Tagged: Volatility

Message vs Messages

It’s earnings season. Across the market, companies beat expectations and lift guidance and stocks decline. 

Huh?

I can offer a broad array of cases.  Take TSLA.  Massive quarter, monstrous boost to forward views.  Stock declines.

And yes, I Tweeted before TSLA reported that its price would probably fall.

A Consumer Staples stock beat all the key metrics, lifted guidance. Stock fell 10%, another 10% in following days.

There’s a figure that explains what’s happening: 350 billion. 

That’s the number of order messages processed on a single March day this year by the NYSE, according to head of equities Hope Jarkowski in a TABB Forum interview.  It was a new highwater mark for the exchange, where the previous record in March 2020 was 330 billion.

What’s that got to do with reporting great numbers and seeing your stock swoon? Public companies and investors both deserve to know, and the answer is there in the mass pandemonium of message traffic.

When billions of messages for stock orders are flying around, that’s not rational behavior. That’s money moving near the speed of light.  That’s speculation.

The market is crammed with it.

And what are we doing, public companies (investors, I’ll come to you in a bit)?  We’re prepping our numbers and expecting the stock to reflect what those say, good or bad.

Too many of us are still leading our boards and executive teams to think the numbers drive the stock, even though it’s 2021 and we’ve had this high-speed chaff-winnowing market since 2007 when Regulation National Market System was implemented.

It’s part of the investor-relations job to know the ORDER MESSAGES, not the message, drive the stock. About 350 billion of them on high-traffic days at just the NYSE Group of five stock exchanges and two options markets.

And why does the NYSE operate seven stock and options markets if an exchange is supposed to AGGREGATE buy and sell interest?

Because they’re NOT aggregating buy and sell interest. They want message traffic, a lot of orders.  This is why you need firms like ModernIR, a check and balance on the exchanges, which don’t tell you what the money is doing.

The image here comes courtesy of IEX, the Investors Exchange, and shows how bursts of trades – which flow through messaging traffic – come from proprietary trading firms within two milliseconds of changes in price.

For comparison, hummingbirds flap their wings about 80 times per second, equivalent to about once every 12 milliseconds.  So in a fraction of the flap of hummingbird wings, your entire market structure could shift from positive to negative.  Rational? Nope.

Case in point.  I bought 200 shares of NCLH at the market and it executed at the NYSE RLP.

What’s that?  My broker, Interactive Brokers, is a Retail Member Organization.  It can execute the trade for a tenth of a penny higher than the offer at the NYSE’s Retail Liquidity Program, where a high-speed trader can earn three cents per hundred shares for filling my order.

And if the seller is a NYSE Designated Market Maker (see page 20 here), it’s 20 cents per hundred, 40 cents to sell me 200 shares at one-tenth of a penny better than the best displayed price.

Got that? Sure, I got $30.169 instead of $30.17.  Oh boy. But talk about convoluted.  Why the hell would an exchange do that?

For 350 billion reasons.  Traffic is data. The RLP and my broker set the best bid and offer. That’s money – literally.  Data is money. Best prices are data. We’ve all been buffaloed into believing a tenth of a penny matters. No it doesn’t. We’re being gamed, merchandised.

The more platforms, the more prices, the more data – and especially if five are stocks and two are options on those stocks.    

That’s why your shares implode on results.  Suppose a million of those messages are a bunch of parties shorting, and the market tips the other way in tenths of pennies on hummingbird beats?  In the case of the Staples stock above, over 72% of volume that day was short – borrowed. Not story. Just data. Bets exchanges fill.

So the whole food chain of order-flow messages and order types to take advantage of a retail trade or pay a high-speed trader to be the best bid or offer can cook the market.

Now, why is that all right with you, public companies?

Part of the answer is not knowing enough about the stock market.  We can help.

Investors, this is your market too. I looked at TSLA Market Structure Sentiment. Peaked and falling. Probability is the stock declines. Doesn’t matter what Elon Musk says.

You’re better to trade using Market Structure Sentiment. Stocks can’t be relied upon to behave rationally.  They DO follow supply and demand.

Other than that, everything’s fine.

Swapping Volatility

Google chose as motto “don’t be evil.” “Beware derivatives” isn’t a bad motto either.

If you’ve read the MSM long, you know we’ve beaten the drum like Boneshaker (when you hear the sound of the drum, here we come) over the risk in derivatives.

Oh please, Quast.  Can’t we talk about something more interesting, like the molecular structure of Molybdenum?

Do you want to know what’s coming, public companies and investors?  We’ve now been warned twice.  I’ll explain.

Before that, this: Recall that we said the market could take a beating this week because of derivatives. A raft of major banks have reported combined damage in the billions from bad derivatives bets by one hedge fund, Archegos Capital.

And VIX bets hit today.  Volatility bets blew up another fund.  Warning Signal No. 2.

Gunjan Banerji wrote about it yesterday in the WSJ (subscription required), admirably explicating the complexities of variance swaps.  The Infinity Q Diversified Alpha Fund shut down.

Diversified Alpha, a mutual fund marketed as a hedge fund for the masses, had roughly $1.75 billion of assets at last word.  The fund aimed in part at volatility strategies.  It said:

“The Volatility Strategy seeks to profit from the mispricing of volatility related instruments across equities, currencies, bonds, interest rates, and commodities markets. These instruments include options, variance swaps, correlation swaps, and total return swaps. The Strategy invests across a wide range of time horizons and takes long and short positions in the underlying volatility instruments.”

The fund went broke betting on volatility – mispricings.  That’s two in short succession.  Diversified Alpha filed its plea with the SEC Feb 21 to halt redemptions. Right after February expirations. Archegos Capital went belly-up with March expirations.

Much of the money in equities trades mispricings. That’s what ETFs do (ETF vs a basket). It’s what Fast Traders do (one price vs another). It’s what derivatives traders do (stocks vs options).  Those behaviors are roughly 80% of US equity volume.

These disasters you describe, Tim, are isolated to leveraged outfits.

Nope.

Here’s the SAI for the Blackrock Technology Opportunities Fund. I have read a great many SAIs, a reason I’ve in the past highlighted risks, especially for Exchange Traded Funds.

On page 3 is this: Only information that is clearly identified as applicable to the Fund is considered to form a part of the Fund’s SAI.

Then follows a table, with X’s by what applies.  See page 4, the derivatives section. Derivatives for hedges and speculation apply.  Credit default swaps, interest-rate swaps, total return swaps, options on swaps, on it goes.

I’m sure it’s a small part of this fund’s assets, used within rules to true up tracking or remediate some of the unremitting volatility that’s been seeded in all financial instruments by vast artificial quantities of money and low interest rates. But read the SAI on your favorite fund. What’s it say?

By the way, volatility in stocks has plunged by 50% the past couple weeks. Almost like a tide going out ahead of a tsunami. Behind it in other data we track are vast swings in standard deviation between the prices of sector stocks and the ETFs tracking them.

That is, if we compile moves of all sector stocks and the average is a 1.8% decline and the composite average for sector ETFs is 0.1%, standard deviation is 625%.

It suggests to me that ETFs are substituting stuff that moves less than stocks – like swaps or IOUs of some sort, or cash – to get away from the error-inducing volatility in stocks.

But that could blow up derivatives predicated on a statistical equity basket. What the hell is going on?  Exactly.  That’s what I want to know. Something is wrong, and we’re seeing little fissures, seeping steam, wisps of ash.

We’ve long been concerned about these risks. But they’re like the way Ernest Hemingway described how one goes broke (a line I’ve used often): very slowly then all at once.

I’m not wringing my hands. Forewarned is forearmed. Investors and traders, it’s wise to get out of the pool around these things, which we observe in the data, and report.

And for public companies, it’s high time to make sure your executive teams realize risk resides beyond “alternative investments.” It’s everywhere. All around us. 

How central are Morgan Stanley, JP Morgan, Credit Suisse, Deutsche Bank, banks losing on Archegos, to financial markets from IPOs to Treasury Open Market operations?  Derivatives to equity and ETF trading?

It may be the cost of paying ourselves to sit out a Pandemic is the stability of our financial markets. We’re inflating everything including derivatives.  We can survive it.  In fact, it would do us good to roll around in the dirt and develop some resilience.

Whatever happens, we’ve got the data.  We warned EDGE users to be out by last Friday. We can tell you, public companies, if these instruments are large in your price. 

Everybody is swapping volatility. Beware.

Fama Market

Eugene Fama, Booth School, Univ of Chicago

 

Do you know traders could have made 580% in the S&P 500 the past 200 days?

Public companies, your stock need not rise.  I’ll explain.

The S&P 500 is up almost 20% the last six months. The math says 454 of the 500 are up. That also means 46 stocks are down. Including some big ones like Verizon, Lockheed Martin, Procter & Gamble, Kellogg, Zoetis.

But up isn’t the point. It’s up and down. Traders could have made all the returns in the S&P 500 from October 1995 to present – about 600% – in just 200 days on volatility.

By capturing all of it perfectly, which is next to mathematically impossible. But follow me here.

Across the 500 components, average intraday volatility the past 200 days is 2.9%. That is, the typical S&P 500 stock will gyrate almost 3% from lowest to highest intraday prices.

Add that up.  Over 200 days it’s 580%.

And it bugs the bejesus out of Chief Financial Officers. As it should.  The Wall Street Journal highlighted the investor-relations profession and our own Laura Kiernan in a piece (subscription required) last week called CFOs Zero in on Shareholders as Stock Volatility Soars.

But holders aren’t behind volatility.

The University of Chicago’s Eugene Fama won a Nobel Prize on efficient markets and the effects of volatility.  He famously said, “If active managers win, it has to be at the expense of other active managers. And when you add them all up, the returns of active managers have to be literally zero, before costs. Then after costs, it’s a big negative sign.”

Why?  I’m oversimplifying but he showed that volatility risk, size risk and value risk make stock-picking inefficient and ineffectual.

The data prove it.  Most stock-pickers can’t beat the market because they don’t understand why volatility exists.

What is volatility? Changing prices. We’ve written often about it over the years as this search on the word “volatility” at the ModernIR blog shows.  Stock prices constantly change.

Why?

Regulations require it.  Think I’m overstating it? Rules for stocks require trades to occur between the best bid and offer. And regulators mandated penny spreads for stocks 20 years ago.  Thus trades can only occur at the best current price, which changes often.

The best price for stocks cannot be established by a single principle. That idea earned a Nobel Prize.  Other factors matter including volatility, size and value.  And I’d argue convenience, time-horizon, purpose. You can probably add more.

The market is only efficient for parties benefiting from constantly changing prices. Who’s that? Traders and stock exchanges. 

Profiting on price-changes is arbitrage. We have the perfect arbitrage market. How? There are almost 50 different places where trades can occur in the National Market System, a cornucopia for changing the price if you’re fast and algorithmic.

And now the market is chock full of things that look like stocks but aren’t stocks. ETFs, options, futures.  They all converge and diverge in price.  The parties feasting on this environment need prices to change all the time.

Enter the exchanges. They sell data. The data is comprised of quotes and trades. The more the price changes, the more data there is.  Heck, they lose money on trades to make it selling data.

Only trades involving different owners will settle. About 95% of my trades – I understand market mechanics and I become my own algorithm to take advantage of how it works – match at my broker’s internalizer.  No measurable ownership-change.

And Fast Traders are 54% of market volume. No ownership-change. And trades tied to derivatives are 18% of volume. Little to no ownership-change. And half the market’s volume reflects borrowed stock. No ownership-change.

Let’s review.  Shareholders don’t create volatility. They try to avoid it.  Most trades don’t result in ownership-change because the market is stuffed with efforts to profit on changing prices. And that is the definition of volatility, which exists because of rules that promote constantly changing prices.

There’s a simple fix.  Put the focus back on stable prices, by emphasizing factors other than price, such as size and value.  Call it the Fama Market.  When my dad sold cattle from our ranch, we wanted an average price for a herd, not a price per steer.

If public companies want to fix volatility, we need a different market. You can’t fix it by telling the story. And that can’t be the heart of the investor-relations job. It’s now understanding the market for shares – just as my dad knew the cattle market.

If we lack the collective verve to lobby for better markets, then we have to adapt to this one, by understanding it. We have the tools and data for both companies and investors.

IS REPORTING NOW JUST A SIDESHOW?

“Looking good, Valentine!” “Feeling good, Louis!” A gentleman’s bet. But maybe not so fast.

Farce met Street last week with good reason distracting many in the Finance and public company arenas. Far better chronicled elsewhere (here a good one on Benzinga’s Monday Pre-Market Prep – pls skip the clunky ad), but this weekend I couldn’t resist the parallels to 1983’s Trading Places – I’ll leave you to Twitter, your browser or favorite streaming service and bring the focus to Market Structure.

With all rights to Messrs. Russo, Landis, Harris, Weingrod, Aykroyd, Murphy, Ms. Curtis and Paramount, et al.

We start February with a significant percentage of our clients yet to report quarterly and year-end results and to confirm their forward-looking expectations. Tough challenge in a Market seemingly growing more disinterested.

No question your IR team is working long hours with counselors and non-public facing finance, accounting and marketing coworkers to develop a cogent, clear message, to tie-out results and craft outlook statements and public disclosures; all too often, a thankless job.

It doesn’t help that the Market and the trading in individual equities are seemingly chaotic and unpredictable. But are they? As a subscriber you’re likely conversant in Market Structure – our view of the Market here at ModernIR (if no, read on and please reach out to our Zach Yeager to set up a demo). So like the polar bear swimmers here in Minnesota let’s dive in – we’ll be quick.

Here’s how the Market has evolved in the first month of 2021 – changes in the demographics of trading:

Note the Passive Investment retreat – would have been fair to expect the opposite with all the month-end true-ups for ETFs, Index and Quant Funds – but it’s a repeating month-end behavior recently followed by buying. The surge of volatility arose from increased Fast Trading – machine-driven High Frequency trading, and yes, some Retail day trading.

Both categories are largely populated by algorithmically driven trading platforms; “Passive” (a largely  anachronistic designation – and far from it or the buy and hold strategies the name conjures) today constantly recalibrate collateral holdings with dominate behaviors suggesting little long-term primary focus. “Fast Trading” – pure execution speed, volume-based trading; its goal beyond vast incremental profits – no overnight balance sheet exposure.

Short Volume trading rather than building, declined and Sentiment remained persistently positive (5.0 = Neutral) and never negative. Does this sound disorganized? For forces dominating early Q1/21 equity trading this was a strong, dynamic and likely very profitable period.

The cruel truth – machine trading is no gentlemen’s bet. Brilliant in execution, these efforts have one goal – to game inherent trading advantages over slower moving Market participants – folks that demand conference calls, executive time, build and tie-out spreadsheet models and trade in non-Market-disruptive fashion – the traditional IR audience. The system rewards this – topic for another time.

From a pure trading standpoint, traders behind 9 out 10 trades in the final day of January trading placed minimal value on traditional IR efforts as their bots rocket through Short Seller reports and quarterly management call transcripts, scan real-time news feeds and playbacks for tradable intonation in your executives’ delivery and make mathematical judgments about the first 100 words of each press release.

As IR professionals its incumbent that we, rather than be demoralized by the evolution and dominance of short-term trading, engage, and become intimately versed in these data and these Market realities. The competitive advantage is in understanding and minimizing false conclusions in decision-making. Management and the constituents of long-term investors – yes, they are still legion – and expect no less.

Let us show you how.

Perry Grueber filling in for Tim Quast

  

 

Onward and Upward

The market is always forward-looking, said the pundit.

courtesy Cnet.

We were driving back from Steamboat to Denver and listening to satellite radio.  It was noon coming through Kremmling in Grand County and the temperature was five degrees Fahrenheit, 50 degrees chillier than Denver.

And I thought, “Do these people pay attention?”

I like traditions.  Thanksgiving.  Anniversaries.  Hieratic observances that remind us there are bigger things than ourselves.  Skiing before the riff-raff gets to the slopes.  Reading Federalist 41 periodically and then looking at our government and laughing.

But clinging to traditions like sell in May and go away and the market is always forward-looking while ignoring the geological upheaval in market form and function the past 15 years is inexcusable.

How can you say the market is always forward-looking when Citadel Securities is its largest volume-driver and its investment horizon is a day or less?  Over 52% of all trading volume has an investment horizon of a day or less. It’s machines changing prices and profiting by sitting in the middle.

If you wonder if that pays, have a look at the stuff Ken Griffin owns.  And Doug Cifu. And Vinnie Viola.  Ed Bosarge (that’s quite entertaining, no offense to this innovative high-frequency trader).

The market cannot be forward-looking if the majority of its volume is living in the moment. The market then lives in the moment.

Do you follow?

It’s not just wrong to cast the market as a forward-looking.  It’s dangerous.  Take Transports, a classic subdivision of the stock market long used as a barometer of commerce. They’re trading at all-time highs. The thinking is a strong Transports group predicts economic prosperity.  After all, it’s the machinery and apparatus of the movement of goods.

And how about retail stocks?  I was just saying to the folks at EDGE, the decision-support platform built on market structure that we founded to help mom and pop traders out-think the machines, that retailers looked best.

That’s not because we examined all the data on spending patterns in the USA or concluded that folks would plow their latest Covid cash from the government into garments and furniture.  No, it’s math. The short volume trend was down, and the ramp in Sentiment was the best of any sector or industry.

Son of a gun.  Look at Overstock, Wayfair, pick your component.

But supposing that it’s anything other than math is supposing amiss.  You can no more look at the market and draw a reliable economic conclusion than you can look at a forked stick and hope it leads you to water.

Unless you’ve been touched by the spirit, I suppose.

You get the point.

Transports?  Sure, the stay-at-home pandemic culture enriched distribution channels like trucking and rails.  AMZN isn’t a component of the Dow Jones Transportation Index (DJT).  But a bunch of airlines and a rental-car company are.

You can try like all the pundits to come up with a rational reason for why the future is brighter than ever for Transports. And you can always find one.

That doesn’t make it so.  The reason Transports are up is because they’re volatile. You can make a crap ton – to use an elegant Latin term – trading volatility in the moment.

Speaking of volatile, so is the outlook for Activism in 2021.  It may be INTC is a harbinger of things to come.

If you want to know what that data looks like and how you can see it coming in your own trading, I’ll show you at the NIRI Twin Cities program this Thursday at 11a CT. I’m moderating a discussion on the data, the preparation and the battle – and why 2021 might bring the Viking raiders back ambuscading our ranks.

Back to the present.  I’ve said it before. There are facts apparent to any observer about the stock market.  More assets are passive now than Active.  Citadel Securities dominates.  Options trading is at records.  Volatile is a plague. Short volume is nearly half the total.

When is our profession, the investor-relations discipline, going to adapt? Are these facts part of your regular communication to your boards and executive teams?  If not, why not? If you’re ready, we’ve got the orbit, the data, the tools and the structure to help you keep your relevance in a right-now market. Have for 16 straight, unrelenting years.

The world moves on. We must too. We can’t be the last people on the planet to catch up.  Now if you’ll excuse me, there are three planets upward in the sky I want to see (Jupiter, Saturn, Mercury, this week),  moving onward, like time and the stock market.

On the Skids

If electoral processes lack the drama to satisfy you, check the stock market.

Intraday volatility has been averaging 4%. The pandemic has so desensitized us to gyrations that what once was appalling (volatility over 2%) is now a Sunday T-shirt.

Who cares?

Public companies, your market-cap can change 4% any given day. And a lot more, as we saw this week.  And traders, how or when you buy or sell can be the difference between gains and losses.

So why are prices unstable?

For one, trade-size is tiny.  In 1995, data show orders averaged 1,600 shares. Today it’s 130 shares, a 92% drop.

The exchanges shout, “There’s more to market quality!”

Shoulder past that obfuscating rhetoric. Tiny trades foster volatility because the price changes more often.

You follow?  If the price was $50 per share for 1,600 shares 25 years ago, and today it’s $50 for 130 shares, then $50.02 for 130 shares, then $49.98 for 130 shares, then $50.10 for 130 shares – and so on – the point isn’t whether the prices are pennies apart.

The point is those chasing pennies love this market and so become vast in it. But they’re not investors.  About 54% of current volume comes from that group (really, they want hundredths of pennies now).

Anything wrong with that?

Public companies, it demolishes the link between your story and your stock. You look to the market for what investors think. Instead it’s an arbitrage gauge. I cannot imagine a more impactful fact.

Traders, you can’t trust prices – the very thing you trade. (You should trade Sentiment.)

But wait, there’s more.

How often do you use a credit or debit card?  Parts of the world are going cashless, economies shifting to invisible reliance on a “middle man,” somebody always between the buying or selling.

I’m not knocking the merits of digital exchange. I’m reading Modern Monetary Theory economist Stephanie Kelton’s book, The Deficit Myth.  We can talk about credit and currency-creation another time when we have less stuff stewing our collective insides.

We’re talking about volatility. Why stocks like ETSY and BYND were halted on wild swings this week despite trading hundreds of millions of dollars of stock daily.

Sure, there were headlines. But why massive moves instead of, say, 2%?

The stock market shares characteristics with the global payments system.  Remember the 2008 financial crisis? What worried Ben Bernanke, Tim Geithner and Hank Paulson to grayness was a possibility the plumbing behind electronic transactions might run dry.

Well, about 45% of US stock volume is borrowed. It’s a payments system. A cashless society. Parties chasing pennies don’t want to own things, and avoid that by borrowing. Covering borrowing by day’s end makes you Flat, it’s called.

And there are derivatives. Think of these as shares on a layaway plan.  Stuff people plan to buy on time but might not.

Step forward to Monday, Nov 9. Dow up 1700 points to start. It’s a massive “rotation trade,” we’re told, from stay-at-home stocks to the open-up trade.

No, it was a temporary failure of the market’s payments system. Shorting plunged, dropping about 4% in a day, a staggering move across more than $30 trillion of market-cap. Derivatives trades declined 5% as “layaways” vanished.  That’s implied money.

Bernanke, Geithner and Paulson would have quailed.

Think of it this way. Traders after pennies want prices to change rapidly, but they don’t want to own anything. They borrow stock and buy and sell on layaway.  They’re more than 50% of volume, and borrowing is 45%, derivatives about 13%.

There’s crossover – but suppose that’s 108% of volume – everything, plus more.

That’s the grease under the skids of the world’s greatest equity market.

Lower it by 10% – the drop in short volume and derivatives trades. The market can’t function properly. Metal meets metal, screeching. Tumult ensues.

These payment seizures are routine, and behind the caroming behavior of markets. It’s not rational – but it’s measurable.  And what IS rational can be sorted out, your success measures amid the screaming skids of a tenuous market structure.

Your board and exec team need to know the success measures and the facts of market function, both. They count on you, investor-relations professionals. You can’t just talk story and ESG. It’s utterly inaccurate. We can help.

Traders, without market structure analytics, you’re trading like cavemen. Let us help.

By the way, the data do NOT show a repudiation of Tech. It’s not possible. Tech sprinkled through three sectors is 50% of market-cap. Passive money must have it.

No need for all of us to be on the skids.  Use data.  We have it.

-Tim Quast

Placid

The data are more placid than the people.

When next we write, elections will be over. We may still be waiting for the data but we’ll have had an election. Good data is everything.  Story for another time.

The story now is how’s money behaving before The Big Vote? Depends what’s meant by “behave.” The Wall Street Journal wrote for weeks that traders saw election turmoil:

-Aug 16:  “Traders Brace for Haywire Markets Around Presidential Election.” 

-Sep 27: “Investors Ramp Up Bets on Market Turmoil Around Election.”

-Oct 3: “Investors Can Take Refuge from Election Volatility.”

Then the WSJ’s Gunjan Banerji wrote yesterday (subscription required) that volatility bets have turned bearish – now “low vol” rather than higher volatility. Markets see a big Biden stimulus coming.

It’s a probable political outcome.

However.

The shift in bets may be about prices, not outcomes.  When there is a probability somebody will pay you more for a volatility bet than you paid somebody else for it, bets on volatility soar.  It hits a nexus and reverses. Bets are ends unto themselves.

On Oct 26, S&P Global Market Intelligence offered a view titled, “Hedging costs surge as investors brace for uncertain election outcome.”

It says costs for hedges have soared. And further, bets on dour markets are far more pronounced in 2021, implying to the authors that the market fears Covid19 resurgence more than election outcomes.

Two days, two diametric opposites.

There’s the trouble. Behaviors are often beheld, not beatified.

One of our favorite targets here in the Market Structure Map, as you longtime readers know, is the propensity among observers to treat all options action as rational. The truth is 90% of options expire unused because they are placeholders, bets on how prices change, substitutes. They don’t mean what people think.

S&P Global says the cost of S&P 500 puts has risen by 50% ahead of the election. Yet it also notes the open interest ratio – difference between the amount contracts people want to create versus the number they want to close out – is much higher in 2021 than it is around the election.

The put/call ratio can be nothing more than profiting on imbalances. And what behavior is responsible for an imbalance, valid or not? Enter Market Structure Analytics, our forte.  You can’t look at things like volume, prices, open interest, cost, etc., in a vacuum.

Let me explain. Suppose we say, “There is a serious national security threat from a foreign nation.”

Well, if the foreign nation is Switzerland, we laugh. It’s neutral. Has been for eons.  If it’s China or Iran, hair stands up.

Context matters. I said the behaviors were more placid than the people. I mean the voters are more agitated than the money in US equities.

Standard deviation – call it degree of change – is much higher in the long-run data for all behaviors, by 20% to more than 130%, than in October or the trailing 30 trading days back before September options-expirations.

Meaning? Eye of the beholder. Could be nothing. Could mean money sees no change.

Remember, there are four reasons, not one, for why money buys or sells. Investment, asset-allocation, speculation, taking or managing risk. None of these shares an endpoint.

Active money is the most agitated and even it is subdued. But it’s sold more than bought since Sep 2.  I think it means people read the stuff other people write and become fearful. It’s not predictive.

The other three behaviors show diminished responsiveness.  Yes, even risk management.

I could read that to mean the machines that do things don’t see anything changing.  The machines may be right in more ways than one! The more things change, the more they stay the same.

One thing I know for sure. I’ve illustrated how headlines don’t know what’s coming.  It’s why investor-relations and investment alike should not depend on them.

The data, however, do know.  And every investor, every public company, should be metering behavior, be it volatile or placid. We have that data.  I just told you what it showed.

Now, we’ll see what it says.

Oh, and this is placid to me, the Yampa River in CO, anytime of the year, and this is Oct 27, 2020.

Vahlcue

You’re wondering what the heck “vahlcue” is. It was up almost 4% in the last hour yesterday as stocks tipped off the diving board.

Meanwhile, cue fall.  The photo at right reminds us that today is a consequence of yesterday. Autumn follows summer. In the Flat Tops near Steamboat, fall flames as summer smolders out.

In the stock market, cue volatility.  Pursuing “vol,” as the traders call it, is big business. It’s everything that depends on an implied price, such as the VIX index tracking implied volatility over the next 30 days in the S&P 500.  It’s priced from options on the index, which in turn is comprised of futures.

Got that?  Volatility is the implied price of an implied price, gleaned from other implied prices.  All instruments derived from implied prices are ways to trade volatility – gaps between rising and falling prices.

Cue intro music.

The Nasdaq, in concert with the Chicago Mercantile Exchange (CME), launched the VOLQ this past Monday, Oct 5, another way to play volatility.

I assume it’s pronounced “vahlcue.”

VOLQ is a futures contract reflecting the implied volatility of the Nasdaq-100, the NDX. It employs a methodology developed by Nations Indexes, innovator in volatility products that isolates the implied volatility of at-the-money options.

Ready to run a power drill through the palm of your hand to stay awake?  If you want intricate details about how it works and how it’s calculated, you can read more.

I’ve got a specific purpose.

VOLQ, like the VIX, is a futures contract derived from options on underlying stocks – three steps from the asset.  It’s a particular set of both put and call options designed to get to the volatility of instruments priced the same as the futures contract, called at-the-money options.

Have you moved on from drilling a hole in your hand to braining yourself on a brick wall?

Here’s the point. Derivatives have proliferated in the stock market. All derivatives are a right but not an obligation.  As such, the propensity to quit them is much higher than one finds in the actual asset.

Famed hedge-fund manager Lee Cooperman, whom I interviewed in the plenary session of the 2019 NIRI Annual Conference, back when humans gathered innocently, lamented in a CNN interview that stock indexes shouldn’t gap 50 points in a matter of minutes.

He blamed trading machines, the rapid-fire intermediaries setting prices. And he’s right.  But the more trading chases products that are rights but not obligations, ways to pursue changing prices, the more heightened the risk of sudden lurches.

Why? All layers of options and futures are forms of implied supply or demand.  But the moment prices move, those layers become ethereal, dissolving in an instant like those animated transitions you can put in you Powerpoint slide deck.

And the more people pursue the gaps rather than the assets, the greater the assets can be blighted by sudden lurches.  Realize VOLQ is just another clip for the automatic weapons in the Nasdaq’s volatility arsenal that already includes e-Minis and micro e-Minis on the Nasdaq 100.

The first e-Mini S&P 500 futures contract began trading in 1997 and was 20% the size of the standard contract.  Micro e-Minis are a tenth of the e-Mini, 2% of the original contract.  And you can trade options on Micro e-Mini futures too.  We wrote about them in August.

Markets keep migrating away from size, away from the core asset, toward tiny, uncommitted bets and hedges comprised of multi-layered derivatives.

It’s great for the firms selling the products.  But it makes volatility accessible to the masses.  And the masses don’t understand it. And the more the masses are exposed to things that vanish, the more given to wild swings become the underlying assets.

Sure, derivatives can work well.  VOLQ was the right play today.  Traders can hedge exposure to sudden market moves, play the probability of profits in snap swings.

But the consequence is a market that cannot be trusted.

Market Structure Analytics help one survive it. Everybody should have baseline market-structure metrics.

The market is likely to rebound, data say. But this lurch manifested a week ago – much of implied volatility is predicated on weekly options – when the sector data looked ragged to us.  Sure enough it was.  Blame volatility and its instruments. Cue the exit music.

Volatile Liquid

There’s a beer in this for you.  A glass of rosé from Provence if you prefer.

What’s the most liquid stock in the US market?

I’m writing this after the virtual happy hour for the NIRI Big I Conference (it’s a strong event, and you can catch Day Two and our wrap-up today that I’ll take part in), which of course makes one think of beverages. Liquid. Virtual drinks are no match for the real thing, nor is false liquidity in stocks.

Let’s lay the groundwork.  Stock exchanges describe market quality as low spreads.  Spreads have never been tighter, they say, and costs for trading were never lower.

Heck, you can trade for free. That’s about as inexpensive as it gets. So, is a low-cost, low-spread stock market a quality and liquid place?

Depends what you mean.  The market doesn’t fail often. Yes, we’ve recorded nearly 13,000 volatility halts since Mar 9.  Remember all the marketwide pauses that month? Still, it didn’t quit operating.

The Nasdaq just corrected – dropped 10% – in three days. And rebounded as fast. It highlights the importance of the definition of “quality.”

Which leads back to liquidity, and by extension, volatility. All three words ending in “y” are related.

Let’s begin with what liquidity is not.  Volume. Liquidity, bluntly, is the amount of a thing that will trade before the price changes. Put an offer on a house.  What’s the spread between the price you’d pay, and the last that somebody else paid?

I’ve just debunked the idea that low spreads reflect quality.  For the seller, a high spread is a reflection of quality.

Low spreads help parties with short horizons.  If my investment horizon is 250 milliseconds, a spread of a penny is wildly attractive. How many pennies can I make, in how many different issues, every quarter-second?

But if my horizon is more than a day, a wider spread reflects higher quality.  How come stock exchanges don’t mention that?

Let’s go one step further. To me, the measures we traditionally look to for guidance about market quality need revamping. For instance, beta, a measure of volatility, has the same flaws as our current economic measures of inflation.  Beta measures how a stock moves from close to close in relation to the market.

Terrible measure of market quality.  WMT, for instance has a beta score of 0.19, 20% of the volatility of the market. Yet its intraday volatility the past 20 days is 2.9%. The S&P 500 is 2.7% volatile over the same time (intraday high and low).

WHEN an investor buys during the day could in theory be nearly 3% different from somebody else’s price.  And WMT, contradicting beta, is not a fifth as volatile as the market but 7% more volatile.

The truth is low spreads PROMOTE frequent price-changes, which is the definition of volatility. The parties driving low trading spreads are ensuring volatility. Creating it.  And telling us it signals market quality.

They mean well. But good intentions pave roads to oblivion.

(Editorial note: Inflation isn’t the rate at which prices increase. It’s whether you can buy things.  All over the economy, people now buy on credit. Debt has exploded. That’s the evidence of inflation. Not the Fed’s equivalent of beta.)

And liquidity isn’t volume. That’s confusing busy with productive. Volume is stuff changing hands. Liquidity is how MUCH of it changes hands.  The most liquid stock in the market is AMZN (not counting BRK.A, a unique equity), at $70,000 per trade.

The mean component of the S&P 500 trades about $17,000 at a time.  But here’s the kicker. Just 50 companies, 10% of the index, trade MORE than $17,000 per trade. That’s the list from AMZN to DPZ. Everybody else trades less.

Including now, AAPL. It used to be in the top ten. Now it’s 146th post-split, trading about $12,000 per transaction on average.  TSLA was top five but post-split is now 49th at $17,600, well behind 32nd-ranked MSFT at $20,100.

Splits don’t foster liquidity. They breed volume. And price-changes. Volatility. We’re not anti-split. We’re anti-volatility, which increases risk for investors and the cost of capital for companies.

Why does the market promote one at the expense of the other? It’s a question owed an answer. All investors, every public company, should know liquidity. We have the data.

Roll Call

Apr 21, yesterday, is Texas A&M Aggie Muster.  Aggies everywhere gather to say “here” for Aggies lost in the past year, a roll call. It’s more poignant this time for my Aggie, Karen, and the many friends and family hailing from College Station.  Gig’em, Aggies.

Speaking of Texas, let’s talk oil.  We’ve been saying for years that volatility during the next crisis, whenever it came, would be exacerbated by Exchange Traded Funds (ETFs) and lead to large failures.  It’s now happened in oil, which freakishly settled Monday at $37 below zero.

Oil prices are predicated in the USA on futures contracts for West Texas Intermediate (WTI). Overflowing storage facilities mean few parties want to take delivery of oil. That pressures prices.

But oil isn’t worth nothing. It’s not worth less than nothing. That futures went south of zero is a product of the supply/demand distortions ETFs introduce.

Futures are themselves derivatives that obligate one to action only if held to settlement. ETF investors are not buying barrels of oil. They’re buying the PRICE of oil.

But they’re really buying derivatives that represent derivatives that represent the price of oil.  The massive oil ETF, USO (always among the most active stocks, it yesterday traded a billion shares, one of every twelve, leading the market), currently claims assets of $3 billion comprised heavily of June and July WTI contracts.  It’s down 80% in a year.

We’ve explained before that ETFs work similarly to, say, buying poker chips.  You pay cash to the house and receive chips of equal value. The chips represent the cash.  The difference with ETFs is there’s an intermediary between you and the house.

So the intermediary, the broker, pays the house for the chips and sells them to you.  Suppose the intermediary, the broker, gave energy futures as payment for the chips, rather than cash.

Then the value of the futures plunged. ETFs compound the damage. The broker is out the value of it collateral, futures, and you’re out the value of your chips, which also collapse.

The broker may stop transacting in the ETF because it’s out a lot of money. Now you can’t find a buyer – and you suffer even more damage.

This happened.  Interactive Brokers said it lost $88 million, its portion of the excess losses by its customers, some of whom lost everything in their accounts. The firm’s CEO said in a CNBC interview yesterday it had exposure to about 15% of the May WTI futures contracts behind the damage, meaning some $500 million more exists.

And the damage yesterday to the June WTI contract, the next in the series, was as impactful.  Massive Singapore futures broker Hin Leong, which moves physical commodities, filed for bankruptcy. It had been in business since 1963.

Banks most exposed to Hin Leong’s billions in obligations:  HSBC and ABN Amro.  We’ve long said we thought HSBC was a counterparty at risk in a financial crisis, on exposure to derivatives.  ABN Amro lost big already, on Ronin Capital’s March failure.

The biggest derivatives counterparties though are all names you know: JP Morgan, Goldman Sachs, Morgan Stanley, BofA, Citi (which has vastly more derivatives exposure via swaps than anyone).  They may be fine – but the world relies on these firms to make every meaningful market, from helping the Fed, to trading ETFs.

We’re leaving out a key piece of the story. The big way ETFs cause trouble is by distorting the market’s perception of supply and demand. In 2008, securitized mortgage derivatives bloated the appearance of demand for real estate.

USO owned some 25% of the subject oil futures contract. Yes, we’ve got too much oil (remember peak oil? Cough, cough.) because travel died. Sure, we know supply exceeds demand.

But.

Demand from derivatives of derivatives is extended reach to an asset class – which inflates its price.  I submit:  WTI May futures traded to -$37 Apr 20 because ETFs grossly inflated the price despite its apparent weakness. When books were squared and inflationary “financial” demand from ETFs removed, oil was worth 200% less than zero.

Said another way, when money in ETFs not wanting to take delivery of oil didn’t even want its price, we discovered that demand implied in futures misrepresented reality.

Thank you, ETFs.

Barclays shuttered two oil instruments. A dozen more are at risk.  USO is at risk. The roll call of the threatened is lengthening.

Where else are ETFs inflating prices relative to underlying demand? Well, the greatest instance of asset-class extension is in US equities. Especially the FAANGs – FB, AAPL, AMZN, NFLX, GOOG (and the pluses are MSFT, AMD, TSLA, a handful of others).

These bellwethers have weathered better than the rest in a global shutdown.  But they all depend on consumer-discretionary income. People have to be working to pay for subscriptions, and businesses must be operating to spend advertising dollars.

The drums are drumming. I expect we’ll see some even more surprising ETF failures before the roll call is done.  The sooner we’re back to work, the quicker the drumbeat ends.