Tagged: Stocks

Collateral

I apologize.

Correlation between the market’s downward lurch and Karen’s and my return Sunday from the Arctic Circle seems mathematically irrefutable.  Shoulda stayed in Helsinki.

I wouldn’t have minded more time in the far reaches of Sweden and Finland viewing northern lights, sleeping in the Ice Hotel, riding sleds behind dogs, trekking into the mystic like Shackleton and Scott, gearing up for falling temperatures.  We unabashedly endorse Smartwool and Icebreaker base layers (and we used all we had).

Back to the market’s Arctic chill, was it that people woke Monday and said, “Shazam! This Coronavirus thing is bad!”

I’m frankly stupefied by the, shall we say, pandemic ignorance of market structure that pervades reportage.  If you’re headed to the Arctic, you prepare. If you raise reindeer, you’ve got to know what they eat (lichen). And if you’re in the capital markets, you should understand market structure.

There’s been recent talk in the online forum for NIRI, the investor-relations association, about “options surveillance.”   Options 101 is knowing the calendar.

On Aug 24, 2015, after a strong upward move for the US dollar the preceding week, the market imploded. Dow stocks fell a thousand points before ending down 588.

New options traded that day.  Demand vanished because nothing stresses interpretations of future prices – options are a right but not an obligation to buy or sell in the future – like currency volatility.

Step forward.  On Monday Feb 24, 2020, new options were trading.

Nobody showed up, predictively evident in how counterparty trading in support of options declined 5% the preceding week during expirations. Often, the increase or decrease in demand for what we call Risk Management – trades tied to leverage, portfolio insurance, and so on – during expirations is a signal for stocks.

Hundreds of trillions of dollars of swaps link to how interest rates and currency values may change in the future, plus some $10 trillion in equity swaps, and scores of trillions of other kinds of contracts. They recalibrate each month during expirations.

They’re all inextricably linked.  There is only one global reserve currency – money other central banks must own proportionally. The US dollar.

All prices are an interpretation of value defined by money. The dollar is the denominator.  Stock-prices are numerators.  Stronger dollar, smaller prices, and vice versa.

The DXY hit a one-year high last week (great for us buying euros in Finland!).

Let’s get to the nitty gritty.  If you borrow money or stocks, you post collateral.  If you hawk volatility by selling puts or calls, you have to own the stock in case you must cover the obligation.  If you buy volatility, you may be forced to buy or sell the underlying asset, like stocks, to which volatility ties.

Yesterday was Counterparty Tuesday, the day each month following the expiration of one series (Feb 21) and the start of a new one (Feb 24) when books are squared.

There’s a chain reaction. Counterparties knew last week that betting on future stock prices had dropped by roughly $1 trillion of value.  They sold associated stocks, which are for them a liability, not an investment.

Stocks plunged and everyone blamed the Coronavirus.

Now, say I borrowed money to buy derivatives last week when VIX volatility bets reset.  Then my collateral lost 4% of its value Monday. I get a call: Put up more collateral or cover my borrowing.

Will my counterparty take AAPL as collateral in a falling market?  Probably not. So I sell AAPL and pay the loan.  Now, the counterparty hedging my loan shorts stocks because I’ve quit my bet, reducing demand for stocks.

Volatility explodes, and the cost of insurance with derivatives soars.

It may indirectly be true that the cost of insurance in the form of swap contracts pegged to currencies or interest rates has been boosted on Coronavirus uncertainty.

But it’s not at all true that fear bred selling.  About 15% of market cap ties to derivatives.  If the future becomes uncertain, it can be marked to zero.  Probably not entirely – but marked down by half is still an 8% drop for stocks.

This is vital:  The effect manifests around options-expirations. Timing matters. Everybody – investors and public companies – should grasp this basic structural concept.

And it gets worse.  Because so much money in the market today is pegged to benchmarks and eschews tracking errors, a spate of volatility that’s not brought quickly to heel can spread like, well, a virus.

We’ve not seen that risk materialize in a long while because market-makers for Exchange Traded Funds that flip stocks as short-term collateral tend to buy collateral at modest discounts. A 1% decline is a buying opportunity for anyone with a horizon of a day.

Unless.  And here’s our risk: ETF market-makers can substitute cash for stocks. If they borrowed the cash, read the part on collateral again.

I expect ETF market-makers will return soon. Market Structure Sentiment peaked Feb 19, and troughs have been fast and shallow since 2018. But now you understand the risk, its magnitude, and its timing. It’s about collateral.  Not rational thought.

Proportional Response

Proportional Response is the art of defusing geopolitical conflict.

Proportional Response is also efficient effort. With another earnings season underway in the stock market, efficient effort should animate both investment decisions, and investor-relations for public companies.

I’ve mentioned the book The Man Who Solved the Market, about Jim Simons, founder of Renaissance Technologies. There’s a point where an executive is explaining to potential investors how “RenTec” achieves its phenomenal returns.

The exec says, “We have a signal. Sometimes it tells us to buy Chrysler, sometimes it tells us to sell.”

The investors stare at him.

Chrysler hadn’t been a publicly traded stock for years (they invested anyway – a proportional response).

That executive – a math PhD from IBM – didn’t care about the companies behind stocks. It didn’t bear on returns. There are vast seas of money rifling through stocks with no idea what the companies behind them do.

RenTec is a quant-trading firm. Earnings calls are irrelevant save that its models might find opportunity in fleeting periods – even fractions of seconds – to trade divergences.

Divergences, tracking errors, are the bane of passive money benchmarked to indexes. If your stock veers up or down, it’ll cease for a time to be used in statistical samples for index and exchange-traded funds (ETFs).

And hedge funds obsess on risk-adjusted returns, the Sharpe Ratio (a portfolio’s return, minus the risk-free rate, divided by standard deviation), which means your fundamentals won’t be enough to keep you in a portfolio if your presence deteriorates it.

Before your eyes glaze over, I’m headed straight at a glaring point.  Active stock-pickers are machinating over financial results, answers to questions on earnings calls, corporate strategy, management capability, on it goes.

On the corporate side, IR people as I said last week build vast tomes to help execs answer earnings-call questions.

Both parties are expending immense effort to achieve results (investment returns, stock-returns). Is it proportional to outcomes?

IR people should have their executive teams prepared for Q&A. But let’s not confuse 2020 with the market in 1998 when thousands of people tuned to Yahoo! earnings calls (that was the year I started using a new search engine called Google).

It’s not 2001 when about 75% of equity assets were held by active managers and some 70% of volume was driven by fundamentals.

It’s 2020. JP Morgan claims combined indexed money, ETFs, proprietary trading and quant funds are 80% of assets. We see in our data every day that about 86% of volume comes from a motivation besides rational thought predicated on fundamental factors.

Proportional Response for IR people is a one-page fact sheet for execs with metrics, highlights, and expected Q&A.  The vast preparatory effort of 20 years ago is disproportionate to its impact on stock-performance now.

Proportional response for investors and public companies alike today should, rather than the intensive fundamental work of years past, now incorporate quantitative data science on market structure.

IR people, don’t report during options-expirations. You give traders a chance to drive brief and large changes to options prices. Those moves obscure your message and confuse investors (and cause execs to incorrectly blame IR for blowing the message).

Here’s your data science: Know your daily short-volume trends and what behaviors are corresponding to it, and how those trends compare to previous quarters. Know your market-structure Sentiment, your volatility trends, the percentages of your volume driven by Active and Passive Investment and how these compare to past periods.

Put these data in another fact sheet for your executive team and board.  Provide guidance on how price may move that reflects different motivations besides story (we have a model that does it instantly).

Measure the same data right after results and again a week and a month later. What changed? If you delivered a growth message, did growth money respond? That’s quantitatively measurable. How long before market structure metrics mean-reverted?

Investors, data science on market structure isn’t another way to invest. It’s core to predicting how prices will behave because it reflects the demographics driving supply and demand.

There are just a thousand stocks behind 95% of market cap. You won’t beat the market by owning something somebody else doesn’t. You’ll beat it by selling Overbought stocks and buying Oversold ones.  Not by buying accelerating earnings, or whatever.

The stock market today reflects broad-based mean-reversion interspersed with divergences. RenTec solved the market, we’re led to conclude, by identifying these patterns.  The proportional response for the rest of us is to learn patterns too.

Six See Eleven

What do you do in Steamboat Springs when autumn arrives at the Botanic Park? Why, have a Food & Wine Festival of course!

Meanwhile the derivatives festival in equities continues, thanks to the SEC, which through Rule 6c-11 is now blanket-exempting the greatest financial mania of the modern era, Exchange Traded Funds (ETFs), from the law governing pooled investments.

I’ll explain what this means to companies and stock-picking investors.

Look, I like Chairman Clayton, Director Redfearn, and others there.  But the SEC isn’t Congress, legislating how the capital markets work (one could argue that the people never delegated that authority to government through the Constitutional amendment process at all. But I digress).

The point is, the SEC is supposed to promote free and fair markets – not one purposely tilted against our core audience of stock-pickers.

The problems with ETFs are they’re derivatives, and they foster arbitrage, or profiting on different prices for the same thing. If arbitrage is a small element – say 15% – it can highlight inefficiencies. But thanks to ETFs, 87% of volume (as we measure it) is now directly or indirectly something besides business fundamentals, much of it arbitrage.

Do we want a market where the smallest influencer is Benjamin Graham?

ETFs in fact can’t function without arbitrage. ETFs have no intrinsic value.  They are a traded substitute for a basket of underlying stocks that depend on prices of those stocks for a derivative price applied to the ETF shares. So, unless brokers trade both ETF shares and stocks simultaneously, ETF prices CAN collapse.

That was an outlier problem until ETFs became the fastest-growing financial instrument of all time outside maybe 16th century Dutch tulip bulbs.

But collapse is not the core threat from ETFs. Arbitrage distorts the market’s usefulness as a barometer of fundamentals, warps the market toward speed, and shrivels liquidity.

How and why are these conditions tied to ETFs and arbitrage?  I’m glad you asked!

The motivation for arbitragers is short-term price-changes.  The motivation for investors is long-term capital formation. These are at loggerheads.  The more arbitrage, the faster prices change.  Price-instability shrinks the size of trades, and liquidity is the amount of something that can trade before prices change. It’s getting smaller as the market balloons.

If money can’t get into or out of stocks, it will stop buying them and start substituting other things for them. Voila! ETFs.

But.

We’ll get to that “but” in a minute.

ETFs are a fantastic innovation for ETF sponsors because they eliminate the four characteristics that deteriorate fund-performance:

Volatility. ETF shares are created off-market in big blocks away from competition, arbitrage, changing prices, that war on conventional institutional orders.

Customer accounts. ETFs eliminate asset-gathering and the cost of supporting customers, offloading those to brokers. Brokers accept it because they arbitrage spreads between stocks and ETFs, becoming high-frequency passive investors (HFPI).

Commissions. ETF sponsors pay no commissions for creating and redeeming ETF shares because they’re off-market.  Everyone else does, on-market.

Taxes. Since ETFs are generally created through an “in-kind” exchange of collateral like cash or stocks, they qualify as tax-exempt transactions.  All other investors pay taxes.

Why would regulators give one asset class, which wouldn’t exist without exemptions from the law, primacy? It appears the SEC is trying to push the whole market into substitutes for stocks rather than stocks themselves.

The way rules are going, stocks will become collateral, investments will occur via ETFs. Period.  If both passive and active investors use ETFs, then prices of ALL stocks will become a function of the spread between the ETFs and the shares of stocks.

Demand for stocks will depend not on investors motivated by business prospects but on brokers using stocks as collateral. Investors will buy ETFs instead of stocks.

If there is no investment demand for stocks, what happens when markets decline?

What would possess regulators to promote this structure? If you’ve got the answer, let me know.

And if you’re in IR and if you play guitar (Greg Secord? You know who you are, guitar players!), start a rock band. Call it Six See Eleven. Book some gigs in Georgetown. Maybe Jay Clayton will pop in.

Meanwhile, your best defense is a good offense, public companies and investors. Know how the market works. Know what the money is doing. Prepare for Six See Eleven.

Curtains

Curtains are window-dressing. Curtains loom. But not the way you think. I’ll explain.

Before that, here in New York it’s Indian Summer, and Karen snapped this midtown shot after we stopped in at The Smith before two busy days of client visits. Next up, Washington DC with the NIRI contingent at Congress and the SEC, as I wrote last week.

Back to curtains, the news cycle forces us to address it. Democrats hope developments are curtains for President Trump. The market fell today. One could say Democrat glee clashes with market euphoria. Impeachment talks snowballed and down went stocks.

Short-term traders can push the snowball where it may want to go, sure. But the DATA changed more than a week ago. Market Structure Sentiment™ topped between Sep 12-17. This is not mass psychology. Our Sentiment index measures whether the probability of prices to rise has peaked or bottomed.

The great bulk of stock orders – around 96% – feed through algorithms and smart order routers. When those systems using extremely high-speed techniques find diminishing probability that trades will fill at the rate, price, and cost desired, they stop buying.

We translate that condition into a sentiment measure on a ten-point scale. For single stocks it’s 10/10 Overbought. For the total stock market or key benchmarks within it (S&P 500, reflecting about 88% of market capitalization, Russell 1000 comprising 95% of market cap), 7.0 is Overbought, and topped. Readings below 4.0 are Oversold and bottomed, meaning machines can fill orders better than models show.

The stock market measured this way rather than by fundamentals, headlines, blah blah, was topped more than a week ago and thus unlikely to rise further.

On Monday, Sep 23, new options and futures on everything from individual stocks to currencies and US Treasurys and indexes began trading.  We feared that disruptions in the overnight lending market coupled with big currency volatility would alter demand.

What’s more, as we’ve written, there was no momentum to value shift by INVESTORS in the first part of September. It’s happening now only because business journalists have written about it so relentlessly that people are beginning to believe it.

What manifested in the data was a massive short squeeze on Exchange-Traded Fund (ETF) market-makers, caught out by a surge in Fast Trading of VALUE stocks (and corresponding rejection of growth stocks) propelled by one stock, AT&T, where Activist investor Elliott showed. Machines duped humans. Spreads gapped, a squeeze formed.

What’s that got to do with curtains? I’m getting to it.  Stay with me.

Short-covering is a margin call. Margin calls drive up the cost of borrowing (it rippled through the overnight lending market, forcing the Federal Reserve to intervene), which meant the next time around, leverage would cost more.

That recalibration occurred yesterday, and behavioral change in ETFs exploded to near 30% – a black swan, three standard deviations from norms. You didn’t see it in price and volume. You can’t see it that way.

But with Sentiment topped, the market was destined to give us a swoon.  What if there’d been no news on impeachment? Which thing would have been blamed instead?

Behavioral change in markets is CAUSING pundits to cast about for reasons and incorrectly assign motivation.

Window-dressing, when passive money adjusts assets to reflecting benchmarks, has got to get done the next few days. Volatility skews benchmark-tracking.  Fear feeds through markets to investors. The cost of hedging continues rising.

And there’s a vital futures contract for truing up index-tracking that expires the last trading day of each month. That’s next Monday.

The needs of passive money, leviathan in stocks now, means the patterns of window-dressing stretch long either side of the last trading day. We’re seeing them already (and if you want to know what they say, use our analytics!).

What this means for both investors and public companies is that you must track the underlying data if you want to know what’s coming. It’s there. And we have it.

Headlines are being driven by data-changes behind stocks rather than the other way around (we warned you, clients, in a special private note Monday before stocks opened for trading that we feared just this outcome).

Curtains – window-dressing, the movement of money – are more important than the window, the headlines used to justify unexpected moves.

So every public company, every investor, should put MORE weight on the data than the headlines. We’ve got that data.

Beneath the Surface

I don’t think it should be overlooked that “Quants” and “Quasts” differ by only a letter.

Scott Patterson’s 2010 book, The Quants, is a great read.  You’ll be riveted by what was cascading beneath the market’s surface before the financial crisis.  Here’s a taste:

“That Wednesday, what had started as a series of bizarre, unexplainable glitches in quant models turned into a catastrophic meltdown the likes of which had never been seen before in the history of financial markets….

“Oddly, the Bizarro World of quant trading largely masked the losses to the outside world at first, since the stocks they’d shorted were rising rapidly, leading to the appearance of gains on the broader market that balanced out the diving stocks the quants had expected to rise.

“Monday, the Dow Industrials actually gained 287 points. It gained 36 more Tuesday, and another 154 points Wednesday. Everyday investors had no insight into the carnage taking place beneath the surface, the billions in hedge fund money evaporating.”

Key phrase:  Beneath the surface.

What the market appears to be saying may be the opposite of what gurgles in its depths.

It’s why we say price and volume are CONSEQUENCES, not metrics.  What’s causing price or volume to change?  This is the question every public company, every investor, should answer today (we have that data, so there’s no reason to go begging!).

Take the broad market Monday, with the Dow Industrials up 260 points. Cause? Risk Mgmt – counterparties to bets, covering their exposure.

And shorting rose. Yesterday, 47% of all volume marketwide was borrowed – short.  Intraday volatility, the average move from highest to lowest price, is 3%.

That’s 50% of market volume, combined. Can the market sustainably rise if half its volume depends on lower or fluctuating prices?  Well, it’s not impossible. But probability is poor.

High shorting doesn’t mean the market will tank. But short-covering is necessary for shares to rise.  Consider Jan 2018.  Shorting dropped, volatility vanished, stocks surged.

The VIX (coming volatility destroyed two synthetic ETFs), price and volume, gave everyday folks no clue to the looming maw.  But under the surface the gurgling hit a fever pitch. Market Structure Sentiment, our 10-point gauge of price peaks and troughs, topped Jan 19. Behavioral change was a black swan – more than three standard deviations from norms.

Behavioral change is the daily demographic evolution in the money behind price and volume. A surge is a stampede – with delayed effects. Sentiment usually says which way.

On Jan 22, the market’s Chernobyl core melted under a staggering six-standard-deviations move in behaviors.  The market continued to rise. Nobody on CNBC was warning people.

By mid-February, from peak to trough the S&P 500 fell over 10%.

On Sep 19, 2018, Market Structure Sentiment topped weakly, not even regaining 6.0 (the market trades between 4.0-6.0 most of the time).  Black swans crashed through behavioral-change Sep 14-19.  The market kept rising.

Sep 25-28, behavioral-change demolished every record we’d ever seen, cascading daily at an average six standard deviations over norms.  SPY, the S&P 500 ETF, hit 293.58 Oct 1, 2018.  Yesterday it closed at 286.87.

From its Oct 1 zenith to the Dec 24 nadir of 234.34, SPY declined 20.2%.

SPY reached an all-time peak Jul 15, 2019 as Market Structure Sentiment topped just over 6.0. And yup, you guessed it. Black swans flapped in Jul 31 and Aug 1. Another struck Aug 13.

Why has the market become so mathematical? Behaviors.  All trades must occur between the best bid and offer, and the bid must be lower. Somebody can make a half-penny on each side of the trade – the aim of Fast Traders.  Arbitrage.

ETFs have ten TIMES the assets they did in 2008 — $4 trillion in the US alone, the bulk in equities. There’s one ETF for every four companies. ETFs depend on arbitrage for prices.

Derivatives are an arbitrage trade. What is something worth now versus what it might be in the future?  Put these all together.  It’s 87% of volume. The market runs on arbitrage. Continuously differing prices.

It’s transformative to see, beneath the surface, why your stocks behave as they do.  Then what, public companies?  You have a duty to know what the money is doing and to understand when it’s story and when it’s not. That’s a puzzle solved only with data.

Investors, if you’re one day wrong, you can lose your gains.  Data are protection.

When you’re ready to go spelunking, let us know.

Interesting Year

“It’s going to be an interesting year.”

We wrote that phrase in the Jan 2, 2019 edition of the Market Structure Map. (By the way, we’re in Rhode Island this week visiting customers, and in Newport you’ll see the sea in everything.)

I don’t mean to suggest we’re amongst those arrogant buffoons quoting themselves. I do think we drew the right line from Dec 2018 to the future. We noted, and it’s worth reading, that the Federal Reserve had shut down the Maiden Lane financial entity used to buy assets from AIG. An epochal event.

We said it could mark a top for the inflationary arc in risk assets spawned by the flood of cheap central-bank money.  We’ve had no gains in stocks from Sep 20, 2018 to present.

In December last year, pundits blamed the market maelstrom on impending recession. It was false then and it’s false now. Sure, all economies contract – fall into recession.  It wasn’t a uniformly engrossing event before central banks, though.

The human propensity to borrow and spend on growth, which at some point slows, leading to the collapse of borrowers and lenders alike, is normal and not something we should be trying to eradicate by juicing credit markets.

The bigger the credit wave, the farther the economic surfboard skims, and everyone marvels at the duration of the expansion cycle. And then the wave dies on the shoals. We’re now riding it, wind in our hair, with a vast curl beginning to form overhead.

But that’s not what sparked the market’s volatile descent.

One client (thank you!) shared notes from a JP Morgan conference call on recent volatility. JPM says economic underpinnings are reasonably sound and no cause for market troubles. Hedging strategies leading to the consumption of fixed income securities and sale of equities generated market duress (and skyrocketing bond prices), says JPM.

What prompted hedging strategies to change?  The cries of “recession!” didn’t commence until the market had already plummeted.

The same thing happened last December. After the market tanked, people were searching for reasons – failing to consider the structure of markets today and once again errantly supposing rational thought was at fault – and decided that so large a drop could only mean economic contraction had arrived.

It had not.

Think about how incorrect premises cost public companies money. There’s lost equity value. Higher equity cost of capital on volatility. Time and money spent messaging to the market about recession defenses.

CNBC had data yesterday on the spiking occurrence of Google searches around “the R word,” as they say.  No doubt a chunk of readers were searching earnings-call transcripts and press releases for it.

Behavioral data show no evidence of rational thought behind the market’s decline. Passive Investment plunged 20% the week ended Aug 2.  Stocks cratered.

Further, our data show the same thing JPM discussed. At Aug 19, order flow related to directional bets is down 11% versus the 200-day average. Occurring with expiring August options and newly trading September instruments Aug 15-21, it’s telling. Bets and hedges have gone awry. Low volatility schemes have failed. Insurance costs are up.

Low volatility investing is the most popular “smart beta” technique used to beat general market performance with rules-based investments. The dominance of smart beta is largely responsible for the outperformance of Utilities stocks tied to smart beta Exchange Traded Funds (ETFs.). Those strategies failed in August.

Volatility bets like the VIX expire today, Aug 21.

We can often peg the amount a stock will fall on bad earnings news to the percentage of market-cap tied to derivatives. Why? If future prices become indeterminate, the value of the instruments predicated on them declines near zero.

Currently, 16.4% of market cap traces back to derivatives and leverage, such as borrowing, down from pre-August levels over 18%. Volatility clouds predictability. The cost of leverage and protection increases, while use diminishes.

What if the market fell because Passive money was overweight equities and overdue for rebalancing, and stopped buying stocks in late July, which caused a gut-lurching swoon, which in turn rendered hedges worthless?

Talk of recession is a consequence of the market’s decline. Not causality.  Think about your own stock, IR professionals. Do you understand what drives it?  Investors, if you weight your portfolio for a recession that doesn’t exist, you’ll be wrong.

Our premise Jan 2 was that the end of Maiden Lane was the end of a monetary era, and it had the potential to create an interesting year. So far, seems right.  We also know what kind of money is waxing or waning. You should too. It’s not just interesting. It’s essential to correct actions.

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.