Eyes Wide Open

Here’s my grand unified theory on the world. We stopped following the rules.

Not that humans don’t color outside the lines routinely. But in the last two years we jettisoned restraint. That gave rise to chaos in the stock market, imperialism in Ukraine.

Here’s what I mean. The Pandemic prompted a reversal of the relationship between people and governments. Governments derive their purpose and support from the people.

Even in tyrannies.  French Nobel-Prize-winning writer Albert Camus who coincidentally wrote a book called The Plague said, “The welfare of humanity is always the alibi of tyrants.”

We did it for the people.

During the Pandemic, governments uniformly, whether free or autocratic, assumed supreme authority and bullied everybody into submission. Rules be damned.

That’s a bullhorn to brigands, cretins and miscreants.  If the rules don’t apply, then what’s to stop me?

Everybody started taking other people’s stuff.

Here in the USA, the country’s system of production and distribution through free-market capitalism was crushed by a tsunami of manufactured money. Businesses were unevenly and forcibly shuttered (some essential, others not, for no reason save an opinion) when the cornerstone of the rule of law is uniform justice.

And the money whooshed away from commerce into financial assets and real estate. There was a geyser drenching everything.

Waves come in, waves go out. 

I told users of our trading decision-support platform Market Structure EDGE last May that the long Pandemic Money momentum arc might have ended. The data signaled it (see image).

Market Structure EDGE data. Sentiment (Demand) changed in May 2021. Price has returned there, and Demand is ever more volatile.

The market doesn’t suddenly recede.  The tsunami comes in.  Reaches a zenith. Goes back out. You can see it in the sea but the ebb and flow is deceitful in asset markets.

Plus, human attention spans are short. We think that whatever is happening at this moment is reflected in the mirror of capital markets, forgetting the most basic economic principle besides Supply and Demand: Cause and Effect.

The tripwires might be immediate. Somebody coughs in a quiet theater. Russia invades Ukraine. Jay Powell says, “We’ll raise rates…” and everybody stampedes. And then he adds, “By and by.”

The stock market is now trading where it was in May 2021 when Pandemic Momentum died. Sure, there was a carryover. (We wrote about the changes here and here.)

But the wave that advanced for more than a year is receding. We’re experiencing the consequences of monetary actions that smashed every concept of good behavior.

We shouldn’t have thrown the rules out.

The roiling waters now may calm and settle and return to a regular tidal cadence. The data suggest a surge in Tech stocks in particular is possible and maybe in the whole market.

But we’ve done damage that may be far longer-lasting ultimately.

There are bigger reasons why Russia invaded Ukraine and no excuses for thuggery (though thuggery is a timeless imperialist trait).  But what greenlights bad behavior is evidence the rules don’t apply anymore.

And so here we are at the crossroads of geopolitics and markets in a world where anything goes. Russia ETFs are cratering. Nickel was halted. Wheat doubled in a day. Oil is at 2008 weak-dollar pre-Financial-Crisis prices as the dollar hits Pandemic highs.

Half the S&P 500 is down 20% or more. Half the Nasdaq stocks are down by half, and the Nasdaq Composite is now down 2% for the trailing year!

Consequences.

Now, throw in market mechanics. Market Structure. The reason the trouble from Ukraine is so cataclysmic for asset markets isn’t rational but structural.  I wrote about volatility last week in a post called Rise and Fall. I think it’s worth reading.

By the way, did you see John Stewart is the new Market Structure expert?

The stock market is volatile because 53% of trading volume derives from participants with better data and faster prices and shorter horizons than the investors and companies who depend on the market.

They magnify markets up and down.

Once we thought markets should be free, fair and open, and rules should level the playing field for all. We’ve thrown those rules out.  Now rules promote specific outcomes.

How do we get back to good? Stop doing all that stuff. And in case that’s awhile coming, our best defense is understanding what’s happening.

The great international relations classicist Hans Morgenthau said all politics are the pursuit of power defined by self-interest, and human nature doesn’t change.

That’s a good lens for seeing the world.

And in the stock market, understand that 10% of volume is rational. The rest is reactive, leveraged, constantly evolving, changing prices, hedging. It’s all measurable, though.

Eyes wide open is always the best strategy. 

It begins with understanding what’s going on. In the stock market, we can help you.  In life, my advice is biblical: The prudent foresee evil and hide themselves.

Rise and Fall

The stock market last week posted its best day since 2020 and gave it back.

Why?

And why does your stock rise while another falls, and how do stocks trade today?

I’m glad you asked!

A week ago on Feb 23, the market moved clear of February derivatives-expirations.  Stocks surged. Then index futures expired Feb 28. Stocks swooned (the event isn’t neat but spills over the vessel either side).

The mechanics of those moves are forms of arbitrage. There are two parties to both, and at least one hedges exposure, compounding both market volume and volatility.

Tim, it’s Ukraine, you say.

Has your investment plan changed?

In my adult life, never have TV images of invading forces been other than Americans.

Hm.

All money tracking a benchmark or model depends to some degree on futures contracts. Using futures, passive money transfers responsibility for holding the right components in the right amounts at month-end to banks.

Banks like Goldman Sachs in turn mitigate exposure by buying, selling, shorting, stocks.

That tumult just happened.

Ukraine? The Federal Reserve? War? Inflation? Earnings?

Illustration 67216931 © Thelightwriter | Dreamstime.com

Risk and uncertainty affect markets, yes. But gyrations aren’t the juking and jiving of investors. It’s hedging and arbitrage.

(Editorial note: For more on that topic, here’s a list from The Map).

What you get from your stock exchange daily, public companies, is the same wherever you’re listed. It’s peer, sector, industry, performance; broad measures, market commentary, the dollar, gold, oil. Now maybe crypto. When appropriate, stuff on wars and rumors of wars.

Same that I received as an investor-relations officer in 2001.  Why no change? No reason. No one cares.

Anyway, it’s only possible for your stock to behave the same as your peers if the characteristics are the same. Liquidity, supply, demand, behavior.

CEOs think, “My stock’s down, my peer is up, investors are buying them, not me.”

The math says no. The stock market is like every market. There are supply-chain disruptions. Demand fluctuations.

The average trade-size in S&P 500 components last week was 98 shares – less than the regulatory minimum bid or offer of 100 shares, lowest we’ve marked. So prices are unseen till afterward.

If a market order – a trade without a price – is 100 or fewer shares, the law of the stock market says it must be filled. Now.

So. Either the broker receiving the trade can automatically route it away to somebody else, or they’ve got to buy or sell the stock.

Don’t ponder the risk implications. Your head will explode. Stay with me here.

It gets to why the stock market does things you don’t expect, why your stock doesn’t trade as you suppose.

That trade I just described? It’s filled even if no actual buyer or seller exists (part of the reason you can’t track what sets your price with settlement data. Doesn’t work anymore.).

It’s the law. Market-makers are exempt from locating shares to short.

The machines, the algorithms, are programmed to know this fact. They change the price.

Tim, I don’t get it. What are you saying?

That it’s most times not about you. And you should know what it IS.

Your CEO asks, “How come our stock was down and so-and-so, our closest peer, was up? What investor is buying them and not us?”

Statistically, 90% of the time it’s supply/demand or liquidity differences and not some investor picking your peer.

Last week in the S&P 500, the average stock traded 60,000 times daily, up 50% from long-term averages.  Intraday volatility – spread between high and low – was 3.6%.  Average dollars/trade was $17,000 and index stocks traded $1 billion daily.

The median is about $9,000/trade. To be in the top thousand marketwide, where 95% of the money is, you’ve got to trade $4,200 at a time.

Back up 200 days and it was $5,000.

You got that, IR people? It speaks to what investors can BUY. Or sell. What are your stock’s liquidity characteristics?

The best three S&P 500 stocks the past five days:

ETSY the last five days: 130,000 trades/day, $9,000/trade, dollars/day, $1.2 billion. Computerized speculation led gains, and Demand was bottomed, Supply was extreme and created a short-squeeze.

ENPH:  66,000 trades/day, $8,000/trade, dollars/day was $530 million. Computerized trading led ENPH too. Demand was bottomed, Supply was on trend.

MOS: 90,000 trades/day, $6,000/trade, dollars/day, $530 million. Active Investment was the lead behavior, and Demand rose while Supply fell.

Wouldn’t you want to know this stuff? We have more, including all the trends.

Why isn’t every public company measuring these data? Dunno. Mystery.

But. We’re going to democratize it. All public companies can and should know these data, and we’ll open that door.  Stay tuned.  

Cliffside

I took a screenshot yesterday at 2:22pm, on Feb 22, 2022. 

Sign from God? Turning point? Hogwash?

Those are better than most proffered reasons for the stock market’s moves.

Lately it’s been delivering pain. Blame goes to Ukraine, where the Gross Domestic Product of about $155 billion is 40% of Apple’s 2021 revenue. Way under Denver’s $200 billion GDP. A tenth of Russia’s.

Illustration 45324873 © Iqoncept | Dreamstime.com

Ukraine is not destabilizing global stocks. Numbers help us understand things.  The numbers don’t add up, without offense, for Ukraine.

So, why are stocks falling? Answering why is like explaining what causes earthquakes: We understand they’re products of mathematical facts insinuated into our dirt.

Well, mathematical facts shape equity markets too, and the construction emanates from the USA and its 40% share of the total global equity market.

Anybody remember the Flash CrashFlash orders?  Books were written. Investigations convened.  Congressional hearings held.  MSM’s good friend Joe Saluzzi was on CBS 60 Minutes describing how the stock market works.

We seem to have forgotten. 

Now the Department of Justice is probing short-selling.  The SEC is investigating block trades.

For God’s sake.

The block market that should be investigated is the off-market one where Exchange Traded Funds are created in huge, swapped block trades of stock without competition, taxes, or commissions. The SEC is fine with that. Approved it.

The short-selling needing investigating is the market-maker exemption from short-locate rules that powers the stock market.  Academic studies claiming clouds of short-selling around big declines lack comprehension of how the stock market works.

The SEC knows how it works. I doubt the DOJ does. 

Everybody wants to find that volatility springs from nefarious intent. Greedy people. Cheats.

No, it’s the rules. The SEC publishes data on cancelled trades – legal spoofing.  That’s the MIDAS system, built for the SEC by a high-frequency trader.

People have gone to jail for what’s a fundamental fact of market function. The truth is, most orders are cancelled.  How can you parse what’s legal or not when the market is stuffed with behaviors that if separated by label or exemption move from illegal to legal?

Something should be wrong, or not.  Don’t lie. Don’t steal. Don’t cheat.  The Ten Commandments are simple.

When you say, “Don’t cheat – unless you’re a market-maker,” your stock market is already a disaster in the making.  People won’t understand why prices go up or down.

Here’s some math.  The average trade-size in the stock market – shares trading hands at a time – is down more than 50% since 2016.  It dropped 10% just in the past 200 days in the S&P 500.

The average S&P 500 stock trades 100 shares at a time, data ModernIR tracks show. That’s exactly the regulatory minimum for quoting a bid or offer.

Meanwhile, the number of trades daily is up more than 20% from a 200-day average of 40,000 trades daily per S&P 500 component to nearly 50,000 in the last five trading days.

Oh, and roughly 48% of all stock volume the last five days was SHORT (vs about 45% 200-day average).

And the DOJ is investigating short-selling.

Combine stocks and ETFs and 90% of trades are cancelled. Over 90% of all short-selling is sanctioned, exempted market-making – firms making stock up out of thin air to keep all those 100-share trades happening.

The DOJ is searching for a private-sector speck while a beam protrudes from the all-seeing government eye.

Do we want a stock market that gives you 100 shares that might not exist? Or a stock market that reflects reality?  People don’t even know.  You can’t have both.  The SEC simply hasn’t explained to anybody this Hobson’s Choice.

The principal stock buyers and sellers embed their computers in every tradable market on the planet, and all the machines share instant information. They’re 50% of volume. That’s why equities rise and fall in relative global uniformity (not perfectly – there are always asymmetries to exploit).

Machines identify breakdowns in supply and demand and magnify them. Stock exchange IEX made famous by Michael Lewis’s book Flash Boys calls it “crumbling quotes.”  The stock market becomes like California cliffsides.  It…dissolves.

Investigations are wasted time.  Constant scrutiny of headlines and fundamentals for meaning behind the market’s moves is mostly pointless.

I’m not saying nothing matters. But the central tendency, the principal answer, is market structure.

I could also say math signals gains next, and also says stocks are down because momentum died in Jun/Jul 2021. Another story.

There’s just one thing wrong with the stock market.  Its singular purpose is the perpetuation of continuous activity.  When activity hiccups, the market crumbles like a California cliffside.

The rest is confusing busy with productive.

And that’s why if you’re a trader or public company in the stock market, and you don’t spend SOME time understanding how it works, you’re on that cliffside.

Extended Chaos

See this photo?  Winter Carnival in Steamboat Springs. The Old West. Sort of. People ride shovels on snow down main street behind horses.

Courtesy Karen Quast. 2022 Steamboat Winter Carnival.

Now. What the hell is happening in extended-hours trading? Could be a shovel ride.

You might’ve forgotten with the pace of news and markets, but during Q4 2021 earnings, SNAP lost 24% of its value by market-close, then soared 62% in the hour and a half after.

Facebook – Meta Platforms (strange to brand as something nonexistent) – lost $235 billion of market cap after the market closed.

Amazon was down 8% at the close, then rose 18% afterward.  Market cap, $1.5T.

What’s going on?

Let me tell you a story. Settle in.

Once there was a buttonwood tree in New York City and stockbrokers would gather to trade there. In 1792 the brokers formed the NYSE.  To trade securities listed at the NYSE, you had to be a member.

Time passed. It worked. In 1929, the stock market blew up.

The government flexed. The Constitution authorizes no intervention in securities markets, but people were economically panicked.  Congress passed the Securities Acts of 1933 and 1934, taking control. Stuff got complicated.

In 1975, with inflation soaring and a war in Asia ending badly (déjà vu), Congress decided the stock market was a vital national interest and should be a System.

They passed the National Market System amendments to the Securities Acts after finding that new data technology could mean more efficient and effective market operations.

So Congress, pursuing the nebulous “public interest,” decided it must decree fair competition among brokers, exchanges, and other markets.

And they said opportunity should exist for trades to execute without the middleman, the broker-dealer or exchange – rejecting the buttonwood model.

With me still? 

I’m explaining how we ended up with extended-hours trading, and why it bucks like a bronc. We’re not there yet. 

In 1971, the National Association of Securities Dealers launched an automated quotation system. That became the Nasdaq.

In the 1990s, computerized trading systems outside the stock markets – as Congress envisaged – sprang up. No broker-dealers. No middlemen (save the software).

They demolished stock markets, taking more than half of all trading.

They were firms like Island, Brut, Archipelago, Instinet (the oldest, from 1969). They weren’t stock exchanges, weren’t brokers.  They were software companies matching buyers and sellers.

Ingenious, frankly. The exchanges cried foul.

The SEC intervened with a set of rules forcing these so-called Electronic Communications Networks (ECNs) to become broker-dealers.

And extended-hours trading began.

Why?

Because exchanges had to display ECN prices, and ECNs had to become brokers. So exchanges would win the price business, and ECNs would win the size business.

By the way, the exchanges bought the ECNs and incorporated the technology. The Nasdaq runs on vestiges of Brut and Island, the NYSE on Arca – Archipelago.  Instinet is owned by Nomura.

In 2005, the SEC fulfilled the vision of Congress from 1975, imposing Regulation National Market System – Reg NMS. That’s the rule running the stock market today, with its 17 exchanges and about 34 “dark pools,” which are ATS’s.  Latter-day ECNs.

Reg NMS links all markets, removes the differences in listing one place versus another, shares all prices and all data, and mandates trading at the best systemwide price.

But rules preceding Reg NMS for ATS’s didn’t proscribe extended-hours trading.

The irony? Congress wanted to cut out the middleman, the broker and exchange, and instead ALL trading is intermediated. It might be the craziest thing in human history outside emergency powers.

Plus, the rise of Passive Investment means vast sums need reference prices – a set price each day – to comply with the Investment Company Act of 1940 (another rule).  So exchanges persist with a 4p ET close.

But Exchange Traded Funds (ETFs) match off-market in blocks – and the parties running those trades are the same operating dark pools (ATS’s), behind most derivatives.

And there you have it.  Exchanges create prices for “40 Act” funds at 4p ET. And broker-dealers trade stuff other times, getting ever bigger.  Gyrating prices when the Stock Market is closed.

It’s now at times the tail wagging the dog.  It’s incongruous if the aim of the legislation behind Reg NMS is a free, fair, regulated, orderly, connected market.

That’s your answer.

Stocks gallop after the market closes because rules have fostered an arbitrage trade between market hours, and after-hours. The reason for extended-hours chaos is rules bifurcating the stock market into prices for thee but not for me.

The fix? I think it’s wrong for a “market system” to own the price of anything.  Stores for stocks should be no different than grocery stores – stocking what they wish and offering prices and supply.

How do we change it? Fix government powers. The SEC owns the market. Not us.

Predicting Moves

One hundred seventy-eight companies reported earnings yesterday. Could one predict which would rise or fall?

There are 148 on deck today, 149 tomorrow.  The high point here in the Q4 2021 cycle was Feb 2 with 330.

Back in early 2016, Goldman Sachs found that stocks underperforming the market in the two weeks before results tended to outperform on the news.  Goldman recommended buying calls on those stocks and found that it returned an average of 18% (that is, buying and selling the calls).

They didn’t say how the stocks themselves fared.

Illustration 35557373 / Earnings © Iqoncept | Dreamstime.com

And there’s no indication the strategy continues to work as it did then.  But you’ll recall that Jan 2016 was pretty volatile.

Not as bad as Jan 2022. 

Bloomberg wrote Jan 31 (thank you, Alert EDGE user John C for the tip) that the market’s capacity to handle trades tumbled during volatility in January. The trouble was so bad that the spread between bids to buy and sell S&P 500 futures contracts widened to levels seen during the Pandemic crash of March 2020.

Nowhere does the article say, as we told all clients, that this same set of futures contracts expired the last trading day of January (and every last trading day of each month), and to prepare for tumult because volatility would make derivatives settlements a hot mess.

Index funds use futures contracts on the S&P 500 to get performance back in line with the benchmark at month-end. They’re an excellent proxy for nearly any basket and “40 Act” funds are permitted by rules to use up to 10% of assets on substitutes.

Tim, I thought you were going to tell us how to know if stocks will surge or swoon on results?

Hang on, I’ll get to that.  There’s an important point here, first.  Futures and options both depend on the value of underlying assets but routinely separate from them.  In fact, stocks in the S&P 500 last week were up 50% more than the derivatives that are supposed to track them.

Stocks comprising the SPX were up 2.3% on average last week, while the SPX, the futures contract, rose 1.5%. That’s a spread of 50% — a crazy divergence. 

Meanwhile, Short Volume hit a record 49% of trading volume in the S&P 500.

It’s all related.

Indexes need to get square. Banks absorb the task, for a fee. Massive volatility ensues. Banks trade like crazy to transfer the risk – they’re not front-running customers but mitigating derivatives risk – from giant gaps and maws in the data to the stock market.

Stocks gyrate. Short volume soars, spreads explode.

And it’s all about derivatives. Not much to do with investor sentiment at all.

Now, can we predict these effects in your stock at results?  Yes.  Not perfectly, but well. Derivatives play a colossal role at earnings, and it can be seen, measured, predicted.

Every public company should measure and observe what the money is doing ahead of results.  Measure what Active money is doing. Check Short Volume. Meter derivatives (we do all of that with machines).

We use that and Supply/Demand data to forecast volatility and direction and to understand the reasons WHY.

For instance, SNAP traded near $24, down from over $83 back in September, before results.  It then skyrocketed after reporting its first quarterly profit to near $40.  That’s terrific, but it’s also crazy.  What kind of market behaves that way?

A story for another day.

Anyway, SNAP showed big LONG bets during January options expirations. The stock price didn’t show it.  But the data sure did.  Short Volume set a six-month low and correlated to a big surge in derivatives (that’s measurable too).

Long bets on SNAP’s earnings.

That didn’t guarantee a big jump. SNAP Short Volume was back to 50% ahead of earnings – a straddle – and currently sits at 61%. But the bets were there.  It was possible to know just about everything that might happen.

If you can know all that, why wouldn’t you? 

If your CEO or CFO knew you could see which way the bets were going, and what was responsible for it, they’d probably appreciate learning about it from the investor-relations officer.  And they’d want to know if money focused on the Story played a role.

Measurable. We can help. Press of a button for us.

I’ll leave you with a tidbit. Statistically, stocks did better reporting AFTER options expirations, regardless of results. Bets cost more.

Public companies, report after expirations. Beware month-end futures expirations. Traders, predictability is better outside options-expirations.

Big lesson? Derivatives are running the stock market.  And data will help you understand the effects.  Don’t go through another earnings cycle guessing at what might happen.

Electric Jellyfish

There are four Pinthouse locations in Austin and Round Rock, TX.

We’ve not been to any of them but we’ve had their scrumptious hazy IPA beer, Electric Jellyfish.  It may be the world’s best.

And the stock market has been an electric jellyfish.

Illustration 234002321 / Electric Jellyfish © Rul Stration | Dreamstime.com

Let me explain, on this Groundhog Day (it’s 2/2/22!).  Jellyfish float on the currents.  They don’t propel themselves with purpose around the sea.  But an electric one probably would, except you’d never know where it was headed.

Substituting, the stock market floats on the currents, and if it was electric, it would propel itself around and you’d never know where it was headed.

Look, I’m joking to some degree!  We all make our living in the stock market.  And as Joe Walsh said, life’s been good to me.  Remember, the name of that album was “But Seriously, Folks….”

And the stock market has measurably predictive characteristics. So do jellyfish from the standpoint that ocean currents will tell you where they’ll go.  Currents drive both.

And it’s hard to fight the current.  Friday Jan 28 and Monday Jan 31 reflected the explosive role of futures contracts in the stock market, which in turn effectuate the epochal role of Passive money in stocks.

One thing leads to another (a good song by The Fixx but maybe the better version of one thing leading to the next is the great country tune by Hardy called “One Beer”).

Passive money follows a model. Fast Traders set the prices. 

Suppose investors are biased toward GROWTH. Those stocks get an outsized allocation in models tracking otherwise statistically predictable benchmarks like the S&P 500.

That in turn drives up the value of associated options contracts.  The notional value of traded put and call options exceeded the value of trading in the underlying stocks in 2021.

And that’s a further input into the value of futures contracts used by index and exchange-traded funds to match benchmarks.  They can transfer the risk of buying or selling stocks to banks through baskets of futures expiring the last monthly trading day.

All of that stuff compounds, driving values artificially high. If that current changes, markets can lose value at stunning speeds.

Jan 28 was the day before options contracts expired. Right before the close, stocks surged – as an electric jellyfish might.  Happened again Jan 31 as Dec-Jan futures contracts true-ups hit, and money reset to contracts lapsing the last day of February.

Last week, trading data we track showed investment declined about 12% in the S&P 500, while trading tied to derivatives that we call Risk Mgmt rose over 3%, Fast Trading 2%.

That’s the effect of futures contracts used by Passives – transferred to banks – and machines sifting the prices of stocks and derivatives and rapidly repricing both.

There’s another electric jellyfish datapoint here.  Short Volume, daily trading on borrowed or created stock, hit 49% of total market volume Monday Jan 31, the highest level we believe we’ve ever recorded in the S&P 500.

In a sense, the stock market went beyond electric jellyfish into the metaverse.  Banks tasked with truing up indexes had to buy gobs of stuff to make index clients whole after a tumultuous January.

That’s the implication.

And because there was very little stock for sale, Short Volume – the supply chain of the stock market – surged to accommodate it.

Market-makers can manufacture stock. They are required to make bids and offers even when no one is buying and selling. They’re exempt from rules requiring others to first locate shares.

We might say that banks prestidigitated stock to fill orders for derivatives.  Just made up shares to back instruments that might not get used.

I’m sure it’ll all work out.  Cough, cough.

And look, it might.  Weird things can occur, without apparent consequences.  But it all compounds.

At some point, all the screwy stuff we humans are doing to escape reality is going to bring us crashing back to earth. So to speak.  Monetary policy is artificial. The stock market is artificial. And now people are spending hundreds of millions of dollars on dirt that doesn’t exist, in the metaverse.

It was a terrific January 2022 for ModernIR as companies of all sizes sought us out for a grounding in the reality of data, a way to track the electric jellyfish.

And we can track it.  We can’t predict when it’ll stop working. We can predict that if you like IPAs, you’ll love Electric Jellyfish.

No Excuses

There’s no excuse. 

It’s 2022.  Not 1934, when Benjamin Graham wrote Security Analysis.

Back then, the timeless notion of buying profitable companies with undervalued growth opportunity took firm shape. But its interpretation would have to be shaped by the Securities Acts of 1933 and 1934, which birthed the SEC and part of the market’s structure that prevails still.

In 2022, the stock market has been operating under Regulation National Market System for 15 years.  Anybody in the stock market – investor, trader, public company – who doesn’t know what Reg NMS is and does is without excuse.

And any company reporting financial results during options expirations is without excuse. Like NFLX. Shareholders should rightly be upset.  There is no excuse for a public company to be ignorant of market form and function in 2022.

Monthly options expirations. Illustration 23855600 © John Takai | Dreamstime.com

Isn’t that a bit harsh, Tim?  No excuse? 

It’s been 15 years. We’ve watched meme stocks. Surges and collapses in prices. No connection to reality.  And we’re here to help you. You need not go through an NFLX experience.

Here’s some perspective. In 1995, well before Reg NMS when Yahoo!’s earnings call was an event attracting tens of thousands of retail investors as CEO Tim Koogle, who called himself “the adult supervision,” discussed financial performance, you didn’t need to worry about the options calendar. Options trading was a blip on the equity radar.

The goal then was to show you could close the books fast.  Koogle and team reported Q4 outcomes within ten days of year-end.  Remember that?

Today, the daily notional trading value in options is greater than the dollar-volume of stocks.  The latter is $600 billion. 

Derivatives comprise close to 20% of all market-capitalization. Derivatives are a right but not an obligation to do something in the future.

Suppose, public companies, that 20% of your sales at any given moment were a bet – a possibility but not a certainty.  You’d have to account for that when setting internal and external expectations for results. Right?  That’s very material.

And that’s the stock market.  If 20% of your value depends on something that might not happen, should you take that into account?  And are you irresponsible if you don’t?

I don’t know this stuff, you say.  Well, learn it! It’s a primary part of the investor-relations job in 2022. The calendar is here, and here, and here and here. It’s public information.

And we can help you measure and understand behaviors and see what the money is doing BEFORE you report results, before expirations.

Options expire all the time, but the RHYTHM of the stock market moves with monthly expirations.

Weeklies are too short a timeframe for indexes and Exchange Traded Funds that use them for substitutes, too unstable for the market-makers driving colossal trading volumes to keep ETFs aligned with underlying stocks – while profiting on directional options plays.

In 1995, most of the market’s volume tied back to the 90% of institutional assets that were actively managed.  For NFLX, between Dec 1, 2021 and Jan 24, 2022, Active money averaged 9%of daily volume.

Eighteen percent of volume tied to derivatives, which expired last week as NFLX reported financial results.  And 55% of NFLX trading volume is driven by machines that exploit price-changes and want to own nothing.

Fast Trading.  High Frequency Trading. Whatever you want to call it.  Firms that are exempt from having to locate shares to short, under Reg SHO Rule 203(b)(2).

Investor Relations Officers, it’s your job to know the market’s risks and advise your executive team and board on how best to maximize shareholder value and minimize risks to shareholder interests.

Shareholders should, can and will expect it of you, public companies. You shepherd money, time and resources belonging to other people.

MSFT is reporting on the RIGHT side of expirations. Same with IBM.  Doesn’t mean stocks aren’t volatile with new options. But they haven’t time-decayed yet. Bets are much more expensive.

Yesterday was Counterparty Tuesday when banks squared the books on wins and losses related to last week’s January derivatives and the new February derivatives that traded Monday and prompted one of the epic 21st century trading days.

Don’t report results in the middle of that.

Oh, we have an internal calendar from the General Counsel. Well, tell the GC to change it!  Stop acting like it’s the 1990s.  It’s not.

Your priority, your job, your responsibility, is to be an informed participant in 21st century American public equity markets.  To your credit, IR community, a meaningful part has adapted, changed behaviors, learned how the market works.

If you’re ready to drag your executive team into the 21st century, tell them there’s no excuse.  It’s time to change behavior, reduce risks for shareholders. Come join the market structure family.

Uneven Market

My advice?

When the market gets tough, go sailing.  Heck, go sailing when stocks are soaring.  I recommend it.

If you missed the Market Structure Map, we were on hiatus the past two weeks whilst undulating via catamaran over azure seas along the Sir Francis Drake Channel, sailing the whole of the British Virgin Islands from Jost Van Dyke to Anegada.

This photo below is in The Bight where lies the famous Willy T at anchor, off Norman Island.  You can get used to bare feet, tides, the absence of time save the rising and setting sun.

Photo courtesy Tim Quast

I had time to read Raj Rajaratnam’s new book, Uneven Justice, mostly on the long flights there and back.  I lived for a year in Sri Lanka during college, from whence he hails.

You colleagues long in the capital markets will remember the 2009 arrest of the Galleon hedge-fund founder for insider trading. 

The book is repetitive, has some copy-editing shortcomings. But it’s a remarkable read and I recommend it.  If you like the HBO show Billions, you’ll appreciate the sordid conniving by the attorney for the Southern District of New York, Preet Bharara.

I’ve long thought insider-trading was a mushy “crime.” You may disagree. I think Rajaratnam does a creditable job establishing that he committed no insider trading, whatever one thinks of it.

(I understand the stock market and here’s my issue: All high-frequency traders are armed with material nonpublic information called proprietary data, from which they generate ALL their profits.  And investment, public and private, is a continuous pursuit of what others don’t know, or overlook. To criminalize subjective aspects while permitting the vast sea of the rest is nonsensical and cognitively dissonant.)

This isn’t a book review.  Read it and draw your own conclusions.  But Raj Rajaratnam’s jury could not comprehend how the stock market worked. 

Heck, the attorneys didn’t understand it! The judge didn’t understand it. 

Try explaining to a jury of moms and pops (I can’t tell you how many times I’ve gotten the blink-blink explaining a continuous auction market) how a hedge fund works, the buyside, the sellside, what drives trading decisions, interaction with investor relations departments and corporate execs, the bets and gambles on beats and misses at earnings, the relentless thrum of information everywhere.

The defense team presented vast reams of data illustrating how Galleon developed its investment ideas, all of which traced back to colossal volumes of trading records. The firm managed about $8 billion of assets but traded over $170 BILLION in a year.

The government took issue with 0.01% of trades that by Galleon’s math resulted in a loss. But the prosecution simply said, “This Wall Street billionaire who caused the Financial Crisis is a cheat, and these wiretap snippets prove it.”

Again, draw your own conclusions.  But it resonated with me because there’s a pervasive propensity in the stock market to choose the easy snippet over grasping how it works.

Take for instance the market’s struggle since Jan 5, when we left for Tortola and the trade winds.  The easy explanation is we caused it.  I mean, it coincided, right?

I’m joking but you get the point.

The prevailing trope is Tech stocks are falling as investors wrestle with when the Fed will hike rates.

Years of trailing data show no clear correlation between interest rates and how Tech performs. It’s not difficult analysis.  Check the ten-year data for XLK. Compare to your favorite measure for interest rates, such as DXY or GLD.

There IS, however, correlation between periods of strong gains for Tech, and subsequent pullbacks.  There are just three of those for Tech the past decade:  latter 2018 (spilling into 2019), the Pandemic (spring 2020), and late 2021 (spilling into 2022).

These data suggest that save for Pandemics, investors in retirement accounts get overweight equities and especially Tech, and they recalibrate, especially in the fourth quarter.

Consequences rise as Tech gets bigger and bigger and bigger. Recalibrations rumble through how Fast Traders set 60% of prices and how derivatives underpin 20% of market cap, and how Short Volume (the supply chain), surges or stalls.

And then it starts over.  At some point, it won’t, sure. But the cause will be larger than hypothetical interest-rate hand-wringing.

And public companies, it’s measurable. Take AAPL, world’s biggest stock. Between Oct 1, 2018 and Jan 29, 2019, AAPL was never a 10.0 on our ten-point Demand scale.  Between Feb 28-Apr 15, 2020, it was not a 10.0.

And now? AAPL last had ceiling-rattling 10.0 Demand Dec 16. It’s now a 2.6 and bottomed. Right on schedule.

These are the facts, and the math. Headlines are not. Keep that in mind as earnings kick off. You can do what you’ve always done, the easy course. Or you can be armed with facts and details.  We have them.

The Big Story

Here we go again. 

Twitter fans of Fast Trading are claiming these firms help markets and especially the little guy. Now, before you check out, what’s the Big Market Story of 2021?

Retail trading. Right?  Meme stocks. The rise of the Reddit Mob.

Illustration 209856483 © Hafakot | Dreamstime.com

Editorial Note: And the rise of the #EDGEMob, the success of our trading decision-support platform, Market Structure EDGE, winner of the 2021 Benzinga Global Fintech Award for Best Day Trading Software.  EDGE helps retail traders win by seeing Supply and Demand, the very thing Fast Traders obfuscate daily.

Okay, back to our story.

Fast Trading is computerized speculation.  What most call “market-making.” In the sense that these firms buy stuff wholesale – orders from retail traders – and sell it retail (in the stock market and often back to retail traders via dark pools in bits), that’s true.

But it’s not market-making like Goldman Sachs providing research coverage on hundreds of stocks and committing to buy and sell them.

Fast Traders don’t have customers, don’t write research, don’t most times even commit to both buying and selling. They aim to own nothing at day’s end.  They profit on how prices change. Ironically, they create volatility to vacuum it away through tiny spreads.

Money for nothing.

So, these people on Twitter were saying Citadel and Jane Street and Two Sigma and G1X (unit of Susquehanna that buys retail flow) have better execution-quality than stock-exchange IEX.

That’s like saying sprinters have faster 100-meter times than marathoners.  Well, no kidding. They’re doing different things.  IEX is trying to increase trade-size so we can buy something meaningful. Fast Traders are after the opposite. Tiny spreads, tiny trades.

If you’re getting a headache, let me bring it all around.

“Execution Quality” is part of Reg NMS, the regulatory structure of the stock market. It’s benchmarked by thin gaps between prices, in effect. That is, a spread of a penny is no good. A spread of a tenth of a penny, awesome.

Yet Reg NMS prohibits quoting prices in increments of less than a penny, so there’s an element of irony here.  Quote sub-penny? Illegal. Trade sub-penny? The goal!

At any rate, the SEC determined that it could validate how great the market it had created worked by metering whether brokers executed trades near the best overall prices.

Well, that seems good.

Except the best price is determined by the brokers who are being measured on delivering best prices. That’s like saying, “Whoever you see in the mirror gets to judge you.”

I’m talkin’ ‘bout the man in the mirror. He’s gonna have to change his—sorry, digression. Thank you, Michael Jackson, for that awesome song.

Why use data from firms with no customers – Fast Traders serve none in the sense that Goldman Sachs or IEX do – to determine if there is market quality?

And would someone explain who benefits from a narrow spread?  Anyone? Anyone?

The parties buying and selling stuff but not wanting to own it.  That’s who.

The stock market is supposed to help investors, who want to own stuff.  Yet the rules give kudos to trading firms exploiting retail money, clouding supply and demand, and owning nothing.

That’s how retail money chased herds of buffalo off cliffs in AMC, GME and others. Market regulation crowns highwaymen champions for “narrowing the spread” while meanwhile no one knows what the hell is going on.

Well, we do.  We’re not confused at all.

But what reached a climax in 2021 besides retail trading was confusion. Public companies, do you know why your stock went up or down? Investors and traders, did the market make sense to you?

Stocks fell. Pandemic fears. Stocks zoomed. Fears were easing. Wash, rinse, repeat.

We found it entertaining, as we watched Supply and Demand and saw the market move largely in synchrony with that beat.

Low spreads don’t help public companies or traders. They help regulators justify market structure, market operators make money selling data, Fast Traders make money buying low and selling high in tenths of pennies.

All while saying the market exists for investors and public companies.

Good one, that.

Will it change in 2022?  No.

So, will you?

Traders, if you don’t know Supply and Demand, you’re kidding yourself.

And public companies, I’m not sure what else to say that I haven’t said in 17 years. We can be the people who answer an ever quieter phone, the setters of dwindling meetings as money goes quantitative, data goes quantitative.

Or we can understand Supply and Demand in the stock market.  Ask, and we’ll show you.

Two choices in 2022. Happy New Year! 

Human Nature

Science and the stock market both aim for outcomes data don’t support.

I’m going to take you on a short but intense journey, with ground rules. I’ll ask that you check politics at the door.  Keep an open mind.

I’ll take Science first.  Suppose it was a business plan.  You craft an objective, and the path to achieving it.  It’s something I know after roughly 30 years in business.

Science said it aimed to flatten the Covid curve. That we could create a vaccine that would immunize us all, and we’d be free.

Now pelting toward two years of Covid, a great bulk of the population is vaccinated, many boosted too, and Covid abounds.

I’m vaccinated but not boosted and I had it.  Karen and I heard CNBC’s Jim Cramer, perhaps the World’s Most Vaccinated Person, Friday, and looked at each other and said, “He’s got Covid.”

Sure enough.

Here’s the point. Science has known for decades that coronavirus vaccines don’t work because the viruses constantly mutate.

I think mRNA research will be a boon for treating pathologies from cancer to respiratory disease. But Science did what science shouldn’t do.  It gambled.  Dismissed known data, central tendencies, facts. Proclaimed it would eradicate the virus.

You’d expect that from inveterate optimists like entrepreneurs, cowboys riding the bull that’s never been ridden, politicians, the Cinderella team playing the reigning champs.

That’s hope.  Hope isn’t a strategy.

Religion is in the hope business.  Science is supposed to be in the data business.  If we’re objective, stripped of politics, zeitgeist, predilections – shall I say hope – we have to say Science failed.  We didn’t conquer Covid. Our immune systems did.

Can we admit we were wrong?

Yeah, but vaccines lower severity.

That’s an assumption. A hope. And it wasn’t the objective.

Let’s shift to the stock market.  Regulation National Market System is 524 pages dictating a mathematical continuous auction market that works only with pervasive mandatory intermediation and a market-maker exemption from short-locate rules.

It is by design not rational but mathematical.  Yet everywhere, in everything we hear, read, see, is a thesis that the stock market is a constant rational barometer.

The stock market was declining because the Fed was tapering.  Then on the day the Federal Reserve met, stocks soared. Oh no wait, markets like rising rates because it means the economy is better.

Then stocks plunged. It’s Omicron.  Then stocks soared. Omicron fears have faded.

For God’s sake.

The problem is the explanation, nothing else. We know how the market works. It’s spelled out in regulations.  If you want a summary, read the SEC’s Gamestop Memo.

Options expired last week, while the Federal Reserve was meeting. You should expect bets. Indexes rebalanced Friday and demand was down.  So with new options trading Monday, the market fell.

Then Counterparties squared books yesterday, and one would naturally expect a big surge in demand for options at much better prices.  Stocks surged.

VIX volatility hedges expire today. If money sees a need for volatility hedges, stocks will rise.  If not, they’ll fall.  But that’s not humans reacting to Omicron. It’s programmed.

Weather forecasts are predicated on expert capacity to measure and observe weather patterns.  It’s data science.

The stock market is data science. 

If we have vast data science on weather, coronaviruses, the stock market, why would we hope rather than know? 

It happened to Copernicus too.  The sun is the center. No, shut up or die.

Science thought so much of itself that it believed it could do what they say can’t be done.  Save that for Smokey and the Bandit.

What happened?  Human nature. No matter how much one claims to be objective, there is confirmation bias, a belief – hope? – in one’s desired outcome.

Is the investor-relations profession able to let go its predilections, its hope, and shift to objective data science on what drives shareholder value?

What matters is the whole picture. Do you know if Story, Characteristics and capital allocation mesh, or contradict each other? If you’re a long or short trade?

Math. Measurable.

Illustration 131408341 © Zybr78 | Dreamstime.com

It’s of no help to your executive team and Board to paint an unrealistic picture that says Story drives value when the data tell us the opposite. Who cares what drives price? So long as we understand it.  That should be the view.

Humorously, there is hope.  Hope is like faith, a belief in things unseen, in outcomes no data yet validate. There’s hope we’ll come around to reality.  We can help you get there.

And with that, we hope your reality for the Holiday Season 2021 is blissful, joyful, thankful. Merry Christmas! We’ll see you on the far side.