Why are the Nasdaq and the Dow Jones Industrial Average diverging wildly? 

It might resolve in the next few days.  But it’s not small. Back up to June 20 and performance was aligned. At one point Monday, five-day divergence was more than 4%. 

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Photo 27911598 | Divergence © Yeyendesign | Dreamstime.com

The DJIA is just 30 stocks, sure.  But it’s $15 trillion of market cap, give or take, about 30% of the market.  So why would these thirty gyrate away from those comprising the Nasdaq (about $35 trillion of market cap)?

In the investment business, standard deviation is often used to manage risk. That is, when gaps widen, risk rises.  Of course, the knock on standard deviation for risk management is it assumes you can’t beat the market. Because beating the market requires…yup, outsized standard deviation.

By and large, it’s true. There’s no alpha in equities, as I’ve written before. John Rekenthaler writing at Morningstar found that sustained performance standard deviation by stock-pickers is rare and those that manage it never duplicate it.

We tell traders using EDGE that the simpler approach is to consider what’s going on around you (and take your gains within standard deviation rather than chasing it). Not in the psychological sense, but in terms of the cadence and calendar of the market.

I’m getting to the answer. This idea of knowing the calendar still almost wholly eludes public companies (save the ModernIR slice!).  If you don’t like risk, avoid options-expirations, we tell traders. Because it’s where standard deviation widens. 

And no wonder. A chunk of derivatives are hedges. Risk management.

Back up 30 years, and who cared about expirations? They had no correlated bearing on equity outcomes. Now, derivatives are 20% of market cap, sometimes more.  We observed in CVX, mired in deal litigation with XOM over HES, that derivatives surged 50% in the most recent period.

Between Jun 17 and yesterday, we had VIX expirations, the lapse of June-dated stock and index options and futures, a major round of quarterly index-rebalances, phase I of annual Russell rebalances (with Phase II for large stocks this Friday), new options for July expiration trading, and Counterparty Tuesday yesterday when banks square books.

Public companies, you shouldn’t report results during these periods.

And have you noticed how analysts upgrade and downgrade stocks during expirations?  And stocks move more.  Why are they doing that?  Because big banks providing sellside research are also the largest derivatives counterparties. They’re drumming up business.

I’m going to throw in another wrinkle before we pull this thing up into the driveway and to a conclusion.  The stock market just moved to T+1 settlement. The most expensive aspect of trading is settlement. Not for little guys. For the big money.

The idea behind this SEC-driven shift is to tighten up function.  Smaller gaps between clearing and settlement, less risk, better safety and stability. That’s the thinking anyway. 

But Northeastern Univ finance professor Kurt Dew wrote in a TABB Forum opinion that futures markets have been T+0 for 50 years by combining clearing and settlement. 

In futures markets, traders post margin – the cash – before the transactions, effectively removing clearing and settlement risk.  Stock exchanges don’t.  They farm out settlement.

And realize: all those leveraged ETFs like NVDL, the 2x leveraged ETF tracking NVDA, use swaps, a sort of futures contract that trues up on margin.  GraniteShares posts up to 50% of its assets every day for NVDL (which means a 50% slide in NVDA shares would wipe it out).  Some theorize NVDA’s big dive the past few days related to this leverage.

So futures contracts don’t settle per se. They’re deducted from or credited to margin.   Professor Dew writes that ETFs do the same thing.  They don’t settle. We long theorized that this is the case.  If big firms are moving massive positions every few days, why settle? Just post against margin, so to speak by using cash collateral.

Okay, if these practices come to dominate the short-term movement of money, what does it mean for how your shares trade, public companies?  More of your market cap will be ethereal.

What if the movement to T+1 has pushed more money toward margin accounts?  Not borrowing stock but borrowing short-term cash and taking positions via swaps.

Heck, even big index funds could do it for a period, to meet rebalance timetables, then true up positions over the next couple months. That’s entirely permissible under “40 Act” rules.

It would explain the walloping divide at OPTIONS EXPIRATIONS between the big and stable DJIA requiring LESS margin capital, and the rest. 

Ah but Tim. The Nasdaq surged yesterday, the DJIA swooned. 

Well, sure. Counterparty Tuesday. The yin and yang, counterparties truing up the books.

We’ve got a good handle on it at ModernIR by tracking the explosive rise in Risk Mgmt as a percentage of trading volume. And it shows up in the role big counterparties play (we call it green and purple bars in patterns). 

Maybe there’s a simpler explanation. But that to me is already simple. It’s happening at times – like options-expirations – when the mark-to-market effect is pronounced. 

And it may push more money into low volatility stocks with less chance of margin calls.  We’ll see. Stocks can’t rise sustainably without Tech (MSFT, AAPL, CRM, CSCO, INTC, IBM are DJIA components).

One thing is certain: Better to keep your earnings reports out of the expirations cycle.

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