November 7, 2018

Pricing Everything

As the colors of political persuasion in the USA ripple today, what matters in the equity market is what the money is doing.

We measure Sentiment by company and sector and across the whole market daily. It’s not mass psychology. Rational thought sets a small minority of prices (your board and execs should know, investor-relations professionals, or they will expect you to move mountains when the power at IR fingertips now is demographics – just as in politics).

We’re measuring ebbs and flows of money and the propensity of the machines executing the mass of trades now to lift or lower prices.

When the market is Oversold by our measures, it means Passive money is likely to be underweight relative to its models and benchmarks, and probability increases that machines will lift prices for stocks because relative value – the price now versus sometime in the past 20 days – is attractive. We call it Market Structure Sentiment.

In Oct 2016, before the Presidential election, Market Structure Sentiment saw its worst stretch since Sep-Oct 2014 when the Federal Reserve stopped buying debt, sending the dollar soaring and the energy industry into a bear market.

We at ModernIR thought then that after pervasive monetary intervention the next bear market would be two years out. On the eve of the Presidential election two years ago, and two years out, the Dow 30 traded at Dec 2014 levels.

We figured we’d called it.

We were wrong (the market makes fools of most who propose to prophesy).  Donald Trump won, and stocks surged until October this year.

As I write Nov 6, Market Structure Sentiment has bottomed at 3.5/10.0 on our 10-point scale. In 2016 it bottomed Nov 9, the day of the election (and stocks surged thereafter).

Conclusions?  Maybe rational thought means little.

Consider: The SEC has approved Rule 606(b)(3) (if rules need parentheses it means there are too many – but I digress) for brokers, requiring that they disclose (thank you, alert and longtime reader Walt Schuplak) when they’re paid by venues for trades and trade for their own accounts.

Public companies and investors, why do we need rules requiring brokers to tell us if they’re getting paid for orders or trading ahead? Because they’re doing it. And it’s legal.

If we want to suppress both things, why not outlaw them?

Because the market now depends on both to price everything.

Let me explain. When the SEC exempted Exchange Traded Funds from the Investment Company Act’s requirement that fund-shares be redeemable for underlying assets, they did so because ETFs had an “arbitrage mechanism,” a built-in way for brokers to profit if ETFs deviated from its underpinning index.  (NOTE: If you don’t know how ETFs work, catch the panel at NIRI Chicago next week.)

Those exemptions preceded Regulation National Market System, which capped trading fees – but left open what could be PAID for trades. I bet the SEC never saw this coming.

Rule 606(b)(3) forces brokers to tell customers when they get paid for trades and if they are trading for themselves at the same time.

In ETFs, the two dovetail. Brokers can earn trading incentives legitimately because they’re fueling the SEC-sanctioned arbitrage mechanism, which requires changing prices. Rules let you get paid for it!

Second, since ETFs are created and redeemed by brokers (not Blackrock), much ETF market-making is principal trading – for a broker’s own account.

So ETFs create opportunity for brokers to get paid for setting price, and to put their own trades ahead of customer orders – the things 606(b)(3) wants to highlight.

Now ETFs are the largest investment vehicle in markets, and Fast Trading prices stocks more often than anything else. Suppose you’re the SEC. What would you do?

Let’s put it in mathematical terms. Our analytics show 88% of trading volume is something besides rational investment. We blame rules that focus on price. Whatever the cause, there’s a 12% chance rational thinking is why Sentiment is bottomed at midterms.

I think the SEC knows. Can they fix it? Well, the SEC created it to begin.

For now, public companies, every time you look at stock-price, there’s a 12% chance it’s rational. Does your board know? If not, why not? Boards have fiduciary responsibility.

And investors, are you factoring market structure into your decisions? You’d best do so. Odds favor it.

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