Stocks are up. So are the number of trades and the amount of volume that’s short. But trade-size has plunged.
The stock market is up 87% the past five years while trade-size is down 37% from 154 shares per trade on average in S&P 500 stocks to 97 shares now (200-day averages at Sep 16, 2024 and Sep 18, 2019). Daily trades have risen 90%, from about 27,000 to 51,000.
Short Volume, the percentage of total volume that’s short, borrowed, created, has risen from below 45% in 2019, to about 50%.
What to make of these data points? Look around at who’s making money. Citadel and Jane Street are on pace for record revenues this year, says Bloomberg. They’re among firms buying retail order flow, making markets in ETFs.
That’s arbitrage and intermediation. I’m not knocking the role they play. But they’re not investors. They’re taking fractions of pennies per share and changing all the prices.
Smaller and more numerous trades are a profitable byproduct. The more intermediation, the less efficient a market. Yes, the proponents of algorithmic trading say speed corrects mispricing.
Hogwash.
Speedy machines shift the focus of the stock market from investment to changing prices.
What is profiting on changing prices? Arbitrage. How are ETFs priced? By an arbitrage mechanism. How are options priced? By the spread between the right to buy or sell at a future price and the current price of the underlying asset – which is arbitrage.
Arbitrage that closes incorrect gaps in asset prices isn’t bad. People are free to trade what they want. Modern markets trade everything all the time. Fine.
But let’s be clear-eyed about the results and consequences of a stock market where 90% of the volume is something other than rational thought, and where half of it is artificial and the prices are set by parties who don’t own anything.
You public companies seeing your stock price as a proxy for your business’s value, realize it may be subject to sudden and unexpected resets. Arbitrage is contributing to the explosion of volatility around your earnings. It’s become pandemic.
Arbitrage isn’t the only reason. Big directional bets by hedge funds outside market hours are a cause too (we have a mitigating strategy for both bets and arbitrage).
And a market stuffed with arbitrage can react violently to macro events. Like today’s Federal Reserve meeting and press conference where it’s expected chair Jay Powell will announce a rate-cut of 25-50 basis points.
The Federal Reserve has become the arbitrager of the American economy by intermediating labor, capital and the cost of everything – and introducing artificial money not dissimilar to Short Volume in the stock market.
Just as arbitrage in the stock market obscures reality, so does Fed intervention.
The Fed doesn’t just change the rate member banks pay to borrow excess reserves from each other that’s set to change today from the current level of about 5.4%.
The Fed pays interest on reserves, which Congress authorized in the Emergency Economic Stabilization Act of 2008.
Are we in an economic emergency? Why are taxpayers still paying banks interest on money created by the Federal Reserve? It balloons financial returns for institutions that engage in, yup, ARBITRAGE. Put money on reserve with the Fed, then pay some to depositors, boosting assets and interest income.
Mass arbitrage signals inefficiency and confusion about proper prices in both the stock market and the economy.
Core inflation is still 3.2%, said the Bureau of Labor Statistics a couple weeks back. Has the Fed subtly changed its inflation target to 3% from 2%? Wow.
John Maynard Keynes, inventor of deficit spending, said in 1919: By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.
The “some” are the arbitragers. The root word of arbitrage is “arbitrary.”
Inflation confiscates from you. Arbitragers take part of your profits. Over time, a gap forms. The books stop balancing so you journalize a plug to retained earnings.
Cough, cough.
At some point it’ll get marked to market. It will happen to stocks and the economy both.
It’s already happening in the economy. People are reducing their retirement contributions. Refinancing to extract money from their homes. Did you know beer sales have plunged? AB InBev unit Coors is shutting down its Colorado Native craft brand.
We observed the change Monday night dining out. I looked across a busy South Pearl Street restaurant in Denver and saw that only one other party (I just gave myself away) had an adult beverage. Sumthin’s gotta give.
The Fed shouldn’t be incentivizing more borrowing by cutting rates – which is inflationary. It should be incentivizing saving. It’s a strange time. I’m not sure what to expect. But we’ll find out.
If you want to know how to navigate this market as a public company, let us know. And traders, we sort Supply and Demand so you’re not fooled by arbitragers.
