October 22, 2014


It’s not what you think.  Heard that phrase before?

Last Wednesday, Oct 15, apparently everybody trading equities believed the world was dissolving in an apocalyptic stew of Ebola, European recession, unused petroleum, Chinese debt and Mideast terror. The DJIA at one point dropped 460 points.

Son of a gun. By Friday, October 17 we were back to milk and honey and Captain Crunch! The DJIA rose 263 points. Human nature is fickle. But this juxtaposition stretches credulity. It’s also a lesson on market structure.

In 2013, according to the Investment Company Institute, net US inflows to mutual funds were $152 billion, of which $52 billion went to target-date hybrid funds (mixes of bonds and equities based on one’s age), and about $53 billion to index funds, 82% of which track major market measures like the S&P 500. Exchange-traded funds garnered another $180 billion, mostly equity instruments that track funds tied to indices.

If two-thirds of the net new cash followed asset-allocation vehicles and a greater sum still sought ETFs, which post daily market positions, the likelihood that most of your price-movement reflects fundamentals is low unless you have an activist (event-driven money can catalyze bipolarity in market behavior – higher highs and lower lows).

There’s an animation sequence I’ve seen that starts with what appears to be mountains or desert from great height. Then our vantage point pans back and we see with surprise that it’s something else entirely: the brown pupil of a person’s eye.  We sweep back and the person is standing on a shoreline. Then back we scan across forests, mountains, rivers, countries and then continents until we’re in space seeing below us a lovely cobalt sphere, and we pan further, and it’s the blue pupil of a giant being.

Equities are trading about $200 billion daily. But with high-frequency flows in our data routinely ten times the price-setting authority of any other behavior, true dollar flow could be a small fraction of that.

The US Treasury auctions over $100 billion of notes, bond and bills every week on average (about $8 trillion refinanced or issued in fiscal 2014), data we track in your Market Structure Reports on page two under Macro commentary, clients. Currency trading daily averages more than $4 trillion and routinely tops $5 trillion. That daily figure equals all the cash held outside US retirement accounts, about $5.1 trillion.

According to Sifma, the securities industry association, swaps involving interest rates and currencies total more than $800 trillion of notional value globally. And there we are. We’ve panned back to the eye of the giant.

Last Wednesday as the stock market plunged, so did the US dollar, the steepest slide in our currency versus others since it began running up mid-August. Magically, oil prices stopped slipping and by Friday stocks zoomed.

The vast global accumulation of derivatives contracts have dates-certain. Most use monthly expirations set by the Options Clearing Corp. Contracts for options and futures expired Oct 16-17.  A new series began trading Oct 20.

Today, Oct 22, contracts tied to implied volatility in the S&P 500 – there are some 34 ETFs, along with the famous Fear Index, the VIX, and associated options and futures providing exposure to volatility as an asset class – lapse. The period between September and October expirations has offered volatility traders a cornucopia not seen in years.

Perhaps we’ve settled out.  Back to steady-on. But the ModernIR 10-point Behavioral Index (MIRBI) remains dour, worse even than a week ago. With the European Central Bank set to buy corporate bonds as the US economy steadies, a rising dollar is nearly certain. A strong buck weakens oil and stocks. The Fed meets next week.

Never trust an expirations rally.  You don’t know if you’re standing on the shoreline of a gentle sea, or seeing ductile effluvia from a giant set to shed tears.

This same principle applies to your shares. It’s probably not what you think. Far better to measure the data (market structure!), which never laugh or cry. They just…are.

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