Tagged: Stocks

Minnows

Softbank bet big on call-options and Technology stocks are sinking.

So goes the latest big story. Business-reporting wants a whale, a giant trade that went awry.  A cause for why Tech stocks just corrected (off 10%).

In reality the market today rarely works that way.  Rather than one big fish there are a thousand minnows, swimming schools occasionally bringing the market down.

We wrote about this last week, regarding short volume. You should read it. We highlighted a key risk right before the market fell.

The same things driving stocks up unassailably toward the heavens, which should first have gotten our attention, often return them to earth. But we humans see no flaws in rising stocks.

Back to Softbank. If you’ve not read the stories, we’ll summarize. CNBC, the Wall Street Journal and other sources have reported on unconfirmed speculation the big Japanese private equity firm bet the equivalent of $50 billion on higher prices for Tech stocks.

Maybe it’s true.  Softbank owned about $4 billion of Tech stocks in the last 13Fs for the quarter ended June 30 (the filings the SEC wants to make less useful, by the way).

Rumor is Softbank levered those holdings by buying call options, rights to own shares at below-market prices if they’re worth more than a threshold level later, on big Tech stocks like MSFT and AAPL.

Here’s where the story ends and market structure begins. The truth is the market neither requires a leviathan to destabilize it, nor turns on this colossus or that. It’s minnows.

It’s always thrumming and humming in the lines and cables and boxes of the data network called the stock market.  And everything is magnified.

A single trade for a single stock, coupled with an order to sell options or buy them, sets off a chain of events.  Machines send signals like radar – ping! – into the network to learn if someone might take the other side of this trade.

Simultaneously, lurking mechanical predators are listening for radar and hearing the pings hitting a stock – MSFT! Wait, there are trades hitting the options market.  Get over to both fast and raise the price!

Compound, compound, compound.

Prices rise.  Retail traders say to themselves, “Let’s buy tech stocks!  Wait, let’s buy options too!”

And the same lurking machines buy those trades from the pipelines of online brokerage firms, assessing the buy/sell imbalance. They rush to the options market to raise prices there too, because once the machines own the trades from retail investors, they are no longer customer orders.  And the machines calculate demand and run prices up.

And index futures contracts rise, and the options on those. Then index funds using options and futures to true up index-tracking lift demand for options and futures, magnifying their own upside.

Read prospectuses, folks. Most index funds can spend up to 10% of assets on substitutes for tracking purposes, and a giant futures contract expires the last trading day of each month that helps indexed money square its assets with the benchmark.

And then the arbitragers for Exchange Traded Funds drive up the prices of ETF shares to keep pace with rising stocks, options, futures.

And there are options on ETFs.

Every price move is magnified by machines.  Up and up and up go stocks and people wonder does the stock market reflect reality?

The thing about prices is you never know precisely when they hit a zenith, the top of the arc. The last pump of your childhood legs in the playground swing, and that fleeting weightlessness.

And then whoosh!  Down you come.

Did Softbank make money or lose it?  I don’t know and it makes no difference. What I just described is relentlessly occurring every fraction of every second in the stock and options markets and there comes a moment of harmonic convergence after long arcs up and down, up and down, like children on swing sets.

It’s a thousand cuts, not a sword. Schools of minnows, not a whale.  The problem isn’t Softbank. It’s a market that depends on the machine-driven electromagnification of every action and reaction.

The reason we know is we measure it. For public companies, and investors. You can wait for stories after the fact surmising sea monsters swam through. Or you can watch it on the screen and see all the minnows, as we do (read last week’s MSM).

What’s next? The same thing. Again.

Dark Edges

The stock market’s glowing core can’t hide the dark edges – rather like this photo I snapped of the Yampa River in downtown Steamboat springs at twilight.

Speaking of which, summer tinkled its departure bell up high.  We saw the first yellowing aspen leaves last week, and the temperature before sunrise on the far side of Rabbit Ears Pass was 30 degrees, leaving a frosty sheen on the late-summer grass.

The last hour yesterday in stocks sent a chill too. Nothing shouts market structure like lost mojo in a snap.  I listened to pundits trying to figure out why.  Maybe a delay in stimulus.  Inflation. Blah blah.  I didn’t hear anyone blame Kamala Harris.

It’s not that we know everything.  Nobody does.  I do think our focus on the mechanics, the machinery, the rules, puts us closer to the engines running things than most observers.

And machines are running the market.  Machines shift from things that have risen to things that have fallen, taking care to choose chunks of both that have liquidity for movement. Then all the talking heads try to explain the moves in rational terms.

But it’s math. Ebbs and flows (Jim Simons, the man who solved the market at Renaissance Technologies, saw the market that way).

Passives have been out of Consumer Staples. Monday they rushed back and blue chips surged. The Nasdaq, laden with Tech, is struggling. It’s been up for a long time. Everybody is overweight and nobody has adjusted weightings in months. We can see it.

By the way, MSCI rebalances hit this week (tomorrow on the ModernIR Planning Calendar).

This is market structure. It’s morphed into a glowing core of central tendencies, such as 22% of all market capitalization now rests on FB, AAPL, AMZN, NFLX, GOOG, MSFT, AMD, TSLA and SHOP.

That’s the glowing core.  When they glow less, the dark edges grow.

Then there’s money.  Dough. Bucks. Specifically, the US dollar and its relationship to other global currencies. When the dollar falls, commodities surge. It’s tipped into the darkness the past month, marking one of its steepest modern dives.  Gold hit a record, silver surged, producer prices dependent on raw commodities exploded.

Then the dollar stopped diving. It’s up more than 1% in the last five days. And wham! Dark edges groped equities late yesterday. Gold plunged. Silver pirouetted off a 15% cliff.

August is traditionally when big currency-changes occur. Aug last year (massive move for the dollar versus the Chinese Renminbi Aug 5, 2019). Aug 2015. Aug 2018. Currencies rattle prices because currencies underpin, define, denominate, prices.

Back up to Feb 2020.  The dollar moved up sharply in late February, hitting the market Monday, Feb 24, as new options traded.  Pandemic!

Options expire next week.  The equivalent day is Aug 24, when new options will trade. Nobody knows when the dark edges will become cloying hands reaching for our investment returns or equity values.

In fact, Market Structure Sentiment™, our algorithm predictively metering the ebb and flow of different trading behaviors, peaked July 28 at 7.7 of 10.0, a strong read.  Strong reads create arcs but say roughly five trading days out, give or take, stocks fall.

They didn’t. Until yesterday anyway. They just arced.  The behavior giving equities lift since late July in patterns was Fast Trading, machines chasing relative prices in fractions of seconds – which are more than 53% of total volume.

Then Market Structure Sentiment bottomed Aug 7 at 5.3, which in turn suggests the dark edges will recede in something like five trading days.  Could be eight. Might be three.

Except we didn’t have dark edges until all at once at 3pm ET yesterday.

Maybe it lasts, maybe it doesn’t. But there’s a vital lesson for public companies and investors about the way the market works.  The shorter the timeframe of the money setting prices, the more statistically probable it becomes that the market suddenly and without warning dives into the dark.

It’s because prices for most stocks are predicated only on the most recent preceding prices.  Not some analyst’s expectation, not a multiple of future earnings, not hopes for an economic recovery in 2021.

Prices reflect preceding prices. If those stall, the whole market can dissolve into what traders call crumbling quotes.  The pandemic nature of short-term behavior hasn’t faded at the edges. It’s right there, looming.  We see it in patterns.

If something ripples here in August, it’ll be the dark edges, or the dollar. Not the 2021 economy.

Mr. Smith’s Money

The price-to-earnings ratio in the S&P 500 is about 23.  Is it even meaningful?

Some say a zero-interest-rate environment justifies paying more for stocks. That’s compounding the error. If we behaved rationally, we’d see both asset classes as mispriced, both overpriced.

All investors and all public companies want risk assets to be well-valued rather than poorly valued, sure. But Warren Buffett wasn’t the first to say you shouldn’t pay more for something than it’s worth.

What’s happening now is we don’t know what anything is worth.

Which reminds me of Modern Monetary Theory (MMT).  The words “money” and “theory” shouldn’t be used in conjunction, because they imply a troubling uncertainty about the worth of the thing everyone relies on to meter their lives.

That is, we all, in some form or another, trade time, which is finite, for money, which is also finite but less so than time, thanks to central banks, which create more of it than God gave us time.

Every one of us trading time of fixed value for money of floating value is getting hosed, and it’s showing up in the stock and bond markets.

Let me explain.  Current monetary thinking sees money as debits and credits.  If gross domestic product is debited by a pandemic because people lose their jobs and can’t buy stuff, the solution is for the government to credit the economy with an equal and offsetting amount of money, balancing the books again.

This is effectively MMT.  You MMTers, don’t send me long dissertations, please. I’m being obtuse for effect.

The problem in the equation is the omission of time, which is the true denominator of all valuable things (how much times goes into the making of diamonds, for instance? Oil?). Monetarists treat time as immaterial next to money.

If it takes John Smith 35 years to accumulate enough money to retire on, and the Federal Reserve needs the blink of an eye to manufacture the same quantity and distribute it via a lending facility, John Smith has been robbed.

How? Mr. Smith’s money will now be insufficient (increasing his dependency on government) because the increase in the availability of money will reduce the return Mr. Smith can generate from lending it to someone else to produce an income stream.

Mispriced bonds.  They don’t yield enough and they cost too much.

So by extension the cost of everything else must go up.  Why? Because every good, every service, will need just a little more capital to produce them, as its value has been diminished.  To offset that effect, prices must rise.

And prices can’t rise enough to offset this effect, so you pay 23 times for the earnings of the companies behind the goods and services when before you would only pay 15 times.

And this is how it becomes impossible to know the worth of anything.

And then it gets complicated.  Read a balance sheet of the Federal Reserve from 2007.  The Fed makes up its own accounting rules that don’t jive with the Generally Accepted Accounting Principles that all public companies must follow.

But it was pretty straightforward.  And there were about $10 billion of excess bank reserves on a monthly average, give or take.

Try reading that balance sheet today with all its footnotes.  It’s a game of financial Twister, and the reason isn’t time or money, but theory.  A theory of money that omits its time-value leads people to write things like:

The Board’s H.4.1 statistical release, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has been modified to include information related to TALF II LLC. The TALF II LLC was introduced on the H.4.1 cover note on June 18, 2020 https://www.federalreserve.gov/releases/h41/current/.

The theory is that if you just keep footnoting the balance sheet to describe increasingly tangled assets and offsetting liabilities, so long as it zeroes out at the end, everything will be fine.

Except it leaves out Mr. Smith and his limited time on the earth.

Oh, and excess bank reserves are now nearly $3 trillion instead of $10 billion, proof money isn’t worth what it was.

This then breaks down fundamental constructs of valuation.  And it’s why we offer Market Structure Analytics.  While fundamentals can no longer in any consistently reliable way be used to discern what the stock market is doing, Market Structure Analytics lays reasons bare.

For instance, Market Structure Sentiment™ ticked up for TSLA July 2. Good time to buy. It’s got nothing to do with fundamentals.  FB Market Structure Sentiment™ ticked up June 23. Good time to buy. In fact, it’s a 1.0/10.0 right now, but it’s 57% short, so it’s got just limited upside.  Heard all the negative stuff that would tank FB? Fat chance. Market structure rules this Mad Max world.

Public companies, if you want to understand your stock, you have to use tools that take into account today’s madness. Ours do.  Same for you, traders. Sign up for a free 14-day trial at www.marketstructureedge.com and see what drives stocks.

How does it all end? At some point Mr. Smith will lose faith, and the currency will too.  We should stop the madness before then.

Squid Ink

Is retail money creating a Pandemic Bubble? Sort of. Really, it’s Fast Traders turning those orders into clouds of squid ink.

There are 47 million customer accounts at Schwab, Fidelity, Ameritrade, E*Trade and Robinhood.  These big online brokers sell their flow to Citadel, Two Sigma, Susquehanna’s G1X options platform, Virtu, UBS, options trader Wolverine, and others.

Nearly all of the orders are “non-directed,” meaning the broker determines where to send them.  Also, more than three paragraphs of market structure goop and people grab a bottle of tequila and go back to day-trading.

So, let me explain.

Do you know CHK?  A shale-oil play, it’s on the ropes financially. In May it was below $8. Yesterday CHK was near $70 when it halted for news. Which never came, and trading resumed. (Note: A stock should never, ever be halted for news, without news.)

It closed down hard near $24. Rumors have flown for weeks it’ll file bankruptcy.  Why was it at $70? People don’t understand that public equity often becomes worthless if companies go bust. Debtholders convert to equity and wipe out the old shareholders.

Hertz (HTZ) went bankrupt May 26 and shares closed at $0.56.  Monday it was over $5.50, up about 900%. HTZ debt is trading at less than 40 cents on the dollar, meaning bondholders don’t think they’ll be made whole – and they’re senior to equity.

This is bubble behavior. And it abounds. Stocks trading under $1 are up on average 79% since March, according to a CNBC report.

ABIO, a Colorado biotech normally trading about 10,000 shares daily with 1.6 million shares out made inconsequential reference to a Covid preclinical project (translation: There’s nothing there). The stock exploded, trading 83 million shares on May 28, or roughly 50 times the shares outstanding.

Look at NKLA.  It’s been a top play for Robinhood clients and pandemic barstool sports day-trading. No products out yet, no revenue. DUO, an obscure Chinese tech stock trading on the Nasdaq yesterday jumped from about $10 to $129, closing above $47.

Heck, look at Macy’s.  M, many thought, was teetering near failure amidst total retail shutdown. From about $4.50 Apr 2, it closed over $9.50 by June 8.

W, the online retailer that’s got just what you need, is up 700% since its March low despite losing a billion dollars in 2019.

When day traders were partying like it was 1999, in 1999, stocks for businesses with no revenues and products boomed.  Then the Nasdaq lost 83% of its value.

About 95% of online-broker orders are sold to Fast Traders – the Citadels, the Two Sigmas, the Virtus.  They’re buying the tick data (all the prices) in fractions of seconds. They know what’s in the pipeline, and what’s not.

Big online brokers sell flow to guarantee execution to retail traders.  I shared my experience with GE trades. The problem is retail prices are the ammunition in the machine gun for Fast Traders. They know if clips are being loaded, or not. And since retail traders don’t direct their trades (they don’t tell the broker to send it to the NYSE, Nasdaq, Instinet, IEX, etc., to hide prices from Fast Traders), these are tracer rounds stitching market prices up and down wildly.

The Fast Traders buying it can freely splatter it all over the market in a frenzy of rapidly changing prices, the gun set on Full Automatic.

This is how Fast Traders use retail trades to cause Wayfair to rise 700%. The order flow bursts into the market like squid ink in the Caribbean (I’ve seen that happen snorkeling), and everyone is blinded until prices whoosh up 30%.

A money manager on CNBC yesterday was talking about the risk in HTZ. She said there were no HTZ shares to borrow. Even if you could, the cost was astronomical.

Being a market structure guy with cool market structure tools (you can use them too), I checked HTZ.  Nearly 56% of trading volume is short. Borrowed. And the pattern (see here) is a colossus of Fast Trading, a choreographed crescendo into gouting squid ink.

How? Two Sigma, Hudson River Trading, Quantlab, etc., Fast Trading firms, enjoy market-making exemptions. They don’t have to locate shares. As high-speed firms “providing liquidity,” regulators let them do with stocks what the Federal Reserve does with our money. Digitally manufacture it.

Because they buy the flow from 47 million accounts, they know how to push prices.

That’s how ABIO traded 83 million shares (60% of the volume – nearly 50 million shares – was borrowed May 28, the rest the same shares trading many times per second).

It’s how CHK exploded up and then imploded as the manufactured currency vanished. And when stocks are volatility halted – which happened about 40 times for CHK the past two trading days – machines can game their skidding stop versus continuing trades in the ETFs and options and peer-group stocks related to the industry or sector.

This squid ink is enveloping the market, amid Pandemic psychology, and the economic (and epic) collapse of fundamental stock-pricing.

Dangerous.

You gotta know market structure, public companies (ask us) and investors (try EDGE).

Unknowable

The question vexing Uber and Grubhub as they wrestle over a merger is which firm’s losses are worth more?

And for investors considering opportunities among stocks, a larger question: What companies or industries deserve better multiples on the Federal Reserve’s backstopping balance sheet and Congress’s operating loans?

Sure, I’m being cheeky, as the Brits would say.  The point is the market isn’t trading on fundamentals. Undeniable now to even the most ardent skeptics is that something is going on with stocks that wears an air of unreality.

And there is no higher impertinence than the somber assertion of the absurd. It deserves a smart retort.

We’ve been writing on market structure for over a decade. Market structure is to the stock market what the Periodic Table is to chemistry. Building blocks.

We’ve argued that the building blocks of the market, the rules governing how stock prices are set, have triumphed over the conventions of stock-valuation.

SPY, the S&P 500 Exchange Traded Fund (ETF), yesterday closed above $308. It last traded near these levels Mar 2.

What’s happened since? Well, we had a global pandemic that shut down the entire planetary economic machinery save what’s in Sweden, North Dakota and Africa. Over 40 million people in the United States alone took unemployment. Perhaps another 50 million got a paycheck courtesy of the US Congress’s Paycheck Protection Program.

Which means more than half the 160 million Americans working on Mar 2 when stocks last traded at current levels have been idled (though yes, some are returning).

At Feb 27, the Federal Reserve’s balance sheet was $4.2 trillion, of which $2.6 trillion sat in excess-reserve accounts earning interest of about 1.6% (why banks could pay some basis points on your savings account – arbitrage, really, that you, the taxpayer, footed).

By May 28 the Fed’s obligations on your behalf (all that money the Fed doles out has your name on it – “full faith and credit of the United States”) were $7.1 trillion, with $3.3 trillion in excess reserves now earning ten cents and wiping out meager savings-account returns but freeing taxpayers of interest expense.

The nearest facsimile I can arrive at for this great workforce idling, casting about in my history-obsessed mind, is the American Indians.  They were told, stop hunting and gathering and go on the government’s payroll.

Cough, cough.

You cannot idle the industrious and value their output the same as you did before.

Yet we are.

While I’m a pessimist about liberal democracy (classical meaning of “freedom”) because it persisted through a pandemic by the barest thread, I’m an inveterate optimist about American business.  I’ve obsessed on it my adult life. It affords a fulsome lifestyle.

The goal of good fiction is suspense of disbelief. That is, do I buy the thesis of the story? (News of the World is by the way brilliant fiction from Paulette Jiles with a high disbelief-suspension quotient).

Well, the stock market is supposed to be a barometer for truth. Not a litmus test for suspension of disbelief.

Sure, the pandemic cut some costs, like business travel. But contending a benefit for bottom lines ignores the long consequential food chain of ramifications rippling through airlines, hotels, restaurants, auto rentals, Uber, Lyft, on it goes.

How about corporate spending on box seats at big arenas?

Marc Benioff is still building his version of Larry Ellison’s Altar to Self in downtown San Francisco (no slight intended, just humor) for salesforce.  Yet he said to CNBC that some meaningful part of the workforce may never return to the office.

An empty edifice?

And nationwide riots now around racial injustice will leave at this point unknown physical and psychological imprints on the nerve cluster of the great American economic noggin.

Should stocks trade where they did before these things?

The answer is unknowable. Despite the claims of so many, from Leuthold’s Jim Paulson to Wharton’s Jeremy Siegel, that stocks reflect the verve of future expectations, it’s not possible to answer something unknowable.

So. The market is up on its structure. Its building blocks. The way it works.

Yes, Active investors have dollar-cost-averaged into stocks since late March. But that was money expecting a bumpy ride through The Unknowable.

Instead the market rocketed up on its other chock-full things.

Quants chased up prices out of whack with trailing data. ETF arbitragers and high-speed traders feasted on spreads between the papery substance of ETF shares and the wobbly movement of underlying stocks.  Counterparties to derivatives were repeatedly forced to cover unexpected moves. The combination lofted valuations.

None of these behaviors considers The Unknowable.  So, as the Unknowable becomes known, will it be better or worse than it was Mar 2?

What’s your bet?

Daily Market Structure Sentiment™ has peaked over 8.0/10.0 for the third time in two months, something we’ve not seen before. The causes are known.  The effects are unknowable save that stocks have always paused at eights but never plunged.

The unknowable is never boring, sometimes rewarding, sometimes harsh. We’ll see.

Reg Nemesis II

In the Colorado mountains at Steamboat Springs, the pixie dust florescence of greening aspen leaves paints spring onto the high country.

In the bowels of equity markets there gurgles an emergent leviathan (maybe I should choose different imagery – but we’ll talk about what stinks and what doesn’t in this…movement).  The Securities Exchange Commission (SEC) in January asked stock exchanges to rethink Reg NMS.

Everybody who trades stocks, every investor-relations officer for a public company, should know some key facts about this regulation.

Yes. Of course it’s a pain in the butt (I need a new motif).  Who wants to read regulations?

Reg NMS is Regulation National Market System. In one of our all-time most frequented posts, called Reg Nemesis, we described the effects this law has had on the stock market.

We also explained in our recent NIRI webcast on market structure that its four components regulate stock data, stock quotes, stock prices, and access to all three.

Now the SEC wants to modernize it. I think that’s not a stinker at all. Rules should reflect how the market works, and Reg NMS hatched in the contemporary minds of members of Congress in 1975.

Then, amid caroming inflation and screaming currency volatility of the post-gold, bell-bottomed pandemic-haired hippie era, the legislative halls of Columbia echoed with calls to protect the vital “system” of our stock market.

So Congress added the 11A national market system amendments to the Securities Act.  And thirty years later, the SEC got around to regulating Congress’s will upon free markets, and in 524 sweepingly droll pages that one cannot help but read in the same soporific nasal tone as Ben Stein in Ferris Bueller’s Day Off, the stock market became the national market system.

You cannot bear imagining the cacophony with which the stock exchanges met this plan, back then.  There was shrieking and gnashing of legal teeth, the rending of garments and the donning of sack cloth. Ashes were poured on heads. Hieratic beseeching, a great priestly tumult, roared over capital markets.  It was like a pandemic.

Reg NMS was approved in 2005, about four years after the drumbeat began, and implemented in 2007.

Thirteen years on now, nobody loves Reg NMS like stock exchanges love Reg NMS. They’ve even sued the SEC to stop the regulator from questioning its own rules.

As Dave Barry, one of my favorite humorists (if your car is making a knocking noise, turn the radio up) of all time, used to say, “We are not making this up.”

So the SEC basically said, to quote Jerry Stiller (RIP, Ben Stiller’s dad), “Do you want a piece of me!!!!????”

And they’ve instructed exchanges and other market participants to help redraw Reg NMS.  And somehow the sequel is even longer than the original, at 595 pages.

And once again, even though the Securities Act of 1933 and 1934 as amended (oh so very many times amended) specifically includes issuers as constituents not to be discriminated against, we’re omitted from this re-imagining.

That’s a major reason to me why more than 55% of all trading volume currently comes from firms that don’t know what you do or who you are, public companies. They care only that your price profitably changes in fractions of seconds at your investors’ expense.

But I digress.

The Festivus for the rest of us that’s thus far been as elusive as holiday aluminum poles and feats of strength is a market that really works for our profession.

What would that be?  For one, a market that produced more IR jobs rather than fewer (we continue to lose more stocks each year than we gain and there are less than half what there were when I started in this profession in 1995).

And a market where stock pickers favoring your story have the same chance to make money as ETF market-makers and Fast Traders (so blissfully optimistic you want to start humming Fred Rogers, and, were we not socially distanced, hugging your neighbor).

Hey, maybe this is our chance. We can form opinions, speak up.  We’ll have that opportunity as this process, likely to take years as it did the first time around, unfolds.

So, what’s the SEC wanting to put in Nemesis II?  It wants competition for consolidated market data.  The Securities Information Processor (SIP) is a monopoly run by one firm (currently the Nasdaq).  It’s the official source of price and quote information – but it’s slower than all the proprietary data feeds. So everybody sells access even though the law says access must be uniform.

That needs fixing and the SEC is right.

And they want to redefine a “round lot” to reflect an Amazon market. Right now, stocks quote in 100-share increments.  The problem is AMZN, BKNG, GOOG and other stocks trade for well more than $1,000.  The average trade-size in these is about 30 shares.

In fact, almost 60% of trades now are for less than 100 shares, so stocks are trading at prices differing from quotes. It merits analysis, we agree. But do we further “yellow pencil” the market? Should we force all stocks to be $25-50? Is the round lot dead?

I haven’t finished reading all 595 pages yet. We’ll have more to say. We need rules that reflect reality. But we also need simple, comprehensible markets that work for all of us, and not just for speedy machines and stock exchanges.

Maybe we should all yell at them, “Do you want a piece of me!!!!????”

Benjamin Graham

A decade ago today, stocks flash-crashed.  I’m reminded that there are points of conventional market wisdom needing reconsideration.

It’s not because wisdom has diminished. It’s because the market always reflects what the money is doing, and it’s not Ben Graham’s market now. I’ll explain.

There are sayings like “sell in May and go away.”  Stocks fell last May. You’ll find bad Mays through the years. But to say it’s an axiom is to assert false precision.

Mind you, I’m not saying stocks will rise this month. They could plunge. The month isn’t the reason.

Graham protégé Warren Buffett told investors last weekend that he could find little value and had done the unthinkable: Reversed course on an investment. He dumped airlines. Buffett owned 10% of AAL, 11% of DAL, 11% of LUV and 9% of UAL.

Buffett and Berkshire Hathaway, sitting on $137 billion, believe in what Buffett termed “American Magic.” But they’ve sold, and gone away in May.

There are lots of those sayings. As January goes, so goes the market.  Santa Claus rallies come in December.  August is sleepy because the traders are at the Cape, the Hamptons.

These expectations for markets aren’t grounded in financial results or market structure.

Blackrock, Vanguard and State Street own 15-20% of the airlines, all of which are in 150-200 Exchange Traded Funds (ETF).  Passive money holds roughly half their shares.

Passives don’t care about the Hamptons, January, or May.  Or what Warren Buffett does.

In JBLU, which Buffett didn’t own, the Big Three own 20%, and Renaissance Technologies and Dimensional Fund Advisors, quants with track records well better than Buffett’s in the modern era, invest in the main without respect to fundamentals.

Unlike Buffett, RenTech and DFA continually wax and wane.

It’s what the money is doing now.  Its models, analysis, motivation, allocations, are not Benjamin Graham’s (he wrote Security Analysis, The Intelligent Investor, seminal tomes on sound stock-picking from the 1930s and 1940s).

And that’s only part of it.  New 13fs, regulatory details on share-ownership, will be out mid-May. Current data from the Sep-Dec 2019 quarters for DAL show net institutional ownership down 17m shares, or 3%.

But DAL trades over 70 million shares every day. Rewinding to the 200-day average before the market correction exploded volumes, DAL still traded over 16m shares daily.  The total net ownership change quarter-over-quarter was one day’s trading volume.

Since there are about 64 trading days in a quarter, and 13fs span two quarters, we could say DAL’s ownership data account for about 1/128th of trading volume. Even if we’re generous and measure a quarter, terribly little ownership data tie to volume.

Owners aren’t setting prices.

Benjamin Graham was right in the 1930s and 1940s.  He’s got relevance still for sound assessment of fundamental value.  But you can’t expect the market to behave like Benjamin Graham in 2020.

The bedrock principle in the stock market now is knowing what motivates the money that’s coming and going, because that’s what sets prices.  Fundamentals can’t be counted on to predict outcomes.

In DAL, Active Investment – call it Benjamin Graham – was about 12% of daily volume over the trailing 200 days, but that’s down to 8% now. Passive money is 19%, Fast Traders chasing the price long and short are 62% of the 73m shares trading daily. Another 11% ties to derivatives.

Those are all different motivations, reasons for prices to rise or fall.  The 11% related to derivatives are hoping for an outcome opposite that of investors. Fast Traders don’t care for more than the next price in fractions of seconds. They’re the majority of volume and will own zero shares at day’s end. You’ll see little of them in 13fs.

The airline showing the most love from Benjamin Graham – so to speak – is Southwest.  Yet it’s currently trading down the most relative to long-term performance. Why? Biggest market cap, biggest exposure to ETFs.  It’s not fundamental.

If you’re heading investor-relations for a public company or trying to invest in stocks, what I’ve just described is more important than Benjamin Graham now.

The disconnect between rational thought and market behavior has never been laid so bare as in the age of the pandemic.  It calls to mind that famous Warren Buffett line:  Only when the tide goes out do you discover who’s been swimming naked.

Might that be rational thought?

How airlines perform near-term depends on bets, trading, leverage. Not balance sheets.  It’s like oil, Energy stocks – screaming up without any fundamental reason.  And market structure, the infinite repeating arc from oversold to overbought, will price stocks. Not Ben Graham.  Though he was wise.

Sneeze Cloud

I know this Friday will be good.

I’ll let you think about that one. By the way, markets are closed then.

For a decade we’ve written about the way the stock market has disconnected from reality.  Nothing lays bare the truth like a Pandemic.  More on that later.

First I’ve got to get something off my chest.

I’m not a doctor. But ModernIR is as good at the physiology of American equities as those medically trained are with humans. We’re experts at threshing dense, complicated information for central tendencies, patterns.

We’ve studied and validated data around this Pandemic.  The Centers for Disease Control reports (statistics as of 2017) that in New York annually more than 4,500 people die from the flu and pneumonia.

I saw a headline yesterday saying New York City Covid-19 deaths had surpassed those on Sep 11, 2001, as if the two were related.  At least seven morbidities kill more New Yorkers every year.

I’m proud of my fellow Americans for their indefatigable patience. And I’m also tired of hysteria, propaganda turning mask-wearers against non-mask-wearers, false correlations.

Over 115,000 New Yorkers die per annum, chiefly from heart disease (a co-morbidity with Covid-19) and cancer. And 3.5 million Americans die every year.

Now we find that our rush to respirators for a Coronavirus response may be wrong.  Read about Cytokine storms. See this. We put our haste to confront a threat ahead of understanding it.

You know viruses are inanimate?  We think they’re “bugs,” malevolent living things. In fact they’re hunks of protein, sequences of RNA or DNA coated in a fatty lipid layer. They’re inert unless they encounter susceptible hosts like mucosal cells.

In the truest sense, computer viruses are like human viruses, both meaningless unless they encounter code to corrupt, incapable of corrupting otherwise.

Healthy skin is impervious to them. Alcohol dissolves lipids, proteins decay under foamy soap. Sunlight and air are also enemies of proteins.

One could say, “Yeah Quast. But they’re transmitted by people.”

True. Viruses replicate in host cells and spread through human contact.  As ever.  Karen and I joke that every time we board a plane we leave our little antibody bubble world.

Fifteen million people die yearly around the globe from viruses.  The CDC offers vastly greater numbers falling ill from virally triggered maladies. It’s always true and will be tomorrow as much as today.  We’re ever walking into someone else’s sneeze cloud.

This paper’s opening salvo says: “Influenza-like illness (ILI) accounts for a large burden of annual morbidity and mortality worldwide (WHO 2020). Despite this, diagnostic testing for specific viruses underlying ILI is relatively rare (CDC 2019). This results in a lack of information about the pathogens that make between 9 million and 49 million people sick every year in the United States alone (CDC 2020).”

Yet we’re telling people, “Trust the government. We’ll find a vaccine.” Coronaviruses cause the bulk of the one billion common colds in the USA annually.  Look it up.

“Big Short” Michael Burry, an MD turned hedge fund manager famed for betting against mortgage securities before 2008, says our response to Covid-19 is worse than the virus.

A bigger sneeze cloud.

We stipulate that any Presidential administration would be excoriated for less than pulling out all the stops, whatever that phrase means.

Today it means monetizing any economic deficiency.  Or in English, having government compensate loss with money it borrows or creates. Yet government has only the money the people surrender to it.

So the government instead reaches far into the future through the central bank and hands the future the Coronavirus and takes from the future its money, for us.

We might laugh and say, “Suckers!”

But the Constitution that’s ostensibly the supreme law of this land prohibits taking private property for public use without just compensation. No scepter for any mayor or governor or other official exists under it. There is no authority to order people to do anything unless the people first agree to it. That’s the bedrock of self-government.

In this crisis we’ve taken millions of businesses for public use (here, safety) without just compensation, offering people who expended their lives building restaurants, bars, salons, hotels, stores, gyms, on it goes, on which they depended for retirement, inheritance to pass on to children, a loan.

I’m heartsick. It will take a generation to recover, not a quarter or two.

Most people think viruses are alive and it’s untrue. Most people think the stock market is a barometer for economic outcomes, and it’s untrue. Too many suppose government can save us from life, or death. And it’s untrue.

In a way, the stock market is a sneeze cloud. Trillions in Exchange Traded Fund transactions aren’t counted as turnover (thus Blackrock is unchanged in your 13Fs when it trades frantically). Half the volume is borrowed. Fast Traders set prices. Arbitrage dominates trading. You can’t trust what it signals.

We’re going to show you the behaviors driving stocks during this Pandemic next Wed Apr 15 via a NIRI-sponsored webcast.  We’ll post details at our website, or visit NIRI.org. If you want an email update sent to you, let us know.

I can live with sneeze clouds.  Or die.  We all do someday.  I can’t live with our markets, monetary policy, crisis-response, as masquerades. We can do better.  And we better.

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.