Tagged: Volatility

Volatility Insurance

In Texas everything is bigger including the dry-aged beef ribs at Hubbell & Hudson in the Woodlands and the lazy river at Houston’s Marriott Marquis, shaped familiarly.

We were visiting clients and friends before quarterly reporting begins again. Speaking of which, ever been surprised by how stocks behave with results?

We see in the data that often the cause isn’t owners of assets – holders of stocks – but providers of insurance. To guard against the chance of surprises, investors and traders use insurance, generally in the form of derivatives, like options. 

Played Monopoly, the board game? A Get Out of Jail Free card is a right but not an obligation to do something in the future that depends on an outcome, in this case landing on the “go to jail” space. It’s only valuable if that event occurs. It’s a derivatives contract.

At earnings, if you shift the focus from growth – topline – to value – managing what’s between the topline and the bottom line – the worth of future growth can evaporate even if investors don’t sell a share.

Investors with portfolio insurance use their Get Out of Jail Free cards, perhaps comprised of S&P 500 index futures. The insurance provider, a bank or fund, delivers futures and offsets its exposure by selling and shorting your shares. It can drop your price 10-20%.

Writers Chris Whittall and Jon Sindreu last Friday in the Wall Street Journal offered the most compelling piece (may require registration — send me a note if you can’t read it) I’ve seen on this concept of insurance in stocks.

Investors of all ilks, not just hedge funds, protect assets against the unknown, as we all do. We buy life, auto, health, home insurance.  We seek a Get Out of Jail Free card for ourselves and our actions.

In stocks, we track this propensity as Risk Management, one of the four key behaviors setting market prices. It’s real and by our measures north of 13% of total market cap.

But the market has been a flat sea.  No volatility.  This despite a new President, geopolitical intrigue, global acts of terror, a Federal Reserve stretching after eight Rumpelstiltskin years, and a chasm between markets and fundamentals.

Whittall and Sindreu theorize that opposing actions between buyers and sellers of insurance explains the strange placidity in markets where the VIX, the so-called Fear Gauge derived from prices of options on stocks, has been near record lows.

The thinking goes that the process of buying and selling insurance is itself the explanation for absence of froth. Because markets seem inured to threats, investors stop buying insurance such as put options against surprise moves, and instead look to sell insurance to generate a fee. They write puts or calls, which generate cash returns.

Banks take the other side of the trade because that’s what banks do. They’re now betting volatility will rise. To offset the risk they’re wrong, they buy the underlying: stocks. If volatility rises the bet pays, but the bank loses on the shares, which fall. 

This combination of events, it’s supposed, is contributing to imperturbable markets. Everything nets to zero except the stock-purchases by banks and cash returns generated by investors selling insurance, so there’s no volatility and markets tend to rise.

Except that’s not investment. It’s trafficking in get-out-of-jail-free cards.

And despite low volatility, there’s a cost. We’ve long said there will be a Lehman moment for a market dominated by Risk Management.

We’ve seen hedge funds struggle. They’re big players in the insurance game. And banks have labored at trading. Maybe it’s due to insurance losses. Think Credit Suisse, Deutsche Bank, HSBC.  Someone else?

From Nov 9-Mar 1 the behavior we call Risk Management led as price-setter marketwide, followed closely by Active Investment. The combination points to what’s been described: One party selling insurance on risk, another buying it, and a continual truing up of wins and losses.  

Now, for perspective, the VIX is a lousy alarm system. It tells us only what’s occurred. And intraday volatility, the spread between daily high and low prices across the market, is 2.2%, far higher than closing prices imply.

We may reach a day where banks stop buying insurance from selling investors, if indeed that’s what’s been occurring.  Stocks will cease rising.  Investors will want to buy insurance but the banks won’t sell it.  Then real assets, not insurance, will be sold.

It’s why we track Risk Management as a market demographic, and you should too.  You can’t prevent risk. But you can see it change.

A Year Ago

In Luckenbach, Texas, ain’t nobody feeling no pain. We were just there and I think the reason is the bar out the back of the post office.

A country song by that name about this place released in 1977 by Waylon Jennings begins by asserting that only two things make life worth living, one of which is strumming guitars.

In equities, what makes life worth living is certainty.  TABB Forum, the traders’ community, had a piece out yesterday on the big decline in listed options volume, off 19% from last July to a 14-month low. TABB attributed the drop to falling demand for hedges since the Brexit, the June event wherein the UK voted to leave the European Union and exactly nothing happened.

The folks at Hedgeye, responding to a question about whether volume matters anymore since it’s dried up as stocks have risen to records said, paraphrasing, big volume on the way down, low volume on the way up, is as valid as it ever was for investors wary of uncertain markets and means what you think it does. You should be selling on the way up so you don’t have to join those people distress-dumping on the way down.

I got a kick out of that. Sure enough, checking I found that SPY, the world’s most active stock (an ETF) traditionally trading $25 billion daily is down to $11 billion.  Whether it’s August is less relevant than volume.

On August 24 a year ago, the market nearly disintegrated on a wildly delirious day.  August options-trading set a near-period record.

Now what’s that mean to investor-relations folks trying to understand stock-valuation and trading? We’ve long said that behavioral volatility precedes price-volatility. You can apply it anything. As an example, if housing starts plunge, that’s behavioral volatility.  If a movie starts strong and viewership implodes the second week, that’s behavioral volatility.  Both point to future outcomes.

We track market behaviors. They tend to turbulence anyway around options-expirations, which occurred in the past week, and August 2016 was no exception.  On Aug 19, triple-witching, Asset Allocation (investment tracking a model such as indexes and ETFs) surged nearly 11%, Risk Management – counterparties for derivatives – by 3%.

It’s the double-digit move that got our attention.  Double-digit behavioral change is a key indicator of event-driven activity, or trading and investing following a catalyst such as Activism or deal-arbitrage.  It’s very rare in the whole market.

We also tracked a whopping jump since Aug 15 in Rational Prices, or buying by fundamental money.  When it’s coupled with hedging, it implies hedge-fund behavior.  In effect, the entire market was event-driven under the skin yet not by news. Nor did it manifest in prices or volume (Activism also routinely does not).

We’ve got one more data point for this puzzle. Volatility halts in energy, metals and emerging-markets securities have returned after vanishing in June and July.  Remember, market operators have implemented “limit-up, limit-down” controls to stop prices from moving too much in a short period.

So though the VIX is dead calm other things are moving.  Short volume marketwide is nearly identical (44%) to where it was in latter November preceding December volatility and the January swoon.

We conclude that currency volatility may surge, explaining volatility halts in commodities.  Hedge funds are shifting tactics. The dearth of options trading may rather than mean a lack of hedging instead signal the absence of certainty.

Pricing options accurately requires knowing prices of the underlying securities, plus volatility, plus time.  Volatility isn’t the faulty variable. It’s got to be either the prices of the underlying or the uncertainty of time.

Now it may be nothing. But our job here is to help you understand the market’s contemporary form and function. If behavioral volatility precedes change, then we best be ready for some.  We may all want to pull on the boots and faded jeans and go away.

But hang onto your diamond rings (and that’s all the obscure country-music humor I’ve got for today!).

Correlating Volatility

“Measure the performance of equity securities in the top 85% by market capitalization of equity securities listed on stock exchanges in the United States.”

I made it a sentence here but I clipped that phrase from a Blackrock iShares “minimum volatility” Smart Beta Exchange Traded Fund (ETF) prospectus and Googled it, and got back pages of references.  Apparently many indexes and ETFs meant to diversify and differentiate investments are built on the “top 85% by market capitalization.”

That by the way is about 700 companies. There are now over 700 ETFs in the US stock market and about 3,700 total public companies when you strip out funds and multiple classes of stock.  That’s a 1-to-5 ratio.  If many ETFs track indexes comprised of just 20% of the stocks, would that not produce high correlation?

Answer:  Yes.

I ran correlation for five ETFs from Blackrock, First Trust, Schwab, Vanguard and Invesco (USMV, FVD, SCHD, VIG, SPLV) over the past three months and it was about 90%.  Now, all five seek similar objectives so correlation isn’t surprising. But in truth they’re brewing a mixture of the same stocks.

We had the chance to participate in a wine-blending last month in Napa. The group was tasting mixtures of a core set of grapes.  What if we make it 94% Zinfandel, 3% Petit Syrah and 3% Malbec?  How about 7% Malbec, 3% Petit Syrah, 90% Zinfandel?

The same thing is happening with ETFs. They’re blending the same grapes – stocks.  What if we weight a little more than the index in WMT and a little less in AMZN?

It’s still the same stocks. And it’s earnings season.  Think about the impact of high correlation when in nearly all cases save an outlier handful ETFs track underlying indexes with defined composition.

Say you report results and your stock plunges (we’ll come to why in a moment). Even minute weighting in a falling stock can skew the ETF away from the benchmark, so the authorized participants for the ETF sell and short your shares, raising cash to true up net asset values and ridding the ETF of the offending drag.

At some future point now that your shares are sharply discounted to the group and the market, arbitragers will find you and the authorized participants (brokers creating and redeeming ETF shares to ensure that it tracks its benchmark as money flows into and out of the investment vehicle) who shorted will cover, and suddenly you’re the star again.

Neither up nor down did the behavior of your stock reflect fundamental value or rational thought. It’s high correlation, which rather ironically fosters mounting volatility. We’re seeing a notable increase in instances of large moves with earnings.  And your shares don’t drop 15% because active investors saw your numbers and decided, “Let’s destroy our portfolio returns by buying high and selling low.”

In the last week through Monday, Asset Allocators (indexes and ETFs) and Fast Traders (arbitragers speculating on intraday price-changes) were top price-setters.  Both are quantitative, or machine-driven, behaviors. One is deploying money following a model and the other is betting with models on divergences that will develop during that process.

Both create mass volatility around surprises in earnings reports. Fast Traders are the athletes of the stock market racing to the front of the line to buy and sell. Asset Allocators are lumbering, oblivious to fundamental factors and instead following a recipe.

You report.  Active investors stop their bits and pieces of buying or selling to assess your fundamentals. Sensing slight change, Fast Traders vanish from order books across the interconnected web comprising today’s stock market.  Asset Allocators tracking benchmarks stop buying your shares because you’ve now diverged from the broad measure.

This combination creates a vacuum.  Imagine selling your house and there was a bidding war for it and suddenly all the bidders disappeared. You’d have to cut your price. What changed?  The number of potential buyers, not the value of the house.

This is the problem with how a combination of Fast Traders and Asset Allocators dominate the market now.  Fast Traders set most of the prices but want to own nothing so the demand they create is unreliable and unstable.  Asset Allocators are trying to track benchmarks – that depend on Fast Traders for prices. Throw a wrench into those delicate gears with, say, a surprise in your quarterly earnings, and something will go awry.

Speaking of which, our Sentiment Index just turned Negative for the first time since February and yet the market soared yesterday.  From Feb 8-11, futures contracts behind some of the most actively traded ETFs in the market, concentrated in energy, rolled. The dollar had just weakened. Stocks roared.

The same futures contracts just rolled and the ETFs rebalanced (May 6-11). Counterparties covered. The dollar is rising. We may be at a tipping point again for stocks. Derivatives now price the underlying assets.

Receding

The X-Files are back on TV so the pursuit of paranormal activity can resume. Thank goodness, because the market appears to be paranormal (X-Files theme in background).

Volatility signals behavioral-change, the meaning of which lies in patterns. Sounds like something Fox Mulder would utter but we embrace that notion here at ModernIR. It’s not revolutionary, but it is universal, from ocean tides to personalities, weather forecasts to stock-market trading.  Volatility, patterns.

Stocks are volatile. Where’s the pattern?

Let’s find it. A headline yesterday splashed across news strings said CEOs have “unleashed recession fears” on earnings calls. Fact Set’s excellent Earnings Insight might buttress that assertion with data showing S&P 500 earnings down 5.8% so far, revenues off 3.5%. It marks three straight quarters of declines for earnings, the worst since 2009, and four in a row for revenues, last seen in late 2008.

What happened then was a recession. That’s a pattern, you say.

Hard to argue your reasoning. We’re also told it’s oil pulling markets down. China’s slowing growth is pulling us down.  Slowing growth globally is the problem, reflected in Japan’s shift to negative interest rates. First-read fourth-quarter US Gross Domestic Product (GDP) last week was a wheezing 0.6%.  Slowing is slowing us, is the message.

But what’s the pattern?  One would expect a trigger for a recession so where is it?  In 2008, banks had inflated access to real estate investments by securitizing mortgage debt on the belief that demand was, I guess, infinite. When infinity proved finite, leverage shriveled like an extraterrestrial in earth atmosphere. Homes didn’t vanish. Money did. Result: a recession in home-values.

It spread.  In 2007, the gap between stock-values and underlying earnings was the widest until now, with the S&P 500 at 1560 trading more than 10% higher than forward earnings justified. Oil hit $150.

But by March 2009 oil was $35 and the S&P 500 below 700. To reverse this catastrophic deflation in asset prices, central banks embarked on the Infinite Money Theorem, an effort to expand the supply of money in the world enough to halt the snapping mortgage rubber band.  Imagine the biggest-ever long-short pairs trade.

It worked after a fashion. By the end of 2009, a plunging dollar had shot oil back to $76.  The S&P 500 was over 1100 and rapidly rising earnings justified it. Trusting only broad measures, investors in pandemic uniformity stampeded from stock-picking to index-investing and Exchange-Traded Funds (ETFs).

The Infinite Money Theorem reached orbital zenith in Aug 2014 when the Federal Reserve stopped expanding its balance sheet.  The dollar shot up.  Oil began to fall. By Jan 2015 companies were using the words “constant currency” to explain why currency-conversions were crushing revenues and profits.  In Aug 2015 after the Chinese central bank moved to devalue the yuan, US stocks caterwauled.

On Nov 19, 2015, the Fed’s balance sheet showed contraction year-over-year. Stocks have never returned to November levels. On Dec 16, 2015, the Fed lifted interest rates.  Stocks have since swooned.

Pattern? Proof of the paranormal?  No, math. When a trader shorts your stock – borrows and sells it – the event raises cash but creates a liability. Borrow, sell shares, and reap cash gain (with a debt – shares to return).  When central banks pump cash into the global economy, they are shorting the future to raise current capital.

How?  Money can’t materialize from space like something out of the X-Files. The cash the Fed uses to buy, say, $2 trillion of mortgages is from the future – backed by tax receipts expected long from now. That’s a short.

We’re getting to the root.  Say the global economy fell into a funk in 2008 from decades of overspending and never left it. Let me explain it this way.  One divided by one is one.  But one divided by 0.9 is 1.11.  The way the world counts GDP , that’s 11% growth.  But that growth is really just a smaller denominator – a weaker currency.

Now the dollar is revaluing to one and maybe more (it did the same in 2001 and in 2008). Why? Since the financial crisis trillions of dollars have benchmarked markets through indexes and ETFs.  In 2015, $570 billion flowed to Blackrock and Vanguard alone.  All that money bought rising markets until the excess money was used up by assets with now sharply higher prices.

The denominator is reverting and the economic growth we thought we had is receding back toward its initial shape, such as $35 oil (with stretch marks related to supply/demand issues). That’s what’s causing volatility. This is the pattern.  It’s colossally messy because the dollar is the world’s reserve currency and thus affects all other currencies (unevenly).

Volatility signals behavioral-change, the meaning of which is in patterns. This is it. A boomerang (read Michael Lewis’s book by that title for another perspective).  The dollar was made small to cause prices to grow large and create the illusion of growth in hopes it would become reality.  At the top of the orbit nothing had really changed and now that seven-year shadow on the planet is receding.

We’ll be fine. We humans always are.  But this is no short-term event. It’s a huge short.

Volatility

You’ve heard the saying that’s it all in your perspective. It applies to volatility.

Volatility is up 150% since the post-financial-crisis nadir of 10.32 for VIX Volatility in mid-2014. The “Fear Index” closed yesterday over 26, the highest since August 2015 when it topped 28 (way below 43 in 2011 and nearly 80 in 2008). VIX expirations are hitting today.

I’ve been seeing Mohamed El-Erian, whom I admire, chief economic advisor to Allianz and former right hand to Bill Gross at PIMCO, also now gone from the bond giant, on the business TV circuit saying central banks are ending programs designed to dampen financial volatility.

I think he’s got a point, and he means they’re starting to broaden trading ranges in everything from interest rates to currencies (as if we want them setting prices). But volatility is price-uncertainty reflecting evolving valuation.  Conventional measures often fail to reveal change because behaviors in markets morph while the metrics used to understand them don’t.

Figure 1

Figure 1

I can prove it.  In the first chart here (Figure 1), a small-capitalization technology stock on the Nasdaq hasn’t moved much in the year ended Dec 16, 2015 (I’ll explain that date shortly) but the stock rose from a 200-day average price of $20.67 to a five-day mean of $21.05, up 1.8%.  Not too great – but the Russell 2000 Index was off 1.3% in the year ended Dec 16, 2015. Perspective matters.

Now notice:  Daily volatility, or the difference between highest and lowest prices each day, is greater than the change in average price in all four periods.  Think about that. The price changes more every day than it does in moving averages for months and quarters.

Now see Figure 2 showing short volume Dec 1, 2015-Jan 15, 2016 for the same stock. The upper half is long volume (owned shares), the bottom short volume, or rented stock. The blue line is closing price. The data further back show short volume over the trailing 200 days averaged 60.2% daily.

Figure 2

Figure 2

Combine the charts. The stock moved less than 2% on average over the entire period but 60% of the shares trading every day were borrowed, and the spread between high and low prices was nearly 3% every single day.

Do you understand? On the surface this stock is not volatile. But up close it’s torrid – on rented shares. For a solid year, traders have kept this stock in stasis by borrowing and trading, borrowing and trading, because the cost of borrowing was substantially lower than daily price-movement. That’s market-neutral arbitrage.

Everything changed recently. Short volume in Figure 2 plunged Dec 22, 2015.  On Dec 16 (here’s that date now) the Federal Reserve bumped short-term rates to 0.25-0.50%. On Dec 17-18 vast swaths of interest-rate swaps tied to options-expirations lapsed. On Dec 21, the new series of options and futures (and interest-rate swaps) began trading. And on Dec 22, our small-cap’s short volume imploded, finally landing at 33% Jan 11, down from 71% Dec 10, a decline of 54%.

We’ve slung numbers here, I know. But the conclusion is simple. Whatever traders were doing in this small-cap, the Fed’s rate-hike ended it.  We think that’s good. But markets have been addicted for years to cheap credit, which includes borrowing shares for next to nothing, which shifts attention from long-term owning to short-term renting. That changed when the Fed bumped rates. And equites corrected.

There’s another lesson by extension.  What sets your stock’s price may be radically different than you think.  We’ve offered one example that shows short-term borrowing fueled persistent volatility trading masked by apparent long-term placidity. When interest rates crept up minutely, the strategy stopped working.

What’s your stock show?  Price-performance isn’t story alone, perhaps even over the long run, as we’ve just shown. There’s so much to see when measurements reflect current behavior (as ours do). Volatility is price-uncertainty that thanks to policies promoting short-term behavior is now concentrated intraday.  Sorting this out will take time. We won’t change seven fat years with a lean month. The good news is it’s all measurable.

The Vacuum

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how it’s really priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

The Long Slide

Autumn lavished Chicago and Boston in the past week, where we were sponsoring NIRI programs. While nature celebrated the season, stocks did not, continuing a slow bleed.

In Chicago I spoke on the structure of the market today, how the liquidity is one place and the prices are another, and forcing them together gives arbitragers control.

Let me explain. The roots of both the NYSE and the Nasdaq trace to brokers. In 1792, a group of them decided to throw in together, agreeing to charge a minimum commission so as not to undercut each other on price, and to go first to the group when looking for buyers or sellers, creating a marketplace – aggregated customers. It became the NYSE.

In 1971, the National Association of Securities Dealers took a page from The Institutional Network (Instinet today, a dark pool owned by Nomura) and created an automated quotation market for its members to post buy and sell interest.  It became the Nasdaq.

Both exchanges operated one market each for equities. Both markets were comprised of the customers of the brokers belonging to them.  They were bringing buyers and sellers together – that’s the definition of a market.

Today the exchanges are owned by shareholders and the markets they run are not predicated on underlying conglomerated buy and sell interest from customers of brokers.  Rules give these markets, the exchanges, authority to set prices. The liquidity – shares owned by investors and brokers – is outside the market now.

How to get the liquidity over to where prices are? Pay traders to haul it.  If you’re a top-tier maker of Nasdaq volume, meaning your firm is bringing shares for sale to the Nasdaq equaling 1.6% of total volume, you can be paid $0.30 for each hundred shares you offer for sale.  At current volumes, firms in that bracket can make $86,000 daily for doing nothing more than moving shares from one market to another.

But there’s more. Traders earn payments for selling shares at the main Nasdaq market.  They’re conversely paid at the Nasdaq BX, another platform (formerly the Boston Stock Exchange) owned by the exchange, to buy shares, about $0.17 per hundred shares.  So traders can earn money both buying and selling shares.

Why?  To set prices. If all trades must occur between the best national bid to buy and offer to sell, and the exchanges – the NYSE does the same thing, as does BATS Global Markets – can pay traders to set the bid and the offer with small trades, then other trades by rule are drawn there to match, and the data from these trades becomes a valuable commodity to sell back to brokers, who are also required by regulations to buy it in order to know if they’re providing customers the best prices.

This is how stock markets work today. Exchanges pay traders to set prices in order to draw out orders, and then they sell the data generated from these trades, and sell technology services so traders and brokers can access prices and data rapidly.

It’s the opposite of the old market where brokers set minimum commissions and gave preference. Both those are against the law now, and the market is fractured into 50 different pieces – stock exchanges, broker-operated “dark pool” markets – and is really about setting prices and generating data.

Volatility results from one thing: Continually changing prices. Why are prices in flux?  Rules require eleven different markets to pass orders to each other if they don’t have the best price, and these markets are paying traders to constantly change it. All the trades at broker dark pools must match at prices set by exchanges, so they are continuously morphing too.

According to data from S&P Capital IQ reported in USA Today yesterday, 86% of the S&P 500 (430 of 500 issues) is down 10% or more. A quarter are off at least 30%.

Suppose you’re a big money manager like Blackrock and investors have been making redemptions for days or weeks, yet every time you sell some shares, the market shudders because all the prices race away from you, and down.

You try to control it by leaking out, leaking out, because nobody wins if prices implode when you sell.  Months ago we theorized after studying market structure for now over ten years that when the next bear market developed we’d see a long slow slide because there’s no efficient way to move money of size in the current structure (a disastrous design for anyone who gets supply, demand, scarcity and choice – basic economic concepts).

We’re in it.  The only question now is the length of the slope.

Capital Caprice

Suppose gas prices changed 3% daily.

Pretty soon everyone would look for patterns in volatility and start rushing to fill tanks at low ebbs. Or maybe there’d be a Gasoline Closing Cross, where petrol consumers would cue and then all carom into the pumps to peg the best average for the day.

Daft, you say? How come we do it in equity markets?  On a recent day a big energy company was trading 85,000 times on intraday volatility of 3.2%, meaning the spread from highest to lowest price ranged 320 basis points. It traded less than 200 shares at a time but $16,000 a pop and $1.4 billion total. And 40% was middle men moving price.

So a trader wanting $1 million of stock would chance the market 63 times to get less than a percent of daily volume, with 40% of trades front-run by packs of transient intermediaries, and price would’ve changed 3% throughout the day-long effort.

What if you spent your day driving around trying to fill your gas tank and 40% of the time when you pulled into a station somebody darted into your spot? And the pump price shifted at each glance.

At some point you’d quit driving. In a sense, active investors are driving less, choosing instead ETFs, the assets for which have doubled in three years in part because they function opposite the broad market where prices are a buzzing guywire of instability.

When money flows to ETFs, brokers designated as Authorized Participants manufacture large batches of ETF stuff called creation units. As the Investment Company Institute explains (page 3), they alone interact directly with the ETF’s distributor (and the ICI says 15 sponsors have 90% of ETF assets). They’re following the “recipe” described in an ETF’s prospectus but making enough for a mess hall and supplying straight to big investors or to a chunk of sub-distributors ranging from other brokers to hedge funds and high-frequency traders.

In effect ETFs cut out the middle men (or let them in the back). They’re everything the broad market isn’t. There’s a preferential relationship (the AP) with exclusive access to the source of the money, which is the distributor of the ETFs (Blackrock, Vanguard, Invesco, Janus, BNY Mellon etc.), and the two parties know exactly who each other is.

Don’t ETFs trade like stocks? The ICI data, you might counter, show 90% of ETFs have no daily creation or redemption. That proves they’re trading vehicles, appearing or vanishing through APs at inflections unlike other shares.

If this model is booming, why is the broader market built the opposite way, clogged with intermediaries and tiny shreds of fast-moving shares obscuring perverse liquidity paucity coalescing in forced anonymity around frantic price-instability?  ETFs are created in 25,000-unit chunks but somebody buying the energy company gets 200-share snippets. Which would you take?

Why don’t public companies ask the SEC the same question? If the market for the audience we court year-round appalls upon examination, should we help active investors? (That requires understanding why ETFs are mushrooming, which IR should explain to management.)

We should wish to know why investors who believe in long-term fundamentals get one crappy market while ETFs get an advantageous another. In a bizarre upending of function, the market intended for capital-formation has been constructed to favor derivatives. ETFs don’t listen to earnings calls.

This caprice explains volatility of recent weeks. The market is bifurcated into one that works well if you use derivatives like ETFs and one that doesn’t if you don’t.

Now, you say, “But Quast. Some big ETFs nearly collapsed on Aug 24.”

While the S&P 500 have been reducing share-count by percentage points annually through big buybacks, indexes and ETFs have exploded and the use of derivatives like options and futures have set soaring new records.

Translation: Underlying assets shrink as extrapolations of those assets expand. The same thing happened in mortgages. Demand was huge so mortgages were sliced and tranched and repurposed into collateralized obligations that swelled well past underlying assets but carried the same value.  What popped that bubble wasn’t the first missed mortgage payment but an end to asset-appreciation.

Derivatives become unreliable when the underlying assets stop appreciating. Ponder that. And look back.

Options expire next week at the same time the Fed meets and may hike rates or not, and S&P indices rebalance following a period of high market gyration. Everything may sort into neat piles.  But comportment rarely follows caprice. Drama is more common.

So prepare your executives, and make it a mission to get them involved in the structure of this marketplace. It’s in your power.

Market Facts

Volatility derivatives expire today as the Federal Reserve gives monetary guidance. How would you like to be in those shoes? Oh but if you’ve chosen investor-relations as your profession, you’re in them.

Management wants to know why holders are selling when oil – or pick your reason – has no bearing on your shares. Institutional money managers are wary about risking clients’ money in turbulently sliding markets, which condition will subside when institutional investors risk clients’ money. This fulcrum is an inescapable IR fact.

We warned clients Nov 3 that markets had statistically topped and a retreat likely would follow between one and 30 days out. Stocks closed yesterday well off early-Nov levels and the S&P 500 is down 100 points from post-Thanksgiving all-time highs.

The point isn’t being right but how money behaves today. Take oil. The energy boom in the USA has fostered jobs and opportunity, contributing to some capacity in the American economy to separate from sluggish counterparts in Asia and Europe. Yet with oil prices imploding on a sharply higher dollar (bucks price oil, not vice versa), a boon for consumers at the pump becomes a bust for capital investment, and the latter is a key driver in parts of the US that have led job-creation.

Back to the Fed, the US central bank by both its own admission and data compiled at the Mortgage Bankers Association (see this MBA white paper if you’re interested) has consumed most new mortgages coming on the market in recent years, buying them from Fannie Mae and Freddie Mac and primary dealers.

Why? Consumption drives US Gross Domestic Product (GDP), and vital to recovery in still-anemic discretionary spending is stronger home prices, which boost personal balance sheets, instilling confidence and fueling borrowing and spending.

Imagine the consternation behind the big stone walls on Maiden Lane in New York. The Fed has now stopped minting money to buy mortgages (it’ll churn some of the $1.7 trillion of mortgage-backed securities it owns, and hold some). With global asset markets of all kinds in turmoil, especially stocks and commodities, other investors may be reluctant successors to Fed demand. Should mortgages and home-values falter in step with stocks, mortgage rates could spike.

What a conundrum. If the Fed fails to offer 2015 guidance on interest rates and mortgage costs jump, markets will conclude the Fed has lost control. Yet if a fearful Fed meets snowballing pressure on equities and commodities by prolonging low rates, real estate could stall, collapsing the very market supporting better discretionary spending.

Now look around the globe at crashing equity prices, soaring bonds, imploding commodities, vast currency volatility (all of it reminiscent of latter 2008), and guess what?  Derivatives expire Dec 17-19, concluding with quad-witching. Derivatives notional-value in the hundreds of trillions outstrips all else, and nervous counterparties and their twitchy investors will be hoping to find footing.

If you’ve ever seen the movie Princess Bride (not our first Market Structure Map nod to it), what you’re reading seems like a game of wits with a Sicilian – which is on par with the futility of a land war in Asia. Yet, all these things matter to you there in the IR chair, because you must know your audience.  It’s comprised of investors with responsibility to safeguard clients’ assets. (more…)

IR Pros Must Know Macro Factors

We were sitting on the porch in the shadow of the American flag Sunday September 11 when fighter jets streaked and thundered so low that all of Denver shook. We caught glimpses of pairs of F-15s and F-16s, afterburners hot. Later, we read that warplanes from Denver escorted two flights with suspicious passengers aboard. But the ten-year memorial passed in peace.

Speaking of thunderous roar, I attended the jam-packed NIRI Rocky Mountain Chapter’s kickoff session today. Nasdaq chief economist Frank Hatheway offered a thoughtful and statistical look at the market. He joked that when he first prepared slides two weeks ago, the trends were improving but he’d had to change his comments to reflect reality.

Dr. Hatheway launched his talk by comparing stock indices with VIX volatility, Treasury yields, oil prices and gold. He observed that investor-relations professionals today need to develop a level of understanding of these “macro factors” – benchmarks of group behavior across asset classes (clients, we include a Macro Factors segment on page two of your Market Structure Report). (more…)