Tagged: ETFs

Create and Destroy

The Terra Lunacy (cough cough) is about creating and destroying. 

If you’re thinking, “Lord, I want to read about cryptocurrencies like I want to use a power tool on a molar,” hang on.  It’s about stocks.

Illustration 247279717 / Cryptocurrency © Vladimir Kazakov | Dreamstime.com

But first, here is Market Structure 101, public companies and investors.  If the market is going to turn, or if money is going to shift from Value to Growth, it almost ALWAYS happens at options-expirations.

This is why you shouldn’t report earnings during expirations.

It’s not hard. Sit down with your General Counsel and say, “There are about $900 trillion of derivatives notional value tied to the monthly expirations calendar. Our market cap is a lot less than that.  So is the entire stock market, all the stock markets on the globe. All the GDP on the planet. So how about we don’t report results till AFTER those expire?”

Here’s the 2022 calendar.

In the 1990s, Active money was over 80% of market volume, and you could report whenever the hell you wanted.  In 2022, Active money is less than 10% of volume. 

Read the room.  Don’t hand your hard-earned earnings to the buffalo herd of speculators in derivatives to trample.  Remember that song by Roger Miller, you can’t roller skate in a buffalo herd?  Wise words.

And that’s why the market surged yesterday and may do it again.  It’s short-term trading into expirations, moving stocks to profit on sharper moves in options. It will take more than that to be durable.

Now back to Terra Luna.  A so-called stable coin pegged algorithmically to the US dollar, TerraUSD or UST for short, imploded last week.

It was supposed to be tethered to the dollar.  Monday it was trading at nine cents.  The token used to keep it aligned with the dollar, called Luna, was trading for a thousandth of a penny after at one point being worth over $100.

What’s this got to do with stocks? Exchange Traded Funds have the same mechanism.  It’s the create/destroy model. 

The point of stable coins is that by pegging them to something else, they’re supposed to be…stable.  Otherwise, supply and demand determine the value.

TerraUSD is supposed to be worth $1.  Always.  To sustain that value, Terra and Luna act like two sides of a teeter-totter.  One Terra can be burned, or destroyed, in exchange for one Luna, and vice versa.

So if Terra drops to $0.99, smart arbitragers will destroy Terra and receive Luna, bringing Terra back up to $1. Luna could become worth a lot more than $1 if the ratio skewed big toward Terra.

ETFs work the same way.  ETFs are pegged to a basket of stocks.  So stocks are Terra, ETF shares are Luna. 

As an example, XLC is the Communications Services ETF from State Street. It holds 26 of the roughly 140 stocks in the sector. Issued against that basket of stocks are ETF shares that when created had the same value as the aggregate basket of stocks.

If the stocks rise in value but the ETF lags behind, traders will scoop up ETF shares and return them to State Street, which gives them an equal value from the basket of stocks, which are valued in the open market at higher prices.

So traders can then sell and short the stocks.  That’s an arbitrage profit.

And if spooked investors sell the ETF, the process reverses. Market-makers gather up ETF shares and State Street redeems them – destroys them – in trade for stocks.

The idea is to continuously align the two (of course, that means a great deal of the trading between the ETFs and your stocks is arbitrage). 

The trouble is, even though the value of the stock market has come down markedly, the supply of ETF shares has actually risen. In fact, in March nearly $1 trillion of ETF shares were created or redeemed and creations sharply exceeded redemptions.

The Investment Company Institute publishes that data and we’ve tracked it since 2017.

When both ETF shares and stocks are losing value and prices are moving wildly, it’s much harder for arbitragers to calculate a low-risk trade.  That’s why markets swoon so dramatically now.

If market-makers stop buying or selling one or the other, we’ll have an equity Terra Luna.

It’s a small risk. But because ETFs are so pervasive ($6.5 trillion in the US market alone), at some point we’ll have a colossal failure.

It’s not fearmongering. It’s math.  We can see in the data that money has an easy time getting into the stock market, thanks to vast ETF elasticity, but a hard time getting out.

It will take a dramatic and sustained move down to cause it.

I suspect we came close in the last two months.  Maybe May options-expirations will save us, but the math says more trouble lies ahead.  The prudent foresee evil and hide themselves from lunacy.

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.

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.

Cash in Lieu

Public companies and investors, is the Federal Reserve using cash to hurt you?

What?  Quast, don’t you mean they’re inflating stocks?

To a point, yes. And then history kicks in. There’s no such thing as “multiple expansion,” the explanation offered for why stocks with no increase in earnings cost more.  If you’re paying more for the same thing, it’s inflation.

But that’s not what matters here. The Fed’s balance sheet is now over $7.7 trillion. “Excess reserves” held by member banks are $3.7 trillion, up $89 billion in just a week. In March 2007 excess reserves were about $5 billion.  I kid you not.

What’s this got to do with stocks?

The banks behind about 85% of customer orders for stocks, about 95% of derivatives notional value, and the bulk of the Exchange Traded Fund (ETF) shares trading in the market are the same.  And they’re Fed members.

Cash is fungible – meaning it can be used in place of other things.  Same with ETF shares. About $500 billion of ETF shares are created or redeemed every month.  ETF shares are swapped for stocks of equal value when money flows out of ETFs,  and when it flows in, stocks of equal value are provided by brokers to sponsors like Blackrock so the brokers can sell ETF shares to the public.

Follow? Except it can be cash instead.  Cash in lieu.

I mean, what is more abundant than cash now? There is so much excess money in the system thanks to the Fed’s issuance of currency that banks can find little better to do with it than leave it at the Fed for seven basis points of interest.

Or use it in place of stocks.

Buying and selling them is hard. They’re not liquid like $3.7 trillion of cash. There are transaction costs.  Suppose a bank needs to bring $10 billion of S&P 500 stocks as a prime broker to Blackrock to get it back in line with asset-allocations?  That’s a lot of work.

But what if Blackrock would be happy with $10 billion of cash, plus a few basis points of over-collateralization?  That’s cash in lieu. 

I’m not suggesting it happens all the time. But as the President would say, Come on man.  Imagine the temptation when creating and redeeming ETF shares for both parties to prefer cash.  It’s piled in drifts.

And you don’t have to settle any shares.  You don’t have to pay trading commissions.  And it’s an in-kind exchange of things of equal value. Cash for ETFs, or stocks for ETFs, either way. Tax-free.

Oh, and you won’t see any ownership-change, public companies.  

Don’t you wonder why stock-pickers – who enjoy none of these advantages – accept this disparity? Rules are supposed to level the playing field, not tilt it like a pinball machine.

Anyway, here’s the problem for public companies and investors.  These transactions aren’t recorded in cash. They’re in lieu, meaning the cash represents a basket of stocks. On the books, it’s as though Blackrock got stocks.

So, we investors and public companies think Blackrock owns a bunch of stocks – or needs to buy them. But it’s instead swapping cash in lieu.

The real market for stocks is not at all what it seems. Stocks start doing wonky things like diverging wildly.

Investors, I think you should complain about cash in lieu. It distorts our understanding of supply and demand for stocks.

And public companies, you wonder why you’re not trading with your peers? If you’re “in lieu,” you’re out.  There are more reasons, sure. But nearly all times it’s not your story. It’s this.

And it’s not fraudulent. It’s within the rules. But excess reserves of $5 billion would make substituting cash for stocks all but impossible. The more money there is, the more it will be substituted for other things of value.

It’s Gresham’s Law – bad money chases out good. Copernicus came up with that. Apparently he was known as Gresham (just kidding –Englishman Thomas Gresham, financial advisor to Queen Elizabeth I, lent his name to the rule later).  But it says people will hoard the good stuff – stocks – and spend the bad stuff.

Cash.

And so it is.

The Fed is distorting markets in ways it never considered when it dipped all assets in vast vats of dollars and left them there to soak. 

The good news is we can see it. We meter the ebb and flow of equities with Market Structure Sentiment and Short Volume (for both companies and investors). Broad Market Sentiment peaked right into expirations – telling us demand was about to fall.

It’s one more reason why market structure matters.

Reg Efdy and Thee

The Securities and Exchange Commission is in danger of becoming the Dept of Silly Walks.

Let me explain why I’m calling the SEC Monty Python. And it matters to you, public companies and investors.

Speaking of disclosure: I’m on the NIRI National Ethics Council, and we’re debating this matter.  What I’m saying here is, as usual, my own view.

So back in the go-go late 1990s, “sellside” analysts like Henr

Courtesy Monty Python’s Flying Circus, 1970.

y Blodget and Mary Meeker were the superstars of research. Public companies could be seen groveling at sellside thrones.

And simultaneously, sometimes tens of thousands of retail investors would join a new-fangled communication tool public companies were using, the earnings-call webcast.

And insider-trading was the hottest of buttons for regulators.  They were concerned companies were telling sellside analysts and big institutional investors things before the little guys would hear them.  The disturbing spectacle of the Big Guys getting an edge over the Little Guys.

Nothing smokes the cigar of regulators faster than that.

So in August 2000, the SEC passed Regulation Fair Disclosure requiring public companies not to tell some people stuff that could alter valuation or stock-performance without telling everybody else.

In enacting the rule, the SEC said:  

As reflected in recent publicized reports, many issuers are disclosing important nonpublic information, such as advance warnings of earnings results, to securities analysts or selected institutional investors or both, before making full disclosure of the same information to the general public. Where this has happened, those who were privy to the information beforehand were able to make a profit or avoid a loss at the expense of those kept in the dark.

Step forward to 2021.  The SEC last week brought a Reg FD enforcement against members of the investor-relations team at AT&T for supposed material nonpublic disclosures to analysts and big investors five years ago.

AT&T is contesting these findings in a tartly worded missive.

So now we get to the Ministry of Silly Walks and how it’s dragging its gangly limbs about in comic fashion.  First, if it takes you five years to figure out enforcement is needed, you’ve already made a mockery of the process.

Now, consider the stock market in 2000.  Almost 90% of investment assets were actively managed – overseen by people finding what would set one company apart from another and lead to better investment returns.  And 80% of volume was Active. And market intermediaries like Citadel Securities barely existed.

And in 2000, stocks were not decimalized.  Markets were not connected electronically and forced to share prices and customers and stock-listings so that everything trades everywhere, all the time.

In 2021, about 65% of investment assets are now passively managed using models.  Over $5 trillion in the US alone resides in Exchange Traded Funds (ETFs), stock substitutes backed by cash and securities that trade in place of actual stocks.

And trading machines using lightning-quick techniques from collocating servers right next to the exchanges’ to microwaves and fiberoptics drive over 50% of volume.

And guess where selective disclosures and informational advantages reside now?  You got it.  ETFs.  And Fast Traders.  ETFs know which direction the supply and demand for shares is moving, and they transact off-market with a handful of Authorized Participants in giant blocks called Creation Units.

Imagine if big investors gathered with big companies and traded information in smoky backrooms.  It would at minimum violate Reg FD.  It would no doubt prompt outrage.

So, why is it okay for ETFs and their brokers to do this at the rate of $500 billion per month?  It’s an insurmountable advantage harming non-ETF fund managers.

Second, Fast Traders buy retail stock orders so us little guys can trade for free and in fractional shares.  But Fast Traders can see the limit-order pipeline. Nobody else can.  That’s material nonpublic information, and it permits them to profit at others’ expense.

Why is it okay for the quickest firms to have a first look?  Notice how the operators of big traders own sports teams and $100 million houses?  There’s a reason.  It’s called Informational Advantage.

Third, as I’ve said repeatedly, automated market-makers, a fancy name for parties between buyers and sellers, can short shares without locating them, and they don’t have to square books for more than 30 days.  As we described, it’s how GME went up 1,000%.

Finally, next week indexes and ETFs will have to rebalance, and a raft of options and futures expire. And about ten big banks handle all that stuff – and know which direction it’s going.

A handful have a massive advantage over everybody else – the very thing regulations are meant to prevent. Sure, we get free trading, cheap ETFs and the appearance of liquidity.

But it’s not a fair market – and that’s why this AT&T case is silly.  It’s cognitively dissonant and hypocritical to permit rampant market exploitation while culling a five-year old file from the last regime to score political points.

Reg FD is a quaint relic from a time that no longer exists.  Maybe the SEC should regulate to how the market works now?

IS REPORTING NOW JUST A SIDESHOW?

“Looking good, Valentine!” “Feeling good, Louis!” A gentleman’s bet. But maybe not so fast.

Farce met Street last week with good reason distracting many in the Finance and public company arenas. Far better chronicled elsewhere (here a good one on Benzinga’s Monday Pre-Market Prep – pls skip the clunky ad), but this weekend I couldn’t resist the parallels to 1983’s Trading Places – I’ll leave you to Twitter, your browser or favorite streaming service and bring the focus to Market Structure.

With all rights to Messrs. Russo, Landis, Harris, Weingrod, Aykroyd, Murphy, Ms. Curtis and Paramount, et al.

We start February with a significant percentage of our clients yet to report quarterly and year-end results and to confirm their forward-looking expectations. Tough challenge in a Market seemingly growing more disinterested.

No question your IR team is working long hours with counselors and non-public facing finance, accounting and marketing coworkers to develop a cogent, clear message, to tie-out results and craft outlook statements and public disclosures; all too often, a thankless job.

It doesn’t help that the Market and the trading in individual equities are seemingly chaotic and unpredictable. But are they? As a subscriber you’re likely conversant in Market Structure – our view of the Market here at ModernIR (if no, read on and please reach out to our Zach Yeager to set up a demo). So like the polar bear swimmers here in Minnesota let’s dive in – we’ll be quick.

Here’s how the Market has evolved in the first month of 2021 – changes in the demographics of trading:

Note the Passive Investment retreat – would have been fair to expect the opposite with all the month-end true-ups for ETFs, Index and Quant Funds – but it’s a repeating month-end behavior recently followed by buying. The surge of volatility arose from increased Fast Trading – machine-driven High Frequency trading, and yes, some Retail day trading.

Both categories are largely populated by algorithmically driven trading platforms; “Passive” (a largely  anachronistic designation – and far from it or the buy and hold strategies the name conjures) today constantly recalibrate collateral holdings with dominate behaviors suggesting little long-term primary focus. “Fast Trading” – pure execution speed, volume-based trading; its goal beyond vast incremental profits – no overnight balance sheet exposure.

Short Volume trading rather than building, declined and Sentiment remained persistently positive (5.0 = Neutral) and never negative. Does this sound disorganized? For forces dominating early Q1/21 equity trading this was a strong, dynamic and likely very profitable period.

The cruel truth – machine trading is no gentlemen’s bet. Brilliant in execution, these efforts have one goal – to game inherent trading advantages over slower moving Market participants – folks that demand conference calls, executive time, build and tie-out spreadsheet models and trade in non-Market-disruptive fashion – the traditional IR audience. The system rewards this – topic for another time.

From a pure trading standpoint, traders behind 9 out 10 trades in the final day of January trading placed minimal value on traditional IR efforts as their bots rocket through Short Seller reports and quarterly management call transcripts, scan real-time news feeds and playbacks for tradable intonation in your executives’ delivery and make mathematical judgments about the first 100 words of each press release.

As IR professionals its incumbent that we, rather than be demoralized by the evolution and dominance of short-term trading, engage, and become intimately versed in these data and these Market realities. The competitive advantage is in understanding and minimizing false conclusions in decision-making. Management and the constituents of long-term investors – yes, they are still legion – and expect no less.

Let us show you how.

Perry Grueber filling in for Tim Quast

  

 

Gaffes and Spoofs

You all remember the Fat Finger?

It’s a gaffe, trading-style.  In one 2014 instance, if the record can be believed, somebody in Japan accidentally tried to buy $700 billion of stocks including more than half the total outstanding shares of Toyota.

The trades occurred outside hours and were cancelled but the embarrassment lingers.

Do you know of Harouna Traoré?  A French day trader learning the ropes, Mr. Traoré plunked down twenty thousand euros at online platform Valbury Capital and, thinking he was in simulation mode, began trading futures contracts.

Racking up a billion euros of exposure and about a million euros of losses before he realized his error, the horrified trader said, according to CNBC, “I could only think of my family.”  But the intrepid gaffer – so to speak – soldiered on, turning one billion and losses into five billion and profits of about twelve million euros.

I don’t know how it turned out but not well, it appears. The Chicago Mercantile Exchange sanctioned Mr. Traoré in June 2020 for exceeding credit thresholds, and banned him from trading for two years.

The Fat Finger has become reliably rare in US markets, thanks to security protocols.  It’s improbable we’ll again see a Knight Securities buy $4 billion of stock in 45 minutes and be forced to liquidate to Getco as happened in 2012 (Getco is now Virtu).

That’s the good news. The bad news is bizarre moves in equities such as we’ve seen in 2020 are therefore not due to gaffes.

But they could be spoofs, legal or otherwise.  JP Morgan yesterday agreed to a $920 million fine related to spoofing in futures contracts for metals and US Treasurys.  I can’t recall a larger trading fine.

Spoofing is the deliberate act of entering orders to trade securities and then cancelling them, creating, at least momentarily, the artificial appearance of supply or demand.  Dodd-Frank outlawed spoofing after tumult in the 2008 crisis, and regulations for commodities and stocks have subsequently articulated guidelines.

Investors and public companies alike don’t want fake liquidity in markets. As gaffes do, it’s what causes unexpected lurches in prices – but on purpose.

We can all sleep well, then?

Nope.

Turns out there is illegal spoofing, and legal spoofing.  The SEC’s Midas data platform shows trade-to-cancel ratios for stocks in various volume and market-cap tranches.  Generally, there are about 15 cancellations for every executed trade in stocks.

In Exchange Traded Funds (ETFs), the ratio explodes. The gaps or so severe between quartiles and deciles that an average is difficult to find. But the rate ranges from about 100 to nearly 2,000 cancellations for every completed trade.

Well, how is that not spoofing?

Answer: If you use order types it’s legal. It means – broad definitions here – that Fill or Kill (do it at once or don’t do it at all), Limit/Stop-Loss, All or None (no partial fills, the whole thing or nothing), Iceberg (just a little showing and more as the order fills) or Passive (sitting outside the best prices) orders are sanctioned by the government.

Tons are cancelled. Layer your trades with a machine instead, and it’s illegal.  Spoofing.

Wait a minute.

Order types through a broker are trades in the pipeline. Systems know they’re there. Risk-management protocols require it.  If the orders are at retail firms that sell their trades, then the high-speed buyer sees every layer before it reaches the market.

See the issue?

The market is stuffed with legal cancelled orders – that somebody else can see before the trades execute and who will therefore clearly know what the supply/demand balance is, and what gets cancelled.

I’m not sure which is worse, a fat finger, or this.  The one is just an accident.

Now, why should you care?  Because stocks are awash in compliant spoofs.  Regulators are trying to sort, one from the other, the same kind of activity, except one lets somebody else know ahead of time that it’s there. And that’s fine.  Sanctioned.

If you trade on inside information, data you obtained that others don’t know, in exchange for value, it’s illegal. Well, trades sold to high-speed firms are exactly that, if only for a fraction of a second.

If ETFs are peppered with cancellations at rates dwarfing trades, and money is piling into ETFs, would it be good for the public to know? And why mass cancellations?

Because ETFs are legally sanctioned arbitrage vehicles. That’s another story.

The good news is we track the behavior driving arbitrage.  Fast Trading.  We know when it’s waxing and waning. It imploded into today’s futures expirations – where much spoofing occurs, legally – and just as Market Sentiment turned dour.

I hope there are no gaffes.  Spoofs will abound.  Authorities will pat themselves on the back.  It’s a weird market.

***

By – Tim Quast, President and Founder, ModernIR

Big Blanket

The US stock market trades about $500 billion of stock daily, the great majority of it driven by machines turning it into trading aerosol, a fine mist sprayed everywhere. So tracking ownership-changes is hard. And unless we speak up it’s about to get a lot harder.

In 1975 when the government was reeling like a balloon in the wind after cutting the dollar loose from its anchoring gold, Congress decided to grant itself a bunch of authority over the free stock market, turning into the system that it now is.

How?  Congress added Section 11A to the Securities Act, which in 2005 became Regulation National Market System governing stock-trading today – the reason why Market Structure Analytics, which we offer to both public companies and investors, are accurately predictive about short-term price-changes.

And Congress decided to create a disclosure standard for investors, amending the Securities Act with section 13F. That’s what gave rise to the quarterly reports, 13Fs, that both investors and public companies rely on to know who owns shares.

I use the phrase “rely on” loosely as the reports are filed 45 days after the end of each quarter, which means the positions could be totally different by the time data is released. It’s a standard fit for the post office. Mail was the means of mass communication in 1975.

Currently, the standard applies to funds with $100 million or more in assets. Many managers divide assets into sub-funds to stay below that threshold.  So most companies have shareholders that show up in no reports. But at least they have some idea.

Well, out of the blue the Securities and Exchange Commission (SEC) has decided to lift the threshold to $3.5 billion to reflect, I guess, the collapse of dollar purchasing power.

But nothing else changes!  What would possess a regulatory body ostensibly responsible for promoting fairness and transparency to blanket the market in opacity while keeping in place time periods for reporting that have existed since 1975?

I’m reminded of a great line from the most quotable movie in modern history, Thank You For Smoking: I cannot imagine a way in which you could have $#!!@ up more.

Public companies have been asking the SEC for decades to modernize 13F reporting. Dodd Frank legislation passed in 2010 included a mandate for monthly short-position reporting. It’s not happened because the law put no timeframe on implementation.

But how stupid would it be to require monthly short-position reporting while letting long positions remain undisclosed till 45 days after the end of each quarter?

Much of the world has stricter standards of shareholder disclosure.  Australian markets empower companies and stock exchanges to require of investors full disclosure of their economic interest, on demand.

Our regulators appear to be going the opposite direction.

Australia offers an idea, SEC. If you’re going darken the capital markets with a new (non) disclosure standard, then how about empowering companies to demand from holders at any time a full picture of what they own and how they own it?

Investors, I get it. You don’t want anyone knowing what you have.  Well, it seems to work just fine in Australia, home to a vibrant capital market.

And let’s bring it around to market structure.  There is a woefully tilted playing field around ETFs.  A big investor, let’s say Vanguard, could give a billion-dollar basket of stocks to an Authorized Participant like Morgan Stanley off-market with no trading commissions and no taxes, in exchange for a billion dollars of ETF shares.

None of that counts as fund-turnover.

It could happen by 4p ET and be done the next day.  No trading volume. And then Vanguard could come right back with the ETF shares – again, off-market, doesn’t count as fund-turnover – and receive the stocks back.

Why would investors do that? To wash out capital gains. To profit on the changing prices of stocks and ETFs. This is a massive market – over $500 billion every month in US stocks alone.  It’s already over $3 TRILLION in total this year.

What’s wrong with it?  All other investors have to actually buy and sell securities, and compete with other forces, and with volatility, and pay commissions, pay taxes, alter outcomes by tromping through supply and demand.  Oh, and every single trade is handled by an intermediary (even if it’s a direct-access machine).

So how is that fair?

Well, couldn’t all investors do what Vanguard did?  No. Retail investors cannot.  Yes, big investors could take their stock-holdings to Morgan Stanley and do the same thing. But trading stocks and ETF shares back and forth to profit on price-changes while avoiding taxes and commissions isn’t long-term investment.

That the ETF market enjoys such a radical advantage over everything else is a massive disservice to public companies and stock-pickers.

And after approving the ETF market, you now, SEC, want to yank a blanket over shareholdings to boot?  Really?  Leave us in 1975 but 35 times worse?

Market Structure Analytics will show you what’s happening anyway. And nearly in real time. But that’s not the point. The point is fairness and transparency. Every one of us should comment on this rule.

Unknowable

The question vexing Uber and Grubhub as they wrestle over a merger is which firm’s losses are worth more?

And for investors considering opportunities among stocks, a larger question: What companies or industries deserve better multiples on the Federal Reserve’s backstopping balance sheet and Congress’s operating loans?

Sure, I’m being cheeky, as the Brits would say.  The point is the market isn’t trading on fundamentals. Undeniable now to even the most ardent skeptics is that something is going on with stocks that wears an air of unreality.

And there is no higher impertinence than the somber assertion of the absurd. It deserves a smart retort.

We’ve been writing on market structure for over a decade. Market structure is to the stock market what the Periodic Table is to chemistry. Building blocks.

We’ve argued that the building blocks of the market, the rules governing how stock prices are set, have triumphed over the conventions of stock-valuation.

SPY, the S&P 500 Exchange Traded Fund (ETF), yesterday closed above $308. It last traded near these levels Mar 2.

What’s happened since? Well, we had a global pandemic that shut down the entire planetary economic machinery save what’s in Sweden, North Dakota and Africa. Over 40 million people in the United States alone took unemployment. Perhaps another 50 million got a paycheck courtesy of the US Congress’s Paycheck Protection Program.

Which means more than half the 160 million Americans working on Mar 2 when stocks last traded at current levels have been idled (though yes, some are returning).

At Feb 27, the Federal Reserve’s balance sheet was $4.2 trillion, of which $2.6 trillion sat in excess-reserve accounts earning interest of about 1.6% (why banks could pay some basis points on your savings account – arbitrage, really, that you, the taxpayer, footed).

By May 28 the Fed’s obligations on your behalf (all that money the Fed doles out has your name on it – “full faith and credit of the United States”) were $7.1 trillion, with $3.3 trillion in excess reserves now earning ten cents and wiping out meager savings-account returns but freeing taxpayers of interest expense.

The nearest facsimile I can arrive at for this great workforce idling, casting about in my history-obsessed mind, is the American Indians.  They were told, stop hunting and gathering and go on the government’s payroll.

Cough, cough.

You cannot idle the industrious and value their output the same as you did before.

Yet we are.

While I’m a pessimist about liberal democracy (classical meaning of “freedom”) because it persisted through a pandemic by the barest thread, I’m an inveterate optimist about American business.  I’ve obsessed on it my adult life. It affords a fulsome lifestyle.

The goal of good fiction is suspense of disbelief. That is, do I buy the thesis of the story? (News of the World is by the way brilliant fiction from Paulette Jiles with a high disbelief-suspension quotient).

Well, the stock market is supposed to be a barometer for truth. Not a litmus test for suspension of disbelief.

Sure, the pandemic cut some costs, like business travel. But contending a benefit for bottom lines ignores the long consequential food chain of ramifications rippling through airlines, hotels, restaurants, auto rentals, Uber, Lyft, on it goes.

How about corporate spending on box seats at big arenas?

Marc Benioff is still building his version of Larry Ellison’s Altar to Self in downtown San Francisco (no slight intended, just humor) for salesforce.  Yet he said to CNBC that some meaningful part of the workforce may never return to the office.

An empty edifice?

And nationwide riots now around racial injustice will leave at this point unknown physical and psychological imprints on the nerve cluster of the great American economic noggin.

Should stocks trade where they did before these things?

The answer is unknowable. Despite the claims of so many, from Leuthold’s Jim Paulson to Wharton’s Jeremy Siegel, that stocks reflect the verve of future expectations, it’s not possible to answer something unknowable.

So. The market is up on its structure. Its building blocks. The way it works.

Yes, Active investors have dollar-cost-averaged into stocks since late March. But that was money expecting a bumpy ride through The Unknowable.

Instead the market rocketed up on its other chock-full things.

Quants chased up prices out of whack with trailing data. ETF arbitragers and high-speed traders feasted on spreads between the papery substance of ETF shares and the wobbly movement of underlying stocks.  Counterparties to derivatives were repeatedly forced to cover unexpected moves. The combination lofted valuations.

None of these behaviors considers The Unknowable.  So, as the Unknowable becomes known, will it be better or worse than it was Mar 2?

What’s your bet?

Daily Market Structure Sentiment™ has peaked over 8.0/10.0 for the third time in two months, something we’ve not seen before. The causes are known.  The effects are unknowable save that stocks have always paused at eights but never plunged.

The unknowable is never boring, sometimes rewarding, sometimes harsh. We’ll see.

Benjamin Graham

A decade ago today, stocks flash-crashed.  I’m reminded that there are points of conventional market wisdom needing reconsideration.

It’s not because wisdom has diminished. It’s because the market always reflects what the money is doing, and it’s not Ben Graham’s market now. I’ll explain.

There are sayings like “sell in May and go away.”  Stocks fell last May. You’ll find bad Mays through the years. But to say it’s an axiom is to assert false precision.

Mind you, I’m not saying stocks will rise this month. They could plunge. The month isn’t the reason.

Graham protégé Warren Buffett told investors last weekend that he could find little value and had done the unthinkable: Reversed course on an investment. He dumped airlines. Buffett owned 10% of AAL, 11% of DAL, 11% of LUV and 9% of UAL.

Buffett and Berkshire Hathaway, sitting on $137 billion, believe in what Buffett termed “American Magic.” But they’ve sold, and gone away in May.

There are lots of those sayings. As January goes, so goes the market.  Santa Claus rallies come in December.  August is sleepy because the traders are at the Cape, the Hamptons.

These expectations for markets aren’t grounded in financial results or market structure.

Blackrock, Vanguard and State Street own 15-20% of the airlines, all of which are in 150-200 Exchange Traded Funds (ETF).  Passive money holds roughly half their shares.

Passives don’t care about the Hamptons, January, or May.  Or what Warren Buffett does.

In JBLU, which Buffett didn’t own, the Big Three own 20%, and Renaissance Technologies and Dimensional Fund Advisors, quants with track records well better than Buffett’s in the modern era, invest in the main without respect to fundamentals.

Unlike Buffett, RenTech and DFA continually wax and wane.

It’s what the money is doing now.  Its models, analysis, motivation, allocations, are not Benjamin Graham’s (he wrote Security Analysis, The Intelligent Investor, seminal tomes on sound stock-picking from the 1930s and 1940s).

And that’s only part of it.  New 13fs, regulatory details on share-ownership, will be out mid-May. Current data from the Sep-Dec 2019 quarters for DAL show net institutional ownership down 17m shares, or 3%.

But DAL trades over 70 million shares every day. Rewinding to the 200-day average before the market correction exploded volumes, DAL still traded over 16m shares daily.  The total net ownership change quarter-over-quarter was one day’s trading volume.

Since there are about 64 trading days in a quarter, and 13fs span two quarters, we could say DAL’s ownership data account for about 1/128th of trading volume. Even if we’re generous and measure a quarter, terribly little ownership data tie to volume.

Owners aren’t setting prices.

Benjamin Graham was right in the 1930s and 1940s.  He’s got relevance still for sound assessment of fundamental value.  But you can’t expect the market to behave like Benjamin Graham in 2020.

The bedrock principle in the stock market now is knowing what motivates the money that’s coming and going, because that’s what sets prices.  Fundamentals can’t be counted on to predict outcomes.

In DAL, Active Investment – call it Benjamin Graham – was about 12% of daily volume over the trailing 200 days, but that’s down to 8% now. Passive money is 19%, Fast Traders chasing the price long and short are 62% of the 73m shares trading daily. Another 11% ties to derivatives.

Those are all different motivations, reasons for prices to rise or fall.  The 11% related to derivatives are hoping for an outcome opposite that of investors. Fast Traders don’t care for more than the next price in fractions of seconds. They’re the majority of volume and will own zero shares at day’s end. You’ll see little of them in 13fs.

The airline showing the most love from Benjamin Graham – so to speak – is Southwest.  Yet it’s currently trading down the most relative to long-term performance. Why? Biggest market cap, biggest exposure to ETFs.  It’s not fundamental.

If you’re heading investor-relations for a public company or trying to invest in stocks, what I’ve just described is more important than Benjamin Graham now.

The disconnect between rational thought and market behavior has never been laid so bare as in the age of the pandemic.  It calls to mind that famous Warren Buffett line:  Only when the tide goes out do you discover who’s been swimming naked.

Might that be rational thought?

How airlines perform near-term depends on bets, trading, leverage. Not balance sheets.  It’s like oil, Energy stocks – screaming up without any fundamental reason.  And market structure, the infinite repeating arc from oversold to overbought, will price stocks. Not Ben Graham.  Though he was wise.