November 4, 2015

Stein’s Law

Why are stocks rising if earnings and revenues are falling?

FactSet’s latest Earnings Insight with 70% of the S&P 500 reporting says earnings are down 2.2% versus the third quarter last year, revenues off 2.9%.  Yardeni Reseach Inc. shows a massive stock-disconnect with global growth. Yet since the swale in August marked a correction (10% decline), stocks have recouped that and more.

We’re not market prognosticators. But the core differentiation in our worldview from an analytical standpoint is that we see the stock market the way Google views you:  possessing discrete and measurable demographics. When you search for something online you see what you sought served up via ads at Google, Facebook, Twitter, etc. Advertising algorithms can track your movement and respond to it. They don’t consider you just another human doing exactly the same things as everybody else.

If your stock rises because your peer reports good results, your conclusion shouldn’t stop at “we’re up thanks to them,” but should continue on to “what behavior reacted to their results and what does it say about expectations for us?” Assuming that investors are responsible for the move requires supposing all market behavior is equal, which it is not.

I saw a Market Expectation yesterday for one of our clients reporting today before the open predicting a higher price but not on investor-enthusiasm. Fast traders were 45% of their volume, active and passive investors a combined 40%. So bull bets by speculators trumped weak expectations from investors.  Bets thus will drive outcomes today.

Which leads back to the market. We separate monetary behaviors into distinct groups with different measurable motivation. By correlating behavioral changes we can see what sets prices. For instance, high correlation between what we call Risk Management – the use of derivatives including options and futures – and Active Investment is a hallmark of hedge-fund behavior. The combination dominated October markets. And before the rebound swung into high gear, we saw colossal Risk Management – rights to stocks.

What led markets higher in October are the very things that led it lower Aug-Sep. The top three sectors in October: Basic Materials, Technology, Energy.  Look at three representative ETFs for these groups and graph them over six months: XLB, XLK, XLE.

We might define arbitrage as a buy low, sell high strategy involving two or more securities. The data imply arbitrage involving derivatives and equities. Sell the derivatives, buy the stocks, buy the derivatives, exercise the derivatives.

That chain of events will magnify recovery because it forces counterparties like Deutsche Bank (cutting 35,000 jobs, exiting ten countries), Credit Suisse (raising capital), Morgan Stanley (weak trading results), Goldman Sachs (underperformance in trading) and JP Morgan (underperformance in trading) among others to cover derivatives.

And since the market is interconnected today through indexes and ETFs, an isolated rising tide lifts all boats.  A stock that’s in technology ETFs may also be in broad-market baskets including Russell, midcap, growth, S&P 500, MSCI and other indices.  As these stocks, rise, broad measures do.

At October 22, the ModernIR 10-point Behavioral Index (we call it MIRBI) was topped, signaling impending retreat. That day, the European Central Bank de facto devalued the Euro. The next day, the Chinese Central Bank did the same.  The Federal Reserve followed suit October 28 by holding rates steady. Stocks suddenly accelerated and haven’t slowed. The MIRBI never fell to neutral and is now nearing a back-to-back top.

You’ll recall that Herb Stein, father of famous Ben, coined Stein’s Law: “If something cannot last forever, it will stop.” The rally in stocks has been led by things that cannot last. In fact, the conditions fueling equity gains – everywhere, not just in the US – are comprised of what tends to have a short shelf life (options expire the week after next). Bear markets historically are typified by a steep retreat, followed by a sharp recovery, followed by a long decline.

Whatever the state of the market, what’s occurring won’t last because we can see that arbitrage disconnected from fundamental facts drove it. Understanding what behavior sets prices is the most important aspect of market structure. And it’s the beginning point for great IR.

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