Why does the stock market all at once lurch like a drunk and take out a row of planter boxes containing semiconductor stocks?
Public companies, this is the market you depend on for capital, for a read on fair value. You deserve to know why ten percent of your market capitalization – or more – can vanish in a day.
And investors, if the long-run annualized return in stocks is, call it 5% after taxes and inflation, it’s disconcerting to lose half or all of that in a day. Is it normal, or something else?
Of course, what’s normal? I caught a piece of a discussion on CNBC yesterday as we were returning to Denver from Steamboat Springs about interest rates. The guest said something about eight rate cuts ahead. The host said, “Well, wouldn’t that be just normalizing rates?”
Is 0% normal? Why if we’re drowning in debt would we deprive savers of returns and encourage more debt? Strange thinking. Only if money has no real value is the interest rate zero.
Back to the stock market, yesterday it plowed like a drunk into the wall. Why? After all, the Federal Reserve is set to cut rates. The Wall Street Journal told us in a bold headline yesterday, “Americans are Really, Really Bullish on Stocks.” That followed a weekend story in the same publication about rising consumer sentiment.
I’m not sure either story is substantiable but here’s a headline for you: Those aren’t the forces determining the direction of the stock market.
What does? If you’ve read this blog for any length of time, you know. Regulators decreed the stock market a “system,” and turned it into a data network that shares prices and customers across a mass array of stock exchanges and alternative trading systems. Regulators forced a continuous auction – churning activity – of tiny trades.
And that’s what we’ve got. The average trade-size is under 100 shares. Machines set the prices, incentivized with trading credits called rebates to create volume. Arbitrage (profiting on price-changes) abounds because the market is chock-a-block with doppelgangers for stocks in the form of ETFs, leveraged ETFs, weekly options and zero-days-to-expiration options, all of that becoming competition for real investment.
And most of the money investing in equities now is pegging a benchmark, principally the S&P 500, which is 90% of market cap.
So then, how does this market foster volatility? Most of the time, it doesn’t. Heading into yesterday’s rout, volatility in the average S&P 500 stock was 1.8% — below the long-run over 2% (that’s measuring average five-day spread between high and low daily prices).
But falling volatility paradoxically destabilizes stocks because machines begin to struggle to calculate whether to be long or short. It’s a problem that’s been coming for a month. Short Volume – the daily percentage of borrowed or created stock under market rules – has been roughly 50% of S&P 500 volume for 19 straight days.
That’s not a record. Short Volume was over 50% from Feb 17-Apr 10, 2023, and again from Aug 20-Nov 6 last year. What makes this time different is its flatlining nature. It’s just sitting there without changing, for a month.
Well, any hiccup in DEMAND could tip that condition right over into a drunken faceplant for stocks. Last week as summer unofficially wrapped and kids returned to school, investment declined marketwide more than 8%.
And there you go.
Now, maybe those two conditions reflect something else that’s developing. The WSJ announced after the close yesterday: “Stocks Decline in Broad Retreat on Fears of Slowdown.”
Is that true? Where’s the data? I suppose one could say that high sustained levels of Short Volume, mostly driven by machines, reflects how those machines may be sifting the quotes and finding faltering demand.
And maybe that 8% drop in investment that we observed wasn’t just summer doldrums but signs consumers are cutting 401k contributions because they’re running out of money.
But this I can tell you. The stock market depends on machines to create prices. And the machines need volatility. And if the short side of the trade stops moving and the long side declines, the market can give up ALL its daily volatility – boom! Like that.
Because it’s fragile and illiquid.
Despite trading hundreds of billions of dollars of stocks daily, the market moves in continuously dissolving fragments. Often, you can’t fill a hundred-share trade without seeing it split into two, three, four transactions.
That works where there’s excess demand for equities and bouncy prices that keep the machines taking a tenth of a penny from every share – which is how you get rich enough to buy much of Miami and whole skeletons of dinosaurs.
But vast volume obscures the gossamer film of real liquidity.
So, public companies, the market is fragile through its design, not by accident. It shouldn’t be, but we’ve let regulators convert an efficient mechanism for forming capital into a machine that only benefits large caps and can’t handle a single-digit drop in demand without threatening to come apart at the seams.
If you want help driving value in it, holler. We know how it works. And don’t go public, private companies, unless you’re guaranteed at least $5 billion of market cap.
Investors, you need to pay attention to Demand and Supply. It’s the only answer.
