Tagged: Options Expirations

Panorama

It’s good to get yourself a long way away from things. You might find you’ve been missing the forest for the trees. 

So we’re in Europe, halfway through our longest junket away from Clyde the Cavalier (great name for a medieval court jester but he’s a hound dog). Thank you to our friends and family babysitting him!

This photo is us with gracious Basel hosts Kevin and Tammy (and fabulous hound dog Dakota) in the Alps in Kandersteg, Switzerland.  A panorama will change your perspective.

Photo courtesy Tim Quast. Kandersteg Switzerland.

Here’s a perspective. US stocks swooned Monday into the close. I read it was Apple slowing hiring.  Somebody made that up, a correlation unsupported by math.

A tree in the forest.

The algorithms we write, machines crunching data like the Roomba lawn mower on its programmed rounds at Castello di Spaltenna in Gaiole Italy where we stayed last week, said this about S&P 500 stocks:

Down 7% on selling tied to derivatives like options. Sentiment signals gains, while short volume is up 1% and above the 5-day, 20-day, 50-day and 200-day trend.

It means stocks fell 7% the past week through Monday on derivatives like options. That fits the context. It’s more panoramic than you think.  Options expired and reset.  I didn’t read a word in any business media about lapsing and resetting options.

And Short Volume, the supply chain of the stock market, is above trailing averages. In fact, it’s 49% of trading volume. That’s a 1% spread between long and short volume.

And while Sentiment now signals gains (as we saw Tuesday), a backlog in the supply chain will mute them.

Public companies and investors, THIS is seeing the whole forest, not a random tree.

Yeah, you say. But I can’t control it. 

Controlling outcomes is an illusion. It was possible when 80% of the volume and 90% of the assets were focused on Story. You could court the buyside and sellside and separate yourself.

That was 20 years ago.

Now, the new money in the market is Passive, and large-cap Passive is the biggest asset category, and 90% of the volume is doing something other than buying and selling Story.

Stocks fell Monday because the cost for using substitutes and hedges rose, so demand for new derivatives Monday was down. Lower implied demand hurt prices.

The market is a Roomba running around on a programmed path, demarcated by options-expirations, the ebb and flow of passive money, machines sifting the price data.

What about earnings?  Sure, those affect programmed activity, rather as the lawnmower Roomba at Spaltenna runs in planned circles around swales to even out the grass.

But they’re not the determinants of whether stocks rise or fall. The Roomba running in circles is.

Discouraging? No, a fact. Do we want to matter, or become obsolete?  Ignoring reality is not a strategy for promoting occupational longevity.

Someone asked the online investor-relations community for advice on which investment conferences to attend to garner analyst research (what’s called sellside coverage).

The company has $18 million of market cap. It doesn’t trade enough to generate a return for any market-making desk. Seeking coverage is missing the forest for the trees.

But you know what happened:

CEO: “Get us into some conferences. Get some analyst coverage.” 

IRO: “Yes.” 

Among the trees, you don’t see how the market works. It’s the investor-relations officer’s job to know, though. You can’t provide sound counsel if you don’t.

What should that company do?  Well, 99.8% of the money in the stock market is in larger stocks.  The IR person should give the team and the Board a clear-eyed view:

  1. Take the company private.
  2. Merge with others in the industry to create the largest player possible.
  3. Keep doing what we’re doing but it won’t matter.

Those are the unvarnished facts. You can’t create shareholder value by telling the Story, because that’s not what drives most of the money. You’ll never come to understand what you can and cannot do as a public company without first getting above the trees, seeing the whole picture.

If you’re a serious public company, the roadmap to all the things you want – coverage, share

holder value, liquidity – is understanding how the market works and what the money is doing and figuring out how to get in front of it.

And that’s simple: Size. Have a strategy for joining the 20 largest companies in your industry or sector.

That’s the view from up here.  With that, we’re off to Zermatt (in fact, I’m writing on the train)!  Catch you in a couple weeks after we’ve ridden bikes through the Alps.

Troubling Signs

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.

No Excuses

There’s no excuse. 

It’s 2022.  Not 1934, when Benjamin Graham wrote Security Analysis.

Back then, the timeless notion of buying profitable companies with undervalued growth opportunity took firm shape. But its interpretation would have to be shaped by the Securities Acts of 1933 and 1934, which birthed the SEC and part of the market’s structure that prevails still.

In 2022, the stock market has been operating under Regulation National Market System for 15 years.  Anybody in the stock market – investor, trader, public company – who doesn’t know what Reg NMS is and does is without excuse.

And any company reporting financial results during options expirations is without excuse. Like NFLX. Shareholders should rightly be upset.  There is no excuse for a public company to be ignorant of market form and function in 2022.

Monthly options expirations. Illustration 23855600 © John Takai | Dreamstime.com

Isn’t that a bit harsh, Tim?  No excuse? 

It’s been 15 years. We’ve watched meme stocks. Surges and collapses in prices. No connection to reality.  And we’re here to help you. You need not go through an NFLX experience.

Here’s some perspective. In 1995, well before Reg NMS when Yahoo!’s earnings call was an event attracting tens of thousands of retail investors as CEO Tim Koogle, who called himself “the adult supervision,” discussed financial performance, you didn’t need to worry about the options calendar. Options trading was a blip on the equity radar.

The goal then was to show you could close the books fast.  Koogle and team reported Q4 outcomes within ten days of year-end.  Remember that?

Today, the daily notional trading value in options is greater than the dollar-volume of stocks.  The latter is $600 billion. 

Derivatives comprise close to 20% of all market-capitalization. Derivatives are a right but not an obligation to do something in the future.

Suppose, public companies, that 20% of your sales at any given moment were a bet – a possibility but not a certainty.  You’d have to account for that when setting internal and external expectations for results. Right?  That’s very material.

And that’s the stock market.  If 20% of your value depends on something that might not happen, should you take that into account?  And are you irresponsible if you don’t?

I don’t know this stuff, you say.  Well, learn it! It’s a primary part of the investor-relations job in 2022. The calendar is here, and here, and here and here. It’s public information.

And we can help you measure and understand behaviors and see what the money is doing BEFORE you report results, before expirations.

Options expire all the time, but the RHYTHM of the stock market moves with monthly expirations.

Weeklies are too short a timeframe for indexes and Exchange Traded Funds that use them for substitutes, too unstable for the market-makers driving colossal trading volumes to keep ETFs aligned with underlying stocks – while profiting on directional options plays.

In 1995, most of the market’s volume tied back to the 90% of institutional assets that were actively managed.  For NFLX, between Dec 1, 2021 and Jan 24, 2022, Active money averaged 9%of daily volume.

Eighteen percent of volume tied to derivatives, which expired last week as NFLX reported financial results.  And 55% of NFLX trading volume is driven by machines that exploit price-changes and want to own nothing.

Fast Trading.  High Frequency Trading. Whatever you want to call it.  Firms that are exempt from having to locate shares to short, under Reg SHO Rule 203(b)(2).

Investor Relations Officers, it’s your job to know the market’s risks and advise your executive team and board on how best to maximize shareholder value and minimize risks to shareholder interests.

Shareholders should, can and will expect it of you, public companies. You shepherd money, time and resources belonging to other people.

MSFT is reporting on the RIGHT side of expirations. Same with IBM.  Doesn’t mean stocks aren’t volatile with new options. But they haven’t time-decayed yet. Bets are much more expensive.

Yesterday was Counterparty Tuesday when banks squared the books on wins and losses related to last week’s January derivatives and the new February derivatives that traded Monday and prompted one of the epic 21st century trading days.

Don’t report results in the middle of that.

Oh, we have an internal calendar from the General Counsel. Well, tell the GC to change it!  Stop acting like it’s the 1990s.  It’s not.

Your priority, your job, your responsibility, is to be an informed participant in 21st century American public equity markets.  To your credit, IR community, a meaningful part has adapted, changed behaviors, learned how the market works.

If you’re ready to drag your executive team into the 21st century, tell them there’s no excuse.  It’s time to change behavior, reduce risks for shareholders. Come join the market structure family.

Resistance and Support

Bucket-list seeing Colorado aspens in autumn. It will remind you that the planet is a living canvas and that everything is going to be okay.

Colorado aspens at Muddy Pass summit. Karen Quast

Now, what about the stock market?  I said last week in the Market Structure Map:

“Predictions? I bet we rebound next week. BUT if Monday is bad, the bottom could fall out of stocks.  And you should always know what’s coming, companies, investors and traders. It’s just data.”

Well son of a gun.

New options traded Monday and the market took a vicious thwap to the noggin. Why? No, not Chinese real estate.  Or this thing, or that thing.  There was a buffet of options spread out for consumption and the crowd that showed up to feast was sparse like a pandemic trade show.

That’s weak implied demand. So stocks fell. Again, read last week’s blog. About 20% of market capitalization ties to rights to buy or sell that reset monthly.  If demand drops even a half-percent it can rock equities.

Who’s using those?  Hedge funds.  Traders.  Funds substituting derivatives for equities (permissible up to about 10% of assets).

Shouldn’t we wonder WHY fewer guests came to the options banquet? Yes, but in advance! If you’re casting about AFTER it happens, you’re making it up, like resistance and support. We talked for three weeks about the big risk into Monday.

The point isn’t being right. The point is correct data.  

What’s more, investors didn’t sell. Active Investment was down about 17% marketwide Monday. And the last-hour recovery that clawed back 30% from the lows came on quant money and machines.

I was talking with the investor-relations officer for a Nasdaq-traded Consumer Discretionary company.  I said, “What do you do for answers about why your stock moves differently from your peers?”

She said, “I call the Nasdaq.  The guy there tells me what our levels of resistance and support are.”

There are over $63 trillion in worldwide regulated (following standardized government guidelines like the Investment Company Act of 1940) investment funds, says the Investment Company Institute in its 2021 Factbook.

None of that money makes decisions using levels of support or resistance. So why would that be the explanation, if the job of the investor-relations officer is to help the board and executive team understand what drives shareholder value and how to succeed in the public equity markets?

Just askin’.

To be fair, this IR officer is now a client. It’s telling though, isn’t it, that for many in the investor-relations profession a telephone is the chief source of data. And the data provider says, “You broke through your support levels.”

Uh huh.

It’s true machines will calculate how to price bids and offers by sifting the surrounding data.  From that data come levels of support and resistance. The trouble is those machines don’t want to own anything.

Our friend in Consumer Discretionary saw shareholder value plummet 23% from the end of August to September options-expirations. Principal cause, Derivatives.  Active and Passive Investment patterns shrank over that time.

It had nothing to do with story.  In fact, that company’s Engagement score – quantitative measure of influence from Active stock-pickers – is 91%. Superb.  At this moment, the stock is exactly in line with what stock-pickers are willing to pay. That’s measurable.

And it wasn’t levels of support or resistance. Yes, over that time the machines manufacturing most prices averaged 55% of the stock’s volume and owned no shares at day’s end (and 60% of volume was short to boot – borrowed or manufactured).

To me, support and resistance are like the daytime temperature. Today’s high and low temperatures reflect seasons and weather-fronts, not support and resistance.  The seasons and weather-fronts of the stock market are patterns of changing behavior.

Last week, the S&P 500 saw a 1% drop in demand for derivatives – we call that a 1% decline in Risk Mgmt – when options-expirations should have driven an increase in demand.

Against falling demand (Sentiment) and rising supply (Short Volume) marketwide, we thought, “The market could take a Mike Tyson to the chin.”

Indexes reweighted too, and Passive investment was down 5% in the S&P 500.  Suggests weaker flows to Tech since that’s where all the market cap is.

What now? The Fed meets at 2p ET today.  Our 10-point index of short-term supply and demand called Broad Sentiment is 4.4, and 4.0 is a bottom. Probably stocks recover.

If the bottom turns to mush, people will be saying, “The market’s next level of support is…”

And that won’t be it. The data say we’ve been in a long slowdown from momentum since April. The consequences can show up all at once.  I doubt it’s right here, right now. But it’s possible. 

Optional Chaos

So which is it?  

Monday, doom loomed over stocks. In Punditry were wringing hands, hushed tones. The virus was back. Growth was slowing. Inflation. The sky was falling!

Then came Tuesday. 

Jekyll and Hyde? Options expirations.  Only CNBC’s Brian Sullivan mentioned it. As ModernIR head of client services Brian Leite said, there wasn’t otherwise much effort to explain where the doom went. One headline said, “Stocks reverse Monday’s losses.”

WC Fields said horse sense is the thing a horse has which keeps it from betting on people. We could have used some horse sense.  I Tweeted this video.

Anyway. What must you know, investors and public companies, about why options cause chaos in stocks? (I’m explaining it to the Benzinga Boot Camp Sat July 24, 30 minutes at 1220p ET.  Come join.)

It’s not just that options-expirations may unsettle equity markets. The question is WHY?

Let me lay a foundation for you. Global Gross Domestic Product (GDP) is about $85 trillion. The notional value – exposure to underlying assets – of exchange-traded options and futures is about the same, $85 trillion give or take, says the Bank for International Settlements. The BIS pegs over-the-counter derivatives notional value at $582 trillion.

So call it $670 trillion. All output is leverage 8-9 times, in effect.

Now, only a fraction of these derivatives tie to US equities. But stocks are priced in dollars. Currency and interest-rate instruments make up 90% of derivatives.

All that stuff lies beneath stocks. Here, let’s use an analogy. Think about the stock market as a town built on a fault line.  The town would seem the stolid thing, planted on the ground. Then a tectonic plate shifts.

Suddenly what you thought was immovable is at risk.

Remember mortgage-backed securities?  These derivatives expanded access to US residential real estate, causing demand to exceed supply and driving up real estate prices.  When supply and demand reached nexus, the value of derivatives vanished.

Suddenly the market had far more supply than demand.  Down went prices, catastrophically. Financial crisis.

Every month, what happened to mortgage-backed securities occurs in stocks. It’s not seismic most times. Stocks are assets in tight supply.  Most stocks are owned fully by investors.  Just three – Blackrock, Vanguard, State Street – own a quarter of all stocks.

So just as real estate was securitized, so are stocks, into options, futures, swaps.  While these instruments have a continuous stream of expiration and renewal dates, the large portion ties to a monthly calendar from the Options Clearing Corp (our version is here).

Every month there’s a reset to notional value. Suppose just 1% of the $50 trillion options market doesn’t renew contracts and instead shorts stocks, lifting short volume 1%.

Well, that’s a potential 2% swing in the supply/demand balance (by the way, that is precisely last week’s math).  It can send the Dow Jones Industrials down a thousand points.  Hands wring.  People cry Covid.

And because the dollar and interest rates are far and away the largest categories, money could leave derivatives and shift to the assets underpinning those – BONDS.

Interest rates fall. Bonds soar. Stocks swoon.  People shriek.

Marketstructureedge.com – Broad Market Sentiment 1YR Jul 21, 2021

Options chaos.  We could see it. The image here shows Broad Market Sentiment – DEMAND – for the stocks represented by SPY, the State Street S&P 500 Exchange Traded Fund (ETF).  Demand waxes and wanes.  It was waning right into expirations.

In fact, it’s been steadily waning since Apr 2021.  In May into options-expirations, Sentiment peaked at the weakest level since Sep 2020. Stocks trembled. In June at quad-witching, stocks took a one-day swan dive.

Here in July, they cratered and then surged.  All these are signals of trouble in derivatives. Not in the assets.  It’s not rational. It’s excessive substitution.

We can measure it at all times in your stock. Into earnings. With deals. When your stock soars or plunges.

In 1971, the USA left the gold standard because the supply of dollars was rising but gold was running out. The derivative couldn’t be converted into the asset anymore. The consequence nearly destroyed the dollar and might have if 20% interest rates hadn’t sucked dollars out of circulation.

High interest rates are what we need again. During the pandemic the Federal Reserve flooded the planet with dollars. Money rushed into risk assets as Gresham’s Law predicts. And derivatives.

When the supply/demand nexus comes, the assets will reprice but won’t vanish. The representative demand in derivatives COULD vanish.  That’s not here yet.

The point: Derivatives price your stock, your sector, your industry, the stock market. Adjustments to those balances occur every month.  We can see it, measure it. It breeds chaos. Pundits don’t understand it.

It’s supply and demand you can’t see without Market Structure goggles. We’ve got ‘em.

Many Tiny Trades

All 20 biggest points-losses for Dow Jones Industrials (DJIA) stocks in history have occurred under Regulation National Market System.

And 18 occurred from 2018-2020. Fifteen of the 20 biggest points-gains are in the last two years too, with all save one, in Mar 2000, under Reg NMS (2007-present).

It’s more remarkable against the backdrop of the Great Depression of the 1930s when the DJIA traded below 100, even below 50, versus around 20,700 now and small moves would be giant percentage jumps. Indeed, fifteen of the twenty biggest percentage gains occurred between 1929-1939. But four are under Reg NMS including yesterday’s 11.4% jump, 4th biggest all-time.

Just six of the biggest points-losses are under Reg NMS (we wrote this about the rule). But ranked second is Mar 16, 2020. And 19 of the 20 most volatile days on record – biggest intraday moves – were in the last two years, and all are under Reg NMS.

Statistically, these concentrated volatility records are anomalous and say what’s extant now in markets promotes volatility.  Our market is stuffed full of many tiny trades.

Volume the past five days has averaged 9.9 million shares per mean S&P 500 component, up 135% from the 200-day average.  But intraday volatility is up nearly 400%, trade-size measured in dollars is down 30%.

That’s why we’re setting volatility records. The definition of volatility is unstable prices.

I’m delighted as I’m sure CVX is that the big energy company led DJIA gainers yesterday, rising 22%.  But stocks shouldn’t post an excellent annual return in a day.

CVX liquidity metrics (volume is not liquidity!) show the same deterioration we see in the S&P 500, with intraday volatility up 400%, trade-size down 47%, daily trades up over 240% to 196,000 daily versus long-run average of about 57,000.

Doing way more of the same thing in tiny pieces means intermediaries get paid at the expense of investors.

Every stock by law must trade between the best national visible (at exchanges) bid to buy and offer to sell.  When volatility rises, big investors lose ability to buy and sell efficiently, because prices are constantly changing.

Regulators and exchanges have tried to deal with extraordinary volatility by halting trading.  We’ve tracked more than 7,500 individual trading halts in stocks since Mar 9 – twelve trading days.  Marketwide circuit breakers have repeatedly tripped.

Volatility has only worsened.

In financial crises, we inject liquidity to stabilize prices.  We can do the same in stocks by suspending the so-called “Trade Through Rule” requiring that stocks trade at a single best price, if the market is more than 5% volatile.

Trade size would jump, permitting big investors to move big money, returning confidence and stability to prices. We’ve proposed it three times to the SEC now.

Investors and public companies need to understand if the market is working. Let’s define “working.” The simplest measure is liquidity, which is not volume but dollars per trade, the amount one can buy or sell before price changes.  By that measure, the market has failed utterly during this tumult.

Let’s insist on a market capable of burstable bandwidth, so to speak, to handle surges.  Suspending Rule 611 of Reg NMS during stress is a logical strategy for the next time.

Let’s finish today by channeling the biblical apostles, who came to Jesus asking what would be the sign of the end of the age?  Here, we want to know what the sign is that market tumult is over.

At the extremities, no model can predict outcomes.  But given the nature of the market today and the behaviors dominating it, the rules governing it, we can inform ourselves.

This market crisis commenced Feb 24, the Monday when new marketwide derivatives traded for March expiration.  In the preceding week, demand for derivatives declined 5% at the same time Market Structure Sentiment topped.

We had no idea how violent the correction would be. But these signals are telling and contextual. They mean derivatives play an enormous role.

We had massive trouble with stocks right through the entire March cycle, which concluded Mar 20 with quad-witching.  Monday, new derivatives for April expiration began trading.

It’s a new clock, a reset to the timer.

You longtime clients know we watch Counterparty Tuesday, the day in the cycle when banks square the ledger around new and expired derivatives. That was yesterday.

That the market surged means supply undershot demand. And last week Risk Mgmt rose by 5% and was the top behavior – trades tied to derivatives, insurance, leverage. Shorting fell to the lowest sustained level in years. Market Structure Sentiment bottomed.

It’s a near-term nadir. The risk is that volatility keeps the market obsessed with changing the prices, which is arbitrage. Exchange Traded Funds depend on arbitrage (and led the surge in CVX).  Fast Traders do too. Bets on derivatives do.

The tumult ends in my view when big arbitragers quit, letting investment behavior briefly prevail.  We’ll see it. We haven’t yet.  The market may rise fast and fall suddenly again.

Time Changes

Public companies, are you still reporting financial results like it’s 1995?

Back then, Tim Koogle and team at Yahoo! made it a mission to be first, showing acuity at closing the books for the quarter faster than the rest. Thousands turned out for the call and – a whiz-bang new thing – webcast.

Ah, yesteryear and its influence.  It’s still setting time for us all.  No, really.  Benjamin Franklin penned a 1784 letter to a Parisian periodical claiming his experiments showed sunlight was available the moment the sun rose and if only Parisians could get out of bed earlier instead of rising late and staying up, they could save immense sums on candles.

Some say his levity gave rise to the notion of Daylight Savings Time. A closer look suggests it was the Canadians.  Sure, scientist George Hudson of the Wellington Philosophical Society presented an 1895 paper saying New Zealand would improve its industry by turning clocks forward two hours in October, back two in March.

But the occupants of Thunder Bay in northern Ontario first shifted time forward in 1908.

What do Canada and New Zealand have in common besides language and erstwhile inclusion in a British empire upon which the sun never set?  They’re at extreme latitudes where light and dark swing mightily.

The push to yank clocks back and forth swept up much of the planet during World War I in an effort to reduce fuel-consumption.

Here in Denver we’re neither at war and hoarding tallow nor gripping a planetary light-bending polar cap in mittened hands.  So why do we cling to an anachronistic practice?

Speaking of which, in 1995 when the internet throngs hung on every analog and digital word from the Yahoo! executive fearsome foursome (at least threesome), most of the money in the market was Active Investment. That was 24 years ago.

Back then, investor-relations pros wanted to be sellside analysts making the big bucks like Mary Meeker and Henry Blodget. Now the sellsiders want to be IR pros because few hang on its words today like it was EF Hutton and the jobs and checks have gone away.

Volume is run by machines. The majority of assets under management are Passive, paying no attention to results. Three firms own nearly 30% of all equities. Thousands of Exchange Traded Funds have turned capital markets into arbitrage foot races that see earnings only as anomalies to exploit. Fast Traders set most of the bids and offers and don’t want to own anything. And derivatives bets are the top way to play earnings.

By the way, I’m moderating a panel on market structure for the NIRI Virtual Chapter Nov 20 with Joe Saluzzi and Mett Kinak. We’ll discuss what every IRO, board member and executive should understand about how the market works.

Today 50% of trades are less than 100 shares.  Over 85% of volume is a form of arbitrage (versus a benchmark, underlying stocks, derivatives, prices elsewhere).

Active Investment is the smallest slice of daily trading. Why would we do what we did in 1995 when it was the largest force?

Here are three 21st century Rules for Reporting:

Rule #1: Don’t report results during options-expirations.  In Feb 2019 Goldman Sachs put out a note saying the top trading strategy during earnings season was buying five-day out of the money calls. That is, buy the rights (it was 1996 when OMC offered that same advice in a song called How Bizarre.). Sell them before earnings. This technique, Goldman said, produced an average 88% return in the two preceding quarters.

How? If calls can be bought for $1.20 and sold for $2.25, that’s an 88% return.  But it’s got nothing to do with your results, or rational views of your price.

The closer to expirations, the cheaper and easier the arbitrage trade. Report AFTER expirations. Stop reporting in the middle of them. And don’t report at the ends of months. Passives are truing up tracking then. Here’s our IR Planning Calendar.

Rule #2: Be unpredictable, not predictable.  Arbitrage schemes depend on three factors: price, volatility, and time. Time equals WHEN you report. If you always publish dates at the same time in advance, you pitch a fastball straight down the middle over the plate, letting speculative sluggers slam it right over the fence.

Stop doing that. Vary it. Better, be vague. You can let your holders and analysts know via email, then put out an advisory the day of earnings pointing to your website.  Comply with the rules – but don’t serve speculators.

Rule #3: Know your market structure and measure it before and after results to shape message beforehand and internal feedback afterward. The bad news about mathematical markets is they’re full of arbitragers.  The good news is math is a perfect grid for us to measure with machines. We can see everything the money is doing.

If we can, you can (use our analytics!).  If you can know every day what sets your price, how it may move with results, whether there are massive synthetic short bets queued up and looming over your press release, well…why wouldn’t you want to know?

Let’s do 21st century IR. No need to burn tallow like cave dwellers. Go Modern. It’s time.

 

In Control

This is what Steamboat Springs looked like June 21, the first day of summer (yes, that’s a snow plow).

Before winter returned, we were hiking Emerald Mountain there and were glad the big fella who left these tracks had headed the other way (yes, those are Karen’s shoes on the upper edge, for a size comparison).

A setup for talking about a bear market?  No.  But there are structural facts you need to know.  Such as why are investor-relations goals for changes to the shareholder base hard to achieve?

We were in Chicago seeing customers and one said, “Some holders complain we’re underperforming our peers because we don’t have the right shareholder mix. We develop a plan to change it.  We execute our outreach. When we compare outcomes to goals after the fact, we’ve not achieved them.”

Why?

The cause isn’t a failure of communication. It’s market structure.  First, many Active funds have had net outflows over the last decade as money shifted from expensive active management to inexpensive passive management.

It’s trillions of dollars.  And it means stock-pickers are often sellers, not buyers.

As the head of equities for a major fund complex told me, “Management teams come to see my analysts and tell the story, but we’ve got redemptions.  We’re not buying stocks. We’re selling them. And getting into ETFs.”

Second, conventional funds are by rule fully invested.  To buy something they must sell something else.  It’s hard business now.  While the average trade size rose the past two weeks from about 155 shares to 174 shares, it’s skewed by mega caps.  MRK is right at the average.  But FDX’s average trade size is 89 shares.  I saw a company yesterday averaging 45 shares per trade.

Moving 250,000 shares 45 at a time is wildly inefficient. It also means investors are continually contending with incorrect prices. Stocks quote in 100-share increments. If they trade in smaller fractions, there’s a good chance it’s not at the best displayed price.

That’s a structural problem that stacks the deck against active stock pickers, who are better off using Exchange Traded Funds (ETFs) that have limitless supply elasticity (ETFs don’t compete in the market for stocks. All stock-movement related to creating and redeeming ETF shares occurs off-market in giant blocks).

Speaking of market-structure (thank you, Joe Saluzzi), the Securities Traders Association had this advice for issuers:  Educate yourself on the market and develop a voice.

Bottom line, IR people, you need to understand how your stock trades and what its characteristics are, so you and your executive team and the board remain grounded in the reality of what’s achievable in a market dominated by ETFs.

Which brings us to current market structure.  Yesterday was “Counterparty Tuesday” when banks true up books related to options expiring last week and new ones that traded Monday.  The market was down because demand for stocks and derivatives from ETFs was off a combined 19% the past week versus 20-day averages.

It should be up, not down.

Last week was quad-witching when stock and index options and futures lapsed. S&P indexes rebalanced for the quarter. There was Phase III of the annual Russell reconstitution, which concludes Friday. Quarterly window-dressing should be happening now, as money tracking any benchmark needs to true up errors by June 28.

Where’d the money go?

If Passive money declines, the market could tip over. We’re not saying it’s bound to happen.  More important than the composition of an index is the amount of money pegged to it – trillions with the Russells (95% of it the Russell 1000), even more for S&P indices.

In that vein, last week leading into quad witching the lead behavior in every sector was Fast Trading.  Machines, not investors, drove the S&P 500 up 2.2%, likely counting on Passive money manifesting (as we did).

If it doesn’t, Fast Traders will vanish.

Summing up, we need to know what’s within our control.  Targeting investors without knowing market structure is like a farmer cutting hay without checking the weather report.  You can’t control the weather. You control when you cut hay – to avoid failure.

The same applies to IR (and investing, for that matter) in modern markets.

Jekyll and Hyde

Your stock may collateralize long and short Exchange-Traded Funds (ETFs) simultaneously.

Isn’t that cognitive dissonance – holding opposing views? Jekyll and Hyde? It’s akin to supposing that here in Denver you can drive I-25 north toward Fort Collins and arrive south in Castle Rock. Try as long as you like and it’ll never work.

I found an instance of this condition by accident. OXY, an energy company, is just through a contested battle with CVX to buy APC, a firm with big energy operations in the Permian Basin of TX (where the odor of oil and gas is the smell of money).

OXY is in 219 ETFs, a big number.  AAPL is in 271 but it’s got 20 times the market-capitalization.  OXY and its short volume have moved inversely – price down, shorting up. The patterns say ETFs are behind it.

So I checked.

Lo and behold, OXY is in a swath of funds like GUSH and DRIP that try to be two or three times better or worse than an index. These are leveraged funds.

How can a fund that wants to return, say, three times more than an S&P energy index use the same stock as one wanting to be three times worse than the index?

“Tim, maybe one fund sees OXY as a bullish stock, the other as bearish.”

Except these funds are passive vehicles, which means they don’t pick stocks. They track a model, and in this case, the same model.  If the stock doesn’t behave like the ETF, why does the fund hold it?

I should note before answering that GUSH and DRIP and similar ETFs are one-day investments. They’re in a way designed to promote ownership of volatility. They want you to buy and sell both every day.

You can see why. This image above shows OXY the last three months with GUSH and DRIP.

Consider what that means for you investor-relations professionals counting on shares to serve as a rational barometer, or you long investors doing your homework to find undervalued stocks.

Speaking of understanding, I’ll interject that if you’re not yet registered for the NIRI Annual Conference, do it now!  It’s a big show and a good one, and we’ve got awesome market structure discussions for you.

Back to the story, these leveraged instruments are no sideshow. In a market with 3,500 public companies and close to 9,000 securities, tallying all stock classes, closed-end funds and ETFs, some routinely are among the top 50 most actively traded.  SQQQ and TVIX, leveraged instruments, were in the top dozen at the Nasdaq yesterday.

For those juiced energy funds, OXY is just collateral. That is, it’s liquid ($600 million of stock trading daily) and currently 50% less volatile than the broad market. A volatility fund wants the opposite of what it’s selling (volatility) because it’s not investing in OXY. It’s leveraging OXY to buy or sell or short other things that feed volatility.

And it can short OXY as a hedge to boot.

All ETFs are derivatives, not just ones using derivatives to achieve their objectives. They are all predicated on an underlying asset yet aren’t the underlying asset.

It’s vital to understand what the money is doing because otherwise conclusions might be falsely premised. Maybe the Board at OXY concludes management is doing a poor job creating shareholder value when in reality it’s being merchandised by volatility traders.

Speaking of volatility, Market Structure Sentiment is about bottomed at the lowest level of 2019. It’s predictive so that still means stocks could swoon, but it also says risk will soon wane (briefly anyway). First though, volatility bets like the VIX and hundreds of billions of dollars of others expire today. Thursday will be reality for the first time since the 15th, before May expirations began.

Even with Sentiment bottoming, we keep the market at arm’s length because of its vast dependence on a delicate arbitrage balance. A Jekyll-Hyde line it rides.

Form Follows Function

We’re told that on Friday Jan 18, the Dow Jones Industrial Average soared on optimism about US-China trade, then abruptly yesterday “global growth fears” sparked a selloff.

Directional changes in a day don’t reflect buy-and-hold behavior, so why do headline writers insist on trying to jam that square peg every day into the market’s round hole?

So to speak.

It’s not how the market works. I saw not a single story (if you did, send it!) saying options expired Jan 16-18 when the market surged or that yesterday marked rare confluence of new options trading and what we call Counterparty Tuesday when banks true up gains or losses on bets.

Both events coincided thanks to the market holiday, so effects may last Wed-Fri.

The point for public companies and investors is to understand how the market works. It’s priced, as it always has been, by its purposes. When a long-term focus on fundamentals prevailed, long-term fundamentals priced stocks.

That market disappeared in 2001, with decimalization, which changed property rights on market data and forced intermediaries to become part of volume. Under Regulation National Market System, the entire market was reshaped around price and speed.

Now add in demographics.  There are four competing forces behind prices. Active money is focused on the long-term. Passive money is focused on short-term central tendencies, or characteristics. Fast Traders focus on fleeting price-changes. Risk Management focuses on calculated uncertainties.

Three of these depend for success on arbitrage, or different prices for the same thing. Are we saying Passive money is arbitrage?  Read on. We’ll address it.

Friday, leverage expired. That is, winning bets could cashier for stock, as one would with the simplest bet, an in-the-money call option. The parties on the other side were obliged to cover – so the market soared as they bought to fulfill obligations.

Active money bought too, but it did so ignorantly, unaware of what other factors were affecting the market at that moment.  The Bank for International Settlements tracks nearly $600 trillion of derivatives ranging from currency and interest-rate swaps to equity-linked instruments. Those pegged to the monthly calendar lapsed or reset Friday.

Behavioral volatility exploded Friday to 19%. Behavioral volatility is a sudden demographic change behind price and volume, much like being overrun at your fast-food joint by youngsters buying dollar tacos, or whatever. You run out of dollar tacos.

That happened Friday like it did in late September. The Dow yesterday was down over 400 points before pulling back to a milder decline.

And there may be more. But it’s not rational thought. It’s short-term behaviors.

So is Passive money arbitrage?  Just part of it. Exchange-Traded Funds (ETFs) were given regulatory imprimatur to exist only because of a built-in “arbitrage mechanism” meant to keep the prices of ETFs, which are valueless, claimless substitutes for stocks and index funds, aligned with actual assets.

Regulators required ETFs to rely on arbitrage – which is speculative exploitation of price-differences. It’s the craziest thing, objectively considered. The great bulk of market participants do not comprehend that ETFs have exploded in popularity because of their appeal to short-term speculators.

Blackrock and other sponsors bake a tiny management fee into most shares – and yet ETFs manage nobody’s money but the ETF sponsor’s. They are charging ETF buyers a fee for nothing so their motivation is to create ETF shares, a short-term event.

Those trading them are motivated by how ETFs, index futures and options and stocks (and options on futures, and options on ETFs) may all have fleetingly different prices.

The data validate it.  We see it. How often do data say the same about your stock?  Investors, how often is your portfolio riven with Overbought, heavily shorted stocks driven by arbitrage bets?

What’s ahead? I think we may have another rough day, then maybe a slow slide into month-end window-dressing where Passive money will reweight away from equities again.  Sentiment and behavioral volatility will tell us, one way or the other.

Ask me tomorrow if behavioral volatility was up today. It’s not minds changing every day that moves the market. It’s arbitrage.