Tagged: supply chain

Suddenly

Things are getting worrisome. 

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

Illustration 179312099 / Ernest Hemingway © Lukaves | Dreamstime.com

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

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

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

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

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

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

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

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

None showed up.

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

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

It gets worse.

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

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

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

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

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

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

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

Elementary, Watson.

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

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

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

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

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

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

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

So what do we do about it?

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

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

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

Fab Problem

The world relies on one semiconductor company. 

How did an economic ecosystem let itself get boxed in like that?  About the same way it happened in the stock market.  There’s a lesson for public companies and investors.

Yang Jie and colleagues at The Wall Street Journal June 19 wrote a thorough treatise (subscription required) on the extraordinary rise of TSMC, as it’s known, under founder and Texas Instruments veteran Morris Chang.

Courtesy Dreamstime.com

And how 92% of the world’s most sophisticated chips depend on it. And nearly 60% of all chips, including all the ones for iPhones, the chips for cars, for PCs, for a vast array of devices operating on microcircuitry.

The company is a juggernaut and Morris Chang, 89 and now retired, is a genius.  But a different term comes to mind for participants in the semiconductor industry who let themselves become so perilously dependent.

And what about the consumers of the products?  Was no one aware that the boulevard ferrying technological essentials had a sign on it saying “not a through road?”

There was a failure of hindsight and foresight, a fixation on discrete objectives at the expense of broad comprehension of its mechanics and structure. Seems to me, anyway.

What’s this got to do with the stock market?

There’s a similar lack of imagination over the past 15 years among public companies participating in it.  Finra says it regulates about 3,400 brokers.  But 30 of them execute nearly all trading volume, data we’ve observed ourselves as the leader in Market Structure Analytics for public companies.

If you want to know how the stock market works, join ModernIR June 24 to learn how the Great Meme Stock Craze of 2021 happened – and can happen to you. 

Back to the point, it’s far worse than 30. About ten firms handle nearly all customer orders, and another ten set most of the prices but have no clients and aim to own nothing.

And $500 billion daily dances delicately through that machinery.

It happened the way it did for TSMC.  Once, there were many designers and fabricators.  Then designers discovered they could cut costs and burdens by leaving the fab business, outsourcing it to TSMC.

It made sense operationally. It’s a lot cheaper not building and running factories.  The WSJ article says a single fab may cost $20 billion to build.

And by the time you finish, maybe the technology has moved on, and now what?  TSMC will spend $100 billion the next three years staying current.  Hard to compete with that.

The same thing happened in the stock market, though for somewhat different reasons.  Among the thousands of broker-dealers buying and selling securities for investors, the great majority got out of the fab business, so to speak.

They don’t clear their own trades. They don’t even execute their own trades. They’re introducing brokers.  They sell to customers but outsource trading and account services.

It’s an operational decision. You can’t make money owning the infrastructure.  But the reason is market rules created by Congress and regulators.  First, stocks were decimalized. Brokers counted on the spread between buying and selling for profits.  Poof, gone. There went the fabs.

Then regulators in 2007 implemented the 1975 Congressional vision of a “national market system” connecting all markets electronically and setting in motion a rigorous rules matrix on handling trades. It forced most firms to send their trades to a handful capable of making the equivalent of a $20 billion investment in chip fabrication.

And intermediary profits didn’t vanish. Oh no, they’re larger than ever. But where big spreads between stocks in the past supported sellside research and deep arrays of stock-trading by firms with customers, now tiny spreads accrue colossally to a handful of firms you’ve barely heard of.

Read the Front Month Newsletter piece called Jane Street and the Arbitrage Royal Family.  Sounds like a vocal group from the 1960s. If Gladys Knight ran a market-making firm, she’d call it PipTrading LLC.

Jane Street is killing it. Arbitragers. Should that not raise eyebrows?

The Stock Market has the very same supply-chain issue that besets chips.  We only learned about Chip Trouble through the 2020 Pandemic. We shut down the global supply chain.  Now it can’t get back to level.

Supply-chain flaws will show in the stock market when a fab fails, the supply chain stalls. I’m not worried about it. You should be!  Public companies. Investors.  You’ve let parties with no vested interest in the market – regulators – hang it on a fragile wire.  Like the kind etched by Extreme Ultraviolet Lithography.

Look that one up.

Will we ask for a report on the stock-market supply chain before it’s our undoing?  Or is it TSMC all over again?

Suppy Chain Trouble

If you go to the store for a shirt and they don’t have your size, you wait for the supply chain to find it.  There isn’t one to buy. Ever thought about that for stocks?

I just looked up a client’s trade data. It says the bid size is 2, the ask, 3.  That means there are buyers for 200 shares and sellers of 300.  Yet the average trade-size the past 20 days for this stock, with about $27 million of daily volume, is 96 shares.  Not enough to make a minimum round-lot quote.

That means, by the way, that the average trade doesn’t even show up in the quote data. Alex Osipovich at the Wall Street Journal wrote yesterday (subscription required) that the market is full of tiny trades. Indeed, nearly half are less than 100 shares (I raised a liquidity alarm with Marketwatch this past Monday).

Back to our sample stock, if it’s priced around $50, there are buyers for $10,000, sellers of $15,000. But it trades in 96-share increments so the buyer will fill less than half the order before the price changes. In fact, the average trade-size in dollars is $4,640.

The beginning economic principle is supply and demand. Prices should lie at their nexus. There’s an expectation in the stock market of endless supply – always a t-shirt on the rack.

Well, what if there’s not? What if shares for trades stop showing up at the bid and ask?  And what might cause that problem?

To the first question, it’s already happening. Regulations require brokers transacting in shares to post a minimum hundred-share bid to buy and offer to sell (or ask). Before Mr. Osipovich wrote on tiny trades, I’d sent data around internally from the SEC’s Midas system showing 48% of all trades were odd lots – less than 100 shares.

Do you see? Half the trades in the market can’t match the minimum. Trade-size has gone down, down, down as the market capitalization of stocks has gone up, up, up.  That’s a glaring supply-chain signal that prices of stocks are at risk during turbulence.

Let’s define “liquidity.”

I say it’s the amount of something you can buy before the price changes. Softbank is swallowing its previous $47 billion valuation on WeWork and taking the company over for $10 billion. That’s a single trade. One price. Bad, but stable.

The stock market is $30 trillion of capitalization and trades in 135-share increments across the S&P 500, or about $16,500 per trade.  Blackrock manages over $6.8 trillion of assets. Vanguard, $5.3 trillion. State Street. $2.5 trillion.

Relationship among those data?  Massive assets. Moving in miniscule snippets.

Getting to why trade-size keeps shriveling, the simple answer is prices are changing faster than ever.  Unstable prices are volatility.  That’s the definition.

I’ll tell you what I think is happening: Exchange Traded Funds (ETFs) are turning stocks from investments to collateral, which moves off-market. As a result, a growing percentage of stock-trades are aimed at setting different prices in stocks and ETFs. That combination is leading to a supply-chain shortage of stocks, and tiny stock-trades.

ETFs are substitutes dependent on stocks for prices. The ETF complex has mushroomed – dominated by the three investment managers I just mentioned (but everyone is in the ETF business now, it seems) – because shares are created in large blocks with stable prices. Like a WeWork deal.

A typical ETF creation unit is 50,000 shares.  Stocks or cash of the same value is exchanged in-kind. Off-market, one price.

The ETF shares are then shredded into the stock market amidst the mass pandemonium of Brownian Motion (random movement) afflicting the stocks of public companies, which across the whole market move nearly 3% from high to low every day, on average.

Because there are nearly 900 ETFs, reliant on the largest stocks for tracking, ever-rising amounts of stock-trading tie back to ETF spreads. That is, are stocks above or below ETF prices? Go long or short accordingly.

Through August 2019, ETF creations and redemptions in US stocks total $2.6 trillion.  From Jan 2017-Aug 2019, $10.1 trillion of ETF shares were created and redeemed.

ETFs are priced via an “arbitrage mechanism” derived from prices in underlying stocks. Machines are chopping trades into minute pieces because the smaller the trade, the lower the value at risk for the arbitragers trading ETFs versus stocks.

ETFs are the dominant investment vehicle now. Arbitrage is the dominant trading activity. What if we’re running out of ETF collateral – stocks?

It would explain much: shrinking trade-sizes because there is no supply to be had. Rising shorting as share-borrowing is needed to create supply. Price-instability because much of the trading is aimed at changing the prices of ETFs and underlying stocks.

Now, maybe it’s an aberration only. But we should consider whether the collateralization feature of ETFs is crippling the equity supply-chain. What if investors tried to leave both at the same time?

All public companies and investors should understand market liquidity – by stock, sector, industry, broad measure. We track and trend that data every. Data is the best defense in an uncertain time, because it’s preparation.