Tagged: Fast Trading

Constant Change

The SEC wants to save the little guy. Again. 

A number of you alert readers sent me this story (WSJ registration required but there are similar versions) about the Gensler SEC weighing changes to how trades from retail brokerages are handled.

For those new to market structure, the SEC has a long history of adding complexity to the stock market in the name of helping retail money that ends up instead aiding computerized traders and stock exchanges.

Would that we had less noise and more substance! But we need to first understand the problem. It’s that the stock market is full of tiny trades, and not that retail traders are getting hurt.

Meanwhile, this photo is not of market structure.  Normally in early June – for the bulk of my adult life – I’d be at the NIRI Annual Conference circulating with colleagues.

Photo by Tim and Karen Quast, Jackson Hole, June 2022.

I’d have to count to know for sure, but for most of the past 27 years I’ve been there.  We took a break and this year we’re in Jackson Hole, WY, and other spots in a big loop through WY and MT seeing the west (I’m writing Tuesday night in Billings).

We were in Yellowstone much of Monday covering more than ten miles afoot, riveted by the constancy of change in nature.  Some of it is predictable, like Old Faithful and the Grand Geyser (footage here).

A lot of it isn’t.  And you can’t manage it or direct it.

The point?

Stuff constantly changes.  It’s the most inerrant feature of nature. Change is integral to human nature, which animates the stock market.

Regulators are possessed of that same nature yet want to cast the market like pewter.  Create a model and force every free-moving thing to conform.

It’s most certainly not that SEC chair Gary Gensler is smarter than millions of self-interested participants.  No, regulators want to make a mark, the same as anybody else. 

Pharaohs in Egypt hoped for immortality through pyramids.  Carnegie built libraries.  You can go to Newport and see the edifices of the rich, built to last long beyond the builders.

As ever, I have a point about the stock market. The preceding SEC administration under Jay Clayton revamped the rules, too.

I discussed their final proposed rule, Regulation National Market System II – which I called Reg Nemesis II (see what I wrote about Reg Nemesis I here) – with SEC head of Trading and Markets Brett Redfearn, who described it to the NIRI board at our request.

That rule considered many of the same things Gensler is weighing including redefining the meaning of “round lot,” currently 100 shares regardless of price, to reduce market-fragmentation that harms investors of all kinds.

After all that work, the expended taxpayer resources, the studies and lawsuits and machination, it’s set aside because the new SEC wants to build its own pyramids.   

Okay, Quast, you’ve convinced me everybody wants an ovation. Your point?

The problem is the stock market is stuffed full of tiny trades that devolve purpose from investment to chasing pennies and generating data to sell.

Which in turn is the consequence of rules. I’ve explained before that the SEC’s paramount objective is 100 shares of everything to buy and sell, all the time.

Which is impossible.

I know. I trade.  Trades fragment more at exchanges than in broker-operated markets called dark pools.  Routinely I buy in a chunk in a dark pool and then watch my trades get splintered into 5, 7, 34, 61, shares at exchanges (especially the NYSE).

The exchanges pay traders to set the bid and offer, which snap at my order like piranhas, chopping it into pieces and pricing the market with it.

In Yellowstone, nature takes its course. It’s a marvel, cinematic artistry that takes one’s breath away.  It cannot be and does not need to be directed by humans. We observe it and love it, and it changes.  Some stuff like the Grand Geyser and Old Faithful, follow a clock.  A lot of things don’t.

The same is true of human commerce. The more the few machinate interaction into exceptions and directives and objectives, the less it works.  It should in large part follow its own course, with a clear boardwalk for traipsing through the geysers.

Put another way, rather than merchandising retail trades to build pyramids, we should insist on a single set of standards, no exceptions.  And let the game be played.

There are too many complex rules, too many exceptions.  That’s the real problem.  And so the market lacks the elegance of chance, the beauty of organic and constant change.

The Big Story

Here we go again. 

Twitter fans of Fast Trading are claiming these firms help markets and especially the little guy. Now, before you check out, what’s the Big Market Story of 2021?

Retail trading. Right?  Meme stocks. The rise of the Reddit Mob.

Illustration 209856483 © Hafakot | Dreamstime.com

Editorial Note: And the rise of the #EDGEMob, the success of our trading decision-support platform, Market Structure EDGE, winner of the 2021 Benzinga Global Fintech Award for Best Day Trading Software.  EDGE helps retail traders win by seeing Supply and Demand, the very thing Fast Traders obfuscate daily.

Okay, back to our story.

Fast Trading is computerized speculation.  What most call “market-making.” In the sense that these firms buy stuff wholesale – orders from retail traders – and sell it retail (in the stock market and often back to retail traders via dark pools in bits), that’s true.

But it’s not market-making like Goldman Sachs providing research coverage on hundreds of stocks and committing to buy and sell them.

Fast Traders don’t have customers, don’t write research, don’t most times even commit to both buying and selling. They aim to own nothing at day’s end.  They profit on how prices change. Ironically, they create volatility to vacuum it away through tiny spreads.

Money for nothing.

So, these people on Twitter were saying Citadel and Jane Street and Two Sigma and G1X (unit of Susquehanna that buys retail flow) have better execution-quality than stock-exchange IEX.

That’s like saying sprinters have faster 100-meter times than marathoners.  Well, no kidding. They’re doing different things.  IEX is trying to increase trade-size so we can buy something meaningful. Fast Traders are after the opposite. Tiny spreads, tiny trades.

If you’re getting a headache, let me bring it all around.

“Execution Quality” is part of Reg NMS, the regulatory structure of the stock market. It’s benchmarked by thin gaps between prices, in effect. That is, a spread of a penny is no good. A spread of a tenth of a penny, awesome.

Yet Reg NMS prohibits quoting prices in increments of less than a penny, so there’s an element of irony here.  Quote sub-penny? Illegal. Trade sub-penny? The goal!

At any rate, the SEC determined that it could validate how great the market it had created worked by metering whether brokers executed trades near the best overall prices.

Well, that seems good.

Except the best price is determined by the brokers who are being measured on delivering best prices. That’s like saying, “Whoever you see in the mirror gets to judge you.”

I’m talkin’ ‘bout the man in the mirror. He’s gonna have to change his—sorry, digression. Thank you, Michael Jackson, for that awesome song.

Why use data from firms with no customers – Fast Traders serve none in the sense that Goldman Sachs or IEX do – to determine if there is market quality?

And would someone explain who benefits from a narrow spread?  Anyone? Anyone?

The parties buying and selling stuff but not wanting to own it.  That’s who.

The stock market is supposed to help investors, who want to own stuff.  Yet the rules give kudos to trading firms exploiting retail money, clouding supply and demand, and owning nothing.

That’s how retail money chased herds of buffalo off cliffs in AMC, GME and others. Market regulation crowns highwaymen champions for “narrowing the spread” while meanwhile no one knows what the hell is going on.

Well, we do.  We’re not confused at all.

But what reached a climax in 2021 besides retail trading was confusion. Public companies, do you know why your stock went up or down? Investors and traders, did the market make sense to you?

Stocks fell. Pandemic fears. Stocks zoomed. Fears were easing. Wash, rinse, repeat.

We found it entertaining, as we watched Supply and Demand and saw the market move largely in synchrony with that beat.

Low spreads don’t help public companies or traders. They help regulators justify market structure, market operators make money selling data, Fast Traders make money buying low and selling high in tenths of pennies.

All while saying the market exists for investors and public companies.

Good one, that.

Will it change in 2022?  No.

So, will you?

Traders, if you don’t know Supply and Demand, you’re kidding yourself.

And public companies, I’m not sure what else to say that I haven’t said in 17 years. We can be the people who answer an ever quieter phone, the setters of dwindling meetings as money goes quantitative, data goes quantitative.

Or we can understand Supply and Demand in the stock market.  Ask, and we’ll show you.

Two choices in 2022. Happy New Year! 

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.

On the Skids

If electoral processes lack the drama to satisfy you, check the stock market.

Intraday volatility has been averaging 4%. The pandemic has so desensitized us to gyrations that what once was appalling (volatility over 2%) is now a Sunday T-shirt.

Who cares?

Public companies, your market-cap can change 4% any given day. And a lot more, as we saw this week.  And traders, how or when you buy or sell can be the difference between gains and losses.

So why are prices unstable?

For one, trade-size is tiny.  In 1995, data show orders averaged 1,600 shares. Today it’s 130 shares, a 92% drop.

The exchanges shout, “There’s more to market quality!”

Shoulder past that obfuscating rhetoric. Tiny trades foster volatility because the price changes more often.

You follow?  If the price was $50 per share for 1,600 shares 25 years ago, and today it’s $50 for 130 shares, then $50.02 for 130 shares, then $49.98 for 130 shares, then $50.10 for 130 shares – and so on – the point isn’t whether the prices are pennies apart.

The point is those chasing pennies love this market and so become vast in it. But they’re not investors.  About 54% of current volume comes from that group (really, they want hundredths of pennies now).

Anything wrong with that?

Public companies, it demolishes the link between your story and your stock. You look to the market for what investors think. Instead it’s an arbitrage gauge. I cannot imagine a more impactful fact.

Traders, you can’t trust prices – the very thing you trade. (You should trade Sentiment.)

But wait, there’s more.

How often do you use a credit or debit card?  Parts of the world are going cashless, economies shifting to invisible reliance on a “middle man,” somebody always between the buying or selling.

I’m not knocking the merits of digital exchange. I’m reading Modern Monetary Theory economist Stephanie Kelton’s book, The Deficit Myth.  We can talk about credit and currency-creation another time when we have less stuff stewing our collective insides.

We’re talking about volatility. Why stocks like ETSY and BYND were halted on wild swings this week despite trading hundreds of millions of dollars of stock daily.

Sure, there were headlines. But why massive moves instead of, say, 2%?

The stock market shares characteristics with the global payments system.  Remember the 2008 financial crisis? What worried Ben Bernanke, Tim Geithner and Hank Paulson to grayness was a possibility the plumbing behind electronic transactions might run dry.

Well, about 45% of US stock volume is borrowed. It’s a payments system. A cashless society. Parties chasing pennies don’t want to own things, and avoid that by borrowing. Covering borrowing by day’s end makes you Flat, it’s called.

And there are derivatives. Think of these as shares on a layaway plan.  Stuff people plan to buy on time but might not.

Step forward to Monday, Nov 9. Dow up 1700 points to start. It’s a massive “rotation trade,” we’re told, from stay-at-home stocks to the open-up trade.

No, it was a temporary failure of the market’s payments system. Shorting plunged, dropping about 4% in a day, a staggering move across more than $30 trillion of market-cap. Derivatives trades declined 5% as “layaways” vanished.  That’s implied money.

Bernanke, Geithner and Paulson would have quailed.

Think of it this way. Traders after pennies want prices to change rapidly, but they don’t want to own anything. They borrow stock and buy and sell on layaway.  They’re more than 50% of volume, and borrowing is 45%, derivatives about 13%.

There’s crossover – but suppose that’s 108% of volume – everything, plus more.

That’s the grease under the skids of the world’s greatest equity market.

Lower it by 10% – the drop in short volume and derivatives trades. The market can’t function properly. Metal meets metal, screeching. Tumult ensues.

These payment seizures are routine, and behind the caroming behavior of markets. It’s not rational – but it’s measurable.  And what IS rational can be sorted out, your success measures amid the screaming skids of a tenuous market structure.

Your board and exec team need to know the success measures and the facts of market function, both. They count on you, investor-relations professionals. You can’t just talk story and ESG. It’s utterly inaccurate. We can help.

Traders, without market structure analytics, you’re trading like cavemen. Let us help.

By the way, the data do NOT show a repudiation of Tech. It’s not possible. Tech sprinkled through three sectors is 50% of market-cap. Passive money must have it.

No need for all of us to be on the skids.  Use data.  We have it.

-Tim Quast

Dark Edges

The stock market’s glowing core can’t hide the dark edges – rather like this photo I snapped of the Yampa River in downtown Steamboat springs at twilight.

Speaking of which, summer tinkled its departure bell up high.  We saw the first yellowing aspen leaves last week, and the temperature before sunrise on the far side of Rabbit Ears Pass was 30 degrees, leaving a frosty sheen on the late-summer grass.

The last hour yesterday in stocks sent a chill too. Nothing shouts market structure like lost mojo in a snap.  I listened to pundits trying to figure out why.  Maybe a delay in stimulus.  Inflation. Blah blah.  I didn’t hear anyone blame Kamala Harris.

It’s not that we know everything.  Nobody does.  I do think our focus on the mechanics, the machinery, the rules, puts us closer to the engines running things than most observers.

And machines are running the market.  Machines shift from things that have risen to things that have fallen, taking care to choose chunks of both that have liquidity for movement. Then all the talking heads try to explain the moves in rational terms.

But it’s math. Ebbs and flows (Jim Simons, the man who solved the market at Renaissance Technologies, saw the market that way).

Passives have been out of Consumer Staples. Monday they rushed back and blue chips surged. The Nasdaq, laden with Tech, is struggling. It’s been up for a long time. Everybody is overweight and nobody has adjusted weightings in months. We can see it.

By the way, MSCI rebalances hit this week (tomorrow on the ModernIR Planning Calendar).

This is market structure. It’s morphed into a glowing core of central tendencies, such as 22% of all market capitalization now rests on FB, AAPL, AMZN, NFLX, GOOG, MSFT, AMD, TSLA and SHOP.

That’s the glowing core.  When they glow less, the dark edges grow.

Then there’s money.  Dough. Bucks. Specifically, the US dollar and its relationship to other global currencies. When the dollar falls, commodities surge. It’s tipped into the darkness the past month, marking one of its steepest modern dives.  Gold hit a record, silver surged, producer prices dependent on raw commodities exploded.

Then the dollar stopped diving. It’s up more than 1% in the last five days. And wham! Dark edges groped equities late yesterday. Gold plunged. Silver pirouetted off a 15% cliff.

August is traditionally when big currency-changes occur. Aug last year (massive move for the dollar versus the Chinese Renminbi Aug 5, 2019). Aug 2015. Aug 2018. Currencies rattle prices because currencies underpin, define, denominate, prices.

Back up to Feb 2020.  The dollar moved up sharply in late February, hitting the market Monday, Feb 24, as new options traded.  Pandemic!

Options expire next week.  The equivalent day is Aug 24, when new options will trade. Nobody knows when the dark edges will become cloying hands reaching for our investment returns or equity values.

In fact, Market Structure Sentiment™, our algorithm predictively metering the ebb and flow of different trading behaviors, peaked July 28 at 7.7 of 10.0, a strong read.  Strong reads create arcs but say roughly five trading days out, give or take, stocks fall.

They didn’t. Until yesterday anyway. They just arced.  The behavior giving equities lift since late July in patterns was Fast Trading, machines chasing relative prices in fractions of seconds – which are more than 53% of total volume.

Then Market Structure Sentiment bottomed Aug 7 at 5.3, which in turn suggests the dark edges will recede in something like five trading days.  Could be eight. Might be three.

Except we didn’t have dark edges until all at once at 3pm ET yesterday.

Maybe it lasts, maybe it doesn’t. But there’s a vital lesson for public companies and investors about the way the market works.  The shorter the timeframe of the money setting prices, the more statistically probable it becomes that the market suddenly and without warning dives into the dark.

It’s because prices for most stocks are predicated only on the most recent preceding prices.  Not some analyst’s expectation, not a multiple of future earnings, not hopes for an economic recovery in 2021.

Prices reflect preceding prices. If those stall, the whole market can dissolve into what traders call crumbling quotes.  The pandemic nature of short-term behavior hasn’t faded at the edges. It’s right there, looming.  We see it in patterns.

If something ripples here in August, it’ll be the dark edges, or the dollar. Not the 2021 economy.

The Daytraders

 

A year ago, Karen and I were flying to Fiji, 24 hours of travel from Denver to LA, to Auckland, to Nadi.

We took a ferry out of Denarau Island into Nadi Bay and north toward the Mamanuca Islands, all the way past the castaway home for television’s Survivor Fiji to our South Pacific gem, Tokoriki.

It’s not that I wish now to be a world away.  We can ride bikes past this gem, Catamount Lake, any crisp Steamboat morning (while the fruited plain radiates, it’s 45 degrees most days at 630a in northern Colorado).

It’s the shocking difference a year makes. Everybody’s trading. Instead of going to Fiji or whatever.

Schwab and Ameritrade have a combined 26 million accounts. Fidelity has 13 million in its brokerage unit. E*Trade, over 5 million.  Robinhood, the newest, has 13 million users.

Public companies wonder what impact these traders have on stock prices.  The old guard, the professional investors, seem to be praying daily that retail daytraders fail.

In some sense, the Dave Portnoy era (if you don’t know Barstool Sports and Davey Daytrader – perhaps our generation’s most adroit marketer – you must be a hermetic) has pulled the veil off the industry. It appears the pros know less than they led us to believe.

The pros say just wait.  The wheels are going to come off the retail wagon in a cacophony of sproinging springs and snapping spokes.

Of course, as Hedgeye’s Keith McCullough notes, if the wagon splinters, we’re all in the smithereens because there’s just one stock market.

We wrote in our widely read June 10 post, Squid Ink, about what happens to the millions of online retail trades.  They’re sold to what we call Fast Traders, machines that trade everything, everywhere, at the same time and thus can see what to buy or sell, what to trade long or short.

How does this flow that Citadel Securities, the biggest buyer of retail trades, says is now about 25% of market volume, affect the stock market, public companies and investors?

Two vital points about market structure here.  First, market-makers like Citadel Securities enjoy an exemption from rules governing stock-shorting.  Second, Fast Traders run trading models that predict in fleeting spaces how prices will behave.

Put these two factors together and you have the reason why stocks like TSLA can double in two weeks without respect to business fundamentals – or even the limitations of share supply.

If three million accounts at Robinhood want fractional exposure to TSLA, the problem for Fast Traders to solve is merely price and supply.  If you go to the grocery store and they don’t have shishito peppers, you go home without shishitos.

If you’re a retail trader wanting TSLA, you will get TSLA, and the price will rise, whether any shares exist or not.  Fast Traders will simply manufacture them – the market-maker SEC exemption on shorting.

The market-maker will cover before the market closes in 99% of cases.  So the market-maker isn’t short the stock anymore.  But maybe TSLA will have 25% more shareholdings than shares outstanding permit.

Worse, it’s impossible to understand supply and demand. If market-makers could only sell existing shares – back to shishito peppers – TSLA would skyrocket to $5,000 and plunge to $500.  Frankly, so would much of the market.

Which is worse?  Fake shares or fake prices?  Ponder it.

And machines will continuously calculate the supply or demand of shares of a stock versus others, and versus the exchange-traded derivatives including puts, calls and index futures (oh, and now Exchange Traded Funds which like prestidigitated shares have no supply limitations), to determine whether to lift prices.

As we said in Squid Ink, we believe Fast Traders buying order flow from retail brokers can see the supply in the pipeline.

Combine these features. Fast Traders see supply and demand. They relentlessly calculate how prices are likely to rise or fall. They manufacture shares to smooth out imbalances under SEC market-making exemptions.

And the market becomes this mechanism.

Risks? We’ve declaimed them for years.  The market will show a relentless capacity to rise, until something goes wrong. And then there won’t be enough stock to sell to meet redemptions, and prices will collapse. We’ve had tastes of it.  There will be more.

But it’s not the fault of the daytraders.

Rotation

There’s a story going around about an epochal rotation from momentum (growth) to value in stocks. It may be a hoax.

I’ll explain in a bit. First the facts. It began Monday when without warning the iShares Edge MSCI USA Value Factor ETF (VLUE) veered dramatically up and away from the iShares Edge MSCI USA Momentum Factor ETF (MTUM).

CNBC said of Monday trading, “Data compiled by Bespoke Investment Group showed this was momentum’s worst daily performance relative to value since its inception in early 2013.”

The story added, “The worst performing stocks of 2019 outperformed on Monday while the year’s biggest advancers lagged, according to SentimenTrader. This year’s worst performers rose 3.5% on Monday while 2019’s biggest advancers slid 1.4%, the research firm said.”

A tweet from SentimenTrader called it “the biggest 1-day momentum shift since 2009.”

It appeared to continue yesterday. We think one stock caused it all.

Our view reflects a theorem we’ve posited before about the unintended consequences of a market crammed full of Exchange Traded Funds, substitutes for stocks that depend for prices on the prices of stocks they’re supposed to track.

To be fair, the data the past week are curious. We sent a note to clients Monday before the open. Excerpt:

“Maybe all the data is about to let loose. It’s just. Strange.  Fast Trading leading. ETFs more volatile than stocks. Spreads evaporating. Sentiment stuck in neutral. More sectors sold than bought….Stocks should rise. But it’s a weird stretch ahead of options-expirations Sep 18-20.  It feels like the market is traversing a causeway.”

That stuff put together could mean rotation, I suppose.

But if there was a massive asset shift from growth to value, we’d see it in behavioral change. We don’t. The only behavior increasing in September so far is Fast Trading – machines exploiting how prices change.

What if it was AT&T and Elliott Management causing it?

If you missed the news, T learned last weekend that Activist investor Elliott Management had acquired a $3.2 billion stake in the communications behemoth and saw a future valuation near $60.  On that word, T surged Monday to a 52-week high.

T is the largest component of the MSCI index the value ETF VLUE tracks, making up about 10% of its value.  ETFs, as I said above, have been more volatile than stocks.

Compare the components of MTUM and VLUE and they’re shades apart. Where T is paired with VLUE, CMCSA ties to MTUM, as does DIS.  MRK is momentum, PFE is value. CSCO momentum, INTC, IBM value. PYPL, V, MA momentum, BAC, C, value.

Look at the market. What stuff did well, which did poorly?

The outlier is T. It’s a colossus among miniatures. It trades 100,000 times daily, a billion dollars of volume, and it’s been 50% short for months, with volatility 50% less than the broad market, and Passive Investment over 20% greater in T than the broad market.

T blasted above $38 Monday on a spectacular lightning bolt of…Fast Trading. The same behavior leading the whole market.  Not investment. No asset-shift.

What if machines, which cannot comprehend what they read like humans can, despite advances in machine-learning, artificial intelligence (no learning or intelligence is possible without human inputs – we’re in this business and we know), improperly “learned” a shift from growth to value solely from T – and spread it like a virus?

Humans may be caught up in the machine frenzy, concluding you gotta be in value now, not realizing there’s almost no difference between growth and value in the subject stocks.

Compare the top ten “holdings” of each ETF. Easy to find. Holdings, by the way, may not reflect what these ETFs own at a given time. Prospectuses offer wide leeway.

But let’s give them the benefit of the doubt. What’s the difference between MRK and PFE? V, MA, and PYPL and C, BAC and, what, GM and DIS?

Stock pickers know the difference, sure.  Machines don’t. Sponsors of ETFs wanting good collateral don’t.  Except, of course, that cheap collateral is better than expensive collateral, because it’s more likely to produce a return.

Such as: All the worst-performing stocks jumped. All the best-performing stocks didn’t.

What if this epochal rotation is nothing more than news of Elliott’s stake in T pushing a domino forward, which dropped onto some algorithm, that tugged a string, which plucked a harp note that caused fast-trading algorithms to buy value and sell momentum?

This is a risk with ETFs. You can’t trust signs of rotation.

We have the data to keep you from being fooled by machine-learning.

Flying Machines

While France roasts on both the heat of the US women’s soccer strikers and mother nature’s summertime glow, in Steamboat Springs Lake Catamount sits alpine serene, and it was 46 degrees Fahrenheit (about the same read in Celsius in France) on our early bike ride yesterday.

In the USA, we join figurative thankful hands with you across the fruited plain to mark this amazing republic’s 243rd birthday.  Long may the stars and stripes fly.

What’s flying in markets are a bunch of machines.

Joe Saluzzi, one of our marquee panelists at the NIRI Annual Conference last month, spoke to IR Magazine on how the market works and why investor-relations professionals need to educate themselves. As Joe says, much of your volume isn’t investment but trading. It distorts perceptions of real supply and demand.

Why does that matter?  Because your board, your executive team, your investors, see your stock as a barometer of fundamentals. You need to know when that’s true – and when it’s not.  Misunderstanding what the market is doing can lead to big mistakes.

What if your stock declines sharply with results and management believes it has miscommunicated key messages (and blames you)?

Suppose market structure shows Active money bought in the preceding two weeks – because you’ve been talking regularly over the quarter about what you’re trying to do strategically. Then before the call, they stop buying to pay attention to what you say.

The absence of what had been present will be patently apparent to Fast Traders. They will sell and short you.  Whoosh! The flying machines take you down.

Every IRO should understand, and observe, and report internally to the executive team and the board, the starkly apparent data demonstrating these facts. We have that data. For anyone traded in US markets.  Including your peers. And yes, you can see that data.

Story is vital, sure.  But the way we think about the influence of story, fundamentals, strategy, should be predicated on facts, not a perception diverging from reality.

Illustratively, CNBC ran a headline last Saturday reading “80% of the stock market is now on autopilot.”  Referencing a JP Morgan client note, the reporter said about 60% of assets are in passive indexes and Exchange-Traded Funds (ETFs), with another 20% following systematic strategies.

An aside, I think Morningstar is behind the curve on measuring the pervasive and endemic shift to passive in stocks. It’s not just assets under management but the composition of volume.

A WSJ article (registration required) last December describing the “herdlike behavior of computerized trading” also quoted JP Morgan officials estimating that 85% of market volume was something other than Active investing.

Those of you using our analytics know we track the facts with precision. Currently, it’s 87%, with just 13% of market volume the past week from Active investment.

Does it render IR obsolete?  Of course not!  Stop thinking your job consists of talking to investors.

That’s part of the job, sure. But IR is a strategic management function. Your job is to know what all the money is doing, all the time, and communicate important facts about trends and drivers to the board and executives so they’ll have realistic expectations.

And your job is to manage the market for your shares, which includes sorting out what’s controllable and what’s not, and providing important metrics on equity health and drivers around news, earnings, and non-deal road shows – and on a regular basis, proactively, as all good business managers do.

That’s IR today. The market is not full of “noise.” It’s full of flying machines, amazing sensors feeding back vital data to observers like us, who in turn help you take command of the equity-market battlefield as trusted strategic advisor to your executive team.

Ponder that with a cold beer (or a cold Rose from Provence!) and a flag this holiday week.  Happy birthday, USA!

Short-Term Borrowing

Half the volume in the stock market is short – borrowed. Why?

It’s the more remarkable because stocks since late December have delivered an epic momentum rebound. A 15% gain is a good year. Half the sectors in the market were up 15% in just the last 25 trading days.

Yet amid the stampede from the depths of the December correction, short volume, the amount of daily trading on borrowed shares, rose rather than fell, and remains 48%.  That means if daily dollar-volume is $250 billion, $120 billion is borrowed stock.

What difference does it make? We’ve written before that the stock market now has characteristics of a credit market.  That is, if lending is responsible for half the volume, the market depends on short-term loans rather than long-term investment.

And share-borrowing, credit, will give the market a false appearance of liquidity.

Think about the sudden and massive December declines that included the worst-ever points-loss for the Dow Jones Industrial Average.  Was that a liquidity problem? Does a V-shaped recovery signal a liquidity problem?

Before the Dodd-Frank financial legislation, large banks might carry a supply of shares to meet the needs of customers, especially stocks covered by equity research.

With rigid value-at-risk regulations now, banks don’t hold inventory.  The supply chain for the stock market has shifted to proprietary fast traders, which don’t carry inventory either. They borrow it.

We define liquidity as the number of shares that can be traded before the price changes.  Prior to electronic markets, trade-sizes were ten times larger than today.  The mean trade-size the last five days was 181 shares, or about $13,500 against an average market price of $74.61.

But a few liquid stocks skew the average.  AAPL’s liquidity is over $23,000, its average trade-size. WMT is the average, about $13,000. GIS is half that, about $6,800.

AAPL is also 57% short – over half its liquidity is borrowed.  And AAPL is used as collateral by 270 Exchange-Traded Funds (ETFs). Related?

(Side note: Why would AAPL be used more than other stocks in an index if ETFs are tracking an index? Because ETFs only use a sample, often the biggest stocks that are liquid and easy to borrow.)

These three elements – fast traders, high borrowing levels, ETFs – are intertwined and they create risks of inflation and deflation in stocks that bear no correlation to fundamentals.

The market, as we’ve said before, always reflects its primary purposes. If the parties supplying the market with shares are borrowing them, they have an economic interest that will compete with the objectives of those buying shares as an equity investment.

Second, borrowing is a back-office brokerage function. With massive short-term securities lending, the back office becomes as important as the cash equities desk. And it’s a loan business, a credit market (a point made by the insightful academics comprising the Bogan family).

And ETFs? If you want to know how they work, read our white paper. ETFs are not pooled investments. They are collateralized stock substitutes. Derivatives.

Collateral is something you find in a credit market. ETF collateralization, the wholesale market where ETF shares are created and redeemed, is a staggering $400 billion per month in US equities, says the Investment Company Institute.

It’s cheap and easy for brokers to borrow the shares of a basket of stocks and supply them as collateral to the Blackrocks of the world (does Blackrock then loan them out, perpetuating the cycle?) for the right to create and sell ETF shares (or provide them to a hedge-fund customer wanting to short the whole Technology sector).

And how about the reverse? Brokers can borrow ETF shares and return them to Blackrock to receive collateral – stocks and/or cash that Blackrock puts in the redemption basket to offer in-kind for ETF shares.

These are the mechanics of the stock market.  It works well if there’s little volatility – much like the short-term commercial paper market that froze catastrophically during the financial crisis.

We are not predicting doom. We are highlighting structural risks investors and public companies should understand. The stock market depends for prices and liquidity on short-term borrowing. In periods of volatility, that dependency will amplify moves.

In extreme cases, it’s possible the stock market could seize up not through investor panic but because short-term borrowing may freeze.

How might we see that risk? Behavioral volatility. When the movement of money becomes frantic behind prices and volume where only a few firms like ours can see it, market volatility tends to follow (as Sept 2018 behaviors presaged October declines).

Currently, behavioral volatility is muted ahead of the Fed meeting concluding today, loads of earnings, and jobs data Friday. It can change on a dime.

Mercenary Prices

Florida reminded us of high-speed traders.  I’ll explain.

An energized audience and the best attendance since 2012 marked NIRI National, the investor-relations annual confab held last week, this year in Orlando.

We spent the whole conference in the spacious and biggest-ever ModernIR booth right at the gateway and in late-night revelry with friends, clients and colleagues, and I don’t think we slept more than five hours any night.  Good thing it didn’t last longer or we might have expired.

I can’t speak to content because we had no exposure. But asking people coming through the exhibit hall what moved them, we heard about IEX CEO Brad Katsuyama’s general session on the state of markets (we said hi to Brad, who was arriving in from New York about 1am as we were wrapping for the night and heading to bed).

“He said the exchanges are paying $2.7 billion to traders.”

That what folks were reporting to us.

You remember how this works, longtime readers?  The big listing duopoly doled out $500 million in incentives to traders in the most recent quarter.  That is, exchanges paid others to trade on their platforms (the rest came from BATS Global, now part of CBOE).

Both exchanges combined earned about $180 million in fees from companies to list shares. Data and services generated a combined $750 million for the two.

There’s a relationship among all three items – incentives, listing fees, data revenues.  Companies pay to list shares at an exchange. The exchange in turn pays traders to set prices for those shares. By paying traders for prices, exchanges generate price-setting data that brokers and market operators must buy to comply with rules that require they give customers best prices.

I’m not ripping on exchanges. They’re forced by rules to share customers and prices with competitors. The market is an interlinked data network. No one owns the customer, be it a trader, investor or public company. Exchanges found ways to make money out there.

But if exchanges are paying for prices, how often have you supposed incorrectly that stocks are up or down because investors are buying or selling?

At art auctions you have to prove you’ve got the wherewithal to buy the painting before you can make a bid. Nobody wants the auction house paying a bunch of anonymous shill bidders to run prices up and inflate commissions.

And you public companies, if the majority of your volume trades somewhere else because the law says exchanges have to share prices and customers, how come you don’t have to pay fees to any other exchange?  Listing fees have increased since exchanges hosted 100% of your trading.  Shouldn’t they decrease?

Investors and companies alike should know how much volume is shill bidding and what part is real (some of it is about you, much is quant).  We track that every day, by the way.

The shill bidders aren’t just noise, even if they’re paid to set prices. They hate risk, these machine traders.  They don’t like to lose money so they analyze data with fine machine-toothed combs.  They look for changes in the way money responds to their fake bids and offers meant not to own things but to get fish to take a swipe at a flicked financial fly.

Take tech stocks.  We warned beginning June 5 of waning passive investment particularly in tech. The thing that precedes falling prices is slipping demand and nobody knows it faster than Fast Traders.  Quick as spinning zeroes and ones they shift from long to short and a whole sector gives up 5%, as tech did.

Our theme at NIRI National this year was your plan for a market dominated by passive investment.  Sometime soon, IR has got to stop thinking everything is rational if billions of dollars are paid simply to create valuable data.

We’ve got to start telling CEOs and CFOs and boards.  What to do about it? First you have to understand what’s going on. And the buzz on the floor at NIRI was that traders are getting paid to set prices. Can mercenary prices be trusted?