August 17, 2016

Low Spreads

What keeps stocks going is low volatility.

By seeking only to earn the spread on each transaction and not bet on the direction of markets, you can make money close to 50 percent of the time.

This one sentence from a profile of high-speed firm Virtu by Bloomberg’s Matt Leising to me summarizes the US stock market and its durability.

Computers focus on the difference in cost to buy or sell a very small thing – a handful of shares. They don’t weigh the viability of the entity reflected in the shares or any measure humans use to determine fair value. Thus, what difference does it make whether so-called fundamentals support the price? We’re asking the wrong question.

In the world apart from stocks, European growth is abysmal. Emerging economies are sputtering. The US economy is growing about 1% and juxtaposed with a long slide in productivity, falling revenues in the S&P 500 and five quarters of earnings contraction.

Since 1954, according to Financial Advisor magazine, twelve earnings recessions have met ten actual ones, and stocks have always fallen, the least, 7%, in 1967, and the most, 57%, in 2008-9.  In this one, the stocks of businesses making what drives consumption and employing the consumers and earning the profits that fund the investments core to economic growth are thus far up.

Why is it different this time? One could say “central banks.” Yes, today’s foremost Enron-like off-balance-sheet entities, central banks, have conspired to force people to overpay for most things in the name of helping us all. But they’re a supporting cast.

The main actors are nearer. This era in stocks, thanks to regulations implemented in 2007, is the first to depend almost entirely in the very short-term for prices from computerized systems tracking spreads in prices.

What motivates machines are small spreads. Virtu, with but one losing day from 2009-2014 often pockets peanuts. In one instance from the story, Virtu traded gold ETFs and futures 26 times and earned $36.

But Virtu trades securities from Africa to London sometimes five million times in a day. Its software sits in more financial markets (Bloomberg says 230 globally) than its employee headcount (148 as of Dec 2015).

I hear good things about Virtu from people I respect.  The point here isn’t to judge Virtu or fast trading but to explain why the market cannot, for now, be measured fundamentally. Last week, silver ETFs were top performers and gold and steel ETFs lagged most. It was excruciating hearing analysts trying to explain it rationally.

How stocks behave fits the low-spread phenomenon. The market is a daily life cycle from highs to lows and recoveries and vice versa. It’s a product of tiny spreads and small changes. Narrow gaps mean limited risk as automated trading systems search for ways to set prices between buyers and sellers.

Of course there must be buyers and sellers. The epic symbiosis of our era is high-speed trading and Asset Allocation. This is investing via apportionment such as indexes, exchange-traded funds and quantitative models. This money doesn’t assess prices but follows the map, bread crumbs dropped in enticing meager increments by machines.

Watching the steady march, stock-pickers then reach a nexus of fear and greed, taking the baton and carrying on even as the most ebullient bulls put pensive scratching fingers to noggins. Yesterday we tallied new Rational Prices indicating buying by Active money in nearly 20% of our client base. Fund managers are paid to invest and do, despite wariness.

Low volatility means not the absence of risk but that machines are in charge. Shares falter only when spreads become unmanageable as on May 6, 2010, August 24, 2015, and other manic gap episodes. Big gaps form on distortion among traded asset classes such as stocks, bonds, currencies, commodities and derivatives.

What causes unexpected distortions? If we knew, I’d be writing to you from Monaco. Here outside Austin as we visit family this week, I can only theorize from a decade modeling market behavior.  Distortions today form when the value assigned to any asset class in the future is wrong.  Derivatives are the weak link.

Options expirations for August start tomorrow. Sentiment is positive and stocks are rising, which means they’ll probably fall afterward. But there’s little risk. The machines are in charge. Volatility is low.

Now if you’ll excuse me, I want to get off the bridge over these placid waters.

Share this article:
Facebook
Twitter
LinkedIn

More posts

dreamstime m 105330423
June 19, 2024

One of our customers at EDGE calculated that 82% of Demand in the S&P 500 is from three stocks (NVDA – now the largest –...

June 12, 2024

High-frequency traders are data-dependent. The Federal Reserve ought not be.  I’ll explain. The U.S. central bank today concludes its open-market (FOMC) meeting. Jay Powell speaks. ...

dreamstime m 4536788
June 5, 2024

Somebody pulled a pin and dropped a grenade in the stock market and nobody noticed. Let me explain: Now, there were explanations. Index options on...

dreamstime m 36265338
May 29, 2024

Size matters.  Does trade-size matter?  The average trade in S&P 500 stocks is 87 shares this week (five-day average). Think about that. Quotes are in...

dreamstime m 87656041
May 22, 2024

It’s tough being a market strategist.  Mike Wilson, chief equity strategist for Morgan Stanley, has thrown his bear towel on the laundry pile and lifted...

dreamstime m 17907458
May 8, 2024

Should a stock like COKE rise 20% in a day?  Executives love it, sure. But it’s aberrant behavior at loggerheads with what the dominant money...