December 8, 2021

Big Strategy

Let’s have a show of hands. 

How many of you think investors woke up, several pounds heavier, the day after Thanksgiving, and opened a browser up to news out of South Africa, and said, “Shazam! Omicron!” And dumped their equities?

Second question, how many of you say that on Monday, Dec 6, investors said, “Screw it, this omicron thing is crap. Buy!” And stocks soared?

If we had a poll on our polls, I’d bet not 30% would have raised hands on either question.

So, why did the headlines say that?  And a step further, if we don’t believe humans knee-jerked the market around the past week, why suppose humans are doing it other times?

Quast, where are you going with this? What do you want us to say? 

I’d like us to come to terms as investors and public companies with the presence of automated trading strategies capable of acting

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independently.  Not as a side show, a reaction.  As valid as Ben Graham’s Intelligent Investor. Ron Baron picking stocks.

Blackrock runs over a thousand funds, the bulk of which follow mathematical models having little directly to do with earnings multiples.  Blackrock, Vanguard, State Street and Fidelity run $20 trillion of assets, most of it passive.

Yet many believe investment models follow the market, and the market is priced by rational thought. 

Why would one think stocks are priced by rational thought?  Give me data to support that view. They trade more? They own more?

Neither of those is true. My long-only investors twenty years ago were generally buy-and-hold.  Are your top 20 core Active holders in and out all the time?  Course not.

The stock market today is 100% electronic, close to 95% algorithmic, and nearly all prices are products of software. So it’s the opposite then. Buy-and-hold investors are accepting prices set by others.

A week ago Olin Corp. (OLN), the world’s largest chlorine company and owner of the Winchester arms brand, was trading near $65. Last Friday it touched $51, and now it’s back to $58. It dropped 22%, a spread of 28% from best to worst.

Anything to do with the fundamentals of Olin’s business? Active money never changed its mind, valuing OLN about $61 since early November (that’s as measurable as any other behavioral factor behind price and volume, by the way. We call it Rational Price.).

It’s volatility, Tim. Noise. 

If we’re willing to characterize a 20% change in price over a week as noise, we’re saying the stock market is a steaming pile of pooh.  A real market wouldn’t do that.

But what if it’s not pooh?  Suppose it’s a strategy that performs best when demand and supply alike both fall?

Then that strategy deserves the same level of treatment in what drives shareholder value as company fundamentals. 

Do you see where I’m going?  The hubris of business news is its fruitless pursuit of human reason as the explanation for everything happening in the stock market.  And it’s the hubris of investor relations too.

Do you know Exchange Traded Funds have created and redeemed nearly $6 trillion of shares in 2021, in US equities alone (data from the Investment Company Institute)?  Nothing to do with corporate fundamentals. All about supply and demand for equities.

Bank of America said last month flows to equities globally have topped $1.1 trillion, crushing all previous records by more than 200%. Most of that money is going to model-driven funds (and 60% to US equities).

Intermediating equity flows all the time, everywhere, are high-speed trading firms like Citadel Securities, Virtu, Hudson River Trading, Two Sigma, Infinium, Optiv, GTS, Quantlab, Tower Research, Jane Street, DE Shaw, DRW Trading and a handful of others.

They follow real methods, with actual tactics and strategies.  ModernIR models show these trading schemes were 54% of trading volume the past week in S&P 500 stocks. Derivatives, a key market for Fast Traders, traced to 18% of equity volume.  About 19% was Passive models like Blackrock’s ETFs.

That leaves about 9% from Active money, your core long-only investors. 

So, what drove the stock market up and down? On a probability basis alone, it’s the 54%. 

It’s not the same everywhere, but the principle applies. For NVS Nov 18-Dec 6, 38% was Passive, just 31% Fast Trading – those machines.  For TSLA, 57% was Fast Trading, 17% from Passives.

For the record, OLN was 54% Fast Trading, 19% Passive, in step with the S&P 500.

Moral of the story?  No view of the market should ever exclude the 54%. Nor should it be seen as noise. It’s a strategy. The difference is it’s driven by Price as an end, not financial returns as an end. (If you want to know your company’s behavioral mix, ask us.)

And it’s the most successful investment strategy in the market.  That should concern you. But that’s a whole other story about the way stocks trade.

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