Tagged: Stocks

Human Nature

Science and the stock market both aim for outcomes data don’t support.

I’m going to take you on a short but intense journey, with ground rules. I’ll ask that you check politics at the door.  Keep an open mind.

I’ll take Science first.  Suppose it was a business plan.  You craft an objective, and the path to achieving it.  It’s something I know after roughly 30 years in business.

Science said it aimed to flatten the Covid curve. That we could create a vaccine that would immunize us all, and we’d be free.

Now pelting toward two years of Covid, a great bulk of the population is vaccinated, many boosted too, and Covid abounds.

I’m vaccinated but not boosted and I had it.  Karen and I heard CNBC’s Jim Cramer, perhaps the World’s Most Vaccinated Person, Friday, and looked at each other and said, “He’s got Covid.”

Sure enough.

Here’s the point. Science has known for decades that coronavirus vaccines don’t work because the viruses constantly mutate.

I think mRNA research will be a boon for treating pathologies from cancer to respiratory disease. But Science did what science shouldn’t do.  It gambled.  Dismissed known data, central tendencies, facts. Proclaimed it would eradicate the virus.

You’d expect that from inveterate optimists like entrepreneurs, cowboys riding the bull that’s never been ridden, politicians, the Cinderella team playing the reigning champs.

That’s hope.  Hope isn’t a strategy.

Religion is in the hope business.  Science is supposed to be in the data business.  If we’re objective, stripped of politics, zeitgeist, predilections – shall I say hope – we have to say Science failed.  We didn’t conquer Covid. Our immune systems did.

Can we admit we were wrong?

Yeah, but vaccines lower severity.

That’s an assumption. A hope. And it wasn’t the objective.

Let’s shift to the stock market.  Regulation National Market System is 524 pages dictating a mathematical continuous auction market that works only with pervasive mandatory intermediation and a market-maker exemption from short-locate rules.

It is by design not rational but mathematical.  Yet everywhere, in everything we hear, read, see, is a thesis that the stock market is a constant rational barometer.

The stock market was declining because the Fed was tapering.  Then on the day the Federal Reserve met, stocks soared. Oh no wait, markets like rising rates because it means the economy is better.

Then stocks plunged. It’s Omicron.  Then stocks soared. Omicron fears have faded.

For God’s sake.

The problem is the explanation, nothing else. We know how the market works. It’s spelled out in regulations.  If you want a summary, read the SEC’s Gamestop Memo.

Options expired last week, while the Federal Reserve was meeting. You should expect bets. Indexes rebalanced Friday and demand was down.  So with new options trading Monday, the market fell.

Then Counterparties squared books yesterday, and one would naturally expect a big surge in demand for options at much better prices.  Stocks surged.

VIX volatility hedges expire today. If money sees a need for volatility hedges, stocks will rise.  If not, they’ll fall.  But that’s not humans reacting to Omicron. It’s programmed.

Weather forecasts are predicated on expert capacity to measure and observe weather patterns.  It’s data science.

The stock market is data science. 

If we have vast data science on weather, coronaviruses, the stock market, why would we hope rather than know? 

It happened to Copernicus too.  The sun is the center. No, shut up or die.

Science thought so much of itself that it believed it could do what they say can’t be done.  Save that for Smokey and the Bandit.

What happened?  Human nature. No matter how much one claims to be objective, there is confirmation bias, a belief – hope? – in one’s desired outcome.

Is the investor-relations profession able to let go its predilections, its hope, and shift to objective data science on what drives shareholder value?

What matters is the whole picture. Do you know if Story, Characteristics and capital allocation mesh, or contradict each other? If you’re a long or short trade?

Math. Measurable.

Illustration 131408341 © Zybr78 | Dreamstime.com

It’s of no help to your executive team and Board to paint an unrealistic picture that says Story drives value when the data tell us the opposite. Who cares what drives price? So long as we understand it.  That should be the view.

Humorously, there is hope.  Hope is like faith, a belief in things unseen, in outcomes no data yet validate. There’s hope we’ll come around to reality.  We can help you get there.

And with that, we hope your reality for the Holiday Season 2021 is blissful, joyful, thankful. Merry Christmas! We’ll see you on the far side. 

Right Now

“Do you see the market as disingenuous?” 

That’s what the Benzinga host asked me yesterday on a stock-market web program.  I generally do two Benzinga shows per week on market structure, for traders.

“No, I see the market as genuine but not motivated most times by what people talk about,” I said.

The stock market reflects what the money is doing. Well, what’s it doing right now? (Reminds me of the song by Jesus Jones.)

There’s universality, right now, that the Federal Reserve is why stocks struggled to start the week. 

The Fed, which will today tell us what “The Committee” – as it always refers to itself – is thinking about doing. What it says and what it does aren’t always aligned.  That seems disingenuous, but whatever.  The Fed says it may reduce its support for markets. By that we mean the Fed buys mortgages and government debt, so debt is cheaper.

But how do we know if there’s a debt problem if the Fed keeps propping it up and rates keep falling? And debt doesn’t produce prosperity. Savings do.  The Fed is undermining prosperity and encouraging debt and spending.

My financial advisors preach the opposite.  Yours?

Yes, investors buy stocks, hoping they rise faster than the Fed can destroy our purchasing power and savings.  That’s Sisyphus pushing a stone up a hill. When it ends, we’ll be poorer.

That’s still not what the money is doing RIGHT NOW.

Illustration 34823501 / Etfs © Timbrk | Dreamstime.com

It’s getting ready for year-end.  Exchange Traded Funds (ETFs) will wring taxes out of appreciated holdings.  Or as Vanguard said in its ETF FAQs in 2019, which I included in an ETF presentation:

“Vanguard ETFs can also use in-kind redemptions to remove stocks that have greatly increased in value (which trigger large capital gains) from their holdings.”

Vanguard says this often happens in December, but it can occur other times too. That firm and other ETF sponsors continually adjust ETF shares outstanding.

Like this: Investors want Technology exposure so they buy VGT, the Vanguard Tech ETF. Vanguard puts a grocery list of stocks in the “creation basket,” and brokers bring some mix of those stocks (and cash) to Vanguard, which gives the brokers an equal value of ETF shares, which the brokers sell for a little more to investors.

Near year-end, ETF sponsors get to do what Vanguard said above. They trade appreciated stocks for ETF shares, especially ones where demand is falling. 

They hit the jackpot in Tech, starting at November options-expirations.  Take NVDA. It’s up 116% this year, even after recent declines. NVDA is in 308 ETFs (for comparison, AAPL at nearly $3 trillion of market cap is in 320).

So Vanguard puts NVDA and similar stocks in the basket to trade for falling ETF shares like VGT.  Vanguard gets to wash out its gains. Brokers can sell NVDA, short NVDA, and buy puts on NVDA.  (These aren’t customer orders so they do what they want.)

The real jackpot, though, is that Vanguard can bring NVDA back with a new tax basis (instead of $150 it’s $285 – and this is how ETFs crush stock-pickers).

You and I can’t do that. Index funds can’t do that. Heck, nobody else but ETFs can, leaving one to wonder how the playing field is leveled by this SEC blanket exemption.  

And voila! We have another reason along with Fast Trading, the machines who don’t own anything at day’s end, why the market can stage dramatic moves that everyone wrongly attributes to the Fed, Covid, a Tweet by Kim Kardashian or whatever.

Because this is what the money is doing. About $1 trillion flowed to ETFs this year.  But there’ve been nearly $6 trillion of these back-and-forth transactions as of October.

And funds are constantly encouraging folks to trade out their index-fund shares for ETFs, making ever more assets eligible to dump via the basket and bring back free of taxes.

It’s vastly larger than the amount of money that’ll tweak quarterly or at some other benchmark period to reflect interest-rate or inflation expectations.

And if this principle holds, it’s POSSIBLE that we have some dramatic moves yet coming in stocks.  Maybe this week and next with options-expirations (through Dec 22). Maybe between now and the new year.

The moral of this story never changes: If you’re responsible for the equity market, you need to understand it.  If you trade it, you need to understand it.  If you invest in it, you need to understand it.

And if you depend on it for your currency, your incentive plans, your balance-sheet strength, public companies, your executive team and board better understand it.

ModernIR is the data-analytics gold standard on market structure. We spend every day of the week helping companies understand the market, so they’re better at being public.

Time

The drug wears off.  Four-word summary for monetary policy and markets.

If you’re thinking, “I can’t take any more market structure or monetary policy!” you’re not alone. Karen is with you!

I won’t bore you, promise. There are things to know. Hang with me.

First, this:  Market Structure EDGE LLC, our sister company offering decision-support to active traders, just won Best Day Trading Software at the Benzinga Fintech Awards.

It’s been our dream to democratize markets for public companies and investors. ModernIR has done that for public companies, and now we’ve hit a milestone in our grand scheme, with EDGE.  We give everyday people in the stock market the power to see how money moves. What’s coming. Like we do for you, public companies.

But daytrading? you say. 

We can be flat-earthers. Or not. No matter how much we want to eradicate short-termism, to put time on our side, it won’t happen so long as rules promote one and squelch the other.  We cannot call a market “long-term” that’s 10% about the long-term, 20% about tracking benchmarks, 70% short-term.

If the central tendency is brief, so is the market.

Now, investors can use EDGE for long-term management.  Bias stock-holdings to those that spend time over 5.0, where Short Volume is on a general downtrend. That means demand is greater than supply. When that balance shifts, and it will, reweight.

We use these metrics for you, public companies. Market Structure Sentiment. Short Volume. Demand. Supply.

Illustration 122773491 / Jagger © Creat Art | Dreamstime.com

The truth is short horizons will be loved, as Maroon Five says.  If you want the moves like Jagger – we’re seeing Mick and the remaining Rolling Stones in Atlanta tomorrow – don’t spend every day out on your corner in the pouring rain, wishing for what isn’t.

Back to the drug.  Money.  Once, you could pledge $600 billion to save everyone from a financial crisis, and the market would soar like an eagle.

Last Friday late, Congress winked and dealed and handshaked and back-slapped to $1.2 trillion for infrastructure, or whatever the number is, and Monday, the market limped to weak gains and Tuesday gave them back.

The drug is wearing off.

Public companies, you’ll get this.  If your market capitalization is $X with 500 million shares out, shouldn’t it go to $2X with a billion shares issued?

Well, no.  You can’t dilute shareholders without delivering more value. Shares reflect business capacity. There must be substance. Stock alone isn’t enough.

What about meme stocks, the short-termism you just talked about?

Those aren’t marks of an evolution in thinking but cracks and strains in cultural credulity.

Follow me here. We’re getting to the crux of why the drug wears off in the economy. 

People in Congress and their theorizing acolytes in academia who author much of what becomes legislation suppose you can create a trillion dollars and voila! Growth.

Except the real world will not stop hassling you, as Matchbox Twenty would say. No matter the headlong societal rush into a mythical metaverse. In the real world, unless you can marshal twice the resources, pouring capital into the market won’t double its value.

I’ve said this before:  All output equals labor x capital. The more money, the more of it you need to make the same stuff, and the less people want to work, the more labor costs.

So the price of stuff goes up, availability goes down.  And worst, the assets that shelter value – stocks, bonds, art, cars, real estate, sports teams, NFTs, cryptocurrencies, social tokens, etc. – will start wobbling too.

And the boomerang comes back. Money loses value, fewer people can afford stuff. Consumption declines, prices fall.

Ironic, isn’t it, as Alanis Morrissette would say.  Give everybody at the table free poker chips and the people who want to win quit, and the game becomes pointless.

What’s the real solution? Spend less, save more, be efficient, be productive, cut the waste, count on nothing, be lean and tough.

No wonder the market is short-term. If you can’t count on tomorrow, trade today. We adapt to that reality, public companies, investors, traders.

I think we need and should want a reckoning, so we can get it back to good (another Matchbox Twenty reference). In the meantime, see the market as it is. Understand why more money is no panacea.

To paraphrase the Rolling Stones, if want to say time is on our side, to shout that if you start us up we’ll never stop, well then. We need a new drug.

Clear the Room

Winter is coming.

But autumn is mighty fine this year in the Rockies, as my weekend photo from Yampa Street in Steamboat Springs shows.

Winter follows fall and summer. Other things are less predictable, such as economic outcomes and if your Analyst Day will do what you hope (read from last week).

Here, two of my favorite things – monetary policy, market structure – dovetail.

Steamboat Springs. Photo by Tim Quast.

If you want to clear the room at a cocktail party, start talking about either one.  In fact, if you’re trapped talking to somebody you’d rather not, wanting a way out, say, “What’s your view of the fiat-currency construct?”  or “What do you think of Payment for Order Flow?”

I’ve told you before about the daily noon ET CNBC segment Karen calls the “What Do You Think of THIS Stock?” show.  Guests yammer about stocks.

Some weeks ago the host said, “What do you think of Payment for Order Flow?”

Silence.  Some throat-clearing.

Nobody understands it!  These are market professionals. Decades of experience. They don’t know how it works.

Not our topic. But so I don’t leave you hanging, PFOF is as usual with the stock market an obfuscating way to describe something simple.  Retail brokers sell a product called people’s stock trades so those people can trade stocks for free.

This is why you’re brow-beaten to use limit orders at your online brokerage.  Don’t you dare put in a market order! Dangerous!  Not true. Fast Traders, firms wanting to own nothing by day’s end and driving 53% of market volume, eschew limit orders.

They know how the market works. Brokers want you to use limit orders because those get sold. Most market orders don’t.

Pfizer wants everybody to be vaccinated and retail brokers want every trade to be a limit order, because both get paid. Same thing, no difference.

Now, back to the point.  If you tell your corporate story to a thousand investors, why doesn’t your price go up?  Similarly, why can’t we just print, like, ten trillion dollars and hand it out on the street corner and make the economy boom?

Simple. Goods and services require two things:  people and money. Labor and capital. Hand out money and nobody wants a job. Labor becomes scarce and expensive.

And if you hand out money, you’re devaluing the currency.  Money doesn’t go as far as it used to.  You need more to make the same stuff.

The irony is that handing out money destroys the economy.  You can’t make stuff, deliver it, ship it, pack it, load it, unload it, move it – and finally you can’t even buy it because you can’t afford it.

Got it?

The best thing we could do for the economy is put everything on sale.  Not drive prices up and evacuate products from shelves.  But that requires the OPPOSITE action so don’t expect it.

What does market structure have in common with monetary policy?

Too many public companies think you just tell the story to more investors and the stock price goes up.  We’re executing on the business plan. The trouble is too few know.

Wrong.  That’s a controllable, sure.  But it’s not the way the market works. AMC Theaters is a value story.  It was a herculean growth stock in early 2021 and along with Gamestop powered the Russell 2000 Value Index to crushing returns.

I was looking at data for a large-cap value stock yesterday.  The Exchange Traded Fund with the biggest exposure is a momentum growth ETF. It’s humorous to me reading the company’s capital-allocation strategy – balance-sheet flexibility with a focus on returning capital to shareholders – and looking at the 211 ETFs that own it.  It’s even in 2x leveraged bull ETFs (well, the call-options are, anyway).

Your story is a factor.  But vastly outpacing it are your CHARACTERISTICS and the kind of money creating supply, and demand. If you trade $1,500 at a time, and AMZN trades $65,000 at a time, which thing will Blackrock own, and which thing will get traded and arbitraged against options and futures?

Your CFO needs to know that, investor-relations people. And we have that data.

That large-cap I mentioned? We overlaid patterns of Active and Passive money.  Active money figured out by May 2021 that this value company was a growth stock and chased it. They were closet indexers, the Active money. PASSIVE patterns dwarf them.

And when Passive money stopped in September, the stock dropped like a rock.

It wasn’t story. It was supply and demand.

Same with the economy. Flood it with cash, and it’s hard to get that cat back in the bag once you’ve let it out.  You cannot reverse easy monetary policy without harsh consequences, and you can’t shift from momentum to value without deflation.

The good news is when you understand what’s actually going on, you can manage the controllables and measure the non-controllables. Both matter.  Ask us, and we’ll show you.

Analyst Day

Why do you hold an Analyst Day? 

Traders and investors, these are what Joel Elconin on Benzinga Premarket Prep this past Monday called “the dog and pony show.”

For the investor-relations profession, the liaison to Wall Street, it’s a big deal, ton of work. We choreograph, prepare, script, rehearse, plan. We’re laying out Management’s strategic vision.

And it’s successful if…what?  The stock jumps?

Analyst Days: Productive, or just busy? Illustration 130957015 © Turqutvali | Dreamstime.com

Before Regulation National Market System in 2007 transformed the stock market into the pursuit of average prices, triggering an avalanche of assets into index funds and ETFs, you could say that.

Even more so before decimalization in 2001 transformed “the spread,” the difference between the prices to buy and sell, into the pursuit of pennies. It’s now devolved to tenths of pennies in microseconds.

The point is, a good Analyst Day meant investors bought the stock. Same with earnings. News. 

Let me take a moment here.  In addition to ModernIR, the planet’s IR market-structure experts and the biggest provider of serious data for serious IR professionals at US-listed companies, Karen and I run a trading decision-support platform called Market Structure EDGE.

Using data from that platform, I bought 200 shares of a known Consumer Discretionary stock this week using an algorithm from my online firm, Interactive Brokers. The order was split into three trades for 188 shares, 4 shares, and 8 shares, all executed at BATS, owned by CBOE, the last trade at a half-penny spread.

Why is this germane to an Analyst Day?  Stick with me, and you’ll see.

Would you go to a store looking for carrots and buy 10 of them at one, then drive to another for 2, and a third for 4?  Idiocy. Confusing busy with productive. So, why is that okay in a market worth $50 trillion of FIDUCIARY assets?

The stock I bought is a household name.  Ranks 463rd by dollars/trade among the 3,000 largest stocks traded in the US market, which are 99.9% of market capitalization. It’s among the 500 most liquid stocks.

Your Analyst Day is a massive target.  And over 90% of volume in the market has a purpose other than investment in mind. My trade in three pieces meant the purpose for the other side was to profit by splitting an order into tiny parts. That’s not investment. It’s arbitrage.

Investor-relations people, you are the market maestros. Your executives and Board count on you to know what matters.  Did it occur to you that your Analyst Day is a giant plume of smoke attracting miscreants? Does your executive team understand that your Analyst Day could produce a vast plume of arbitrage, and not what they expect?  If not, why not?

Look, you say. I run an Analyst Day. Are you saying I shouldn’t?

I’m saying that whether you do or not should be data-driven.  And evaluating the outcome should be data-driven too.  As should be the planning and preparation.

As should the understanding from internal audiences that at least 70% of the volume around it will be profiteers chasing your smoke plume, just like they gamed me for about 2.5 cents.

It’s not the 2.5 cents that matters. It’s the not knowing supply or demand. It’s the absence of connection between price and reality. 

By the way, Rockwell Medical is the current least liquid stock in the National Market System. You can trade $250 of it at a time on average, without rocking the price.  Most liquid? AMZN, at $65,000 per trade (price $3,275, trades 190,000 times per day, 18 shares at a time).

IR does not derive its value from telling the story. Its value lies in serving as trusted advisor for navigating the equity market.  Making the best use of shareholder resources. Understanding the money driving price and volume. You are not a storyteller.  You are the Chief Market Intelligence Officer. 

Think of the gonzo state of things.  I know what revenue every customer generates in our businesses, and what the trends are, the engagement is, the use of our data, what people click or don’t.  Yet too many public companies are spewing information to the market with NO IDEA what creates volume, why they’re traded, what sets price.

Is that wise?

So, what SHOULD we be doing?  The same thing we do in every other business discipline.  Use software and analytics that power your capacity to understand what drives returns. Do you understand what creates your price and volume?

Back to the Analyst Day. Don’t hold one because tradition says so. Do it if you benefit from it!  If your investors are fully engaged, you’re wasting their time and yours. That’s measurable.  You should know it well beforehand.

If they aren’t, set a goal and measure market reactions.  Realize that arbitragers will game your smoke plume.  That’s measurable too. Know what Active stock-pickers pay.  Know when Passives wax and wane. Know what’s happening with derivatives, and why.

Everything is measurable. But not with 1995 tools. Don’t do things just because you always have. Do them because they count.

That’s the IR profession’s opportunity, the same as it is everywhere else.

Bare Windows

It’s window-dressing. 

That saying suggests effort to make something appear better than it is.  And it’s a hallmark of stocks in today’s Relative Value era where the principal way we determine the worth of things is by comparing them to other things (true of stocks, and houses, art, cars, bonds, etc.).

ModernIR clients know we talk about “window dressing” at the ends of months and quarters.  It gets short shrift in the news but the PATTERNS of money that we observe cast long shadows over headlines.

Every month, managers who send investors performance statements want stuff to look as good as it can.  Things get bought and sold.  Then the headline-writers root around for some reason, like the Fed chair testifying to Congress.

Even bigger is the money tracking benchmarks. Every month, every quarter, that money needs to get square with its targets.  If Tech is supposed to be 24% of my holdings, and at quarter-end it’s 27%, I’m selling Tech, and especially things that have just gone up, like SNAP.

So SNAP drops 7%.  What did your stock do yesterday?  There’s a reason, and it’s measurable in behavioral patterns. Market structure.

The reason yesterday in particular was so tough is because it was T+2, trade date plus two more days, to quarter-end. If you need to settle a trade, effect a change of ownership, and it’s a big basket you’re working through, you’ll do it three days from quarter-end to make sure all positions settle in time.

With tens of trillions of dollars benchmarked to indexes around the globe, it’s startling to me how little attention is paid to basic mechanics of the market, such as when index money recalibrates (different from periodic rebalances by index creators).

And realize this.  In the last month, half the S&P 500 corrected – dropped more than 10%. About 90% of the Russell 2000 did.  No wonder small caps were up sharply Monday.  Most indexes were underweight those. But they’re less than 10% of overall market cap (closer to 5% than 10%). Truing up is a one-day trade.

Tech is a different story. Five stocks are almost 25% of the S&P 500 (AAPL, AMZN, GOOG, FB, MSFT).  And technology stocks woven through Consumer Discretionary and Communication Services stretch the effects of Tech north of 40%, approaching half the $50 trillion of US market cap.

The wonder is we don’t take it on the chin more often. I think the reason is derivatives. There’s a tendency to rely on substitutes rather than go through the hassle of buying and selling stocks.

As I’ve explained before, this is both the beauty and ugliness of Exchange Traded Funds (ETFs). They’re substitutes. They take the place of stocks, relieving the market of the…unpleasantness of moving real assets.  ETFs are just bits of digital paper that can be manufactured and destroyed at whim.

Remember, ETFs were created by commodity traders who thought, “Wouldn’t it be cool if we didn’t have to get out the forklift and move all that stuff in the commodity warehouse? What if we could just trade warehouse RECEIPTS instead of dragging a pallet of copper around?”

This time the forklifts are out.  It’s been coming since April.  See the image here? That’s Broad Sentiment, our 10-point index of waxing and waning demand for S&P 500 stocks, year-to-date in 2021, vs SPY, the S&P 500 ETF.  SPY is just 2.8% above its high point when Sentiment lost its mojo in April.

Broad Sentiment, courtesy MarketstructureEDGE.com

From Mar 2020 to Apr 2021, we had a momentum market juiced by time and money. There were surfeits of both during the pandemic. People gambled. Money gushed. Stocks zoomed.

But as with all drugs, the effect wears off.  Sentiment peaked in March. Strong stocks notwithstanding, we’ve been coming off a drug-induced high since then.

And the twitches have begun. You see it first in derivatives.  Every expirations period since April has bumped – before, during or right after.  I’ve circled them on the image. It means the cold shakes could come next.  Not saying they will. All analogies break down.

Back to window-dressing.  When it gets hard to dress up the room no matter what curtains you hang, it means something.  Here we are, on the doorstep of Q4 2021.  It’s possible the market, or a benchmark or two, might’ve turned negative for the third calendar quarter yesterday (I’m writing before the market closes).

The RISK can be seen by observing movement in Passive money.  Because it’s the biggest thing in the market.  The windows are bare this time. If we were smart, we’d take a good look around.

But that’s probably too optimistic.  Governments and central banks will try again to slap on the coverings, dress it up, make it look better than it is.

Growth vs Value

Are you Value or Growth?  

Depends what we mean, I know. S&P Dow Jones says it distinguishes Value with “ratios of book value, earnings and sales to price.”

It matters because Growth is terrorizing Value.  According to data from the investment arm of AllianceBernstein, Growth stocks outperformed Value stocks by 92% between 2015-2020.  Morningstar says it’s the biggest maw on record, topping the 1999 chasm.

If you’re in the Growth group, you’re loving it.  But realize.  By S&P Dow Jones’s measures, anybody could be a Value or Growth stock at any time.  It’s all in the metrics.

The larger question is why the difference?  AllianceBernstein notes that the traditional explanation is earnings growth plus dividends paid.  That is, if your stock is up 50% more than a peer’s, it should be because your earnings and dividends are 50% better.

If that were the case, everybody would be a great stock-picker. All you’d need do is buy stocks with the best earnings growth. 

Well, turns out fundamentals accounted for just ten percentage points of the difference.  The remaining 82% of the spread, as the image here from AllianceBernstein shows, was multiple-expansion.  Paying more for the same thing.

Courtesy AllianceBernstein LP. https://www.alliancebernstein.com/corporate/en/insights/investment-insights/whats-behind-the-value-growth-performance-gap.html

Put differently, 90% of the time Growth stocks outperform Value stocks for no known reason. No wonder stock-picking is hard.

Take Vertex (VRTX) and Fortinet (FTNT), among the two very best and worst stocks of the past year.  I don’t know fundamentally what separates them. One is Tech, the other Healthcare.

I do know that running supply/demand math on the two, there’s a staggering behavioral difference.  FTNT spent 61 days the past year at 10.0 on our ten-point scale measuring demand called Market Structure Sentiment.  It pegged the speedometer 24% of the time.

VRTX spent five days at 10.0.  Two percent of the time.  You need momentum in today’s stock market or you become a Value stock.

We recently shared data with a client who wondered why there was a 20-point spread to the price of a top peer.  We ran the data.  Engagement scores were about the same – 85% to 83%, advantage to our client. Can’t say it’s story then.

But the peer had a 20% advantage in time spent at 10.0.  The behavioral patterns were momentum-style. Our client’s, GARP/Value style.

Okay, Quast.  Suppose I stipulate to the validity of your measure of supply and demand, whatever it is.  Doesn’t answer the question. Why do some stocks become momentum, propelling Growth to a giant advantage over Value?

I think it’s three things. I can offer at least some data, empirical or circumstantial, to support each.

Let’s call the first Herd Behavior.  The explosion of Exchange Traded Funds concentrates herd behavior by using stocks as continuously stepped-up collateral for ETF shares.  I’ll translate.  ETFs don’t invest in stocks, per se.  ETFs trade baskets of ETF shares for baskets of stocks (cash too but let’s keep it simple here). As the stocks go up in value, ETF sponsors can trade them out for ETF shares. Say those ETF shares are value funds.

The supply of Value ETF shares shrinks because there’s less interest in Value.  Then the ETF sponsor asks for the same stocks back to create more Growth ETF shares.

But the taxes are washed out via this process. And more ETF shares are created.  And ETFs pay no commissions on these transactions. They sidestep taxes and commissions and keep gains.  It’s wholly up to traders and market-makers to see that ETF shares track the benchmark or basket.

The point? It leads to herd behavior. The process repeats. Demand for the same stuff is unremitting.  We see it in creation/redemption data for ETFs from the Investment Company Institute. ETF creations and redemptions average over $500 billion monthly. Same stuff, over and over. Herd behavior.

Second, there’s Amplification.  Fast Traders, firms like Infinium, GTS, Tower Research, Hudson River Trading, Quantlab, Jane Street, Two Sigma, Citadel Securities and others amplify price-moves.  Momentum derives from faster price-changes, and Fast Traders feed it.

Third is Leverage with derivatives or borrowing.  Almost 19% of trading volume in the S&P 500 ties to puts, calls and other forms of taking or managing risk with derivatives. Or it can be borrowed money. Or 2-3x levered ETFs. The greater the pool of money using leverage, the larger the probability of outsized moves.

Summarizing, Growth beats Value because of herd behavior, amplification of price-changes, and leverage.

By the way, we can measure these factors behind your price and volume – anybody in the US national market system.

Does that mean the Growth advantage is permanent?  Well, until it isn’t. Economist Herb Stein (Ben’s dad) famously said, “If something cannot last forever, it will stop.”

And it will. I don’t know when. I do know that the turn will prompt the collapse of leverage and the vanishing of amplification. Then Growth stocks will become Value stocks.

And we’ll start again.

Where’s It Going?

Where’s what going?

Time? Hm.

Money?  Well. Yes.

It abounds and yet it doesn’t go far.  Why that’s the case is another story (I can explain if you like but it usually clears a room at a cocktail party).

First, if you were spammed last week with the MSM, apologies! It was inadvertently set on full-auto.  And one other note, our sister company Market Structure EDGE  is up for several Benzinga Fintech Awards.  As in American politics, you may vote early and often (just kidding!). No, you can vote daily though till about Oct 22, 2021.  We hope you’ll help! Click here, and turn it into a daily calendar reminder.

Today we’re asking where the money gushing at US stocks and bonds like a ruptured fire hydrant is going. Morningstar says it’s $800 billion into US securities the last twelve months through July.

That’s minus a $300 billion drop in actively managed equity assets. Stock-pickers are getting pounded like a beach in a hurricane. Public companies, you realize it?

That’s not the point of this piece. But investor-relations professionals, realize the money you talk to isn’t buying. It’s selling.  There are exceptions and you should know them.  But don’t build your IR program around “targeting more investors.” Build it on the inflows (your characteristics), not the outflows.  If you want to know more, ask us.

So where did the $800 billion go? 

About $300 billion went to taxable bond funds.  Not for income. Appreciation. Bonds keep going up (yields down, prices up). They’re behaving like equities – buy appreciation, not income.

The rest, about $500 billion, went to US equities.  We’re going to look at that. 

$500 billion seems like a lot.  Ross Perot thought a billion here, billion there, pretty soon you’re talking real money. For you who are too young to know it, Google that.

But today $500 billion ain’t what it was. And frankly, five hundred billion deutschemarks wasn’t much in the Weimar Republic either.  The problem wasn’t inflation. The problem was what causes inflation: too much money.

Ah, but Weimar didn’t have derivatives. Silly fools.

For perspective, more than $500 billion of Exchange Traded Funds (ETF) are created and redeemed in US equities every month.  Stocks trade more than $500 billion daily in the US stock market.

And the money supply as measured by the Federal Reserve’s “M2” metric reflecting the total volume of money held by the public, increased by $5 trillion from Feb 2020 to July 2021.  That’s a 32% increase. About like stocks (SPY up 33% TTM).

Wait. The stock market is up the same as the money supply? 

Yup.

Did everybody sell stocks at higher prices?

No. Everybody bought stocks at higher prices.

Okay, so where did the stock come from to buy, if nobody sold?

Maybe enough holders sold stocks to people paying 33% more to account for the difference. Good luck with that math. You can root it out if you want.

But it’s not necessary.  We already know the answer. The money went into derivatives. 

The word “derivative” sounds fancy and opaque and mysterious. It’s not.  It’s a substitute for an asset.  You can buy a Renoir painting. You can buy a Renoir print for a lot less. You can buy a stock. You can buy an option on that stock for a lot less.

Suppose you want to buy the stocks in the S&P 500 but you don’t want the trouble and expense of buying 500 of them (a Renoir). You can buy a swap (a print, No. 347 of 3,900), pay a bank to give you the returns on the index (minus the fee).

Or you can buy SPY, the S&P 500 ETF.  You think you’re getting a Renoir.  All those stocks. No, you’re getting a print somebody ran on an inkjet printer.  It looks the same but it’s not, and it’s not worth the stocks beneath it.

Image courtesy ModernIR, Aug 25, 2021.

See this image?  There is demand.  There is supply. The former greatly exceeds the latter like we’ve seen the last year during a Covid Pandemic (chew on that one for a bit), so excess demand shunts off to a SUBSTITUTE. Derivatives. ETFs, options, futures.

That’s what’s going on. That’s where the money went. Look at GME and AMC yesterday. Explosive gains on no news. Why? Banks squared derivatives books yesterday after the August expirations period. Demand for prints (options), not paintings (stock), vastly exceeded supply.

So banks bought the underlying paintings called GME and AMC – and sold traders ten times as many prints. Options. Derivatives. It’s implied demand. The stocks shot up.

Bad? Well, not good. The point isn’t doom. The point is understanding where the money is going. Every trader, investor, public company, should understand it. 

It’s all measurable if you stop thinking about the market like it’s 1995. It’s just math. About 18% of the market is in derivatives.  But about 75% of prices are transient things with no substance.  Prints, not paintings.

Public companies, know what part of your market is Renoir, what part is just a print.  Traders, do the same.

We have that data.  Everybody should always know where the money is going.

Suddenly

Things are getting worrisome. 

It’s not just our spectacular collapse in Afghanistan less than a month before the 20-year anniversary of Nine Eleven.  That’s bad, yes.  Inexcusable.

Illustration 179312099 / Ernest Hemingway © Lukaves | Dreamstime.com

It’s not the spasmodic gaps in supply chains everywhere – including in the stock market. 

It’s not bond yields diving as inflation spikes, which makes sense like accelerating toward a stop sign.

It’s not the cavalier treatment of the people’s money (do you know we spent $750 million of US taxpayer dollars on the Kabul embassy, the world’s largest, then left the keys on the desk?).

It’s all of it.  Stuff’s jacked up, and it should bother us.

Karen and I went to a concert at Strings, the performing arts venue in Steamboat Springs.  If you want to feel better about yourself, go to the state fair.  Or an Asleep at the Wheel concert in Steamboat.

People are showing up with walkers, oxygen tanks, doddering uncertainly up the walkway.  I’m joking!  Mostly.  You get the point. (Lord, I apologize for my poor taste.)

And Asleep at the Wheel is awesome. I grew up on Hotrod Lincoln and The House of Blue Lights.

Anyway, covid mania continues so the hall serves no food or drink inside.  We’re dependent on food trucks outside for snacks.

None showed up.

There was a big bike ride this past weekend, three thousand gravel riders.  The food trucks were there. But there’s not enough staff working to cover more than one base. We and the oldsters were out of luck for tacos and cheesesteak.

But we were told they’d be there, and they weren’t. That kind of thing happened in Sri Lanka when I lived there for a year in college. But not in the World’s Superpower.

It gets worse.

The bartenders were shaking their heads. They couldn’t restock beforehand because the supplier was closed.  No staff.  A major liquor store – the biggest in the region with normally 3-4 registers running simultaneously – had to close because they had no staff to run the shop.

If you can’t stock your bar, you’re in trouble of collapsing as an empire. I say that in the barest jest only.

Back to the stock market.  The supply chain for stocks is borrowed shares. I’ve explained it before.  Dodd Frank basically booted big brokers from the warehouse business for equities.

Used to be, if you were Fidelity you called Credit Suisse and said, “I need a million shares of PFE.”

Credit Suisse would say, “We’ve got 500,000. We’ll call Merrill.”

And the wholesale desk there, the erstwhile Herzog Heine Geduld, would round the other half up.

Not so in 2021.  The banks now are laden to creaking with “Tier One Capital” comprised mostly of US Treasuries.  You’re the government and you need a market for debt, you just change the rules and require banks to own them, and slash interest rates so fixed income funds need ten times more than before.

Elementary, Watson.

What’s more, the stock market is a continuous auction. Everything is constantly for sale in 100-share increments. 

Except there aren’t 100 shares of everything always available. Certainly not 100,000 shares. So the SEC requires – they mandate it – brokers to short stock, create it in effect, to keep the whole continuous auction working.

Well, it’s getting wobbly.  There are sudden surges and swales in short volume now.  And the average trade size in the S&P 500 is 104 shares. Lowest on record.  Almost half that – 44% currently – is borrowed. In effect, the supply chain in the stock market is about 60 shares.

Depending on that tenuous thread is about 75% of three MILLION global index products.  Thousands of ETFs.  And $50 TRILLION of market cap.

The 1926 Ernest Hemingway book The Sun Also Rises has an exchange between two characters.  One asks the other how he went broke.

“Gradually,” he said. “Then suddenly.”

Afghanistan’s sudden collapse was 20 years in the making.  The same thing is happening around us in a variety of ways, products of crises fomenting in our midst that we ignore or excuse.

So what do we do about it?

The societal question is tough.  The market question is simple: Understand the problem, engage on a solution.

Public companies, it’s you and your shareholders sitting at the head of this welling risk.  We owe it to them to understand what’s going on. Know the risk of fragility in your shares’ supply chain. That’s a start. We have that data.

Solving the whole problem will require a well-informed, prepared constituency that cares.  Or all at once it’s going to implode. Not hyperbole. A basic observation.

Optional Chaos

So which is it?  

Monday, doom loomed over stocks. In Punditry were wringing hands, hushed tones. The virus was back. Growth was slowing. Inflation. The sky was falling!

Then came Tuesday. 

Jekyll and Hyde? Options expirations.  Only CNBC’s Brian Sullivan mentioned it. As ModernIR head of client services Brian Leite said, there wasn’t otherwise much effort to explain where the doom went. One headline said, “Stocks reverse Monday’s losses.”

WC Fields said horse sense is the thing a horse has which keeps it from betting on people. We could have used some horse sense.  I Tweeted this video.

Anyway. What must you know, investors and public companies, about why options cause chaos in stocks? (I’m explaining it to the Benzinga Boot Camp Sat July 24, 30 minutes at 1220p ET.  Come join.)

It’s not just that options-expirations may unsettle equity markets. The question is WHY?

Let me lay a foundation for you. Global Gross Domestic Product (GDP) is about $85 trillion. The notional value – exposure to underlying assets – of exchange-traded options and futures is about the same, $85 trillion give or take, says the Bank for International Settlements. The BIS pegs over-the-counter derivatives notional value at $582 trillion.

So call it $670 trillion. All output is leverage 8-9 times, in effect.

Now, only a fraction of these derivatives tie to US equities. But stocks are priced in dollars. Currency and interest-rate instruments make up 90% of derivatives.

All that stuff lies beneath stocks. Here, let’s use an analogy. Think about the stock market as a town built on a fault line.  The town would seem the stolid thing, planted on the ground. Then a tectonic plate shifts.

Suddenly what you thought was immovable is at risk.

Remember mortgage-backed securities?  These derivatives expanded access to US residential real estate, causing demand to exceed supply and driving up real estate prices.  When supply and demand reached nexus, the value of derivatives vanished.

Suddenly the market had far more supply than demand.  Down went prices, catastrophically. Financial crisis.

Every month, what happened to mortgage-backed securities occurs in stocks. It’s not seismic most times. Stocks are assets in tight supply.  Most stocks are owned fully by investors.  Just three – Blackrock, Vanguard, State Street – own a quarter of all stocks.

So just as real estate was securitized, so are stocks, into options, futures, swaps.  While these instruments have a continuous stream of expiration and renewal dates, the large portion ties to a monthly calendar from the Options Clearing Corp (our version is here).

Every month there’s a reset to notional value. Suppose just 1% of the $50 trillion options market doesn’t renew contracts and instead shorts stocks, lifting short volume 1%.

Well, that’s a potential 2% swing in the supply/demand balance (by the way, that is precisely last week’s math).  It can send the Dow Jones Industrials down a thousand points.  Hands wring.  People cry Covid.

And because the dollar and interest rates are far and away the largest categories, money could leave derivatives and shift to the assets underpinning those – BONDS.

Interest rates fall. Bonds soar. Stocks swoon.  People shriek.

Marketstructureedge.com – Broad Market Sentiment 1YR Jul 21, 2021

Options chaos.  We could see it. The image here shows Broad Market Sentiment – DEMAND – for the stocks represented by SPY, the State Street S&P 500 Exchange Traded Fund (ETF).  Demand waxes and wanes.  It was waning right into expirations.

In fact, it’s been steadily waning since Apr 2021.  In May into options-expirations, Sentiment peaked at the weakest level since Sep 2020. Stocks trembled. In June at quad-witching, stocks took a one-day swan dive.

Here in July, they cratered and then surged.  All these are signals of trouble in derivatives. Not in the assets.  It’s not rational. It’s excessive substitution.

We can measure it at all times in your stock. Into earnings. With deals. When your stock soars or plunges.

In 1971, the USA left the gold standard because the supply of dollars was rising but gold was running out. The derivative couldn’t be converted into the asset anymore. The consequence nearly destroyed the dollar and might have if 20% interest rates hadn’t sucked dollars out of circulation.

High interest rates are what we need again. During the pandemic the Federal Reserve flooded the planet with dollars. Money rushed into risk assets as Gresham’s Law predicts. And derivatives.

When the supply/demand nexus comes, the assets will reprice but won’t vanish. The representative demand in derivatives COULD vanish.  That’s not here yet.

The point: Derivatives price your stock, your sector, your industry, the stock market. Adjustments to those balances occur every month.  We can see it, measure it. It breeds chaos. Pundits don’t understand it.

It’s supply and demand you can’t see without Market Structure goggles. We’ve got ‘em.