Tagged: Federal Reserve

A New Construct

Posted on August 10, 2022

What a week back from Switzerland.

We lost historian David McCullough and singer Olivia Newton-John. Meme stocks went berserk anew.

And speaking of berserk, after juicing Demand till inflation surpassed 9%, the Senate ratified a giant Supply-side bill that’ll ramp the cost and production of goods just as everybody is out of money.

The bill also erects a multitude of new offices and sends thither swarms of agents to harass our people and eat out their substance.  No wait, that was Thomas Jefferson writing in the Declaration of Independence about the Crown.

Oh, and the FBI demonstrated that nobody is secure in their persons, property and effects from unreasonable search and seizure.

Just another week in the USA. And everybody wants to know:  Is the bottom in for stocks? 

Did you laugh?  I did.  It’s a curious juxtaposition.

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And maybe none of that is as consequential as a Wall Street Journal opinion (subscription required) by Johns Hopkins Professor Steve Hanke, global authority on currencies.

Wait, Quast. You’re not going to talk about money.

I’ll bring it back to stocks, which are denominated in dollars.

Strange but true, the US dollar will inevitably rise versus other currencies, no matter what economic buffoonery issues like effluvia from government. The dollar, euro and Swiss franc are at parity.  Professor Hanke notes that eight countries have seen their currencies lose 65% or more of their purchasing power.

Why? As the dollar rises, other global banks sell dollars to weaken it. And then they run out of dollars to sell. And their currencies devalue.

The Fed creates dollars by buying government debt, which lowers interest rates. To reverse that course, the Fed sells debt for dollars. Which makes the dollar stronger.

There’s no way out – like that Kevin Costner movie from 1987. 

I’ve said that what will happen after our long experiment in creating money – much like stock is created out of thin air in the US market – is our currency model will fail.

Well, Steve Hanke has now proposed a new one because the current one is at risk.  He’s the creator of most of the currency boards – ways to peg currencies – operative around the planet.  He knows money.  This is no shrill jester in the court.

He says the dollar/euro currency pair should stay in a range.  The Fed and the European Central Bank should buy and sell each other’s currencies to keep it around $1.30 to the euro.

Whoa.

The USA has enjoyed a massive monetary advantage. We alone create currency without having to buy or sell anybody else’s.

The Federal Reserve can whipsaw other currencies while propagating the external belief our resources are endless and the internal capacity to live beyond our means.

Professor Hanke is saying it needs to end. That the only way to constrain US government profligacy is to limit the dollars it can produce – by pegging it to the euro.

What’s this got to do with a bottom for stocks?  A big monetary guy is writing about the end of our monetary regime. Maybe we should be concerned about that?

Which brings us to stocks.

Meme Stocks are repeating microcosms of the lifecycle of currencies. They soar and crash. Value isn’t determined by economic activity but by currency supplies – shares.

And the supply is artificial, like dollars.

How? The US stock market is a “continuous auction” of tiny trades. Brokers by rule stand ready to buy or sell even when no one else is buying or selling. 

To make that happen, the SEC exempts brokers from legal constraints on “naked shorting” – loaning stocks without locating them.

That latter is illegal for you and me.  But for broker-dealers, creating stock to fill buy or sell orders is part of the job the SEC has given them, keeping the artifice of the continuous auction going and bloating and cratering Meme names.

Realize, “continuous auction” is an oxymoron. An auction by definition is a periodic aggregation of buy/sell interest, not a continuous one. So the market depends on artificial – nonexistent – supply to function.

The flip side is, without it you wouldn’t be able to buy or sell stocks at times. There just wouldn’t be any.  Of course, that’s how we understand supply and demand (you can’t buy a house if there aren’t any).

Money works the same way. Central banks create artificial supplies to foster unnatural outcomes disconnected from economics. Stuff soars, and collapses, but over a long arc.

Meme stocks do all of that in months, weeks, days. They surge on artificial supply and then collapse. We measure the market’s Supply and Demand for both companies and investors, so we can predict and observe the behavior.

The money?  Well, Dr. Hanke has fired the first warning volley. 

The market? It’s on a slow arc away from Momentum again, the data say.

Elasticity

Posted on June 15, 2022

CNBC is running a second-by-second countdown to the Federal Reserve decision on rates today.

Seems like a market too dependent on the few. Risk disperses through decentralization.  We’re counting on a central bank to disperse risk.  Hm.  Whatever the Fed does today, from 50 basis points to a hundred, we know risk is concentrated.

In what?

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I’ll come to that. First, every public company should have reliable, accurate market intelligence on what’s driving – or harming – shareholder-value.  With just 5% of trading volume manifesting as ownership-changes, you need quantitative market analytics.

We have them.  You may need them in coming months as much or more than at anytime you’ve occupied the chair, investor-relations professionals. Send me an email and ask about our special deal through Dec 31.

So, where is risk?  It’s been transferred from every part of the economy, from all assets, into our currency, thanks to the central bank’s effort to be on both sides of the Supply/Demand teeter-totter simultaneously.

And since our currency denominates risk assets and all economic interaction including trading time for money, and trading money for good and services, we didn’t transfer it anyplace.  It’s a grenade, pin pulled and hucked, that bounces right back.

The Panic of 1873 collapsed proliferating railroads and the banks and investors backing them. Investors started selling the railroad bonds they owned and pretty soon there were too many bonds around and nobody wanted them.

But it didn’t spread to other parts of the economy. It didn’t threaten the currency, which by 1880 had gained BACK all the lost purchasing power resulting from the Civil War and paper banknotes.

Imagine getting some purchasing power back. Wow.

Anyway, in 2022, people are selling off bonds. But they’re not railroad bonds. They’re government bonds. And the Federal Reserve, which hasn’t started selling its giant trove yet, will follow suit.

The yield, which moves inversely to price, on the five-year US Treasury, for instance, is up from about 70bp last summer to 3.6%. It reflects plunging demand for bonds.

The banks that sold railroad bonds in 1873, and the railroad companies that used the proceeds to lay rails, and the investors who owned the paper backing transportation capital-spending went broke.

Of course nobody bailed them out. The destruction of speculation and overbuilding is a necessary part of any healthy economy.  Otherwise you end up with assets that don’t produce returns.

That’s what happened during the Pandemic.  Assets that were not producing returns were kept afloat by the Fed, which issued bonds to create currency to keep stuff alive through payroll protection plans.

Then the Fed took the unprecedented step of just sending everybody checks (the Treasury did it but that money came from nothing – poof, just like the metaverse), shifting from keeping the supply side going, to juicing the demand side of the teeter-totter.

So you have unproductive assets getting money, and unproductive people getting paid.  And consuming stuff, and trading stocks, and buying bitcoin, blah blah.

At some point, that process stops.

I’m not knocking emergency efforts. But the government gave no thought to having to undo what was done. Elastic money was the Great Elixir that would “promote growth.” The truth might be closer to setting one’s house afire to stay warm.

Leading into 1873, the banks and the builders and the bond-buyers were seeing big future demand for rails.  Instead, there was an economic slowdown, and people had to sell bonds to raise money.

It’s not 1873, because that was only railroads.  I don’t know what will happen here.  But the whole world depends on the dollar.  It’s the only reserve currency. We transferred the entire perceived – which proved wrong – effects of the Pandemic to it.

Bailing stuff out is bad because it compounds until it comes around and what was just a little jab that didn’t land in a boxing match is now a Mike Tyson upper cut.

And who bails out the dollar?

In 1913, the Federal Reserve was created to give money the elasticity to absorb panics. It absorbed WWI. That collapse in output coupled with the explosion of money sent us galloping into the Roaring Twenties.

And the equal and offsetting reaction was the 1930s.

Human nature tends to do things until they blow up. We may have exhausted the elasticity of modern monetary policy. And the snapback could be intense.

Be prepared. We’ve got data for navigating turbulence.

Experience

Posted on May 11, 2022

“The market structure is a disaster.”

That’s what Lee Cooperman said in a CNBC conversation yesterday with “Overtime” host Scott Wapner.

What he thinks is wrong is the amount of trading occurring off the exchanges in so-called dark pools and the amount of shorting and short-term trading by machines.

I’m paraphrasing.

Mr. Cooperman, who was on my market-structure plenary panel at the 2019 NIRI Annual Conference, decries the end of the “uptick rule” in 2007. It required those shorting stocks to do so only on an uptick.

To be fair to regulators, there’s a rule. Stocks triggering trading halts (down 10% in five minutes) can for a set time be shorted only at prices above the national best bid to buy. It’s called Reg SHO Rule 201.

But market-makers are exempt and can continue creating stock to fill orders. It’s like, say, printing money.

Mr. Cooperman has educated himself on how the market works. It’s remarkable to me how few big investors and public companies (outside our client base!) know even basic market structure – its rules and behaviors.

Case in point.  A new corporate client insisted its surveillance team – from an unnamed stock exchange – was correct that a big holder had sold six million shares in a few days.

Our team patiently explained that it wasn’t mathematically possible (the exchange should have known too).  It would have been twice the percentage of daily trading than market structure permits.  That’s measurable.

Nor did the patterns of behavior – you can hide what you own but not what you trade, because all trades not cancelled (95% are cancelled) are reported to the tape – support it.

But they’re a client, and learning market structure, and using the data!

The point though is that the physics of the stock market are so warped by rules that it can’t function as a barometer for what you might think is happening.  That includes telling us the rational value of stuff.

You’d expect it would be plain crazy that the stock market can’t be trusted to tell you what investors think of your shares and the underlying business.  Right?

Well, consider the economy.  It’s the same way.

Illustration 91904938 © Tupungato | Dreamstime.com

The Federal Reserve has determined that it has a “mandate” to stabilize prices.  How then can businesses and consumers make correct decisions about supply or demand?

This is how we get radical bubbles in houses, cryptocurrencies, bonds, equities, that deflate violently.

Human nature feeds on experience. That is, we learn the difference between good and bad judgement by exercising both.  When we make mistakes, there are consequences that teach us the risk in continuing that behavior.

That’s what failure in the economy is supposed to do, too.

Instead, the Federal Reserve tries to equalize supply and demand and bail out failure.  

Did you know there’s no “dual mandate?”  Congress, which has no Constitutional authority to do so, directed the Fed toward three goals, not mandates: maximum employment, moderate long-term interest rates and stable prices.

By my count, that’s three. The Fed wholly ignores moderate rates. We haven’t had a Fed Funds rate over 6% since 2001.  Prices are not stable at all. They continually rise. Employment? We can’t fill jobs.

From 1800-1900 when the great wealth of our society formed (since then we’ve fostered vast debt), prices fell about 50%.  The opposite of what’s occurring now. 

Imagine if your money bought 50% more, so you didn’t have to keep earning more.  You could retire without fear, knowing you wouldn’t “run out of money.”

Back to market structure.

The catastrophe in Technology stocks that has the Nasdaq at 11,700 (that means it’s returned just 6% per annum since 2000, before taxes and inflation, and that matters if you want to retire this year) is due not to collapsing fundamentals but collapsing prices.

How do prices collapse?  There’s only one way.  Excess demand becomes excess supply.  Excess is always artificial, as in the economy.

People think they’re paying proper prices because arbitragers stabilize supply and demand, like the Fed tries to do. That’s how Exchange Traded Funds are priced – solely by arbitrage, not assets. And ETFs permit vastly more money to chase the same goods.

It’s what happened to housing before 2008.  Derivatives inflated the boom from excess money for loans.

ETFs permit trillions – ICI data show over $7 trillion in domestic ETFs alone that are creating and redeeming $700 BILLION of shares every month so far in 2022 – to chase stocks without changing their prices.

And the Federal Reserve does the same thing to our economy.  So at some point, prices will collapse, after all the inflation.

That’s not gloom and doom. It’s an observable, mathematical fact.  We just don’t know when.

It would behoove us all to understand that the Federal Reserve is as big a disaster as market structure.

We can navigate both. In the market, no investor, trader or public company should try doing it without GPS – Market Structure Analytics (or EDGE).

The economy?  We COULD take control of it back, too.

Troubling Signs

Posted on April 13, 2022

Ahoy!

As you read, we are stopping in Charlotte en route to a 2pm arrival in Sint Maarten in the Caribbean.

Illustration 91269233 © Dharshani Gk Arts | Dreamstime.com

We saw the inflation print at 8.5%, plunging consumer confidence, rising credit risk, the supply-chain morass, and said, “Let’s flee to the sea.”

Okay, not really. We reset this sailing trip that vanished into the Pandemic.  Weirdly, we need no Covid test to see the sand and sea but for us citizens of the Land of the Free, we can’t get back in our OWN COUNTRY without one.

After being shot, boosted and afflicted with Covid in roughly that order.

We the People need to put the little despots in their places, power-seekers lording it over others without respect to math, science or common sense.  Untenable.  Unacceptable.

Back to market structure.  And monetary policy. 

Options expire this Good Friday short week, today and tomorrow. Trading is a tug of war between parties to expiring options and futures on Treasuries, currencies, interest rates, commodities, equities and bonds, and the counterparties with risk and exposure on the other side.

Don’t expect the market to be a barometer on investor-sentiment right now.

And new options trade Monday. Then counterparties square books Tuesday. Volatility derivatives expire Wednesday.

What will be apparent is if risk-taking is resuming.  I think Mon-Tue next week (Apr 18-19) are key.  Look, you can’t peg the day. Could be before, could be after.  But the market will either turn because investors and traders reset swaths of options and futures or we could get clocked.

No middle ground?

Broad Sentiment signals risk.  Might be a couple months away, or not.  Data going back the past decade that we track show that Broad Sentiment with a 90-day rolling read near 5.0 precedes a steep decline.

That’s about where it is.  History warns us.

What about the risk of recession?  Well, of course there’s risk.  Central banks globally exploded the supply of currency and shut down output. Nothing could be more damaging to economies.  Trying to remedy that catastrophe will take a toll.

And the Federal Reserve knows it and knows it must get interest rates back to a level that leaves room to chop them to zero to try to forestall an economic collapse. 

The Fed is motivated to stock up some ammo, not to “normalize rates.” The quickest way to do that is to lift overnight rates and start selling off bonds. If demand for bonds falls, interest rates rise.

That simple. And the Fed is wholly willing to put everything and everyone in jeopardy in order to give itself policy tools. 

I’m not opposed to raising rates. I’m opposed to low rates that devalue savings and purchasing power and encourage debt and consumption.

Impact on equities?  I think we’re seeing it already.  Passive Investment marketwide has fallen from 20.4% of trading volume over the trailing 200 days, to 18.8% now.

Doesn’t seem like much. But a sustained recession in demand from indexes, ETFs and quants will reduce stock prices.  Derivatives demand is down too, from 18% to 17.2%.

Mathematically, that’s an 8% long-term decline in Passive Investment, 4% drop in derivatives demand. Is a 12% reduction in real and implied demand meaningful?  

Absolutely.

So, it’s a matter of the degree of effect, and if or when that trend reverses.  A trend-change across the whole market is unlikely here at April options-expirations. 

How about earnings season?  Only if it’s a barnburner, which is improbable.

I think the best chance is June options-expirations, the next time big money can make meaningful changes to asset-allocations.  In between are Russell rebalances in May.

I’m neither bull nor bear. We’re data analysts. We track the trends.  There are troubling signs here.  Yes, they could dissolve again under the inexorable repetition of There Is No Alternative.

But if not, there’s a rough ride ahead.  So.  You will find us on a boat.  See you Apr 27.

Interest(ing) Rates

Posted on April 6, 2022

Cathie Wood says don’t do it.

Raise interest rates, that is.  The founder of Ark Investment Management and guru to retail traders of Tech stocks says the Federal Reserve is playing with fire.

Why?  Because growth is fragile and consumer confidence is woeful.  Hike rates, and we plunge into recession.

Illustration 44644519 © Tashatuvango | Dreamstime.com

I enjoy economics almost as much as market structure. I’ve got observations.

What’s the big threat Ms. Woods sees in higher rates? US Gross Domestic Product is 70% consumption – the stuff we buy.  The consumption linchpin is home equity.

As homes increase in value, consumers borrow equity to fuel both the confidence to go out and buy stuff, and the means to consume big-ticket items like cars and appliances.

If interest rates rise, people stop buying and refinancing homes, and the torrent of cash driving consumption shrivels.

I think the Federal Reserve knows it’s going to muzzle the economy. But The Fed will try to rapidly raise interest rates so it can hack them back to zero as the economy slips. Maybe that’ll juice consumption anew, forestalling recession.

The whole concept is jacked. The Fed shouldn’t be manipulating consumer behavior at all, because then it’s artificial.

The Fed touts its dual mandate – stable prices, low unemployment – as an unassailable hieratic purpose. Well, why should the Fed allocate labor and capital? You’d expect that from a despotic politburo, not a free country.

Yet nobody questions it.

Listen to a Fed press conference and all you’ll hear is how many times will you hike rates?  Do you support 25 or 50 basis points?  Is the Fed too late in the curve?  Will higher rates choke off growth?  Will higher rates bring inflation to heel?

In my entire adult life, not one economist at a Fed presser has asked a good question.  

So here’s one.  Why set rates so low in the first place that they discourage savings and promote borrowing and spending? Isn’t that the opposite of sound financial strategy?

Or how about this?  The US Constitution directs Congress to fix exchange rates for our currency and to back it with just weights and measures, which means with gold and silver. Why does the Fed defy the Constitution?

Because, Tim, gold and silver are stupid antiquated notions about money.

Well, it’s the law in black and white, hasn’t been changed. But government has decided its opinions are superior to the law. In many instances. But I digress.

John Maynard Keynes, the father of deficit spending, said, “The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

You can’t suck all the value out of money backed by metal.

How does inflation debauch capitalism? Businesses struggle to deploy labor and capital to produce goods and services at predictable returns. Consumers who trade time for money can’t make ends meet and become state dependents.

Yes, hourly workers are hurt most. Then the government has the audacity to blame capitalism for the growing wealth gap. No, the Fed does it. Rich people can surf the inflation wave. Poor people can’t.

The problem isn’t higher rates. It’s LOW RATES to begin.

Low rates increase the supply of currency faster than output, which means everybody’s money buys less. The money supply the last two years rose from $16-$22 trillion.

The definition of inflation should be “low interest rates,” because the inevitable consequence is more money chasing the same goods instead of getting saved, invested.

If we wanted people to save, we’d reward them for it. Why don’t we? Because the Fed exists – no matter its pronouncements of independence – to keep the federal government and its policies afloat. Which requires CONSUMPTION. Not saving.

Even if it’s contrary to the interests of the citizenry.

What if we lifted rates to 10% and left them there?  A bunch of stuff would go broke.  Probably our government.

Too high a price? If we want money that buys more over time rather than less, that generates a return when you save it so we become less indebted, less dependent, we have to either bankrupt the government or take away its printing press.

Maybe both.

We will never be financially responsible as a society so long as the Federal Reserve uses interest rates to allocate labor and capital, and the government is printing money.

That is the problem to solve. Everything else is a failure to address the problem.

So, will we?  I’d wager all that Fed paper blighting the fruited plain that it’ll continue until nobody wants dollars (we’re helping Russia, in fact).

Or we could instead fix it.  Anyone?

Right Now

Posted on December 15, 2021

“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.

The Inferiors

Posted on November 3, 2021

One of the penalties of refusing to participate in politics is that you end up being governed by your inferiors.

So, purportedly, said Plato. That’s our sole word on current elections.

Illustration 209532110 / Plato © Naci Yavuz | Dreamstime.com

Now let me tell you how my order to buy 50 shares was internalized by my broker, but my limit order to sell it split into two trades at Instinet, and what that’s got to do with the Federal Reserve and public companies.

Sounds like a whodunnit, right? 

Let me explain. I trade stocks because of our trading decision-support platform, Market Structure EDGE. It’s a capstone for my long market-structure career: I know now what should matter to public companies, what should matter to traders, how it ALL works.

Continuing, the Fed today probably outlines plans to “taper.” Realize, the Fed has been buying US mortgages at the same time nobody can build houses because there isn’t any paint, no appliances, you can’t find glass, wood went through the roof (so to speak).

So the Fed inflated the value of real estate.  Why?  Because it prompts people to spend money. To the government, economic growth is spending.  Mix surging balance sheets with gobs of Covid cash, and it’s like taking the paddles and telling everybody, “Clear!” and hitting the economy with high voltage.

The Fed has concluded the heartbeat is back and it’s putting away the paddles. Its balance sheet, though, says tapering is a ways off.

What’s that got to do with my trade? The Fed is intermediating our buying and selling to make it act and look like more.

But it’s not more.  And the economy rather than looking like an elite athlete – trimmed, toned, fit – is instead just off the gurney.

Put another way, the economy reflects multiple-expansion, a favorite Wall Street explanation for why stocks go up. It means everybody is paying more for the same thing.

We should have let it get tough, trim, fit. Ah well.

Did you see the Wall Street Journal article (subscription required) this week on payment for order flow in stocks and options?  I’m happy market structure is getting more airplay.  It will in the end be what gets discussed when everyone asks what happened.

Everything is intermediated. The Fed buys mortgages. Traders by trades.

I bought 50 shares of a tech stock at the market. That is, I entered the order and said, “I’ll take the best price available for 50 shares.”

I know my 50 shares is less than the minimum 100-share bid so it MUST be filled at the best price.  I also know the stock I bought trades about $16,000 at a time, and my order for 50 shares is just under that.

I’m stacking the deck in my favor by understanding market structure (I also know the stock has screaming Demand, falling Supply, a combo lifting prices, as in the economy, so I’m adding to my advantage, like a high-speed trader).

I had to confirm repeatedly that I understood I’d NOT entered a “limit” order, a trade with a specified price.

Brokers don’t want us traders using market orders because they can’t sell them. So my own broker sold me shares. That’s internalizing the trade, matching it in-house.

I sold via limit order because I was in a meeting. My broker sold it to somebody like Citadel, which split it into two trades at Island (Instinet, owned by Nomura) and took a penny both times. Then price rose almost a dollar more.

Wholesalers see all the flow, everywhere. They buy limit orders only on high odds of rising prices, making a spread, and buying and selling several times over to make more than the $0.08 they paid for my trade. I know it, and expect it.

But the purpose of the market, public companies – you listening to me? – becomes this intermediation. It’s over half of all volume. You think investors are doing it.

And this is the problem with the Fed. It manipulates the capacity to spend, and the value of assets, and manipulation becomes the purpose of the economy.

Markets cease to be free. Outcomes stop serving as barometers of supply and demand.

Actually, we see supply and demand in stocks (ask us). Too many public companies still don’t want to believe the data and instead go on doing pointless stuff. I don’t get that.  Why would we want our executives to be ignorant?

Apply that to the economy (maybe to Plato’s observation).  Let’s be honest. Rising debt and rising prices are clanging claxons of folly, like my 50 shares becoming two trades. They’re not harbingers of halcyon days.

Why be public for arbitrage? Why trade to be gamed?

We should face facts both places. The sooner, the better.  Elsewise we’re governed by our inferiors.

Money Highway

Posted on June 16, 2021

Is Jay Powell the new Investor Relations Officer for all public companies? 

Before we answer, the tranquil image at right free of the Federal Reserve and all the travails of modern economics and politics (and investor relations) is Catamount Lake near Steamboat Springs.  I love this time of year, the way the mountains glow verdant and lakes lie full among the meadows.

Back to the Fed and IR, the gaping deficit in investor-relations today is an application of quantitative and behavioral analytics. We have them. You can use them.  They tell us just about everything one would want to know about the equity market.

For the hermitic amongst us, the Fed chair takes the mic today to end a two-day policy meeting. Some have asked about the impact of monetary policy on Market Structure Sentiment, our ten-point gauge for share supply and demand in your stock, peers, industry, sector, and the whole market, so we’ll address it briefly.

For those not reading the Fed’s balance sheet, you should know it’s $7.993 trillion currently, and includes commitments to buy mortgage-backed securities running north of $200 billion continuously (no wonder mortgage rates are low despite a dearth of homes), reverse repurchases are a record-shattering $720 billion, and excess reserves are nearing $4 trillion.

In 2007, excess reserves averaged $10 billion. It’s 400 times more now, money with no place to go save begging for 10-12 basis points of interest from the Fed, which gave it to banks to begin.

Yeah, weird, right?  Why would you create money and then pay interest on it? Because your models have convinced you this is “good for the economy.”

The Fed’s yearly calendar typically includes four meetings with policy statements in March, June, September and December. The Fed doesn’t convene in May or October and calls an abbreviated November conclave ahead of the US election cycle.

Central banks were considered lenders of last resort under the Thornton-Bagehot (badge-it) model from the UK. They took only good collateral for monetary support (limited by gold and silver) and charged high interest rates.  Central banks were not seen as the fiscal pantheon but a lifeline for only those capable of surviving.

Thus, economies washed out failure.  Economic crises throughout history always trace to the overextension of credit. They are normal parts of the tension between human fear and greed.

Today, central banks take bad collateral and offer low rates. They prevent failure. That truncates the market mechanisms wanting to remove excess capacity when credit is overextended. It obviates competition and promotes monopolism (then government decries business practices).

Failure transfers from economies to the public balance sheet (and citizens bemoan these bailouts that are only possible through the central bank). I’m sure it’ll all work out.  Cough, cough.

Market Structure Sentiment is a constant meter of human fear and greed, through stock-picking, macroeconomic musings, quantitative models and speculation.  We don’t need to make monetary policy a separate input. The behavior of money already tells us what people think.

Money is the drug. The Fed is the dealer. 

Broad Market Sentiment told us in April the monetary party was over. That’s when money stopped flooding to equities and Broad Market Sentiment stopped rising toward 7.0 and stalled near 6.0.  Broad Market Sentiment is falling at an accelerating rate now.

We like to track daily behavioral change in the S&P 500.  Most times it runs from basis points to a few percentages. June 14, with Sentiment accelerating down, behavioral change mushroomed to 14%.

Not good.

We’re all on the Money Highway, public companies. You can have the best strategy for driving 55 (Sammy Hagar notwithstanding! Musical humor for you oldsters like me.). But if the Fed governs the freeway to 30mph, you’ll be stuck in the traffic, no way out.

And you should be measuring the behavior of money because it will tell you what everyone is doing. It’ll tell you what your stock pickers think. It’ll tell you if Passive money is coming or going. If you’re in deals, it’ll tell you if that deal gets done or gets competition.

So, is the Money Highway crumbling? The dollar is rising despite the Fed’s best efforts.  It gets hoarded into assets, and then prices stop rising. I don’t know if we’re about to tip over. I do know that every market correction in the modern era has been preceded by the same data we see now.

I wish we could all get off the Money Highway and take the backroads.

Cash in Lieu

Posted on March 24, 2021

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.

Deal Art

Posted on December 16, 2020

The Federal Reserve’s balance sheet is 185 times leveraged, and DoorDash’s market cap is $50 billion.  I’m sure it’ll all work out.

Image courtesy Amazon and Showtime.

In some ways the Fed is easier to understand than DoorDash. It’s got $7.2 trillion of liabilities and $39 billion of capital.  Who needs capital when you can create money? The Fed is the intermediary between our insatiable consumption and the finite time we all offer in trade for money.

Speaking of money, DoorDash raised over $2.4 billion of private equity before becoming (NYSE:DASH).  For grins, recall that INTC’s 1971 IPO raised $6.8 million.  Thanks to the Fed’s approach to money, it would be worth at least seven times more today.

Really, it says the 1971 dollar is about $0.14 now.  I suspect it’s less still, because humans find ingenious ways to offset the hourglass erosion of buying power running out like sand.  (And INTC’s split-adjusted IPO price would be $0.02 per share rather than the $23.50 at which they then were offered.)

I’m delighted for those Palo Alto entrepreneurs at DASH who early on both wrote the code and delivered the food. And the movie Layer Cake declared that the art of the deal is being a good middleman.  DASH is a whale of a fine intermediary.

As is Airbnb.  The rental impresario is worth $75 billion. Not bad for sitting in the middle.  ABNB is already in six Exchange Traded Funds despite debuting publicly just Dec 10.

Funny, both these intermediary plays are most heavily traded by…intermediaries.  Both in early trading show 70% of volume from Fast Traders, machines intermediating market prices.  More than 50% of daily volume in each thus far is borrowed too.  That is, it’s not owned, but loaned.

ABNB is trading over 22 million shares daily, over 330,000 daily trades, and 54% of volume is borrowed. DASH is averaging 110,000 trades, 9.4 million shares of volume.  And through yesterday, 57% of those shares, about 5.4 million daily, were a bit like the money the Fed creates – electronically borrowed from nowhere.

How? High-speed traders constructing the market’s digital trusses and girders daily like Legos get leeway as so-called market-makers to trade things that might not exist in the moment, if the moment demands it for the sake of stability.

Do you follow?  When the Fed buys our mortgages, it manufactures money. It’s an accounting entry.  Trade banks $200 billion of electronic bucks residing in excess reserves for the mortgages the banks want to sell, which in turn become digital assets on the Fed’s balance sheet. The country didn’t raise that cash by borrowing or taxing.

Pretty cool huh?  Wish you could do that?  Don’t try. It’s fraud for the rest of us.

Anyway, traders can do the same thing, earning latitude to make liquidity from stock marked “borrowed,” so long as the books are squared in 35 days.

And here’s the kicker.  ETFs are intermediary vehicles too.  Man, this art of the deal thing – being a good middle…person – is everywhere.

ETFs take in assets like ABNB shares, and issue an equal value of, say, BUYZ, the Franklin Disruptive Opportunities ETF.  They manage the ABNB shares for themselves (tax-free too). And you buy BUYZ in your brokerage account instead.

Got that?  ETFs don’t manage any money for you. Unlike index funds.  They sell you a substitute, an intermediary vehicle, called ETFs.

Franklin used to be an Active manager. Key folks there told me a couple years ago that unremitting redemptions from active funds had forced them into the ETF business.

One of them told me, paraphrasing, it’s a lot easier running ETFs. We don’t have to keep customer accounts or pick stocks.

You need to understand the machinery of the markets, folks. And the Grand Unified Theory of Intermediation that’s everywhere in our financial markets nowadays.

It’s the art of the deal.  And reason not to expect rational things from the stock market.

If 70% of the volume in ABNB and DASH is resulting thus far from machines borrowing and trading it, and not wanting to own it, valuations reflect the art of the deal, intermediation. Not prospects (which may be great, but the market isn’t the barometer).

Same thing with ETFs.  The art of the deal is exchanging them for stocks.

The Fed? The more it buys, the more valuable debt becomes (and the less our money is worth). So that’s working too.  Cough, cough.

Here’s your lesson, investors and investor-relations folks. You cannot control these things. But ignore them at your peril (we always know the facts I shared about DASH and ABNB). All deals with intermediaries need three parties to be happy, not two.  And one always wants to leave.