Right Now

“Do you see the market as disingenuous?” 

That’s what the Benzinga host asked me yesterday on a stock-market web program.  I generally do two Benzinga shows per week on market structure, for traders.

“No, I see the market as genuine but not motivated most times by what people talk about,” I said.

The stock market reflects what the money is doing. Well, what’s it doing right now? (Reminds me of the song by Jesus Jones.)

There’s universality, right now, that the Federal Reserve is why stocks struggled to start the week. 

The Fed, which will today tell us what “The Committee” – as it always refers to itself – is thinking about doing. What it says and what it does aren’t always aligned.  That seems disingenuous, but whatever.  The Fed says it may reduce its support for markets. By that we mean the Fed buys mortgages and government debt, so debt is cheaper.

But how do we know if there’s a debt problem if the Fed keeps propping it up and rates keep falling? And debt doesn’t produce prosperity. Savings do.  The Fed is undermining prosperity and encouraging debt and spending.

My financial advisors preach the opposite.  Yours?

Yes, investors buy stocks, hoping they rise faster than the Fed can destroy our purchasing power and savings.  That’s Sisyphus pushing a stone up a hill. When it ends, we’ll be poorer.

That’s still not what the money is doing RIGHT NOW.

Illustration 34823501 / Etfs © Timbrk | Dreamstime.com

It’s getting ready for year-end.  Exchange Traded Funds (ETFs) will wring taxes out of appreciated holdings.  Or as Vanguard said in its ETF FAQs in 2019, which I included in an ETF presentation:

“Vanguard ETFs can also use in-kind redemptions to remove stocks that have greatly increased in value (which trigger large capital gains) from their holdings.”

Vanguard says this often happens in December, but it can occur other times too. That firm and other ETF sponsors continually adjust ETF shares outstanding.

Like this: Investors want Technology exposure so they buy VGT, the Vanguard Tech ETF. Vanguard puts a grocery list of stocks in the “creation basket,” and brokers bring some mix of those stocks (and cash) to Vanguard, which gives the brokers an equal value of ETF shares, which the brokers sell for a little more to investors.

Near year-end, ETF sponsors get to do what Vanguard said above. They trade appreciated stocks for ETF shares, especially ones where demand is falling. 

They hit the jackpot in Tech, starting at November options-expirations.  Take NVDA. It’s up 116% this year, even after recent declines. NVDA is in 308 ETFs (for comparison, AAPL at nearly $3 trillion of market cap is in 320).

So Vanguard puts NVDA and similar stocks in the basket to trade for falling ETF shares like VGT.  Vanguard gets to wash out its gains. Brokers can sell NVDA, short NVDA, and buy puts on NVDA.  (These aren’t customer orders so they do what they want.)

The real jackpot, though, is that Vanguard can bring NVDA back with a new tax basis (instead of $150 it’s $285 – and this is how ETFs crush stock-pickers).

You and I can’t do that. Index funds can’t do that. Heck, nobody else but ETFs can, leaving one to wonder how the playing field is leveled by this SEC blanket exemption.  

And voila! We have another reason along with Fast Trading, the machines who don’t own anything at day’s end, why the market can stage dramatic moves that everyone wrongly attributes to the Fed, Covid, a Tweet by Kim Kardashian or whatever.

Because this is what the money is doing. About $1 trillion flowed to ETFs this year.  But there’ve been nearly $6 trillion of these back-and-forth transactions as of October.

And funds are constantly encouraging folks to trade out their index-fund shares for ETFs, making ever more assets eligible to dump via the basket and bring back free of taxes.

It’s vastly larger than the amount of money that’ll tweak quarterly or at some other benchmark period to reflect interest-rate or inflation expectations.

And if this principle holds, it’s POSSIBLE that we have some dramatic moves yet coming in stocks.  Maybe this week and next with options-expirations (through Dec 22). Maybe between now and the new year.

The moral of this story never changes: If you’re responsible for the equity market, you need to understand it.  If you trade it, you need to understand it.  If you invest in it, you need to understand it.

And if you depend on it for your currency, your incentive plans, your balance-sheet strength, public companies, your executive team and board better understand it.

ModernIR is the data-analytics gold standard on market structure. We spend every day of the week helping companies understand the market, so they’re better at being public.

Big Strategy

Let’s have a show of hands. 

How many of you think investors woke up, several pounds heavier, the day after Thanksgiving, and opened a browser up to news out of South Africa, and said, “Shazam! Omicron!” And dumped their equities?

Second question, how many of you say that on Monday, Dec 6, investors said, “Screw it, this omicron thing is crap. Buy!” And stocks soared?

If we had a poll on our polls, I’d bet not 30% would have raised hands on either question.

So, why did the headlines say that?  And a step further, if we don’t believe humans knee-jerked the market around the past week, why suppose humans are doing it other times?

Quast, where are you going with this? What do you want us to say? 

I’d like us to come to terms as investors and public companies with the presence of automated trading strategies capable of acting

Illustration 22077880 © Skypixel | Dreamstime.com

independently.  Not as a side show, a reaction.  As valid as Ben Graham’s Intelligent Investor. Ron Baron picking stocks.

Blackrock runs over a thousand funds, the bulk of which follow mathematical models having little directly to do with earnings multiples.  Blackrock, Vanguard, State Street and Fidelity run $20 trillion of assets, most of it passive.

Yet many believe investment models follow the market, and the market is priced by rational thought. 

Why would one think stocks are priced by rational thought?  Give me data to support that view. They trade more? They own more?

Neither of those is true. My long-only investors twenty years ago were generally buy-and-hold.  Are your top 20 core Active holders in and out all the time?  Course not.

The stock market today is 100% electronic, close to 95% algorithmic, and nearly all prices are products of software. So it’s the opposite then. Buy-and-hold investors are accepting prices set by others.

A week ago Olin Corp. (OLN), the world’s largest chlorine company and owner of the Winchester arms brand, was trading near $65. Last Friday it touched $51, and now it’s back to $58. It dropped 22%, a spread of 28% from best to worst.

Anything to do with the fundamentals of Olin’s business? Active money never changed its mind, valuing OLN about $61 since early November (that’s as measurable as any other behavioral factor behind price and volume, by the way. We call it Rational Price.).

It’s volatility, Tim. Noise. 

If we’re willing to characterize a 20% change in price over a week as noise, we’re saying the stock market is a steaming pile of pooh.  A real market wouldn’t do that.

But what if it’s not pooh?  Suppose it’s a strategy that performs best when demand and supply alike both fall?

Then that strategy deserves the same level of treatment in what drives shareholder value as company fundamentals. 

Do you see where I’m going?  The hubris of business news is its fruitless pursuit of human reason as the explanation for everything happening in the stock market.  And it’s the hubris of investor relations too.

Do you know Exchange Traded Funds have created and redeemed nearly $6 trillion of shares in 2021, in US equities alone (data from the Investment Company Institute)?  Nothing to do with corporate fundamentals. All about supply and demand for equities.

Bank of America said last month flows to equities globally have topped $1.1 trillion, crushing all previous records by more than 200%. Most of that money is going to model-driven funds (and 60% to US equities).

Intermediating equity flows all the time, everywhere, are high-speed trading firms like Citadel Securities, Virtu, Hudson River Trading, Two Sigma, Infinium, Optiv, GTS, Quantlab, Tower Research, Jane Street, DE Shaw, DRW Trading and a handful of others.

They follow real methods, with actual tactics and strategies.  ModernIR models show these trading schemes were 54% of trading volume the past week in S&P 500 stocks. Derivatives, a key market for Fast Traders, traced to 18% of equity volume.  About 19% was Passive models like Blackrock’s ETFs.

That leaves about 9% from Active money, your core long-only investors. 

So, what drove the stock market up and down? On a probability basis alone, it’s the 54%. 

It’s not the same everywhere, but the principle applies. For NVS Nov 18-Dec 6, 38% was Passive, just 31% Fast Trading – those machines.  For TSLA, 57% was Fast Trading, 17% from Passives.

For the record, OLN was 54% Fast Trading, 19% Passive, in step with the S&P 500.

Moral of the story?  No view of the market should ever exclude the 54%. Nor should it be seen as noise. It’s a strategy. The difference is it’s driven by Price as an end, not financial returns as an end. (If you want to know your company’s behavioral mix, ask us.)

And it’s the most successful investment strategy in the market.  That should concern you. But that’s a whole other story about the way stocks trade.

The Flaw

It was Monday, Dec 24, 2018. 

The Friday before, the S&P 500 had dropped 3%, bringing monthly losses to 13% and putting the market on bear turf.  Everybody thought, “Thank God for Christmas, we can catch a breath.”

Instead, stocks caromed down another 3% in the half-day of trading Christmas Eve.  After unwrapping presents, stocks opened the 26th with most on vacation and shot up 5%.

Remember that? 

Suppose you close your offices for the holidays and come back to find the place trashed.  It’s not supposed to happen when nobody is in.  Right?  You wonder who the hell did it.

We first got a sense of the stock market’s capacity for freakish outcomes May 6, 2010. Stocks collapsed in this “Flash Crash,” some to a penny, before resurrecting like a geyser.  We learned about “high-frequency trading,” computers buzz-sawing data, spraying prices, shredding stocks.

Illustration 180830251 / High Frequency Trading © Nadiia Prokhorova | Dreamstime.com

It’s happened a growing number of times since.  Computers thrashed through the market in March 2020 like Godzilla vs Kong, demolishing prices, splashing volume everywhere.

And it just happened again.

Everybody cleared their desks and went off to get a tryptophan high, and while we were cleaning up the dishes and looking at the college sports lineup the day after Thanksgiving, a half-day and often the lightest trading of the year, a Transformer went berserk and blew up on Wall Street, blasting almost a thousand points off the Dow.

This ought to disturb you, public companies and investors.  It’s your equity.  You leave. And some computer freakshow guns up in a hot rod and hits you with a smash-and-grab.

The earth is not flat.  And the stock market doesn’t work the way the CEO thinks.

We were in Fiji sailing before the Pandemic.  There was a low sand bar connecting what would otherwise be two islands. We anchored and walked it, observing large numbers of hermit crabs hurrying across, lengthwise.

We picked some up and put them down by the water. But no, that was distressing to them, and they flailed frantically to catch up to the rest, dragging their little hermit shells.

Later, we got it.  The tide was coming in. If you didn’t make it to the Hermit rendezvous on the right side behind some big rocks, you were swept away.

They were on a clock. They’re programmed with sea market structure. They grasped the divide between Controllables and Non-Controllables and the need to respond to both.

If hermit crabs can, we can. Traders, know when you’re vulnerable. That’s around options-expirations, holidays, month-ends, earnings.  And when Demand is falling, as it’s been doing since Nov 17, when options-expirations started (Broad Sentiment at EDGE shows you).

New month, new money, so it might reverse on a dime. Knowing, making informed choices, is the key.

Public companies, no market constituency has a greater need than you to know how the stock market works. In a sense, you’re the elevators everybody boards for the ride.

Lead riders to think that Story is safety, and you’re not only hurting them but leaving your executives and boards without defense.  The stock market is motivated primarily by things other than Story. Data is always, always, a safeguard.

What about omicron? It’s an anagram for moronic. It’s 15th among 24 Greek letters. The WHO has been using them to track variants. We heard a lot about Delta. Nothing about variants Epsilon through Lambda, which exist but haven’t mattered.

The WHO skipped Nu and Xi, too culturally insensitive. Next up was omicron.

Easy scapegoat. Investors fear omicron!  Except investors didn’t do Friday, didn’t do yesterday. Friday, the only behavior up was Fast Trading. Those bloody machines. Futures expired yesterday. Volatility destroys them. That’s market structure, not a virus.

Our trouble is a stock market where machines sifting data like scientists can exploit supply/demand imbalances to profit on the pursuit of price. 

It’s the prevalent behavior in the market. It manifests starkly whenever there are unusual changes to investment, because that’s when PRICE can be exploited.  Machines don’t “think” but they’re programmed to respond.

Suppose I said, “Here are the keys to this roadster.  It’s powerful, fast, and fun. Enjoy it.”

I hand you the keys and start to walk away.  Then I stop and say, “Oh, every now and then it veers off the road for no reason.”

What would a rational person do?  Ponder that.

Most Important

The most important thing this week is gratefulness. 

We at ModernIR wish you and yours everywhere happiness and joy as those of us here in the USA mark a long and free tenure with Thanksgiving tomorrow.

Karen and I saw the Old South Meeting House in Boston, and the Exchange Building in Charleston last week.  For history buffs, it’s a remarkable juxtaposition.  The former gave root to the Boston Tea Party, the latter anchored South Carolina’s revolutionary role.

Mel Gibson’s character in The Patriot is based on Francis Marion, for whom a square and a hotel and much more are named in town.

Charleston, SC. Photo Tim Quast.

And on June 28, 1776, brave souls bivouacked at Fort Moultrie in Charleston Bay behind palmetto logs (why South Carolina is the Palmetto state) took shells lobbed from British warships that stuck in the soft wood and pried them out and fired them back, sinking two and disabling two more, and the Brits withdrew, the first defeat in a long war.

And the battle of Cowpens in Jan 1781 stopped the British in the south, cementing an American victory at Yorktown.

We walked miles and marveled at history on quaint sidewalks under live oaks. Also, we consumed unseemly amounts of grits, seafood and charming southern hospitality. We arrived concave and left convex.  Stay at the Zero George and dine there.

So, what’s most important to investor-relations officers, and traders, as we reflect this late November 2021?  While in Boston, I had opportunity to join a panel about alternative data for the Boston Securities Traders Association.

I told them I could summarize my twenty years of market structure with three words: Continuous auction market. At my advancing age, I think it’s the most important thing to grasp, because it gives rise to everything else.

I’ll explain.

In a continuous auction market, buying and selling are uninterrupted. It’s not really possible. At the grocery store, a continuous auction market would suggest the store never runs out of anything, even with no time for re-stocking. At least, in a declared amount.

Had you thought about that, IR folks and traders?  There isn’t a continuous stream of stock for sale. That condition is manufactured.

The SEC declared the stock market would never run out of at least 100 shares of everything.  Why? So the little guy’s trade would always get executed.  Consequences? It’s like that scene near the end of Full Metal Jacket where they huck a bunch of smoke grenades to go find the sniper.

The stock market is a confusing smoke cloud.  Let me give you some stats, and then I’ll explain what they mean. First, 70% of market volume in the S&P 500 is either Fast Trading, machines changing prices, or equity trades tied to derivatives.

So only 30% is investment. Yet over 40% of market volume is short – manufactured stock intended to ensure that 100 shares of everything is always for sale. So what’s fake is larger than what’s real.

Plus, 80% of all orders don’t become trades, according to data from the SEC.  And 60% of trades are less than 100 shares (odd lots).  The stock market is mist, a fine spray of form over substance.

What does this mean for all of us?  You can’t tell the Board and the executive team that investors are setting your price, IR people. Yes, it happens. But it’s infrequent. Most of your volume is the pursuit of something other than investment, principally price as an end unto itself (TSLA trades a MILLION times per day and moves 5.5% from high to low daily, on average).

And traders, it means technical signals work poorly.  They don’t account for how many prices are false, how much volume isn’t investment.

Thankfully, there’s a solution. If you understand the PURPOSE of the stock market – to create a continuous auction – then you can understand its behaviors and sort one from the other to see actual supply and demand.

Public companies, there is no other way to delineate Controllables from Non-Controllables. We can help. We’ve done the time, the thinking, the work, so you don’t have to.

And traders, you can trade supply and demand, rather than price.  Vastly more stable, less capricious, duplicitous, cunning.

I’m grateful to know that. And I’m grateful for rich and rewarding time on this planet. All of us have travails, trials. It’s part of life. But it’s vital to consider what’s most important. 

Happy Thanksgiving.

The Days Count

A lot has happened on Nov 17. 

Queen Elizabeth took the throne in 1558. Napoleon beat the Austrians outside Venice (and declared Piazza San Marco the “world’s most beautiful drawing room”) in 1796. On this date in 1855, David Livingstone saw Victoria Falls.

Illustration 114575762 / Napoleon Bonaparte © Boldurevaol | Dreamstime.com

General Ambrose Burnside on Nov 17 set out for Fredericksburg and a December 1862 battle costing the Union 12,500 casualties. A year later on this date, President Lincoln began drafting the Gettysburg Address.

On Nov 17, 1917, Lenin instituted a “temporary” end to the freedom of the press. In 1922, on Nov 17, the Ottoman Empire ended.  The same day in 1928, Boston Garden opened, and Notre Dame lost a home game for the first time in 23 years.

You get the point.  Every day counts.

Today, VIX options reset and Broad Market Sentiment peaks – or so the math suggests.  I don’t expect it’ll be more than just another November expirations period lasting three days, followed by a weekend, and then new options trading next Monday.

But you never know what momentous event is waiting for us tomorrow.  I see Goldman Sachs expects the S&P 500 to reach 5,100 next year, up 9% from now. It’s been a long time since we’ve talked about our expectations for the market. And Goldman Sachs took the pressure off for everybody.

So, what do we expect?  Every day counts.  Broad Sentiment, our 10-point meter for supply and demand, tells us when the four big reasons for buying and selling wax and wane. Traders and investors aren’t all doing the same thing. They’re buying Story, Characteristics, Price, and Association with a Derivative.

And derivatives are expiring. The PROBABILITY in the near-term is that Derivatives and Prices will trump the other two purposes. As to direction, a rising market tends to breed bull bets into expirations.

Which can mean bull bets end when new options trade.  I can’t say for sure.  But that’s the central tendency and has been for the whole time we’ve measured data, back to the advent of Regulation National Market System in 2007, the math from which makes possible observing discrete behaviors.

I thought you were going Big Picture, Tim. 

We don’t predict what the market will do – at least accurately – more than five days out.  Price is the single biggest motivation in the stock market. Take WMT, which reported great results yesterday, and fell.

Why? Because 9% of WMT trading volume is focused on Story. The remaining 91% coalesces around the other three, including 63% on Price or Derivatives. Not results.

Every public company should know that. If you can, why wouldn’t you? It’s math.

Now, broadly, my expectation is that sooner or later a stock market stuffed with derivatives and transitory prices will descend into smoking ruin.  But probably not tomorrow.

It’s also my expectation that the embrace of the ethereal – cryptocurrencies, dollars you manufacture like Happy Meals, NFTs, social tokens, the metaverse, ETFs, options, on it goes – is a sign people have lost touch with reality.

That generally doesn’t work out either.

So, we have to make each day count.  Public companies, spending all your time and dollars on Story when the market isn’t is confusing busy with productive – and leaving a lot of value for your executive team and Board lying on the table.

You have a chance to change the IR profession, you folks doing it now.  That reminds me, I’m in Boston Thursday for a trading panel. The moderator, a longtime quant sellside strategist, said 75% of the buyside uses alt data now — stuff well beyond the story you tell, the financial data you supply.

They’ve moved on.

We can keep doing what we always have while the world changes around us. Or adapt. You choose. Two trees. Obscure theological reference.

And traders, if 91% of the money is doing something else besides studying financial performance, the central tendency is that something besides financial performance will determine outcomes. I give you meme stocks, for instance.  Supply and demand create them. Not Story.

(Editorial note: Traders, try Market Structure EDGE, winner for 2021 Best Day Trading Software at the Benzinga Global Fintech Awards last week).

To wrap, I’ll say this.  Inflation boosts asset prices but is always followed by Deflation. This is a physical fact like Cause, and Effect.  The unknown, the element of uncertainty in the equation, is the gap between them.

So. If you can measure supply and demand, do it. If you can measure behaviors, do it.  You reduce the risk of being caught unaware.  In short, make every day count.

Time

The drug wears off.  Four-word summary for monetary policy and markets.

If you’re thinking, “I can’t take any more market structure or monetary policy!” you’re not alone. Karen is with you!

I won’t bore you, promise. There are things to know. Hang with me.

First, this:  Market Structure EDGE LLC, our sister company offering decision-support to active traders, just won Best Day Trading Software at the Benzinga Fintech Awards.

It’s been our dream to democratize markets for public companies and investors. ModernIR has done that for public companies, and now we’ve hit a milestone in our grand scheme, with EDGE.  We give everyday people in the stock market the power to see how money moves. What’s coming. Like we do for you, public companies.

But daytrading? you say. 

We can be flat-earthers. Or not. No matter how much we want to eradicate short-termism, to put time on our side, it won’t happen so long as rules promote one and squelch the other.  We cannot call a market “long-term” that’s 10% about the long-term, 20% about tracking benchmarks, 70% short-term.

If the central tendency is brief, so is the market.

Now, investors can use EDGE for long-term management.  Bias stock-holdings to those that spend time over 5.0, where Short Volume is on a general downtrend. That means demand is greater than supply. When that balance shifts, and it will, reweight.

We use these metrics for you, public companies. Market Structure Sentiment. Short Volume. Demand. Supply.

Illustration 122773491 / Jagger © Creat Art | Dreamstime.com

The truth is short horizons will be loved, as Maroon Five says.  If you want the moves like Jagger – we’re seeing Mick and the remaining Rolling Stones in Atlanta tomorrow – don’t spend every day out on your corner in the pouring rain, wishing for what isn’t.

Back to the drug.  Money.  Once, you could pledge $600 billion to save everyone from a financial crisis, and the market would soar like an eagle.

Last Friday late, Congress winked and dealed and handshaked and back-slapped to $1.2 trillion for infrastructure, or whatever the number is, and Monday, the market limped to weak gains and Tuesday gave them back.

The drug is wearing off.

Public companies, you’ll get this.  If your market capitalization is $X with 500 million shares out, shouldn’t it go to $2X with a billion shares issued?

Well, no.  You can’t dilute shareholders without delivering more value. Shares reflect business capacity. There must be substance. Stock alone isn’t enough.

What about meme stocks, the short-termism you just talked about?

Those aren’t marks of an evolution in thinking but cracks and strains in cultural credulity.

Follow me here. We’re getting to the crux of why the drug wears off in the economy. 

People in Congress and their theorizing acolytes in academia who author much of what becomes legislation suppose you can create a trillion dollars and voila! Growth.

Except the real world will not stop hassling you, as Matchbox Twenty would say. No matter the headlong societal rush into a mythical metaverse. In the real world, unless you can marshal twice the resources, pouring capital into the market won’t double its value.

I’ve said this before:  All output equals labor x capital. The more money, the more of it you need to make the same stuff, and the less people want to work, the more labor costs.

So the price of stuff goes up, availability goes down.  And worst, the assets that shelter value – stocks, bonds, art, cars, real estate, sports teams, NFTs, cryptocurrencies, social tokens, etc. – will start wobbling too.

And the boomerang comes back. Money loses value, fewer people can afford stuff. Consumption declines, prices fall.

Ironic, isn’t it, as Alanis Morrissette would say.  Give everybody at the table free poker chips and the people who want to win quit, and the game becomes pointless.

What’s the real solution? Spend less, save more, be efficient, be productive, cut the waste, count on nothing, be lean and tough.

No wonder the market is short-term. If you can’t count on tomorrow, trade today. We adapt to that reality, public companies, investors, traders.

I think we need and should want a reckoning, so we can get it back to good (another Matchbox Twenty reference). In the meantime, see the market as it is. Understand why more money is no panacea.

To paraphrase the Rolling Stones, if want to say time is on our side, to shout that if you start us up we’ll never stop, well then. We need a new drug.

The Inferiors

One of the penalties of refusing to participate in politics is that you end up being governed by your inferiors.

So, purportedly, said Plato. That’s our sole word on current elections.

Illustration 209532110 / Plato © Naci Yavuz | Dreamstime.com

Now let me tell you how my order to buy 50 shares was internalized by my broker, but my limit order to sell it split into two trades at Instinet, and what that’s got to do with the Federal Reserve and public companies.

Sounds like a whodunnit, right? 

Let me explain. I trade stocks because of our trading decision-support platform, Market Structure EDGE. It’s a capstone for my long market-structure career: I know now what should matter to public companies, what should matter to traders, how it ALL works.

Continuing, the Fed today probably outlines plans to “taper.” Realize, the Fed has been buying US mortgages at the same time nobody can build houses because there isn’t any paint, no appliances, you can’t find glass, wood went through the roof (so to speak).

So the Fed inflated the value of real estate.  Why?  Because it prompts people to spend money. To the government, economic growth is spending.  Mix surging balance sheets with gobs of Covid cash, and it’s like taking the paddles and telling everybody, “Clear!” and hitting the economy with high voltage.

The Fed has concluded the heartbeat is back and it’s putting away the paddles. Its balance sheet, though, says tapering is a ways off.

What’s that got to do with my trade? The Fed is intermediating our buying and selling to make it act and look like more.

But it’s not more.  And the economy rather than looking like an elite athlete – trimmed, toned, fit – is instead just off the gurney.

Put another way, the economy reflects multiple-expansion, a favorite Wall Street explanation for why stocks go up. It means everybody is paying more for the same thing.

We should have let it get tough, trim, fit. Ah well.

Did you see the Wall Street Journal article (subscription required) this week on payment for order flow in stocks and options?  I’m happy market structure is getting more airplay.  It will in the end be what gets discussed when everyone asks what happened.

Everything is intermediated. The Fed buys mortgages. Traders by trades.

I bought 50 shares of a tech stock at the market. That is, I entered the order and said, “I’ll take the best price available for 50 shares.”

I know my 50 shares is less than the minimum 100-share bid so it MUST be filled at the best price.  I also know the stock I bought trades about $16,000 at a time, and my order for 50 shares is just under that.

I’m stacking the deck in my favor by understanding market structure (I also know the stock has screaming Demand, falling Supply, a combo lifting prices, as in the economy, so I’m adding to my advantage, like a high-speed trader).

I had to confirm repeatedly that I understood I’d NOT entered a “limit” order, a trade with a specified price.

Brokers don’t want us traders using market orders because they can’t sell them. So my own broker sold me shares. That’s internalizing the trade, matching it in-house.

I sold via limit order because I was in a meeting. My broker sold it to somebody like Citadel, which split it into two trades at Island (Instinet, owned by Nomura) and took a penny both times. Then price rose almost a dollar more.

Wholesalers see all the flow, everywhere. They buy limit orders only on high odds of rising prices, making a spread, and buying and selling several times over to make more than the $0.08 they paid for my trade. I know it, and expect it.

But the purpose of the market, public companies – you listening to me? – becomes this intermediation. It’s over half of all volume. You think investors are doing it.

And this is the problem with the Fed. It manipulates the capacity to spend, and the value of assets, and manipulation becomes the purpose of the economy.

Markets cease to be free. Outcomes stop serving as barometers of supply and demand.

Actually, we see supply and demand in stocks (ask us). Too many public companies still don’t want to believe the data and instead go on doing pointless stuff. I don’t get that.  Why would we want our executives to be ignorant?

Apply that to the economy (maybe to Plato’s observation).  Let’s be honest. Rising debt and rising prices are clanging claxons of folly, like my 50 shares becoming two trades. They’re not harbingers of halcyon days.

Why be public for arbitrage? Why trade to be gamed?

We should face facts both places. The sooner, the better.  Elsewise we’re governed by our inferiors.

Whacked and Lulled

D-whacked. 

That’s how some described the stock market the past few days.  Since Donald Trump has been cancelled from popular culture, you’d be excused for missing the debut of a SPAC associated with the former President called Digital World Acquisition Corp (DWAC).

You get it now, right.  D-whack.

Illustration 93383364 / Volatility © Iqoncept | Dreamstime.com

The Twittersphere was a-flurry, amusing given the ex-President’s erstwhile penchant for that platform.

The new SPAC finished Oct 20 at $9.96, and closed the next day at $94.20, an 850% increase.  It was volatility-halted a half-dozen times Thursday, five minutes at a time.  I was on Benzinga shows several times in recent days discussing it.

We’re going to talk about those halts. Hang on for a bit.

On Friday, DWAC went berserk anew amid a rash of volatility halts, and I saw a price north of $187 at one point – a gain of almost 1,800% in two days.  It’s now near $60.

Oh, and get this:  Including warrants, there are about 42 million shares outstanding.  Last Thursday alone, DWAC traded 498 million shares, twelve times what exists.  Through yesterday it’s traded 730 million shares.

It couldn’t be a short squeeze like meme stocks GME and AMC were said to experience.  There were no shares to short. I won’t relitigate that story here, save to say that short squeezes are difficult to effect because market-makers can create stock.

And that’s what happened. If there are orders to buy 100 million shares of DWAC, market-makers will create stock to fill those between the best bid to buy or offer to sell.

Traders and public companies, you best grasp this flaw.  There is theoretically no limit on the stock that brokers executing trades might create. Stock is currency. What happens when you create more currency to chase the same goods – here, prices?

Prices inflate.

The ramifications are breathtaking.  This colossal risk exists because the SEC wants a “continuous auction market” where everything is always for sale, 100 shares at a time.

It’s nobody else’s fault. It’s a choice.

Now, let’s get back to volatility halts. We’ve had hundreds the past week, most in tiny stocks. DWAC was volatility halted almost 20 times in total.

Let’s understand volatility halts. After the May 6, 2010 so-called Flash Crash, the SEC and Finra and the exchanges implemented rules to halt the broad market and individual stocks, and they’ve been updated some since.

The broad market – as we saw repeatedly in March 2020 – hits a Level 1 halt for 15 minutes if the S&P 500 drops 7% below its previous closing price.  That halt doesn’t apply after 3:25p ET, though.  Level 2 is down 13%, and we sit and wait 15 minutes again. That actually happened. Remember?

If we smash into Level 3, down 20%, the market closes for the day.

In single stocks, there are volatility halts called Limit Up/Limit Down (LULD). Nearly 10,000 triggered in the spring of 2020. LULDs stop trading in a stock when price moves outside calculated bands from the SIP, the Securities Information Processor.

That’s the consolidated tape, how we know volume and prices across a byzantine network of nodes where stocks trade.  Trading pauses for five minutes if the bid or offer moves outside the bands.

If those moves last under 15 seconds, the halt dissolves.  If not, trading stops for five minutes, and the primary listing market then re-launches trading (the CBOE says other markets can trade a stock if the listing market can’t reopen it but I can’t confirm that).

DWAC kept rising because bids and offers melted back inside the bands. Well, what’s the point of pausing then?  Why limit a stock up or down if no limit actually happens?

Traders were screaming that the price would move dramatically at resumption too.  Of course. Price bands kept revising.  And for stocks like PHUN, which also traded wildly, the bands are massive – double what they are for stocks with prices higher than $3.

These halts seem pointless. They don’t serve issuers or investors, only the parties responsible for maintaining a continuous auction. That then becomes the purpose of the market – rather than a fair place for investors and public companies to find each other.

What happened in March 2020 will happen again. We see it in the terrible challenge stocks face when they decline rather than rise.  The market shouldn’t be d-whacked.

But it is. So get ready.

Mission SEC

Gamestop wasn’t our fault. 

That’s the conclusion of the Securities Exchange Commission in a 45-page report.  I’m reminded of Gulliver.

Not tiny people with tiny ropes tying down the giant SEC while it slept.  Satire. That the SEC exonerated itself comes as no surprise. Ask the Department of Flooding if it had anything to do with the failure of anti-flooding systems and the answer will be: Nope.

I’ve got just one beef with the SEC in this report, and read on, and you’ll see.  I commend the SEC for saying things like: To understand what transpired in January 2021, it is necessary to understand the market structure within which the events occurred.

We use the phrase “market structure” all the time.  Here, the SEC did.  Coincidence?

Illustration 94594512 / Markets © Idey | Dreamstime.com

Who is the SEC’s audience?  The public, yes. But I’m a market-structure expert. That memo is for market participants, not neophytes. Those who depend on the public equity markets. Such as public companies – who should possess the capacity to understand it (like alert reader Jay D. in New York City did!).

You do it right, public companies.  File your regulatory filings. Tell your superlative story. Meet financial targets, issue your ESG reports, hold your DEI teach-ins, put “sustainable” in everything.

Then your stock soars 500% and you don’t know why. Sure, up 500% is awesome but not knowing why is a condition that should never exist in a free, fair and open market.

Or worse, your stock plunges from $40 to $10 in a day, at the open, even though not a single stockholder sold.  That happened to AVIR yesterday. Sure, bad news on the Covid-19 front. And I can’t say no holder sold.

But isn’t the market supposed to prevent dramatic, reactionary moves in prices? We have a systemwide network of volatility girders instituted by the SEC to prevent midday panic.

Did you know your stock can trade when no holder buys or sells?  We’ll come to that at the end.  It’s how the $50 trillion construct of the US stock market clings together. And why Gamestop happened.

Let’s get to what the SEC said is necessary to understand. I’ll trim it because the memo is 45 pages long – terse for a government missive but I need 800 words for this column.

The SEC says retail trades proceed from a retail broker to somebody else for execution, report to the consolidated tape, and pass on for clearing, which can take up to three days.  Meanwhile in the options market there are a million securities, vastly more than total stocks, where the prices come from brokers and trades settle in two days or less.

How can derivatives change owners before the underlying asset?  Good question.  Unanswered.

And on page 11 of the memo is a painfully discursive paragraph on what traders may do with retail orders.  I’m condensing in Cliff’s Notes fashion: Market-makers may choose to trade with money that’s less sophisticated and avoid what’s more sophisticated, to reduce the risk of loss. And apparently it’s possible to easily segment these orders.

Got that?  I’ll dumb it down one step more, and this is my beef: The SEC is fully aware that some have a huge advantage over others.  Yet the SEC says to begin Section 2.2 that its mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Well, how can that be true if some know what others don’t? People have gone to jail for years because they bought and traded on what others don’t know. Here it appears to be happening willy-nilly.

Because the SEC needs an unfair market. The one we have won’t work if it’s fair. There is no other conclusion.

What about Payment for Order Flow, where retail brokers like Robinhood and Schwab sell trades to “wholesale” buyers like Citadel Securities and Two Sigma?

Wholesalers buy things only because they can sell what they buy at a profit.  Period.

The SEC knows it. The SEC knows some have better information than others.  And the SEC knows it exempts firms like Citadel from the short-locate rules under Reg SHO Rule 203(b)(2).

Because the mission of the SEC is to preserve the market. Which can’t hum continuously. Unless it’s gamed. So the SEC pays whomever it must with favors to see that it hums.

Sounds like politics.

As to how Gamestop happened and why no buyers or sellers are needed, see my Meme Stocks presentation.

Traders, you can’t beat the market if you don’t know how it works.  Public companies, we’re wasting time and money doing things that don’t matter.

The starting point is making sure our CEOs and boards know how the market works. We can help you begin this new mission.

Clear the Room

Winter is coming.

But autumn is mighty fine this year in the Rockies, as my weekend photo from Yampa Street in Steamboat Springs shows.

Winter follows fall and summer. Other things are less predictable, such as economic outcomes and if your Analyst Day will do what you hope (read from last week).

Here, two of my favorite things – monetary policy, market structure – dovetail.

Steamboat Springs. Photo by Tim Quast.

If you want to clear the room at a cocktail party, start talking about either one.  In fact, if you’re trapped talking to somebody you’d rather not, wanting a way out, say, “What’s your view of the fiat-currency construct?”  or “What do you think of Payment for Order Flow?”

I’ve told you before about the daily noon ET CNBC segment Karen calls the “What Do You Think of THIS Stock?” show.  Guests yammer about stocks.

Some weeks ago the host said, “What do you think of Payment for Order Flow?”

Silence.  Some throat-clearing.

Nobody understands it!  These are market professionals. Decades of experience. They don’t know how it works.

Not our topic. But so I don’t leave you hanging, PFOF is as usual with the stock market an obfuscating way to describe something simple.  Retail brokers sell a product called people’s stock trades so those people can trade stocks for free.

This is why you’re brow-beaten to use limit orders at your online brokerage.  Don’t you dare put in a market order! Dangerous!  Not true. Fast Traders, firms wanting to own nothing by day’s end and driving 53% of market volume, eschew limit orders.

They know how the market works. Brokers want you to use limit orders because those get sold. Most market orders don’t.

Pfizer wants everybody to be vaccinated and retail brokers want every trade to be a limit order, because both get paid. Same thing, no difference.

Now, back to the point.  If you tell your corporate story to a thousand investors, why doesn’t your price go up?  Similarly, why can’t we just print, like, ten trillion dollars and hand it out on the street corner and make the economy boom?

Simple. Goods and services require two things:  people and money. Labor and capital. Hand out money and nobody wants a job. Labor becomes scarce and expensive.

And if you hand out money, you’re devaluing the currency.  Money doesn’t go as far as it used to.  You need more to make the same stuff.

The irony is that handing out money destroys the economy.  You can’t make stuff, deliver it, ship it, pack it, load it, unload it, move it – and finally you can’t even buy it because you can’t afford it.

Got it?

The best thing we could do for the economy is put everything on sale.  Not drive prices up and evacuate products from shelves.  But that requires the OPPOSITE action so don’t expect it.

What does market structure have in common with monetary policy?

Too many public companies think you just tell the story to more investors and the stock price goes up.  We’re executing on the business plan. The trouble is too few know.

Wrong.  That’s a controllable, sure.  But it’s not the way the market works. AMC Theaters is a value story.  It was a herculean growth stock in early 2021 and along with Gamestop powered the Russell 2000 Value Index to crushing returns.

I was looking at data for a large-cap value stock yesterday.  The Exchange Traded Fund with the biggest exposure is a momentum growth ETF. It’s humorous to me reading the company’s capital-allocation strategy – balance-sheet flexibility with a focus on returning capital to shareholders – and looking at the 211 ETFs that own it.  It’s even in 2x leveraged bull ETFs (well, the call-options are, anyway).

Your story is a factor.  But vastly outpacing it are your CHARACTERISTICS and the kind of money creating supply, and demand. If you trade $1,500 at a time, and AMZN trades $65,000 at a time, which thing will Blackrock own, and which thing will get traded and arbitraged against options and futures?

Your CFO needs to know that, investor-relations people. And we have that data.

That large-cap I mentioned? We overlaid patterns of Active and Passive money.  Active money figured out by May 2021 that this value company was a growth stock and chased it. They were closet indexers, the Active money. PASSIVE patterns dwarf them.

And when Passive money stopped in September, the stock dropped like a rock.

It wasn’t story. It was supply and demand.

Same with the economy. Flood it with cash, and it’s hard to get that cat back in the bag once you’ve let it out.  You cannot reverse easy monetary policy without harsh consequences, and you can’t shift from momentum to value without deflation.

The good news is when you understand what’s actually going on, you can manage the controllables and measure the non-controllables. Both matter.  Ask us, and we’ll show you.