July 26, 2023

Searching for Why

Now it’s getting weird.

Companies are asking us why their shares are up.  Most times it’s the reverse. Why’s my stock down?

It’s a telling point along the continuum of the Curiously Strong Market.  S&P 500 earnings so far this quarter are down about 9% year-on-year, revenues down 30 basis points (which seems nothing, but revenues fell only 1.1% in Q32020 during the pandemic, the last time revenues declined), says Factset.

Photo 191384771 | Answer To Why © Svetlana Dubovetcaia | Dreamstime.com

And here’s a tidbit, courtesy of Victor Sperandeo and The Curmudgeon, the experienced guys writing the Fiend Bear blog: Investment Company Institute data on mutual fund flows show net declines.

Not just at the moment but since 2015.  I tallied the data from the ICI. In the last three years alone, long-term mutual-fund holdings of both equities and bonds in the US are down $1.4 trillion.

Yeah, but Tim. The money is shifting to ETFs.

Agreed.  But it means mutual ownership of shares is falling. ETFs don’t manage anybody’s money.  They’re not fiduciaries.  If you own Blackrock or Fidelity or Vanguard ETFs, they don’t manage your account. They manage their own money.

You own ETFs in your brokerage account.

The point?

Stocks aren’t rising on long-term fund flows.  There are long-term fund outflows.  Just this year alone, $230 billion has come out of equity mutual funds. So how the heck does the stock market rise?  Can’t say it’s more buyers than sellers.

Because ETFs inflate stocks, that’s why.

I’ve explained it before.  ETFs expand the reach of money into the same underlying stocks. 

Say mutual funds buy all the outstanding shares of a company and sell none of it. Can the stock rise?

Here’s an analogy. Say I want to buy your car. You won’t sell it. So, I can’t buy it. Its value doesn’t change.

But in the stock market, you can buy things that aren’t for sale. Like this:

  1. Institutions own 100% of stock XYZ, a large Technology stock, and none sell it.
  2. There is big demand, though, for the White Pebble ETF, ticker symbol TEK.
  3. Morgan Stanley gives White Pebble a basket of similar tech stocks to XYZ.
  4. White Pebble gives MS a like-kind, equal-value, batch of TEK shares.
  5. MS sells them to the public.
  6. Demand for all tech stocks rises, because TEK is rising and arbitragers lift stocks.

Market-makers keeping TEK shares in line with the value of “the basket” representing the Technology sector, create stock to fill orders – including for XYZ, which rises.

But wait, Tim.  If no holders are selling XYZ, how can it rise?

Read what I wrote. They created stock to fill orders.


Yes. The SEC requires market-makers who buy and sell stocks continuously to fill orders for 100 or fewer shares. Even when no stock exists. It’s the law.  They can “short” new shares into existence for a time.

This births “multiple-expansion,” the silly notion stocks rise because somebody assigns a higher value to price vs earnings.

There is no such thing. There is only paying more for the same thing.

Or in the current case, paying way more for less – since earnings and revenue are down year-over-year, and prices are up.

This is how the stock market works.

And there’s your answer. ETFs permit more money to chase the same stocks, which can be created out of thin air by market-makers.

We can measure it. We can also be much more prosaic. For instance, AT&T is down not because investors have sold it on lead-cable fears but because Passive demand has dropped 25%.

Back to stocks broadly. There has been consistent excess Demand and insufficient Supply in US stocks since June 7.

A year ago, Supply hit a nadir Aug 18 (during options-expirations), against surging Demand. SPY traded near $430, a level it didn’t revisit until June 8 this year.

That’s no coincidence. It’s Demand and Supply.

On Aug 19, 2022, Supply surged, Demand faltered. Stocks fell apart. Stocks kept falling until Demand and Supply both bottomed in October 2022.

The point?  Fundamentals don’t determine it. Fund-flows don’t cause it.

What does? Changes in Demand and Supply. Market-makers create stock, and Demand waxes, and wanes. That’s measurable.

What causes it? 

Well, sometimes nothing more than traders that stop chasing options on stocks and associated ETFs. Sometimes it’s a data point that changes a quantitative macroeconomic model, like inflation data, jobs data, interest rates.

There’s interest-rate data from the Fed today.

Sometimes it’s just an algorithm.

When’s the next rip in the fabric?  Who knows? Currently, Demand is strong but near a statistical ceiling, and Supply is insufficient.

Stocks will stall or fall when either side falters.

Maybe it doesn’t happen. Maybe it happens this week. But that’s the thing you should know – Demand and Supply in your stocks. It’s the way the stock market works.

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