Tagged: Volatility

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.


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.


DoubleLine’s famed Jeff Gundlach says we’ll take out March lows in stocks because the market is dysfunctional.

Karen and I have money at DoubleLine through managed accounts with advisors.  Mr. Gundlach is a smart man. Maybe it’s splitting hairs if I say the stock market isn’t dysfunctional but reflecting its inherent structural risks.

We know as much as anyone including Mr. Gundlach about market mechanics. And I still learn new stuff daily.  Matter of fact, I had an epiphany over the weekend. I compared market behaviors during the Great 2020 Market Correction.

Wow is that something to see.  We might host a webcast and share it.  If you’re interested, let us know.

Over the past decade, the effort to produce returns with lower risk has spread virally in the US stock market.  Call it alpha if you like, getting more than you’re risking.  Hedge funds say it’s risk-adjusted return.

The aim is to protect, or insure, everything against risk, as we everyday people do. We protect our homes, cars, lives, appliances, even our entertainment expenditures, against risk by paying someone to replace them (save for our lives, where beneficiaries win at our loss).

Stock traders try to offset the cost of insurance by profitably transacting in insured assets. That’s the holy grail.  No flesh wounds, no farts in our general direction (for you Monty Python fans).

It works this way. Suppose your favorite stock trades for $20 and you’re a thousand shares long – you own 1,000 shares. For protection, you buy 20 puts, each for 50 shares. You’re now long and short a thousand shares.

If the stock rises, the value of your puts shrinks but you’re up. If the stock declines, your long position diminishes but your puts are worth more.  Say the stock rises to $23. The value of your puts declines, making you effectively long 1,300 shares, short 700.

To generate alpha (I’m simplifying, leaving out how options may decrease in value near expiration, the insurance-renewal date, so to speak), you need to offset the cost of insurance. With a good model built on intraday volatility, you can trade the underlying stock for 20 days, buying high and selling low, going long or short, to mitigate costs.

Everybody wins. Your counterparty who sold you the puts makes money.  You make money trading your favorite stock. You have no fear of risk. And because more money keeps coming into stocks via 401ks and so on, even the losers get lucky (thank you Tom Petty, rest in peace, for that one).

One big reason this strategy works is the rules.  Regulation National Market System requires all stocks to trade at a single daily average price in effect. Calculating averages in a generally rising market is so easy even the losers can do it.

Now, what would jack this model all to hell?

A virus (frankly the virus is an excuse but time fails me for that thesis today).

Understand this:  About 80% of all market volume was using this technique. Quants did it. Active hedge funds. Fast Traders. Exchange-Traded Funds (ETF) market-makers.

Big volatility doesn’t kill this strategy. It slaughters the parties selling insurance. Observers are missing this crucial point. Most active money didn’t sell this bear turn.  We can see it.  Again, a story for later via webcast if you’re interested.

What died in the great 2020 Coronavirus Correction was the insurance business.

Casualties litter the field. The biggest bond ETFs on the planet swung wildly in price. Big banks like Dutch giant ABN Amro took major hits. Twenty-six ETFs backed by derivatives failed. The list of ETFs ceasing the creation of new units keeps growing and it’s spilling into mainstream instruments. Going long or short ETFs is a fave hedge now.

The Chicago Mercantile Exchange auctioned the assets of a major high-speed trader that sold insurance, Ronin Capital (around since 2006. If its balance sheet and leverage can be believed, it may have imputed a loss of $500 billion to markets.

Just one firm. How many others, vastly bigger, might be at risk?

Forget stock-losses. Think about how funds mitigate volatility. How they generate alpha. We’ve been saying for years that if the market tips over, what’s at risk is whatever has been extended through derivatives. ETFs are derivatives. That’s 60% of volume.

And now key market-makers for stocks, bonds, ETFs, derivatives, commodities, currencies, are tied up helping the Federal Reserve. Including Blackrock. They can’t be all things to all people at once.

The market isn’t dysfunctional.  It’s just designed to function in ways that don’t work if insurance fails. And yes, I guess that that’s dysfunctional. That was my epiphany.

I’ll conclude with an observation. We shouldn’t shut down our economy. Sweden didn’t. This is their curve. Using a population multiplier, their curve is 27% better than ours – without shutting down the economy, schools, restaurants. We are the land of the free, the home of the brave. Not the land of those home, devoid of the brave. I think it’s time to put property rights, inalienable rights, above the government’s presumption of statist power.

Many Tiny Trades

All 20 biggest points-losses for Dow Jones Industrials (DJIA) stocks in history have occurred under Regulation National Market System.

And 18 occurred from 2018-2020. Fifteen of the 20 biggest points-gains are in the last two years too, with all save one, in Mar 2000, under Reg NMS (2007-present).

It’s more remarkable against the backdrop of the Great Depression of the 1930s when the DJIA traded below 100, even below 50, versus around 20,700 now and small moves would be giant percentage jumps. Indeed, fifteen of the twenty biggest percentage gains occurred between 1929-1939. But four are under Reg NMS including yesterday’s 11.4% jump, 4th biggest all-time.

Just six of the biggest points-losses are under Reg NMS (we wrote this about the rule). But ranked second is Mar 16, 2020. And 19 of the 20 most volatile days on record – biggest intraday moves – were in the last two years, and all are under Reg NMS.

Statistically, these concentrated volatility records are anomalous and say what’s extant now in markets promotes volatility.  Our market is stuffed full of many tiny trades.

Volume the past five days has averaged 9.9 million shares per mean S&P 500 component, up 135% from the 200-day average.  But intraday volatility is up nearly 400%, trade-size measured in dollars is down 30%.

That’s why we’re setting volatility records. The definition of volatility is unstable prices.

I’m delighted as I’m sure CVX is that the big energy company led DJIA gainers yesterday, rising 22%.  But stocks shouldn’t post an excellent annual return in a day.

CVX liquidity metrics (volume is not liquidity!) show the same deterioration we see in the S&P 500, with intraday volatility up 400%, trade-size down 47%, daily trades up over 240% to 196,000 daily versus long-run average of about 57,000.

Doing way more of the same thing in tiny pieces means intermediaries get paid at the expense of investors.

Every stock by law must trade between the best national visible (at exchanges) bid to buy and offer to sell.  When volatility rises, big investors lose ability to buy and sell efficiently, because prices are constantly changing.

Regulators and exchanges have tried to deal with extraordinary volatility by halting trading.  We’ve tracked more than 7,500 individual trading halts in stocks since Mar 9 – twelve trading days.  Marketwide circuit breakers have repeatedly tripped.

Volatility has only worsened.

In financial crises, we inject liquidity to stabilize prices.  We can do the same in stocks by suspending the so-called “Trade Through Rule” requiring that stocks trade at a single best price, if the market is more than 5% volatile.

Trade size would jump, permitting big investors to move big money, returning confidence and stability to prices. We’ve proposed it three times to the SEC now.

Investors and public companies need to understand if the market is working. Let’s define “working.” The simplest measure is liquidity, which is not volume but dollars per trade, the amount one can buy or sell before price changes.  By that measure, the market has failed utterly during this tumult.

Let’s insist on a market capable of burstable bandwidth, so to speak, to handle surges.  Suspending Rule 611 of Reg NMS during stress is a logical strategy for the next time.

Let’s finish today by channeling the biblical apostles, who came to Jesus asking what would be the sign of the end of the age?  Here, we want to know what the sign is that market tumult is over.

At the extremities, no model can predict outcomes.  But given the nature of the market today and the behaviors dominating it, the rules governing it, we can inform ourselves.

This market crisis commenced Feb 24, the Monday when new marketwide derivatives traded for March expiration.  In the preceding week, demand for derivatives declined 5% at the same time Market Structure Sentiment topped.

We had no idea how violent the correction would be. But these signals are telling and contextual. They mean derivatives play an enormous role.

We had massive trouble with stocks right through the entire March cycle, which concluded Mar 20 with quad-witching.  Monday, new derivatives for April expiration began trading.

It’s a new clock, a reset to the timer.

You longtime clients know we watch Counterparty Tuesday, the day in the cycle when banks square the ledger around new and expired derivatives. That was yesterday.

That the market surged means supply undershot demand. And last week Risk Mgmt rose by 5% and was the top behavior – trades tied to derivatives, insurance, leverage. Shorting fell to the lowest sustained level in years. Market Structure Sentiment bottomed.

It’s a near-term nadir. The risk is that volatility keeps the market obsessed with changing the prices, which is arbitrage. Exchange Traded Funds depend on arbitrage (and led the surge in CVX).  Fast Traders do too. Bets on derivatives do.

The tumult ends in my view when big arbitragers quit, letting investment behavior briefly prevail.  We’ll see it. We haven’t yet.  The market may rise fast and fall suddenly again.

The End

In crises I think of Winston Churchill who said, “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Let’s start now with lessons from a health crisis that became a market crisis and proceeded to an economic crisis.

This last leg is yet murky but with hotels at 15% occupancy and the great American service industry at a standstill in an economy 70% dependent on consumption, it’s big.

First, the stock market. Intraday volatility in the S&P 500 averaged 10% the past week – a daily market correction between mean high and low prices by component.

Volatility is unstable prices, and big money needs stability to move. If the market exists for public companies and investors, it has served them poorly. Short-term machines have dominated. Investors were unable to get in or out without convulsing the whole construct of a $30 trillion edifice now smashed a third smaller.

Energy companies should be the first ones knocking at the SEC because the sector was 22% volatile the past week amid losing vast value. Sure, oil prices fell. Should it be the worst month ever for oil? The sector was battered more than in the maw of 2008.

Market structure is the hubris of equities. We’ve said it for years. We warned that Exchange Traded Funds, derivatives, had pervaded it, spreading the viral threat of severe inflation and deflation if stocks and ETFs move in unison.

There’s another basic problem. I’ll give you an analogy. The local grocery store down the street in Steamboat was denuded of wares as though some biblical horde of incisor-infested critters had chewed through it. I guess in a sense it was.

If there’s no lettuce, you can’t buy it. The price of lettuce doesn’t carom though. Demand ceases until supply arrives.

And it did. We later found lettuce, carrots, onions, eggs in abundance, but no limes (drat! A vital gin-and-tonic component).

We bought what they had.

In the stock market as with groceries there is no limitless supply of XOM or AAPL or whatever. But rules permit machines to behave as though lettuce and carrots always exist on the shelves when they don’t (a majority of volume was shorting and Fast Trading the past week – phantom products).

It’s why prices bucked and seized like a blender hucked into a bathtub. Investors would reach a hand for the proverbial lettuce and it would vanish and lettuce prices would scream smoking off like bottle rockets on July 4.

We don’t do that with groceries. Why in stocks? Energy companies, are you happy that machines can manufacture a crisis in your prices (that rhymes) and destroy the bulk of your value in days?

Look at Utilities. Producing energy to heat and cool American homes is vulnerable to tornadoes. Not viruses. Why did a preponderance of Utilities lose half their market capitalization in days – and then get 20% back yesterday?

These are questions every public company, every investor, should ask.

(Here’s what happened: Utilities were overweight – we warned of it! – in “low volatility” investments. Those blew up, taking Utilities with them.)

And they jumped on options bets. Volatility as an asset class lapses today around VIX expirations, and resets. Tomorrow index options expire, Friday is the first quad-witch of 2020. Derivatives have demolished swaths of equity capital like a runaway Transformer in one of those boom-boom superhero movies trampling through a trailer park.

It should be evident to the last market-structure skeptic – whoever you are – that market structure overwhelms reason, fundamentals, financials. If you’re in stocks, you need to get your head around it (we have, removing that burden for you).

If you want to be prepared and informed, ask us. We have a product that will fit your budget and put you in with the – socially distanced – cool kids who make market structure part of the investor-relations and investing processes.

Speaking of social distancing, there are 71 million American millennials (meaningful numbers living paycheck-to-paycheck). Viral mortality rate for them globally: 0%. There are two million hoary heads over 90. Covid-19 mortality is 19% (and most over 80 have chronic medical conditions).

I’m a data guy. How about keeping oldsters out of bars and youngsters out of nursing homes? I don’t mean to be insensitive and I know the concern is healthcare facilities. But destroying the finances of millennials over sequestering the vulnerable is troubling.

Last, central banks once were lenders of LAST resort taking good collateral at high cost. I would be pulling out all stops too, were I leading. I’m casting no aspersions. But governments are funded by people, not the other way around, and cannot carry the freight by idling productive output. That’s cognitively dissonant, intellectually incongruous.

This may be the last time we get away with it. Let’s stop that before it ends us. Find a new plan.

And investors and IR people, understand market structure. This is a beginning. It’ll again roar in our faces with slavering fangs.

Canary Prices

We’ve written of risks in stocks from proliferating Exchange Traded Funds (ETFs).

We’ve talked long about liquidity risks, here last October with CNBC’s Brian Sullivan.

So what, right?

The market has functioned well in this Coronavirus Pandemonium, argue regulators and reporters (WSJ subscription required).

What’s the definition of functioning?  Volume?  You longtime users of Market Structure Analytics rely on them so as not to confuse busy – volume – with productive – liquidity (and to know when story drives price, and doesn’t, and much more).

Refinitiv Lipper says some $20 billion left US equities the week ended Mar 6. Sounds big but it’s 1% of volume.

Add up shorting (borrowed stock) at 45.2% of daily S&P 500 trading the past week, and Fast Trading (machines hyper-trading intraday and ending flat), 53.3% of volume, and it’s 98.5% of market volume but not liquidity.

There’s your 99% (the difference is a rounding error).

This is why you should care about market structure, if you haven’t yet.

Volatility Monday triggered a marketwide stock circuit-breaker halting trading when stocks drop 7%. First time since the rule was implemented in 2013.

Volatility halts also stopped futures trading Monday. Both events derailed reads of VIX volatility, which depend on futures contracts and put/call pricing for freely trading S&P 500 components.

Maybe the VIX was over 100 Monday. We don’t know, as components stopped trading.

What’s more, volatility halts for stocks and ETFs cascaded to more than a thousand Monday and Tuesday, including pauses in large caps like OXY, stopped eight times. I think we surpassed the record-setting currency-driven (as is this) frenzy of Aug 24, 2015.

Many directional ETFs in energy, commodities, market vectors, bonds, leveraged instruments, were halted too.  Volatility halts are coal-mine canaries.

And we’re led to believe investors are panicking over the Coronavirus, and getting out, because markets are working. Anybody but ModernIR writing about volatility halts, paucity of liquidity? Do tell.

Market Structure Analytics exist, public companies and investors, to know what headlines don’t say.

It’s egregious disservice to tell everyone “the market is working great!” when volatility halts explode, most volume is transient trading, and nobody can get in or out.

Canaries falling in waves.

Active Investment declined in the S&P 500 from early Feb until Mar 6 and Mar 9, then ticked up 3% on selling – less than the 5.4% daily intraday volatility (spread between highest and lowest average prices) in components of the S&P 500.

Responding, the market suffered one of its greatest collapses.

People don’t care about insurance – a canary in the coal mine – until it’s needed. And then it’s too late.

Investors and public companies, if you’re lulled by quiescence like last autumn, you’ll be shocked by its departure regardless of the Coronavirus. You shouldn’t be.

ETFs are a principal cause for both market volatility and vanishing liquidity. Investors can sit on stocks – meaning they don’t circulate – and trade ETFs.  When the market lurched, ETF market-makers withdrew, as we’d reasoned from data.

Then investors wanted to sell.

Without the ETFs driving some 67% of trading volume normally, nobody was there to calculate prices. Markets spun crazily like a fighter jet hit by a missile.

And regulators tell us the market is working fine. What about these dying canaries everywhere?

Here is liquidity simply. Trade-size is down to 132 shares in the S&P 500. If you’re an investor trying to sell 100,000 shares, you fill 1% of it and the price gyrates away from you as Fast Traders jump ahead.

Now your pre-trade analytics are wrong. You can pull your trade. Or try to blitzkrieg it in a thousand 100-share trades “at the market,” the best bid.


The market implodes a thousand points. Try to buy 10,000 shares and the market skyrockets, rising a thousand points.

Investor-relations people for Energy companies, how do your executives feel about this market?

Technology IR people, what if you’re next?  Tech is the biggest sector. Shorting rose 12% last week in the FAANGs (FB, AAPL, AMZN, GOOG/GOOGL, NFLX) and Active money was selling. FAANGs lead the market up and down. They topped Feb 14, bottomed Mar 3. And now?

(We have the answer. Ask us.)

Investors, is a market that can’t accommodate 1% of the audience into and out of the exits without shuddering the whole stadium and threatening its foundations okay?

Sentiment by our measures is the lowest we’ve ever recorded. Yesterday it was still falling but a day or two from bottom. Uncharted territory, yes. But ModernIR is continuously mapping behaviors, trends, spreads, more.  We have that data, right here.

What if markets zoom? Or don’t?

What’s it worth, public companies and investors, to know what the headlines don’t tell you?  What’s the price of a canary? Ask us. You’ll be surprised.

Beneath the Surface

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

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

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

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

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

Key phrase:  Beneath the surface.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Interesting Year

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

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

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

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

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

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

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

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

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

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

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

It had not.

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

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

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

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

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

Volatility bets like the VIX expire today, Aug 21.

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

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

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

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

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

Why Traders Trade

Albert Einstein reputedly quipped that compounding was the 8th wonder of the world. What would he think of negative interest rates?

The 10-year German government bond yield is -0.61%. The Rule of 72, which nobody mentions now, says dividing 72 by the expected rate of investment return tells you when it’ll double. At 6%, that’s 12 years. At 2%, 36 years. Try compounding negative rates.

Believe it or not, the stock market is weirder still.

Volatility in US stocks averaged 3.4% daily the past week, 55% higher than the risk-free return of 2.2% for 30-year US Treasurys.

Plug those figures into an equity cost of capital calculation where the expected return is 8%.  You with me?  It’s 22%!  So, the interest you earn on cash has vanished while the cost of raising it in public markets has exploded.

You may say, investor-relations professionals, there’s no way my equity costs 22%.  The truth is, volatility introduces value-uncertainty, which both increases what you pay for money, and on the other side, decreases returns on it.

University of Chicago professors Eugene Fama, who won a Nobel Prize in 2013, and Kenneth French, who also serves as head of investment policy for quant investor Dimensional Fund Advisors, co-authored a paper describing how equity-market volatility diminishes the apparent superiority of equities over bonds.

To wit, three-month Treasury Bills are returning 2% annualized. The S&P 500 since Sep 20, 2018 is down 0.4% even after yesterday’s gains. What if you’d sold Monday when the Dow Industrials dropped 391 points and bought yesterday when they rose 372? One day can make or break returns for investors.

Same for public companies. Say you issued stock in Dec 2018 and implemented an aggressive buyback in Jan 2019.  On the wrong side of the market, cost of capital skyrockets.

Rather than rationalizing market behavior, we should be asking why it’s become so volatile. And yes, it’s vastly more so now than during earlier epochs.

The answers? Rules. Stocks must trade between the best bid to buy and offer to sell, which cannot be the same. Thus, machines change prices. They’re 45% of volume.

On top of that, stock exchanges give firms economic incentives to trade stocks and derivatives simultaneously, accelerating the rate of change for prices.

For instance, the Nasdaq pays traders with more than 0.6% of sell volume (they call it adding liquidity but it’s paying traders to set the offer, the highest price for a stock) $0.29 per hundred shares.

Sell 1.75% of Nasdaq volume, with 0.6% in derivatives like options and futures, and if that amount is 0.1% of total Nasdaq derivatives volume, the exchanges pays $0.32 per hundred shares. That’s a 10% kicker for more prices.

Now add Exchange Traded Funds, which have no intrinsic value and depend for prices on the stocks that collateralize them. The two – stocks, and ETFs – are always a bit out of step.

Take Energy stocks last week.  XLE, a big Energy ETF, was down 2.2%. But composite Energy stocks were down 5.5% – a spread of 150%!

Capture half that by buying the ETF and selling the stocks, and it’s a 75% return.  No wonder traders trade.

ETFs drive what we estimate is 60% of total market volume now. ETFs exist via a regulatory exemption from the Investment Company Act of 1940 permitting them to trade as stock substitutes around an “arbitrage mechanism.”

That is, they depend on changing prices. There are thousands of ETFs, worth trillions of dollars. It’s a mania.

I’ll summarize: Market rules and investment behavior built on continually changing prices have transformed the market from a place where long-range horizons are the objective, to one where continuously changing prices are the objective.

Changing prices is the definition of volatility. Traders trade to profit on it. They rule.

What we expect from the stock market should derive from these facts. Public companies and investors alike should adapt. How? Understand the ebbs and flows and surf them like waves (we have that data). Modulate your buybacks, your stock issuances, your tactical investor-outreach, your investment decisions, to reflect behavioral facts.

Investors and public companies could also band together to petition the SEC to stop giving arbitrage a leg up.  The first step toward that goal is understanding how and why the market’s focus is now today’s spread, not tomorrow’s capital appreciation. I’ve explained it.

Mark Twain would say: Is the market run by smart people who are putting us on or imbeciles who really mean it?

Phones and Wristwatches

Numbers matter. But not the ones you think, public companies and investors.

For instance, the best sector the past month is Utilities, up 3.5%, inversing the S&P 500’s 3.5% decline over that time (a 7% spread trade, we could say).

Utilities were worst for revenue surprises among the eleven sectors last quarter, says FactSet, and ninth of eleven for earnings surprises. Financial returns were mid-pack among sectors. It wasn’t results.

Sure, Utilities are defensive, along with Staples, Real Estate, Health Care. Those are up too the last month but less than Utilities.

One number sets Utilities apart: volatility.

Or lack thereof. Measured intraday, it’s 1.5% daily between high and low prices for stocks comprising the sector. Broad-market intraday volatility is 2.7%, 50% higher than Utilities.

Staples and Real Estate trail market volatility too, while Health Care, only of late returning to the safe-harbor fold, is more than twice as volatile as Utilities.

The worst sector in the market the last month is Energy, down 8.4% as measured by State Street’s sector ETF, XLE. And Energy stocks, with daily swings of 3.9%, were 44% more volatile than the broad market – and 100% more volatile than Utilities.

Among the most popular recent investments, the WSJ reports (posted here by Morningstar), are low-volatility ETFs like $SPLV and $USMV. Assets have exploded. These funds are disproportionately exposed to Utilities. And our models show massive ETF patterns in Utilities stocks.

Remember, ETFs are not pooled investments. They’re derivatives. If money flows to these ETFs, it’s not aggregating into a big lake of custodial money overseen by Blackrock or Invesco.

Suppose I traded my cell phone for your wristwatch. You’re free to do what you want with my phone because it’s yours now. But in a sense we’re saying the phone and the wristwatch are of similar value.

Say we’re day-trading phones and wristwatches.  Neither of us has a claim per se to the phone or the wristwatch. But we’ll be inclined to buy the wristwatch when it’s worth less than the phone and sell it when it’s worth more.

Same with ETFs. Low-vol ETF sponsors want assets such as Utilities and big stocks like WMT or PFE that don’t move much intraday (about 1.3% for those two).

ETFs are priced on spreads. Low-volatility instruments demand comparatives with low volatility (creating a run on low-vol assets?). They have no intrinsic value. You can’t find an ETF lying on the sidewalk and trade it to, say, Blackrock for its face value in cash.

It has no face value. Unless there’s another item with similar value to which it compares. ETFs are priced via in-kind exchange. Phone and wristwatch.

The ETF, phones, will be attractive to a trader to buy if it’s discounted to the stuff it’s supposed to track, wristwatches, and less attractive (and a short) if it’s currently priced above that stuff (phones). Prices constantly change as a result. Volatility.

The same thing will by extension invade your stock’s pricing, because your stock is the stuff ETFs track.

This is vital to understand, public companies and investors.

If the majority of money in the market fixates on spreads, the spread becomes more important than your financial results. Spreads become better predictors of future stock values than fundamentals.

EDITORIAL NOTE: Come to the NIRI Annual Conference June 2-5 in Phoenix! I’m hosting a session on ETFs with Rich Evans from the Univ of VA Wed morning Jun 5.

Also, the Think Tank chaired by Ford Executive Director of Investor Relations Lynn Tyson has released its white paper on the future of Investor Relations. Adapting to evolving market structure and investment behavior is key.

This image (linked) looks like robot-generated modern art. It’s our data on spreads between ETFs and stocks from Dec 2018 to present.  Wide spreads matched strong markets. Diminishing spreads correlated to weakening stocks. Maybe it’s false correlation.

But what if as spreads narrow the incentive to swap phones for watches fades? Markets could be imperiled by numbers we’re not watching. Shouldn’t we know?

Are you listening, financial reporters?

Jekyll and Hyde

Your stock may collateralize long and short Exchange-Traded Funds (ETFs) simultaneously.

Isn’t that cognitive dissonance – holding opposing views? Jekyll and Hyde? It’s akin to supposing that here in Denver you can drive I-25 north toward Fort Collins and arrive south in Castle Rock. Try as long as you like and it’ll never work.

I found an instance of this condition by accident. OXY, an energy company, is just through a contested battle with CVX to buy APC, a firm with big energy operations in the Permian Basin of TX (where the odor of oil and gas is the smell of money).

OXY is in 219 ETFs, a big number.  AAPL is in 271 but it’s got 20 times the market-capitalization.  OXY and its short volume have moved inversely – price down, shorting up. The patterns say ETFs are behind it.

So I checked.

Lo and behold, OXY is in a swath of funds like GUSH and DRIP that try to be two or three times better or worse than an index. These are leveraged funds.

How can a fund that wants to return, say, three times more than an S&P energy index use the same stock as one wanting to be three times worse than the index?

“Tim, maybe one fund sees OXY as a bullish stock, the other as bearish.”

Except these funds are passive vehicles, which means they don’t pick stocks. They track a model, and in this case, the same model.  If the stock doesn’t behave like the ETF, why does the fund hold it?

I should note before answering that GUSH and DRIP and similar ETFs are one-day investments. They’re in a way designed to promote ownership of volatility. They want you to buy and sell both every day.

You can see why. This image above shows OXY the last three months with GUSH and DRIP.

Consider what that means for you investor-relations professionals counting on shares to serve as a rational barometer, or you long investors doing your homework to find undervalued stocks.

Speaking of understanding, I’ll interject that if you’re not yet registered for the NIRI Annual Conference, do it now!  It’s a big show and a good one, and we’ve got awesome market structure discussions for you.

Back to the story, these leveraged instruments are no sideshow. In a market with 3,500 public companies and close to 9,000 securities, tallying all stock classes, closed-end funds and ETFs, some routinely are among the top 50 most actively traded.  SQQQ and TVIX, leveraged instruments, were in the top dozen at the Nasdaq yesterday.

For those juiced energy funds, OXY is just collateral. That is, it’s liquid ($600 million of stock trading daily) and currently 50% less volatile than the broad market. A volatility fund wants the opposite of what it’s selling (volatility) because it’s not investing in OXY. It’s leveraging OXY to buy or sell or short other things that feed volatility.

And it can short OXY as a hedge to boot.

All ETFs are derivatives, not just ones using derivatives to achieve their objectives. They are all predicated on an underlying asset yet aren’t the underlying asset.

It’s vital to understand what the money is doing because otherwise conclusions might be falsely premised. Maybe the Board at OXY concludes management is doing a poor job creating shareholder value when in reality it’s being merchandised by volatility traders.

Speaking of volatility, Market Structure Sentiment is about bottomed at the lowest level of 2019. It’s predictive so that still means stocks could swoon, but it also says risk will soon wane (briefly anyway). First though, volatility bets like the VIX and hundreds of billions of dollars of others expire today. Thursday will be reality for the first time since the 15th, before May expirations began.

Even with Sentiment bottoming, we keep the market at arm’s length because of its vast dependence on a delicate arbitrage balance. A Jekyll-Hyde line it rides.