What We Do

We’re about to decamp for Switzerland for the month of July.  It’s an example of time and experience changing what we do. 

We’re blessed to have the freedom and means to do it.  But that’s not the point.

The Pandemic and observation – seeing our aging relatives, aging friends, no longer able to do what they’d want, right at the point they’ve got the time and money to do it – have prompted us to seize the day.

Illustration 121184273 © Noree Saisalam | Dreamstime.com

We won’t always be able to ride bikes from Montreux to Zurich.  But we can now.  So we’re doing it now.

Which gets to the question I hear most from investor-relations people.  They’re intellectually interested in “market structure,” the way the market works.

After all, we’re the professionals (a line critical to the great Denzel Washington movie, “Man on Fire”).  We’re supposed to know how the stock market works.

And so often I hear, “What do I do with it?”

If you were to learn through God or some miracle of science (oxymoron purposeful) that you had ten years to live, what would you do?  Keep on doing what you’ve always done?

Here’s what the data show irrefutably about the stock market.  And for backdrop, I think we’ve written more about market form and function than anybody in the USA, right here on this page.  About 800 words per week, nearly every week, since 2006.

I’ve testified to Congress (in writing) about how to improve the market for issuers and investors.  Been on CNBC talking about market structure.  Done it in our profession for two decades.

And I summed up the Essentials last week. Three things every public company should be doing.

If you’re a smallcap, go big or go home. You can’t stay small. If you’re a public company, you should understand the cadence and rhythm of the stock market – its context, let’s call it – and don’t put out earnings, important news, during its violent thunderstorms (options-expirations, rebalances).

And your principal job now is using data to help your executive team and Board of Directors make good decisions about deploying shareholder capital. 

It’s not telling the story to a diminishing audience.

Look, I don’t mean people aren’t showing up at Non-deal Road Shows, sellside conferences. I mean stock-pickers are an endangered species that doesn’t set prices.

I don’t know a profession less data-driven than ours. We do a bunch of things out of tradition, not data demonstrate returns.

Many a time I’ve sat in meetings with IR people who argued that “we’ve got a pretty good sense of what’s going on.”  And they don’t even know what Reg NMS is. 

Would you run a business that way – got a pretty good sense of what’s going on? How the can a professional pursuit like IR, which has a certification program?

You could be the Zoom Video Communications (ZM) investor-relations team talking to investors in 2020 – by web meeting – and think you’re just killing it. And that was before anyone had heard of ZM.

And you could be the ZM IR team now, a ubiquitous brand name and a massively larger business, talking to investors and the 30-odd sellside analysts covering the stock, and it trades below where it did in Mar 2020.

Because telling the story to this crowd doesn’t create shareholder value.

Asset allocation – the earmarking of money to parts and groups and slices of the market according to a model – and speculation, furious trading, and leverage with derivatives, create and dispel shareholder value.

You can measure your Engagement with stock-pickers quantitatively (we do it) but they don’t set prices more than about 10% of the time.

At this moment, it’s a great time for ZM to call on holders. Because the Supply/Demand balance – every public company should know that balance (and you can, just ask) – is favorable.

What you do with it is you ground your company in reality and make the most of an equity market that’s not driven anymore by stock-pickers.

How much money do you spend on targeting, tracking interaction with the buyside and sellside, keeping up with what your peers are doing? About $50,000 annually?

And how do you tie that to shareholder value with data? 

You can’t. It doesn’t.  You CAN use data to help your company make the most of the market.  Just not that data. 

What we come to understand about life should affect how we participate in it.  And it’s all about what we do with the time we’re given.

The same applies to the IR profession, or any endeavor for that matter. Knowledge should change what we do and how we do it.

Investor-relations is the data-driven mission to maximize listing in public equity markets, which starts with understanding the stock market.

And with that, we’re off to Switzerland.

The Essentials

Skip meals, give up beer, burn calories. 

That combination lowers my weight.  The essentials.  In fact, depending on the amount of meal-skipping and skipping-rope (well, riding bikes), I drop pounds in days.

Illustration 186661760 © Balint Radu | Dreamstime.com

What’s the equivalent for creating shareholder-value, public companies?  We ought to know if we’re in the investor-relations profession (as I’ve been for 27 years).  And investors, you’d do well to know, too.

I could give you a list as long as an election ballot of people on TV telling investors to “buy the stocks of great companies.” 

Nvidia is a great company. Zscaler is a great company.  Heck, Netflix is a great company that made $3.53/share last quarter and trades at 15 times earnings.  It’s down 71% this year.

Occidental Petroleum is the best performer in the S&P 500 this year, up 92%.  Over the four years ended Dec 31, 2021, OXY lost $10 billion.  It paid so much for Anadarko that Carl Icahn fought a vicious battle to stop the deal.

You can’t just say “buy good companies.”  You can’t just be a good company and expect shareholder-value to follow.

That would be true if 90% of the money were motivated to own only great companies.  Energy stocks are up 38% this year – even after losing 18% last week.  You don’t have to be great. You just have to be in Energy.

That’s asset-allocation behavior, trading behavior.

Do you know that OXY and ETSY have exactly the same amount of volume driven by Active Investment?  About 9%. Etsy is profitable, too.  But its short volume – percentage of trading from borrowed or manufactured stock – has been over 50% all year and at times over 70%.

And 52% of Etsy’s trading volume comes from machines that don’t own anything at day’s end. Well, there you go. Heavily short, heavily traded. Recipe for declines.

Occidental?  About 44% of its trading volume ties to ETFs and derivatives.  Just 47% is machines wanting to own nothing. Short Volume in OXY had been below 50% until last week, when it jumped to 60% right before price dropped from $70 to $55.

Small variances in market structure are reasons why one is down 65%, the other up 92%. 

In sum, value in the stock market is about Supply and Demand, as it is in every market.  And Supply and Demand are driven by MONEY. And 90% of the money is trading things, leveraging into things via derivatives, allocating according to models.

And it pays to be big.  Occidental is among the 20 largest Energy sector stocks by market capitalization, Etsy is on the small side of a sector dominated by Amazon, Tesla, Home Depot, Alibaba, McDonald’s, Nike.

Callon Petroleum is a darned good company too, but where OXY is over $50 billion of market cap, CPE is under $3 billion, in the Russell 2000 instead of the Russell 1000 where all the money is. It’s down 7% this year.

How about Campbell Soup, Kellogg, General Mills?  Similar companies in Consumer Staples. Which is biggest?  GIS.  Which stock is up most the last year? GIS.

So Occidental did it right.  It got bigger. 

If Kellogg splits into three companies, there will be three choices rather than one for asset-allocation models.  In case you missed that news.  Maybe that’s good for business. It’s bad for size, and size matters (I think increasing operating costs and decreasing synergies is stupid but the bankers don’t).

Mondelez?  Big company. But it was bigger before shedding Kraft. It trades about where it did three years ago.

Lesson? Be the biggest thing in your industry that you can be.  If you’re Energy, become one of the 20-25 largest.

If quitting beer didn’t cut my weight, why would I do it? I love CO beer.  I want to do things that count, not things that go through the motions, form over substance.

Here are your essentials, public companies.  If you want to be in front of as much money as possible, become the biggest in your business.  You can tell your story till you’re blue in the face and it won’t matter if you’re $2 billion and the big dogs are $50 billion.

Another essential to shareholder value, public companies, stop reporting earnings during options expirations, because three times more economic value ties to derivatives paired with your stock than tie to your story.

Are we playing at being public, or taking it seriously? Stop drinking beer and expecting to lose weight.  So to speak.

And Essential #3.  Know your market structure. Investors, understand where the money is going (if you don’t know, use EDGE. It’ll show you. And it works.).  Market Structure, not story, interprets enthusiasm and determines your value.

Do those things, and you’ll be a serious public company, just like it takes three things for me to seriously lose weight. And it’s not that hard. 

Elasticity

CNBC is running a second-by-second countdown to the Federal Reserve decision on rates today.

Seems like a market too dependent on the few. Risk disperses through decentralization.  We’re counting on a central bank to disperse risk.  Hm.  Whatever the Fed does today, from 50 basis points to a hundred, we know risk is concentrated.

In what?

Illustration 164670867 © Adonis1969 | Dreamstime.com

I’ll come to that. First, every public company should have reliable, accurate market intelligence on what’s driving – or harming – shareholder-value.  With just 5% of trading volume manifesting as ownership-changes, you need quantitative market analytics.

We have them.  You may need them in coming months as much or more than at anytime you’ve occupied the chair, investor-relations professionals. Send me an email and ask about our special deal through Dec 31.

So, where is risk?  It’s been transferred from every part of the economy, from all assets, into our currency, thanks to the central bank’s effort to be on both sides of the Supply/Demand teeter-totter simultaneously.

And since our currency denominates risk assets and all economic interaction including trading time for money, and trading money for good and services, we didn’t transfer it anyplace.  It’s a grenade, pin pulled and hucked, that bounces right back.

The Panic of 1873 collapsed proliferating railroads and the banks and investors backing them. Investors started selling the railroad bonds they owned and pretty soon there were too many bonds around and nobody wanted them.

But it didn’t spread to other parts of the economy. It didn’t threaten the currency, which by 1880 had gained BACK all the lost purchasing power resulting from the Civil War and paper banknotes.

Imagine getting some purchasing power back. Wow.

Anyway, in 2022, people are selling off bonds. But they’re not railroad bonds. They’re government bonds. And the Federal Reserve, which hasn’t started selling its giant trove yet, will follow suit.

The yield, which moves inversely to price, on the five-year US Treasury, for instance, is up from about 70bp last summer to 3.6%. It reflects plunging demand for bonds.

The banks that sold railroad bonds in 1873, and the railroad companies that used the proceeds to lay rails, and the investors who owned the paper backing transportation capital-spending went broke.

Of course nobody bailed them out. The destruction of speculation and overbuilding is a necessary part of any healthy economy.  Otherwise you end up with assets that don’t produce returns.

That’s what happened during the Pandemic.  Assets that were not producing returns were kept afloat by the Fed, which issued bonds to create currency to keep stuff alive through payroll protection plans.

Then the Fed took the unprecedented step of just sending everybody checks (the Treasury did it but that money came from nothing – poof, just like the metaverse), shifting from keeping the supply side going, to juicing the demand side of the teeter-totter.

So you have unproductive assets getting money, and unproductive people getting paid.  And consuming stuff, and trading stocks, and buying bitcoin, blah blah.

At some point, that process stops.

I’m not knocking emergency efforts. But the government gave no thought to having to undo what was done. Elastic money was the Great Elixir that would “promote growth.” The truth might be closer to setting one’s house afire to stay warm.

Leading into 1873, the banks and the builders and the bond-buyers were seeing big future demand for rails.  Instead, there was an economic slowdown, and people had to sell bonds to raise money.

It’s not 1873, because that was only railroads.  I don’t know what will happen here.  But the whole world depends on the dollar.  It’s the only reserve currency. We transferred the entire perceived – which proved wrong – effects of the Pandemic to it.

Bailing stuff out is bad because it compounds until it comes around and what was just a little jab that didn’t land in a boxing match is now a Mike Tyson upper cut.

And who bails out the dollar?

In 1913, the Federal Reserve was created to give money the elasticity to absorb panics. It absorbed WWI. That collapse in output coupled with the explosion of money sent us galloping into the Roaring Twenties.

And the equal and offsetting reaction was the 1930s.

Human nature tends to do things until they blow up. We may have exhausted the elasticity of modern monetary policy. And the snapback could be intense.

Be prepared. We’ve got data for navigating turbulence.

Constant Change

The SEC wants to save the little guy. Again. 

A number of you alert readers sent me this story (WSJ registration required but there are similar versions) about the Gensler SEC weighing changes to how trades from retail brokerages are handled.

For those new to market structure, the SEC has a long history of adding complexity to the stock market in the name of helping retail money that ends up instead aiding computerized traders and stock exchanges.

Would that we had less noise and more substance! But we need to first understand the problem. It’s that the stock market is full of tiny trades, and not that retail traders are getting hurt.

Meanwhile, this photo is not of market structure.  Normally in early June – for the bulk of my adult life – I’d be at the NIRI Annual Conference circulating with colleagues.

Photo by Tim and Karen Quast, Jackson Hole, June 2022.

I’d have to count to know for sure, but for most of the past 27 years I’ve been there.  We took a break and this year we’re in Jackson Hole, WY, and other spots in a big loop through WY and MT seeing the west (I’m writing Tuesday night in Billings).

We were in Yellowstone much of Monday covering more than ten miles afoot, riveted by the constancy of change in nature.  Some of it is predictable, like Old Faithful and the Grand Geyser (footage here).

A lot of it isn’t.  And you can’t manage it or direct it.

The point?

Stuff constantly changes.  It’s the most inerrant feature of nature. Change is integral to human nature, which animates the stock market.

Regulators are possessed of that same nature yet want to cast the market like pewter.  Create a model and force every free-moving thing to conform.

It’s most certainly not that SEC chair Gary Gensler is smarter than millions of self-interested participants.  No, regulators want to make a mark, the same as anybody else. 

Pharaohs in Egypt hoped for immortality through pyramids.  Carnegie built libraries.  You can go to Newport and see the edifices of the rich, built to last long beyond the builders.

As ever, I have a point about the stock market. The preceding SEC administration under Jay Clayton revamped the rules, too.

I discussed their final proposed rule, Regulation National Market System II – which I called Reg Nemesis II (see what I wrote about Reg Nemesis I here) – with SEC head of Trading and Markets Brett Redfearn, who described it to the NIRI board at our request.

That rule considered many of the same things Gensler is weighing including redefining the meaning of “round lot,” currently 100 shares regardless of price, to reduce market-fragmentation that harms investors of all kinds.

After all that work, the expended taxpayer resources, the studies and lawsuits and machination, it’s set aside because the new SEC wants to build its own pyramids.   

Okay, Quast, you’ve convinced me everybody wants an ovation. Your point?

The problem is the stock market is stuffed full of tiny trades that devolve purpose from investment to chasing pennies and generating data to sell.

Which in turn is the consequence of rules. I’ve explained before that the SEC’s paramount objective is 100 shares of everything to buy and sell, all the time.

Which is impossible.

I know. I trade.  Trades fragment more at exchanges than in broker-operated markets called dark pools.  Routinely I buy in a chunk in a dark pool and then watch my trades get splintered into 5, 7, 34, 61, shares at exchanges (especially the NYSE).

The exchanges pay traders to set the bid and offer, which snap at my order like piranhas, chopping it into pieces and pricing the market with it.

In Yellowstone, nature takes its course. It’s a marvel, cinematic artistry that takes one’s breath away.  It cannot be and does not need to be directed by humans. We observe it and love it, and it changes.  Some stuff like the Grand Geyser and Old Faithful, follow a clock.  A lot of things don’t.

The same is true of human commerce. The more the few machinate interaction into exceptions and directives and objectives, the less it works.  It should in large part follow its own course, with a clear boardwalk for traipsing through the geysers.

Put another way, rather than merchandising retail trades to build pyramids, we should insist on a single set of standards, no exceptions.  And let the game be played.

There are too many complex rules, too many exceptions.  That’s the real problem.  And so the market lacks the elegance of chance, the beauty of organic and constant change.

Understanding

How do I attract more investors? 

It’s the key question from investor-relations people, the liaison to Wall Street for public companies. The answer, though, isn’t what you think.

And I have to share.  Come in closer, I need to keep my voice down.

I am cracking up over these ex-sellsiders at the IR profession’s online community, who are now investor-relations people, asking how to attract more sellside coverage.

Well, didn’t you used to do that job?  Why are you asking other IR people how to get what you gave?

Anyway, back to my normal voice, for you investors and traders wondering what the hell I’m talking about, let me explain.  There’s the buyside.  That’s investors who buy stocks. Retail investors, you’re generally excluded because you’re a wild and fragmented audience.

(Also, we IR people have a professional association and an online community where we discuss stuff. That’s what I’m talking about, for you folks in other professions.)

The IR job revolves around the buyside and the sellside.  Investors. And stock-research analysts at firms ranging from Goldman Sachs to JMP Securities who cover stocks – write research and make buy/sell recommendations.

The sellside created the stock market. The Nasdaq was the National Association of Securities Dealers – brokers – who devised an automated quotation system.  NASD-AQ.  Nasdaq.

And 24 brokers agreed in 1792 to give each other preference on buy and sell orders. That agreement laid the foundation for the NYSE.

Today, the buyside does its own research.  Hedge funds like Millennium and Point72 buy every conceivable form of data from social-network sentiment to satellite images of parking lots at factories and shipments at ports, and God only knows what else.

They know more about you, public companies, than you do.

And way more than sellside analysts.  The sellside is so yesterday (but Top Gun: Maverick, a reprise from 36 years ago when I was in college, is very much today, very awesome. We saw it, loved it.).

Sure, stocks move on upgrades and downgrades, but that’s mostly machines doing latency arbitrage – trading at different prices in different places but way faster than you can blink.

For the sellside, the result has been a great rout, a diaspora, a scattering.  Demand for their views has collapsed, even though you see analysts all day on CNBC.

So they want IR jobs.  As I’ve said before, when I started in the profession in the 1990s, we wanted to be Mary Meeker and Henry Blodget, making the big bucks. Internet analysts.

Now the Meekers and Blodgets want to be us.  Well, Henry Blodget launched Business Insider, reinventing himself.  Mary Meeker is a venture capitalist.  The point is, the sellside is a dead end.

Tim, you haven’t answered the question. 

I know it.  I’m keeping you waiting.

I was providing an overview of ModernIR Market Structure Analytics to a new investor-relations guy.

He said, “How do these analytics help me attract more investors?”

I said, “You can’t. Not the way you think.”

I said, “The trouble is, unless or until someone – say, you – shows the Board and the executive team what the money is doing today, they will expect you to attract more investors. But Active money is on the same growth trajectory as payphones.”

Now, you CAN attract investors. But you do that with your CHARACTERISTICS, not your story. You do it principally with capital-allocation.

Tim, I don’t get it.  I just go talk to investors, and they buy our stock, and our price goes up.

Would that it were!

See the image here?  In 1995, more than 80% of market volume traced to stock-picking. And over 90% of institutional assets were actively managed. Easy to tell the story.

Copyright Modern Networks IR, LLC, 2022. Image from ModernIR product demo. Data courtesy ModernIR market-structure models.

Now, Active assets are nearing 40%, and falling. One category dominates: Passive Large Cap Blend, approaching 40% of assets. Trading volume is 90% something besides story.

Public companies can’t tell the corporate story to a shrinking audience and get a higher stock price. They CAN determine how to get in front of the money – which is Passive Large Cap Blend. 

If your market cap is under $5 billion, the probability you can become a large cap stock is about 1%. Every investor-relations officer should tell that to every c-suite, every boardroom.

It’s not to discourage you, but to get you focused on what matters. Your story, public companies, doesn’t determine your value.  Your characteristics do.

If 40% of the money is Passive Large Cap Blend, you have at least a 40% chance of being in front of it by achieving those CHARACTERISTICS.  That’s way better than 1%. Go big, or go home.

You want market cap? Go where the money is, by becoming what it wants. We always know where it’s going. If you want to more fully understand what I’m saying here, hit reply (or ask for a Demo through the ModernIR website at upper right).

Snapped

SNAP broke yesterday. I’ll explain two reasons why.

Yes, the company blew the quarter. Dramatic swings in guidance don’t instill joy.

But the losses occurred before anybody talked about them.  SNAP closed Monday at $22.47 and opened Tuesday for trading at $14.49 and closed at $12.79.

It lost 36% when most couldn’t trade it and shed just $1.30 during official market hours.

Illustration 135866583 © Jm10 | Dreamstime.com

How is that fair?

Regulations are meant to promote a free, fair and open stock market. I think premarket trading should be prohibited because it’s not a level playing field.

Who’s using it? Big institutions with direct access to brokers who operate the markets running around the clock. Hedge funds could dump shares through a prime broker, which instantly sells via so-called dark pools.

And the hedge funds could buy puts – and leverage them – on a whole basket including the stock they dumped, peers, ETFs, indices.  All outside market hours.

Something unfair also happens DURING market hours. I’ll explain with my own experience as a retail trader using our decision-support platform, Market Structure EDGE.

It’s not that my trade was unfair.  I understand market structure, including how to use volatility, trade-size, liquidity and stock orders to best effect.  I made money on the trade.

But it’s instructive for public companies, traders, investors.

I sold 50 shares of NXST. Small trade, with a reasonable return. I pay a modest commission at Interactive Brokers to observe how trades execute.

Most times I buy and sell 100 or fewer shares, often 95 or 99. The average trade-size in the market is less than 100 shares so I don’t want to be an outlier. And you’re looking for blocks? Forget it. The market is algorithmic.

And I know the rules require a market order, one accepting the best offer to sell, to execute immediately at the best price if it’s 100 or fewer shares.

Stay with me – there’s a vital point.

NXST trades about $7,300 at a time (a little under 50 shares), the reason for my trade-size. And it’s 2.1% volatile daily. Since it was up 2% during the day, I knew it was at the top of the daily statistical probability, good time to sell.

I checked the bid/ask spread – the gap between the best bid to buy and offer to sell.  Bid was $176.01, offer was $176.25. A spread of $0.25. That’s big for a liquid stock.

So I used a marketable limit order – I picked a spot between them, aiming to the lower side to improve the chance it filled: $176.05. I was wanting to leave.

The trade sat there for a bit, and then filled.  I checked. It split into two pieces, 45 shares at “Island,” which is Instinet, the oldest Electronic Communications Network, now owned by Nomura. I paid a commission of $0.19.

And the other piece, five shares, also executed at Instinet at the same price.  And I paid $1.02 in commission. For five shares!

What the hell happened? 

This is how the ecosystem works.  And this rapid action can smash swaths of shareholder value, foster wild and violent market swings – especially during options-expirations (yesterday was Counterparty Tuesday, when banks square monthly derivatives books, and it was a tug-of-war) – and, sometimes, work masterfully.

It’s market structure.

My broker sent the trade to Instinet, determining by pinging that undisplayed shares there would fill it.

And one or more Fast Traders hit and cancelled to take a piece of it, permitting my broker to charge me two commissions, one on five shares, another on 45 shares.

And now my one trade became ammo for two. The going rate at stock exchanges for a trade that sets the best offer is around $0.25 per hundred shares – the exact spread in NXST.

Yes, that’s right. Exchanges PAY traders to set prices. I traded 50 shares, but since the order split, it could become the best national offer two places simultaneously, generating that high frequency trader about $0.15.

What’s more, my order originated as a retail trade, qualifying for Retail Liquidity Programs at stock exchanges that pay an additional $0.03.

So my intermediary, Interactive Brokers, made $1.21. Some high-frequency trader probably made another $0.18 for breaking the trade up and buying and selling it at the same price two places. Zero risk for an $0.18 return.

Do that 100,000 times, it’s big, risk-free money.

It didn’t cost me much. But suppose it was 500,000 shares or five million?  Every trade navigates this maze, public companies and investors, getting picked and pecked.

Not only do costs mount for moving any order of size but the market BECOMES this maze. Its purpose disappears into the machination of pennies. Oftentimes it’s tenths of pennies in liquid stocks.

And you’re telling your story, spending on ESG reports, a total approaching $10 billion for public companies complying with rules to inform investors.

And the market is the mass pursuit of pennies.  Yes, there are investors. But everybody endures this withering barrage that inflates on the way up, deflates on the way down.

And it’s wrong that the mechanics of the market devolve its form into the intermediated death of a thousand cuts. Is anyone going to do anything about it?

Create and Destroy

The Terra Lunacy (cough cough) is about creating and destroying. 

If you’re thinking, “Lord, I want to read about cryptocurrencies like I want to use a power tool on a molar,” hang on.  It’s about stocks.

Illustration 247279717 / Cryptocurrency © Vladimir Kazakov | Dreamstime.com

But first, here is Market Structure 101, public companies and investors.  If the market is going to turn, or if money is going to shift from Value to Growth, it almost ALWAYS happens at options-expirations.

This is why you shouldn’t report earnings during expirations.

It’s not hard. Sit down with your General Counsel and say, “There are about $900 trillion of derivatives notional value tied to the monthly expirations calendar. Our market cap is a lot less than that.  So is the entire stock market, all the stock markets on the globe. All the GDP on the planet. So how about we don’t report results till AFTER those expire?”

Here’s the 2022 calendar.

In the 1990s, Active money was over 80% of market volume, and you could report whenever the hell you wanted.  In 2022, Active money is less than 10% of volume. 

Read the room.  Don’t hand your hard-earned earnings to the buffalo herd of speculators in derivatives to trample.  Remember that song by Roger Miller, you can’t roller skate in a buffalo herd?  Wise words.

And that’s why the market surged yesterday and may do it again.  It’s short-term trading into expirations, moving stocks to profit on sharper moves in options. It will take more than that to be durable.

Now back to Terra Luna.  A so-called stable coin pegged algorithmically to the US dollar, TerraUSD or UST for short, imploded last week.

It was supposed to be tethered to the dollar.  Monday it was trading at nine cents.  The token used to keep it aligned with the dollar, called Luna, was trading for a thousandth of a penny after at one point being worth over $100.

What’s this got to do with stocks? Exchange Traded Funds have the same mechanism.  It’s the create/destroy model. 

The point of stable coins is that by pegging them to something else, they’re supposed to be…stable.  Otherwise, supply and demand determine the value.

TerraUSD is supposed to be worth $1.  Always.  To sustain that value, Terra and Luna act like two sides of a teeter-totter.  One Terra can be burned, or destroyed, in exchange for one Luna, and vice versa.

So if Terra drops to $0.99, smart arbitragers will destroy Terra and receive Luna, bringing Terra back up to $1. Luna could become worth a lot more than $1 if the ratio skewed big toward Terra.

ETFs work the same way.  ETFs are pegged to a basket of stocks.  So stocks are Terra, ETF shares are Luna. 

As an example, XLC is the Communications Services ETF from State Street. It holds 26 of the roughly 140 stocks in the sector. Issued against that basket of stocks are ETF shares that when created had the same value as the aggregate basket of stocks.

If the stocks rise in value but the ETF lags behind, traders will scoop up ETF shares and return them to State Street, which gives them an equal value from the basket of stocks, which are valued in the open market at higher prices.

So traders can then sell and short the stocks.  That’s an arbitrage profit.

And if spooked investors sell the ETF, the process reverses. Market-makers gather up ETF shares and State Street redeems them – destroys them – in trade for stocks.

The idea is to continuously align the two (of course, that means a great deal of the trading between the ETFs and your stocks is arbitrage). 

The trouble is, even though the value of the stock market has come down markedly, the supply of ETF shares has actually risen. In fact, in March nearly $1 trillion of ETF shares were created or redeemed and creations sharply exceeded redemptions.

The Investment Company Institute publishes that data and we’ve tracked it since 2017.

When both ETF shares and stocks are losing value and prices are moving wildly, it’s much harder for arbitragers to calculate a low-risk trade.  That’s why markets swoon so dramatically now.

If market-makers stop buying or selling one or the other, we’ll have an equity Terra Luna.

It’s a small risk. But because ETFs are so pervasive ($6.5 trillion in the US market alone), at some point we’ll have a colossal failure.

It’s not fearmongering. It’s math.  We can see in the data that money has an easy time getting into the stock market, thanks to vast ETF elasticity, but a hard time getting out.

It will take a dramatic and sustained move down to cause it.

I suspect we came close in the last two months.  Maybe May options-expirations will save us, but the math says more trouble lies ahead.  The prudent foresee evil and hide themselves from lunacy.

Experience

“The market structure is a disaster.”

That’s what Lee Cooperman said in a CNBC conversation yesterday with “Overtime” host Scott Wapner.

What he thinks is wrong is the amount of trading occurring off the exchanges in so-called dark pools and the amount of shorting and short-term trading by machines.

I’m paraphrasing.

Mr. Cooperman, who was on my market-structure plenary panel at the 2019 NIRI Annual Conference, decries the end of the “uptick rule” in 2007. It required those shorting stocks to do so only on an uptick.

To be fair to regulators, there’s a rule. Stocks triggering trading halts (down 10% in five minutes) can for a set time be shorted only at prices above the national best bid to buy. It’s called Reg SHO Rule 201.

But market-makers are exempt and can continue creating stock to fill orders. It’s like, say, printing money.

Mr. Cooperman has educated himself on how the market works. It’s remarkable to me how few big investors and public companies (outside our client base!) know even basic market structure – its rules and behaviors.

Case in point.  A new corporate client insisted its surveillance team – from an unnamed stock exchange – was correct that a big holder had sold six million shares in a few days.

Our team patiently explained that it wasn’t mathematically possible (the exchange should have known too).  It would have been twice the percentage of daily trading than market structure permits.  That’s measurable.

Nor did the patterns of behavior – you can hide what you own but not what you trade, because all trades not cancelled (95% are cancelled) are reported to the tape – support it.

But they’re a client, and learning market structure, and using the data!

The point though is that the physics of the stock market are so warped by rules that it can’t function as a barometer for what you might think is happening.  That includes telling us the rational value of stuff.

You’d expect it would be plain crazy that the stock market can’t be trusted to tell you what investors think of your shares and the underlying business.  Right?

Well, consider the economy.  It’s the same way.

Illustration 91904938 © Tupungato | Dreamstime.com

The Federal Reserve has determined that it has a “mandate” to stabilize prices.  How then can businesses and consumers make correct decisions about supply or demand?

This is how we get radical bubbles in houses, cryptocurrencies, bonds, equities, that deflate violently.

Human nature feeds on experience. That is, we learn the difference between good and bad judgement by exercising both.  When we make mistakes, there are consequences that teach us the risk in continuing that behavior.

That’s what failure in the economy is supposed to do, too.

Instead, the Federal Reserve tries to equalize supply and demand and bail out failure.  

Did you know there’s no “dual mandate?”  Congress, which has no Constitutional authority to do so, directed the Fed toward three goals, not mandates: maximum employment, moderate long-term interest rates and stable prices.

By my count, that’s three. The Fed wholly ignores moderate rates. We haven’t had a Fed Funds rate over 6% since 2001.  Prices are not stable at all. They continually rise. Employment? We can’t fill jobs.

From 1800-1900 when the great wealth of our society formed (since then we’ve fostered vast debt), prices fell about 50%.  The opposite of what’s occurring now. 

Imagine if your money bought 50% more, so you didn’t have to keep earning more.  You could retire without fear, knowing you wouldn’t “run out of money.”

Back to market structure.

The catastrophe in Technology stocks that has the Nasdaq at 11,700 (that means it’s returned just 6% per annum since 2000, before taxes and inflation, and that matters if you want to retire this year) is due not to collapsing fundamentals but collapsing prices.

How do prices collapse?  There’s only one way.  Excess demand becomes excess supply.  Excess is always artificial, as in the economy.

People think they’re paying proper prices because arbitragers stabilize supply and demand, like the Fed tries to do. That’s how Exchange Traded Funds are priced – solely by arbitrage, not assets. And ETFs permit vastly more money to chase the same goods.

It’s what happened to housing before 2008.  Derivatives inflated the boom from excess money for loans.

ETFs permit trillions – ICI data show over $7 trillion in domestic ETFs alone that are creating and redeeming $700 BILLION of shares every month so far in 2022 – to chase stocks without changing their prices.

And the Federal Reserve does the same thing to our economy.  So at some point, prices will collapse, after all the inflation.

That’s not gloom and doom. It’s an observable, mathematical fact.  We just don’t know when.

It would behoove us all to understand that the Federal Reserve is as big a disaster as market structure.

We can navigate both. In the market, no investor, trader or public company should try doing it without GPS – Market Structure Analytics (or EDGE).

The economy?  We COULD take control of it back, too.

Hysteresis

You never know where you’ll hear a new vocabulary word. 

It’s not the word that matters but what it connotes.  And the context in which one hears it.  In this case, it was hedge-fund billionaire Paul Tudor Jones on CNBC Squawk Box yesterday, talking about stocks and bonds.

He said you don’t want to own them. He said, paraphrasing, there’s hysteresis at work in markets. 

Now, I think I’ve got a decent vocabulary. I read Allan Bloom’s “The Closing of the American Mind” in college and recorded roughly 32% of its entire contents as words I didn’t know.  Like palimpsest.

And I didn’t know hysteresis. It’s the delayed effect of causes. The relationship between an outcome and the history preceding it.

Illustration 27944908 © Mopic | Dreamstime.com

I guess it’s good news he didn’t say “there are no words to describe how bad things are in markets.” Warren Buffett, speaking this past weekend to the Berkshire masses gathered in Omaha, called financial markets “a gambling parlor.”

By the way, did you know Berkshire Hathaway holds no earnings call?  They just put out a Saturday press release. Hm, one wonders if we’re all confusing busy with productive.

Anyway, Mr. Buffett said he finds the amount of speculative betting “obscene.”

I’m reminded of a vignette from David Mamet’s book, Recessional. He’s in New York and observing street experts working suckers with Three Card Monte.

You know it? Somebody turns three cards up and says follow the queen, or whatever.  Then he turns them over and shuffles them.

Mamet says Three Card Monte is not a game of chance.  Not a game of skill.  It’s not a game.

And that’s the stock market. It is not a game for those setting most prices. I told traders using our quant decision-support platform that all the middlemen, the toll-takers like money managers, ETF sponsors, market-makers, brokers, exchanges, make money while investors and traders struggle.  Look at Citadel’s great April.

For intermediaries, it’s a job, and the rules and processes are well-known to them. The purpose of the stock market is to facilitate a continuous auction of everything in tiny bits. So the SEC has decreed.

That is, there must always be prices for all stocks, even if the prices are wholly disconnected from supply/demand reality.

Public companies, consider the chasm between Mr. Buffett’s statement and what you want.  You’re after shareholder value, not stimulating the “gambling parlor.”

What are you going to do to sort the one from the other? You can’t do it with “settlement data.”

Bill Gurley, guru of venture capital in Silicon Valley at Benchmark Capital tweeted that earnings multiples have always been a “hack proxy.” He said there’s a lot of what he called “unlearning” coming to the multitude too young to know a bear market.

I know looking at the numbers coming out of Robinhood and other parts of the market that retail traders have taken a drubbing by not understanding what’s happening.

The stock market functions exactly as its rules specify. It’s the system. The word “hysteresis” says the system reflects the state of its history.

And the history of the market, as with money, credit, labor, is about increasingly pervasive government control. Which means market forces lose control.

Bonds and equities are for the first time in decades falling at the same time.  The dollar is at levels one finds during crises when money rushes to it for capital-preservation. The economy doddered into a GDP decline last quarter.

We may be in a financial crisis already. We don’t see it because the credit-overextension causing it isn’t emanating from some part of the economy but from the government itself.

What about jobs, openings, strong consumer credit and balance sheets? They’re part of hysteresis, the milieu resulting from what came before it. They reflect what was stimulated into existence, not what can survive without stimulation.

I’m not saying everything is about to fall apart. The stock market could go on a tear again, although supply/demand trends need big change to make that hold.

Rather, I think the trouble is all the effort to manage outcomes. A handful of members of government, and central bankers and regulators are trying to run everything. The few are not smarter than the many. Hysteresis for any cultural experiment shows it.

Stenosis is a word describing the consequences of narrowing neural passages. Stentorian means loud, thundering.

I think hysteresis in our financial markets is breeding economic stenosis that will lead to stentorian tumult.  We best get prepared (we have the navigational data).

For the Birds

Did you know the Caribbean is full of brown boobies? 

The blue-footed brown booby, about the size of a seagull.  We’re just back from sailing St Martin and St Barts, where the critters of both sea and sky delighted.

Unlike the stock market, apparently, which has gone to, um, the birds. 

By the way, best food in the islands?  Grand Case on St Martin. It’s French. Need I say more?  On our boat, we had French food, French wine, French chef.

It’s a wonder we left. I gained five pounds. You can see it in the photo, aboard our catamaran in St Barts (more trip photos if you’re interested).

Tim and Karen Quast aboard Norsegod in St Barts Harbor (courtesy Tim Quast).

Back to stocks, we should have expected cratering markets because fundamentals have deteriorated dramatically.

Oh no, wait. They haven’t. 

Zscaler (ZS), which has been crushing expectations every quarter, is up just 6.7% the past year now after rising over 500% the past five years. It’s down 33% the last six months.

Philip Morris (PM), which is not growing, is down 7% the past five years but up 8% the past six months.

The popular explanations for why these conditions exist have reached such shrieking insanity that I might be forced to return to the sea.  And French food.

First, let’s understand how stocks go up.  Not the “more buyers than sellers” version but the mechanics. 

There is demand.  It can come from investors, traders or counterparties. Active investors buy opportunity, Passive investors buy products – growth, value, etc. Traders chase arbitrage (different prices for the same thing). Counterparties buy or sell to meet or mitigate demand for derivatives like options.

When all converge, prices explode. 

And there are compounding factors. Many investors now prefer Exchange Traded Funds (ETFs), which don’t increase the SUPPLY of stocks, just the DEMAND for them.

And traders buy or sell short-term prices with connection only to previous prices, leading to spiraling short-term gyrations.

And derivatives as both implied demand and supply magnify moves.

Are you with me still? Think this is for the birds?

The Tetris of the stock market, the arranging of these blocks, distorts perceptions of supply and demand and fosters absurd explanations.

And over time, it erodes realized returns.  All the toll-collectors – money managers, ETF sponsors, trading intermediaries, stock exchanges, counterparties – get rich.

As of yesterday, the Nasdaq is up about 6.5% annually since March 2000, before taxes and inflation and without respect to risk premia. Tech stocks move 3.5% intraday daily.

You see? Daily price-moves are more than half the average expected pre-tax returns. That’s because of what happens when all the Tetris blocks start falling.

Here’s how. Active investors stop buying equities. Passive investors slow allocations and see redemptions.  Speculators stop setting prices. ETFs have to redeem shares so compounding demand is suddenly replaced by a vacuum. Implied demand via derivatives vanishes.

And prices implode.

This is how the DJIA drops 800 points in a day.

And we haven’t even talked about short volume.  The SEC permits intermediaries to create stock when no real supply exists to satisfy it. That is, they can short stocks without borrowing.

That works great on the way up as it provides supply to rising prices that would otherwise go unsatisfied. On the way down, we become aware that the implied demand in created stock just doesn’t exist.

So, Tim. What can we do in this market?  

You can’t control it.  We could fix it if we stopped letting shilling Fast Traders set prices and create stock.

If we junked the continuous auction market and returned to periodic auctions of real demand and supply. No real buyers or sellers, no prices.

And stock markets should actually compete by offering separate “stores” that aren’t connected electronically and forced to share prices. As it is, markets are just a system.

Alas, none of this will happen anytime soon.

So.

We can continue as companies, investors and traders fooling ourselves that fundamentals drive markets.  Or we can learn how markets work. The starting point.

Otherwise, we’re like somebody reading the opening line today. “Did he just say ‘boobies’?”

I was talking about birds.

We need to understand the topic. The market (ask us, we’ll help).