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Suspended

Shocking.

No other word for it.

Yesterday as VIX volatility futures settled on an odd Tuesday, Barclays suspended two of the market’s biggest Exchange Traded Notes (ETNs), VXX and OIL.

Let me explain what it means and why it’s a colossal market-structure deal.

VXX is the iPath Series B S&P 500 VIX Short-Term Futures ETN. OIL is the iPath Pure Beta Crude Oil ETN (OIL). iPath is a prominent Barclays brand. Barclays created the iShares line that Blackrock bought.  It’s an industry pioneer.

Illustration 76839447 © Ekaterina Muzyka | Dreamstime.com

These are marketplace standards, like LIBOR used to be.  This isn’t some back-alley structured product pitched from a boiler room in Bulgaria (no offense to the Bulgarians).

Let’s understand how they work. ETNs are similar to Exchange Traded Funds (ETFs) in that both trade like stocks.  But ETNs are unsecured, structured debt.

The aim of these particular notes is to pay the return via trading reflected in crude oil, and volatility in the S&P 500 stock index. 

OIL uses quantitative data to select baskets of West Texas Intermediate oil futures that the model projects will best reflect the “spot” market for oil – its immediate price.  But nobody owning OIL owns anything. The ETN is just a proxy, a derivative.

VXX is the standard-bearer for trading short-term stock-volatility. It’s not an investment vehicle per se but a way to profit from or guard against the instability of stock-prices.  It’s recalibrated daily to reflect the CBOE Volatility Index, the VIX.

In a nutshell, a security intended to give exposure to volatility was undone by volatility.

I loved this phrase about it from ETF.com: “Volatility ETPs have a history of erasing vast sums of investor capital over holdings periods as short as a few days.”

ETP is an acronym encompassing both ETFs and ETNs as Exchange Traded Products.

It’s not that Barclays shut them down. They continue trading for now. The bank said in a statement that it “does not currently have sufficient issuance capacity to support further sales from inventory and any further issuances of the ETNs.”

ETF industry icon Dave Nadig said, “The ‘Issuance Capacity’ thing is a bit of a get out of jail free card, so we can interpret that as ‘we no longer feel comfortable managing the implied risk of this product.’”

Barclays said it intends to resume supporting the funds at some future point. But we’ll see.  Credit Suisse ETNs that failed in Mar 2020 amid Pandemic volatility were stopped temporarily too but suspensions became permanent.

The lesson is clear. The market is too unpredictable to support single-day bets, which these instruments are principally designed for. 

I’ve long written about the risks in ETPs. They’re all derivatives and all subject to suddenly becoming worthless, though the risk is relatively small.

And it’s incorrect to suppose it can happen only to ETNs. All tracking instruments are at risk of failure if the underlying measure, whatever it is, moves too unpredictably.

You might say, “This is why we focus on the long-term.  You can’t predict the short-term.”

Bosh. Any market incapable of delivering reliable prices is a dysfunctional one.  It’s like saying, “I don’t know what to bid on that Childe Hassam painting but I’m sure over the long-term it’ll become clear.”

Bluntly, that’s asinine. Price is determined by buyers and sellers meeting at the nexus of supply and demand.  If you can’t sort out what any of that is, your market is a mess.

It remains bewildering to me why this is acceptable to investors and public companies. 

It’s how I feel about empty store shelves in the USA. No excuses. It reflects disastrous decisions by leaders owing a civic duty to make ones that are in our best interests.

Same principle applies. We have a market that’s supposed to be overseen in a way that best serves investors and public companies. Instead it’s cacophony, confusion, bellicosity, mayhem.

At least we at ModernIR can see it, measure it, explain it, know it.  We’ve been telling clients that it’s bizarre beyond the pale for S&P 500 stocks to have more than 3% intraday volatility for 50 straight days. Never happened before.

Well, now we know the cost.

Oh, and the clincher? VIX options expired yesterday. Save for four times since 2008, they always expire on WEDNESDAY. Did one day undo Barclays?  Yes.

That’s why market structure matters. Your board and c-suite better know something about it.

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.

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.

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.

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 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.

Behavioral Alerts Definitions

Market Structure Alerts – Definitions & Use

Behavioral Alerts:

  • Active investment = The money you target and with which you communicate. The good stuff. Fundamental investors.
  • Fast Trading = Intermediation. Intraday arbitrage on changing prices. Not “real” ownership-change.
  • Passive Investment = Indexes, ETFs, quantitative investment. Money investing for macro, model-driven reasons. Blackrock, Vanguard, State Street, etc.
  • Risk Management = Portfolio insurance; derivatives to boost performance.

Rational-Price Alert:

  • Rational Price: All prices are not equal. We track when the investors you talk to – Active Investment – outcompete others to buy shares, thus setting price. You should know when that occurs so you can correlate to news or outreach, if applicable.

Short Volume Alert:

  • Short Volume:
    • Over 50% = Headwinds, short-term behavior, renting more profitable than owning. Rotation.
    • Below 50% = Favorable Supply/Demand balance
    • Sharp Rise (up 25% in a week) = probable impending selling, or short bets
    • Sharp Drop (down 25% in a week) = short-covering, Supply/Demand imbalance
  • There’s more to it!  There’s the market-maker exemption to Reg SHO Rule 203(b)(2). Ask us for more.

How to Read:

Purpose: Predictive capabilities for answers & defensive “early alert” characteristics

  • Example: If shares were up on Passive buying on a good day for markets, and the next day is a bad day, shares are likely to give back gains.
  • Example: If your short volume jumps above 50% and the next day your shares are down, the answer isn’t just something occurring today but that market structure indicated rotation was already underway (high short volume can signal rotation).
  • Big behavioral changes signal that pricing of shares has been impacted even if it doesn’t appear so. Harbingers of everything from index rotation to activism or other event-driven behaviors.

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.