Index futures expire today.
Well, if you’re reading November 30, that is. I’m flying today from Charleston where we’ve spent the month of November to Phoenix for a panel on the rise of thematic investing at the NIRI Senior Round Table conference.
Seems a good time to offer a vital lesson on the mechanics of the stock market. You longtime readers know it already but I hope you’ll forbear repetition.
(Side note: We visited the Heyward-Washington house here in Charleston yesterday where George Washington stayed in 1791. There are letters between Washington and John Rutledge on display. They had such an elegant and florid way of writing and it may influence mine today!)
Photo courtesy Karen Quast, Nov 29, 2022
Following the implementation of Regulation National Market System in 2007, passive assets began to rise, exploding in the aftermath of the Financial Crisis in 2008.
The link? Reg NMS forced exchanges to share prices and customers, obliterating competitive distinction and turning average prices into an algorithmic pursuit. Passive money tracks average prices. Regulation gave them a distinct advantage.
Since then, Passive Investment at firms like Blackrock, Vanguard and State Street have surpassed actively managed investment in the USA.
These assets track indexes like the S&P 500. They’re not trying to outperform the benchmark but to track it as closely as possible. So in 2014, the CBOE (formerly Chicago Board Options Exchange) created a futures contract expiring the last trading day of each month to help Passives track their models.
Rather than buying bits and pieces of big baskets of stocks, Passive money managers buy a basket of futures that conform performance to the measure.
The sellers tend to be banks.
Lloyd Blankfein, erstwhile CEO of Goldman Sachs, said his firm was “in the risk-transfer business.” When you buy insurance, you transfer the risk of loss – to fire, theft, flood, accidents, etc. – to somebody else. It’s the same idea.
So big passives transfer the risk of not matching the index to banks, which take the other side of the trade for the same reason insurance companies do. You’ll have to pay out some claims but the spread between premiums and claims is generally profitable. It’s worked well for Goldman Sachs, and insurance mogul Warren Buffett.
These same futures contracts have moved way beyond truing up index-tracking. Trillions of dollars of notional value tie to them. Investors are transferring the risk of trading losses into futures contracts.
And the reset hits each month-end.
When investors transfer the risk of investment losses and tracking errors to futures contracts, banks package the risk and sell it, and hedge it.
How might that manifest? For one, in short volume. The opposite side of insurance against losses is betting on them.
Son of a gun.
Short volume in 2022 is sharply higher than trailing norms and remains at all-time AVERAGE record highs. It’s been about 48% all of 2022 and remains there now.
And you can expect big moves up or down in the broad indices periodically because buyers and sellers of risk-transfer instruments will be forced to cover them.
It’s very difficult to predict on what days that’ll happen, but we can know the general neighborhood.
The market surged ahead of Nov options-expirations mid-month. The market has essentially been flat since that happened Nov 9.
And the market dropped meaningfully after Thanksgiving with attention shifting to the month-end contract.
Yes, observers credit volatility to other factors like China, slowing Fed tightening, plateauing inflation.
They’re inputs. But here are the facts: 10% of trading volume comes from stock-pickers. Over 50% spools out from Fast Trading machines with a horizon of a day or less chasing prices around. About 20% is Passive Investment, about 20% risk-transfer, which we call Risk Mgmt.
Transferring risk is twice the size of Active Investment as a price-setter. And machines then chase the prices around. And almost half of combined volume is short, borrowed.
These mechanics price stocks in the market way more than a multiple of earnings.
This is how the market really works.
There’s more – exchanges paying Fast Traders to set prices, so they can create data to sell to the brokers in the risk-transfer business, which are required by regulations to buy that data, so they can prove to customers under Reg NMS rules 605 and 606 what they did with those customer orders.
But let’s keep it simple. Smile.
China and inflation and the Federal Reserve are factors affecting economics and global geopolitics and stability, which are market inputs. But they don’t price the stock market. The mechanics and rules do, which behaviors adapt to, and reflect.
And they price your stock. They’re most times the reason you trade with your peers, or don’t. They’re why your stock may plunge 20% on missed earnings, or surge 25% premarket on rumors.
That’s a lot to absorb! But if you want to succeed in the stock market, public companies, you must understand how it works. Too many boards and c-suites don’t. Telling the story is not the whole of modern investor-relations. Helping your c-suite understand ALL of the money behind shareholder-value is.
With that, I’m off to Phoenix.
