Tagged: Stocks

Russelling Stocks

We’re back!

At the NIRI Annual Conference last week in Phoenix (where foliage defied fiery environs) we launched an ad campaign for investor-relations professionals that graced the escalator wall into the hall, and the ModernIR booth hummed.

I had the honor of co-vice-chairing, and my market structure panel with hedge-fund legend Lee Cooperman, market commentator Joe Saluzzi, and SEC head of Trading and Markets Brett Redfearn kicked off the conference Monday June 3rd.

Due to an inadvertent clerical error, I was also named a NIRI volunteer of the year (here with NIRI CEO Gary LaBranche and board chair Ron Parham) along with TopBuild’s Tabitha Zane.  And I met NIRI co-founder Dick Morrill who at 97 can still deliver a ringing speech.

Post-conference, Karen and I bolted briefly to our mountain home, Steamboat Springs, where frost dusted the grass twice the last week and Sand Mountain jutted white-capped above a voluptuous carpet of grasses and blooms.

Meanwhile back in the stock market, with trade fears gripping the world – US stocks zoomed at the best rate in 13 months, posting six straight days of gains, a 2019 record, beating even the heady January start.

Against this backdrop loom big index rebalances. The Russell indices have been morphing toward July 1 reconstitution in phases that persist through the next three Fridays. On June 21, S&P quarterly rebalances will join the jammed queue, as will stock and index options and futures expirations June 19-21.

And expiring June 28 when the Russell finalizes are monthly CBOE futures contracts created to help indexers true up benchmark-tracking on the month’s last trading day.

Russell says $9 trillion of assets are pegged to its US equity indexes.  For perspective, the Russell 1000 is 95% of US market cap, the Russell 2000 most of the remaining 5%, as there are only 3,450 public companies.

What’s at stake with rebalances is thus more than pegged assets. It’s all the assets.

Passive assets are now over 50% of managed money, Exchange Traded Funds alone drive more than 50% of volume. The effects of these events are massive not due to susurrations in construction but in the capacity for price-changes to ripple through intertwined asset classes and the entirety of equity capitalization.

It’s like being in Group One on a United Airlines flight.  The fewer the airlines, the bigger the audience, the longer the line.

When the money wanting to queue up beside a benchmark was an eclectic conclave outside Palm Springs, rebalances were no big deal. Now passives are Los Angeles and rebalances are a Friday afternoon rush hour.

Put together the trillions tied to Russell and S&P indexes, the trillions in equity-linked swaps benchmarked to broad measures, the hundreds of trillions tied to expiring currency and interest rate swaps, the ETF market-makers trying to price ETFs and stocks driving $125 billion of daily trading volume, the Active “closet indexers” mimicking models, the Fast Traders with vast machine-computing power trying to game all the spreads. It’s keying the tumblers on the locks to the chains constraining the Kraken.

It’s not a myth. It’s already happening. Stocks imploded when the Communication Services sector was yanked like a rib from the torso of Tech and Consumer Discretionary stocks last September. It happened repeatedly through October, November and December 2018 as sector and market-cap ETFs washed like tides over stocks.

It happened in January, March, May, this year.

And it just happened again. What was it? Strafing waves of short-term passive shifts.

Lead market behavior in June so far? Risk Mgmt – continuous recalibration of derivatives bets.  Followed by Fast Trading – machines changing prices. Followed by Passive Investment (which tied to Risk Mgmt is ETFs, far and away the biggest combined influencer).

All these behaviors are 30%-43% higher than Active Investment as influencers. Defined as percentages of trading volume the past five days, Active is 11.6%, Passive, 26.9%, Fats Trading 41.4%, Risk Mgmt 20.1%.

What’s rustling the thickets of equity volatility, introducing unpredictability into stocks across the board, are vast benchmarked behaviors and their trading remoras.

The longer everyone persists in trying to assign rational motivation to moves, the more dangerous the market becomes. This isn’t complicated: The elephant in the room is the money watching prices – passive, speculative, hedged.  If observers are looking elsewhere, we’ll sooner or later get caught off-guard.

Let’s not.  Instead, be aware. Know the calendar.  Listen for Russelling stocks.

Phones and Wristwatches

Numbers matter. But not the ones you think, public companies and investors.

For instance, the best sector the past month is Utilities, up 3.5%, inversing the S&P 500’s 3.5% decline over that time (a 7% spread trade, we could say).

Utilities were worst for revenue surprises among the eleven sectors last quarter, says FactSet, and ninth of eleven for earnings surprises. Financial returns were mid-pack among sectors. It wasn’t results.

Sure, Utilities are defensive, along with Staples, Real Estate, Health Care. Those are up too the last month but less than Utilities.

One number sets Utilities apart: volatility.

Or lack thereof. Measured intraday, it’s 1.5% daily between high and low prices for stocks comprising the sector. Broad-market intraday volatility is 2.7%, 50% higher than Utilities.

Staples and Real Estate trail market volatility too, while Health Care, only of late returning to the safe-harbor fold, is more than twice as volatile as Utilities.

The worst sector in the market the last month is Energy, down 8.4% as measured by State Street’s sector ETF, XLE. And Energy stocks, with daily swings of 3.9%, were 44% more volatile than the broad market – and 100% more volatile than Utilities.

Among the most popular recent investments, the WSJ reports (posted here by Morningstar), are low-volatility ETFs like $SPLV and $USMV. Assets have exploded. These funds are disproportionately exposed to Utilities. And our models show massive ETF patterns in Utilities stocks.

Remember, ETFs are not pooled investments. They’re derivatives. If money flows to these ETFs, it’s not aggregating into a big lake of custodial money overseen by Blackrock or Invesco.

Suppose I traded my cell phone for your wristwatch. You’re free to do what you want with my phone because it’s yours now. But in a sense we’re saying the phone and the wristwatch are of similar value.

Say we’re day-trading phones and wristwatches.  Neither of us has a claim per se to the phone or the wristwatch. But we’ll be inclined to buy the wristwatch when it’s worth less than the phone and sell it when it’s worth more.

Same with ETFs. Low-vol ETF sponsors want assets such as Utilities and big stocks like WMT or PFE that don’t move much intraday (about 1.3% for those two).

ETFs are priced on spreads. Low-volatility instruments demand comparatives with low volatility (creating a run on low-vol assets?). They have no intrinsic value. You can’t find an ETF lying on the sidewalk and trade it to, say, Blackrock for its face value in cash.

It has no face value. Unless there’s another item with similar value to which it compares. ETFs are priced via in-kind exchange. Phone and wristwatch.

The ETF, phones, will be attractive to a trader to buy if it’s discounted to the stuff it’s supposed to track, wristwatches, and less attractive (and a short) if it’s currently priced above that stuff (phones). Prices constantly change as a result. Volatility.

The same thing will by extension invade your stock’s pricing, because your stock is the stuff ETFs track.

This is vital to understand, public companies and investors.

If the majority of money in the market fixates on spreads, the spread becomes more important than your financial results. Spreads become better predictors of future stock values than fundamentals.

EDITORIAL NOTE: Come to the NIRI Annual Conference June 2-5 in Phoenix! I’m hosting a session on ETFs with Rich Evans from the Univ of VA Wed morning Jun 5.

Also, the Think Tank chaired by Ford Executive Director of Investor Relations Lynn Tyson has released its white paper on the future of Investor Relations. Adapting to evolving market structure and investment behavior is key.

This image (linked) looks like robot-generated modern art. It’s our data on spreads between ETFs and stocks from Dec 2018 to present.  Wide spreads matched strong markets. Diminishing spreads correlated to weakening stocks. Maybe it’s false correlation.

But what if as spreads narrow the incentive to swap phones for watches fades? Markets could be imperiled by numbers we’re not watching. Shouldn’t we know?

Are you listening, financial reporters?

Driverless Market

Suppose you were human resources director for a fleet of driverless taxis.

As Elon Musk proposes streets full of autonomous autos, the market has become that fleet for investors and investor-relations professionals.  The market drives itself. What we measure as IR professionals and investors should reflect a self-driving market.

There’s nothing amiss with the economy or earnings. About 78% of companies reporting results so far this quarter, FactSet says, are beating expectations, a tad ahead of the long-term average of 72%.

But a closer look shows earnings unchanged from a year ago. In February last year with the market anticipating earnings goosed by the corporate tax cut of 2017, stocks plunged, and then lurched in Q3 to heights we’re now touching anew, and then nosedived in the fourth quarter.

An honest assessment of the market’s behavior warrants questioning whether the autonomous vehicle of the market has properly functioning sensors. If a Tesla sped down the road and blew a stop sign and exploded, it would lead all newscasts.

No matter the cacophony of protestations I might hear in response to this assertion, there is no reasonable, rational explanation for the fourth-quarter stock-implosion and its immediate, V-shaped hyperbolic restoration. Sure, stocks rise and fall (and will do both ahead). But these inexplicable bursts and whooshes should draw scrutiny.

Investor-relations professionals, you are the HR director for the driverless fleet. You’re the chief intelligence officer of the capital markets, whose job encompasses a regular assessment of market sensors.

One of the sensors is your story.  But you should consistently know what percentage of the driving instructions directing the vehicle are derived from it.  It’s about 12% marketwide, which means 88% of the market’s navigational data is something else.

Investors, the same applies. The market is as ever driven by its primary purpose, which is determined not by guesses, theory or tradition, but by what dominates price-setting.  In April, the dominating behavior is Exchange-Traded Funds.  Active investment was third of four big behaviors, ahead only of Fast Trading (curious, as Fast Traders avoid risk).

ETF shares are priced by spreads versus underlying stocks. Sure, investors buy them thinking they are consuming pooled investments (they’re not). But the motivation driving ETFs is whether they increase or decrease in price marginally versus stocks.

ETF market-makers supply stocks to a sponsor like Blackrock, which grants them authority to create an equal value of ETF shares to sell into the market. They aim to sell ETFs for a few basis points more than the value of exchanged shares.

The trade works in reverse when the market-maker borrows ETF shares to return to Blackrock in exchange for a group of stocks that are worth now, say, 50 basis points more than the stocks the market-maker originally offered.

If a market-maker can turn 30-50 basis points of profit per week this way, it’s a wildly winning, no-risk strategy. And it can and does carry the market on its updraft. We see it in patterns.

If it’s happening to your stock, IR professionals, it’s your job to know. Investors, you must know too, or you’ll draw false conclusions about the durability of cycles.

Big Market Lesson #1 in 2019: Learn how to measure behaviors. They’re sensors. Watch what’s driving your stock and the market higher (or lower – and yes, we have a model).

Speaking of learning, IR people, attend the 50th Anniversary NIRI Annual Conference. We have awesome content planned for you, including several not-to-be-missed market-structure sessions on hedge funds, the overall market, and ETFs.  Listen for a preview here and see the conference agenda here.  Sign up before May 15 for the best rate.

Big Market Lesson #2: Understand what stops a driverless market.

ETF-led rallies stall when the spread disappears. We have a sensor for that at ModernIR, called Market Structure Sentiment™ that meters when machines stop lifting or lowering prices.

It’s a 10-point scale that must remain over 5.0 for shares to rise. It’s averaged 6.2 since Jan 8 and has not been negative since. When it stalls, so will stocks, without respect to earnings or any other fundamental sensor.

I look forward to driverless cars. But we’ll want perfected technology before trusting them. The same should apply to a driverless stock market.

 

Melting Up

Blackrock CEO Larry Fink sees risk of a melt-up, not a meltdown for stocks.

Speaking of market structure, I’m a vice chair for NIRI’s Annual Conference – the 50th anniversary edition.  From the opening general session, to meeting the hedge funds, to a debate on how ETFs work, we’ve included market structure.  Catch a preview webcast on So-So Thursday, Apr 18, (before Good Friday) at 2pm ET (allow time to download Adobe Connect): https://niri.adobeconnect.com/webinar041819

Back to Larry Fink, is he right?  Who knows. But Blackrock wants to nudge record sidelined retail and institutional cash into stocks because revenues declined 7%.

Data tell us the market doesn’t need more buyers to melt up. Lipper said $20 billion left US equities from Jan through Apr 3, more than the $6 billion Bloomberg had earlier estimated. Stocks rallied 16%.

We wrote April 3 that no net cash fled equities in Q4 last year when the market corrected. If stocks can plunge when no money leaves and soar when it does, investors and public companies should be wary of rational expectations.

We teach public companies to watch for behavioral data outside norms.  Investors, you should be doing the same. Behavioral-change precedes price-change.  It can be fleeting, like a hand shoved in a bucket of water. Look away and you’ll miss the splash.

Often there’s no headline or economic factor because behaviors are in large part motivated by characteristics, not fundamentals.

Contrast with what legendary value investor Benjamin Graham taught us in Security Analysis (1934) and The Intelligent Investor (1949): Buy stocks discounted to assets and limit your risk.

The market is now packed with behaviors treating stocks as collateral and chasing price-differences. It’s the opposite of the Mr. Market of the Intelligent Investor. If we’re still thinking the same way, we’ll be wrong.

When the Communication Services sector arose from Technology and Consumer Discretionary stocks last September, the pattern of disruption was shocking. Unless you saw it (Figure 1), you’d never have known markets could roll over.

Larry Fink may think money should rush in (refrains of “fools rush in…”) because interest rates are low.  Alan Greenspan told CNBC last week there’s a “stock market aura” in which a 10% rise in stocks corresponds to a 1% increase in GDP. Stocks were down 18% in Q4, and have rebounded about 16%. Is the GDP impact then neutral?

To me, the great lesson for public companies and investors is the market’s breakdown as a barometer for fundamentals.  We’ve written why. Much of the volume driving equities now reacts to spreads – price-differences.

In a recent year, SPY, the world’s largest and oldest Exchange Traded Fund, traded at a premium to net asset value 62% of the time and a discount 38% of the time. Was it 2017 when stocks soared?  No, it was 2018 when SPY declined 4.5%.

Note how big changes in behavioral patterns correspond with market moves. The one in September is eye-popping. Patterns now are down as much as up and could signal a top.

SPY trades 93% of the time within 25 basis points of NAV, but it effectively never trades AT net-asset-value. Comparing trading volume to creations and redemptions of ETF shares, the data suggest 96% of SPY trading is arbitrage, profiting on price-differences.

This is the stuff that’s invaded the equity market like a Genghis Kahn horde trampling principles of value investment and distorting prices.

So, what do we DO, investors and public companies?

Recognize that the market isn’t a reliable barometer for rational thought. If your stock fell 40% in Q4 2018 and rebounded 38% in Q1, the gain should be as suspect as the fall.

Ask why. Ask your exchange. Ask the regulators. Ask the business reporters. These people should be getting to the bottom of vanishing rationality in stocks.

It may be the market now is telling us nothing more than ETFs are closing above net asset value and ETF market-makers are melting stocks up to close that gap.  That could be true 62% of the time, and the market could still lose 20% in two weeks.

When you hear market-behavior described in rational terms – even during earnings – toss some salt over a shoulder.  I think the market today comes down to three items: Sentiment reflecting how machines set prices, shorting, and behavioral change.

Behavioral patterns in stocks now show the biggest declines since September. Sentiment reflecting how machines set prices is topped ahead of options expirations that’ll be truncated by Good Friday. Shorting bottomed last week and is rising.

(Side note: patterns don’t vary during earnings. They fluctuate at month-ends, quarter-ends and options-expirations, so these are more powerful than results.)

Nobody knows the future and we don’t either. Behaviors change. But the present is dominated by characteristics, powerful factors behind behavioral patterns.

Watch the Machines

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

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

What’s that mean ahead?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Flowing

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

So how can stocks be up?

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

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

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

That combination is ETFs.

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

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

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

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

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

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

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

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

It happened in December.

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

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

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

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

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

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

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

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

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

Your boards and executive teams deserve to know.

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

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

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

Down Maiden Lane

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

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

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

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

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

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

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

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

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

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

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

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

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

Wow, right? Whew!

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

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

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

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

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

Now we’re at the top of the arc.

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

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

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

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

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

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

 

A Credit Market

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sector Insights

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

When Oil Swoons

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

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

Motivation in markets is money.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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