment, differences in prices between short-term and long-term options and futures can mean returns of 5-10% on a given day, without particular risk to either party.

But if volatility renders futures and options worthless because prices have changed too much, all the investor’s capital vanishes.

Is this what rocked stocks globally? No. There is, however, a lesson about how global financial markets work that can be drawn from the demise of XIV.  Everyone transfers risk. Investing in volatility is in a sense a hedge against being wrong in long and short positions. If you are, you still make money on the spread.

The biggest risk-transfer effort relates to currencies and interest rates. As with stocks, the transference of unexpected fluctuations through swaps – which the Bank for International Settlements says have $540 trillion of notional value (but precious little actual value, rather like XIV) – only works if the disturbances are small.

In the past month, the US Treasury was laying in dry powder before the debt ceiling. The size of auctions exploded by about 50%. Getting people to buy 50% more of the same thing caused interest rates to shoot up. The rise in debt devalued the dollar, a double whammy. Hedges fell apart.

Counterparties for these hedging swaps also transfer the risk, often with short-term Exchange-Traded-Fund (ETF) or ETN hedges that lapse on Fridays. They are the same banks like Credit Suisse making markets in stocks. This is what caused stocks to swoon, not a strong jobs number or higher wages. On Friday, Feb 2, stocks imploded. I suspect counterparties were selling assets to cover losses.

Now we come to a warning about ETFs. Their original creators, who were in the derivatives business, likened ETF shares to commodity warehouse receipts, a representation of something physically residing elsewhere.

In this long bull market, money has poured into ETFs. The supply of things in the warehouse has not kept pace with the exposure to it via ETFs.  We have written over and over about this problem. The way ETFs trade and the way underlying assets increase or decrease are two different processes.  Investors buy and sell the warehouse receipts. The fund and its Authorized Participants in large block transactions occasionally adjust underlying warehouse assets.

We can see by tracking the amount of money flowing to big ETFs from Blackrock, Vanguard and State Street and counter-checking those flows against reported fund turnover that insufficient warehouse commodities (stocks) back ETF shares.

Why? Because buying and selling things incurs transaction costs and tax consequences, which diminishes fund performance. Shaving those is a gutsy strategy – sort of like dumping fuel in a car race to give yourself an advantage in the last flaps by running light and on fumes.

But you can run out of fuel. If the value of the stuff in the warehouse plunges as everybody tries to sell, we’ll find out what part of those warehouse receipts are backed by vapor.

So far that has not happened. But we don’t know what damage has been done to market makers short ETF shares and long stocks or vice versa. The next week will be telling. If a major counterparty was irreparably harmed, we could be in a world of vapor.

If not, the hurt will fade and we’ll revert to normal. Right now, forecasts for stocks in our models say vapor risk is small. But let’s see what happens come Friday, another short-term expiration for derivatives.

Can It Last?

It’s the number one question.  Tack “how long” on the front.

I’m asked all the time: “Tim, do you think the stock market is sustainable? Are fundamentals driving it or is this a bubble? Stock buybacks?  The Fed is behind it, right? Isn’t bitcoin proof of irrational exuberance?”

And everybody with an opinion is asked, and answers. I’ve offered mine (read The 5.5 Market from last week) and I’ll add today what we’ve further learned about the behavior of money.

Speaking of money, Karen and I joke that we miss the recession. Hotels were a bargain.  They gave you free tickets to shows if you just came to Las Vegas. Vacations were affordable (I’m not making light of great stock returns but if we give it all back, how is that helpful?).

Now suppose at the same time interest rates would rise. People and companies with too much debt would suffer, sure. But society would save money and take on less debt. That’s what higher interest rates encourage. From Hammurabi in Babylon until fairly recently we understood this to be the formula for prosperity.

“Quast, do you know nothing about contemporary behavioral economics? What kind of idiot would think it’s better to save money and avoid debt?  Economists agree that debt and spending drive the global consumption economy.”

Ask your financial advisor if you should borrow money and spend more, or save money and invest it.  So how come the Federal Reserve encourages borrowing and spending?

Recessions have purpose – and they’re packed with opportunity!  Seriously. They reset the economic calculus.

I’ll give you an example from the Wall Street Journal yesterday, which reported that here in Denver we have 16,000 vacant metro apartments, most in the luxury category. And 22,000 more are being built. Since they’re unaffordable, the city has launched a program to subsidize rents.

This is the kind of warped outcome one gets from promoting debt and spending, and it’s influencing our stock market too. I’m not the least worried because I know boundless opportunity awaits when prices reset, and that’s the right way to see it.  Warren Buffett said it’s unwise to pay more for a thing than it’s worth.  All right, I look forward to attractive prices ahead.

And prices are products of the behavior of money.  Last week we described how the market could not correctly be credited with rational valuation because stock-picking was not the principal behavior. Over the past ten years, all the NET new inflows into US equities have gone to index and exchange-traded funds. They follow a benchmark. They don’t pick stocks.

They also rarely sell them. If things are bought and not sold, prices rise.  There is a paucity of stocks for sale. In its 2016 prospectus for the S&P 500 ETF SPY, State Street said its turnover – proportion of holdings bought and sold – was 4%.  The fund that year, the latest available, had $197 billion in net asset value. Four percent is about $8 billion.

Yet SPY traded $25 billion daily in 2016 (still does!), about three times the entire annual fund turnover. Explanation? Right there on page 2 of the prospectus: The Trust’s portfolio turnover rate does not include securities received or delivered from processing creations or redemptions of Units.

On page 30 we learn this:  For the year ended September 30, 2016, the Trust had in-kind contributions, in-kind redemptions, purchases and sales of investment securities of $177,227,631,568, $167,729,988,725, $7,783,624,798, and $6,444,954,759, respectively.

Translating to English, it means brokers called Authorized Participants created $177 billion worth of new ETF shares by exchanging assemblages of stocks for them that were not counted as sales by SPY. It counted sales of only about $8 billion – as I said above.

The functional turnover rate for SPY is closer to 100%. If it really was, the market would be volatile. Prices would fall as shares hit the market. SPY drives 10% of the entire stock market’s dollar volume.

But what trades is ETF shares. The creation and redemption process occurs away from the market in some secretive block-transaction fashion that means the natural buying or selling that would otherwise be done is not happening.

Selling lowers prices. The absence of selling, the replacement of selling with trading in ETF shares predicated primarily on price-differences – arbitrage – produces a market that relentlessly rises with very little volatility.

And which notably means investors don’t actually own anything when they buy ETF shares. If they did, that $177 billion SPY exchanged for ETF shares would carry a taxable ownership interest, and transaction costs. It doesn’t.

Think about that.

When the recession comes because of this bizarre displacement of actual buying and selling by derivatives, I look greatly forward to all the bargains, the affordable vacation homes in desirable places, the cheap stocks, and the free show tickets in Las Vegas.

I just can’t tell you when. The wise are always prepared.

The 5.5 Market

The capital markets are riven with acronyms.

One of the first you learn in IR (acronym for investor relations) is “GARP.” Growth at a Reasonable Price.  As 2018 begins, GARP is a great way to describe the stock market, just as it was in 2017. Will it continue?

Let’s set ground rules. What “reasonable” means varies with circumstances but the idea is you’re paying a fair price for appreciation, what investors want and companies hope to deliver.

If arguments were colors, you could hear every hue of the rainbow on whether stocks are overpriced or not. Here at ModernIR, we’re statisticians studying how money behaves. We measure what it’s doing rather than whether it should be doing what it’s doing.

What I’ve learned from observing data is that there is an elegant and uniform explanation for why we have a GARP market. I’ll come to it in a moment.

But to ModernIR GARP is a number: 5.5/10.0 on the ModernIR Behavioral Sentiment Index.  Take the FAANGGs – Facebook, Amazon, Apple, Netflix, the two Alphabets. For 2017, the ModernIR BSI is 5.44 for them. The Russell 1000 is 5.48.  The BSI comprised of our client base with more energy and telecom is 5.39 for 2017.

As 2018 begins, it’s 5.6. All these numbers are within two-tenths of a point. It’s a GARP market.

It means it’s a little better than neutral, which is GARP investment.  For instance, if an economy’s population grew, and the ratio of people employed remained constant, and purchasing power outpaced inflation, you’d have a GARP economy.  Buying and holding it would mean appreciation.

Don’t think too long about that one. You’ll become disturbed by incongruity – but that’s a separate story. We’re after an elegant and uniform explanation to why our market runs according to GARP.

CNBC’s Jim Cramer believes it’s this: “There aren’t enough shares!!!”

It’s a point we’ve made too.  Both the number of companies in the US stock market and the total number of outstanding shares has been in steady decline while the amount of money chasing the shrinking product pool continues to rise.

Is inflation the elegant explanation? More money chasing fewer goods? Discounting fundamentals entirely seems incorrect.

But money chases the goods, and what form is money taking? A passive form. Statistically, 100% of the net inflows to stocks the past decade have gone to index and exchange-traded funds. Over that time, stock pickers have lost trillions.

Therefore, the money chasing the goods is pegging a benchmark, not picking outperformers. And by far the big winner is ETFs. What can ETFs do that no other investment vehicle can? They can substitute shares representing stocks, so they don’t have to buy or sell them like other investors do.

More ETF shares are created to accommodate inflows, and then destroyed during outflows, so ETFs bob on the surface of the market, which otherwise fluctuates with supply and demand.

And since all the new money is using ETFs, the entire market has become the bobber.  ETFs create the capacity for ever more money to have access to the same underlying goods. And that is why the market is up, all other things being equal.

It struck me over the holidays that the structure of ETFs, which depends on arbitrage – profiting on price-differences – would inevitably produce a declining market IF the number of shares or public companies or both were expanding. Arbitrage would consume appreciation, leading to an investor exodus from ETFs.

Thus, the elegant explanation for our GARP market is that ETFs arbitrage stocks back to the mean, which is 5.0, and rising flows of capital and shrinking numbers of public companies combine to breed a 5.5 market. GARP.

Why? Because there are ever more ETF shares to accommodate flows to ETFs. For stocks it means multiple-expansion, since ETFs, unlike IPOs, do not create shares of more value-creating enterprises. They only give more money access to the same stocks.

What stops it? The same thing that haunts the global currency system. If at any point, global currencies stop expanding, the prices of all assets could plummet. Why? Because expanding currency supplies drive up prices and create credit, so people keep borrowing more money to buy things. If that process freezes up, prices will implode. Witness 2008.

For ETFs, the danger is as simple as a market in which inflows stop.  What would cause that?  I don’t know right now!  But for the moment it’s not something to fear. We’re in a GARP world.