If I said the name “Sherlock Holmes” to you, what’s your snap response?

Probably, “Elementary, my dear Watson.”

I have long favored a line by Sir Arthur Conan Doyle, written for his fictitious detective Sherlock Holmes. Eliminate the impossible and what remains, no matter how improbable, is your answer.

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Illustration 56087804 © Iqoncept | Dreamstime.com

It’s routinely useful in the stock market. What about the stock market could we eliminate as impossible so that what remains is merely improbable?

For every buyer there’s a seller?

Depends how you mean that. Stocks can rise a thousand percent without a single owner of shares as buyer or seller.  Meme stocks. Any stock, for that matter.

How? Exemptions to Reg SHO Rule 203(b)ii governing stock-borrowing. Half the volume in the stock market is short, created, artificial, sourced from no one.  Rules say the first duty of market-makers is maintenance of a continuous auction. Unending bids and offers, even if no buyers or sellers exist.

I’ll let you ponder that. You can read more here.

Meanwhile, here’s something improbable. Demand in the stock market sits near 4.7 on a ten-point algorithmic scale despite the nearly 400-point gain for the Dow Jones last Friday with options-expirations.  S&P 500 stocks are up nearly 4% the past two weeks. The primary driver is Active Investment – money motivated by business fundamentals.

What’s improbable about it? For one, stocks rarely rise when Demand falls.  For stocks to sustainably rise, Demand needs to be higher than 5.0. Why? There’s a spread in every trade. The bid to buy is always lower than the offer to sell. So a perfectly balanced market always declines.

Just as a 0% gain in your stock portfolio will always mean a loss. There are FEES.

And there’s this, what Congressman Davy Crockett called a sockdolager (a story for another time about what Congress can and cannot Constitutionally do with the public treasury). Not one of every ten dollars in the stock market is motivated by business fundamentals.

Huge ramifications for how you report earnings, public companies.

I digress.

That means over 90% of volume is motivated by something other than business fundamentals.  About 50% is driven by prices. Citadel for instance – the market-maker, not the hedge fund – makes billions of dollars annually by changing the prices of things and taking a fraction of a penny per share.  Fees, so to speak. A charge for crossing that spread between bids and offers.

The rest is Passive investment and derivatives. 

We can measure all this stuff. It’s math, rules, software.

And there are different ways to think about volume of course.  We could say over 80% of trading volume is in the S&P 500.  We could say the Tech sector trades ten times more than the Energy sector.  That’s also math.

But here’s the improbable part of the math.  Since Dec 27, Demand for stocks as measured algorithmically has fallen from 7.4 to 4.7. An inversion.

And Supply – short volume, the data set from the 2010 SEC Modified Uptick Rule – has risen from 48% to 51% of S&P 500 volume.

Insufficient Demand, excess Supply. Textbook basis for falling prices. Yet from Dec 27 through yesterday, SPY, the ETF proxy for S&P 500 stocks, is up from $477 to $485. About 1.5%. New record high.

We know it’s not impossible because it happened. But it’s improbable. How did it happen?

The tail is wagging the dog. We can see it in the data.  SPY is a proxy for stocks, as all ETFs are proxies for other things (like bitcoin, as I wrote last week).

When you put together the data for stocks and the data for SPY tracking stocks, you come to this improbable conclusion: SPY is carrying the stock market higher. Since Dec 27, SPY has had unwavering 5.0 Demand, while Supply has declined about 7%, from 46% to 43% of trading volume.

Weirder still, SPY short volume the past year (and well longer than that) averaged 55% of SPY daily volume. There was a SUDDEN 20% drop in SPY shorting Dec 22, when January 2024 options began trading.

Steady Demand, declining Supply, price rises.  It’s true in any market.  But. It leads us to the improbable conclusion that investors are buying SPY, and market-makers are supporting SPY by creating shares of underlying stocks. Shorting them, giving them to State Street, the sponsor, as collateral.

Head spinning? SPY is a substitute for stocks that’s collateralized with stocks. And those stocks are being borrowed – created by market-makers.

It’s not happening randomly. Gains for stocks came with options and futures expiring and resetting from Jan 17 through new options trading Monday the 22nd. The very ones that began trading in December on a huge drop in SPY shorting.

Banks squared the books on those transactions yesterday. And stocks were lower Jan 17 than they were Dec 27.  We’ve forgotten that little nugget.  So all the market’s gains came as options reset.

What’s impossible?  Not much these days! But if something cannot last forever, it will stop (Herb Stein’s Law). I don’t know when. But this is what’s driving the stock market.

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