Earnings. 

This is what the stock market is all about. 

That’s what we’re told all day long by the financial media.

And it would be true if just 51% of the money in the market were driven by earnings. With Morningstar data as barometer, about 35% of assets are actively managed and premised on earnings. Just 10% of volume is Active money.

And Actives are sellers, not buyers (there are exceptions like GQG but they’re few). Actives see nearly a half-trillion dollars of annual outflows.  Last weekend, Jack Pitcher wrote about it in the WSJ. 

As I’ve shared before, the global head of equities for one of the world’s largest asset managers told me in early 2019:

“I’ve got 36 analysts and all day long investor-relations people are trooping their CEOs and CFOs by to meet with them. And we’re not buyers! We’re sellers. I’m trying to get out of that business and into ETFs, because we’re getting our lunch handed to us.”

So then, how do we understand the stock market?

As a currency market. ETFs work like asset-backed currencies. 

How does the supply of money increase or decrease? Banks make loans. They hold in reserve a fraction and create the rest. Or a central bank buys assets with created money. 

It’s more nuanced than that – take interest on excess reserves for instance. It’s paid with created money, which increases the supply.

Let’s not worry about that here.

Paying down debt destroys money. Governments are loath to do it because prices fall and that’s called a “recession.” And governments fear that falling prices will lead to layoffs. Neither is true, as history shows. That’s a song for another time, as Old Dominion says.

Shares of Exchange Traded Funds behave like currencies. There are more than 5,000 ETFs, roughly 3,000 public companies in the US market.

ETFs create and redeem shares at a pace of roughly $1.2 trillion monthly, always with more shares issued than redeemed, to the tune of $100 billion monthly. Like this:

1. There are thousands of ETFs that invest in stocks. But they don’t invest per se. They issue ETF shares in trade for stocks. Stocks are collateral.
2. 90% of ETF assets are in large caps. Just 150 stocks are nearly 75% of all market cap. So ETFs hold the same collateral.
3. ETFs receive money by issuing ETF shares in exchange for stocks.
4. The stocks and the ETF shares are valued the same at the time of exchange.
5. ETFs do this through a handful of brokers.
6. Whatever the purpose of the ETF is, they need “collateral” to issue ETF shares.
7. Money pours into ETFs.
8. ETF want big baskets of stocks in exchange for new ETF shares.
9. That currency inflates stock prices.

You with me?  Okay, now you sell ETF shares.  Who buys them?  Somebody else. If there’s not somebody else, the broker scoops them up and returns them to the ETF issuer, who gives the broker stocks (it can be cash, not stocks, but let’s keep it simple).

Does the broker hold onto those stocks? Of course not. It sells the stocks. Or wait, better: It shorts the stocks and buys puts on the stocks. Then it sells the stocks.

Isn’t that illegal? No. You can’t front-run your customer. But here, the bank does not have a customer. It’s the principal trader. No wonder banks are making crushing returns on trading desks.

And because money is leaving Active mutual funds for ETFs, and money is shifting from Passive mutual funds to ETFs, there’s a false sense of flows. They seem larger than they are. There’s a sense money is rushing into stocks.

Anything that cannot last forever will stop (thank you, Herb Stein).

Imagine people sell ETF shares. And nobody buys them. So a broker returns ETF shares to Blackrock.

Let’s say brokers get stocks (could be cash but we’ll keep it simple). So they short the stocks and buy puts on them and sell them.

Most of the time it’s the other way around. Employed people earn money. Some of it goes to retirement plans. Brokers give stocks to ETF creators and get ETF shares to sell to you and me.

Used to be, money was backed by assets. You could trade gold for dollars, dollars for gold. Gold restrained the creation of dollars. Then we just started issuing dollars.

Stocks in theory restrain the creation of ETFs. But they’re not. ETF creations are booming.  Well, how can it be simultaneously true that the number of ETFs skyrockets while the number of public companies declines?

There’s a mismatch. At some point, as Warren Buffett observed, we’ll find out who’s been swimming naked.

Back to the story. If we investors stop buying ETF shares, brokers will return them to Blackrock et al. The supply of currency will shrink and there will suddenly be a surfeit of stocks and no buyers. 

I’ll leave you to think about that.

Investors, it’s why you must track Demand and Supply. Price is set by this arbitrage process and it won’t tell you in time. 

Public companies, this is how the stock market works. If you’re doing IR like you did 20 years ago, you’re harming your shareholders’ interests. We can solve that for you. 

Whether you’re investing in stocks or trying to driver shareholder value at a public company, it’s important to measure the market the way it works.