Tagged: Stocks

A New Construct

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.

Illustration 17689963 © Ashdesign | Dreamstime.com

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.

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.

The Essentials

Skip meals, give up beer, burn calories. 

That combination lowers my weight.  The essentials.  In fact, depending on the amount of meal-skipping and skipping-rope (well, riding bikes), I drop pounds in days.

Illustration 186661760 © Balint Radu | Dreamstime.com

What’s the equivalent for creating shareholder-value, public companies?  We ought to know if we’re in the investor-relations profession (as I’ve been for 27 years).  And investors, you’d do well to know, too.

I could give you a list as long as an election ballot of people on TV telling investors to “buy the stocks of great companies.” 

Nvidia is a great company. Zscaler is a great company.  Heck, Netflix is a great company that made $3.53/share last quarter and trades at 15 times earnings.  It’s down 71% this year.

Occidental Petroleum is the best performer in the S&P 500 this year, up 92%.  Over the four years ended Dec 31, 2021, OXY lost $10 billion.  It paid so much for Anadarko that Carl Icahn fought a vicious battle to stop the deal.

You can’t just say “buy good companies.”  You can’t just be a good company and expect shareholder-value to follow.

That would be true if 90% of the money were motivated to own only great companies.  Energy stocks are up 38% this year – even after losing 18% last week.  You don’t have to be great. You just have to be in Energy.

That’s asset-allocation behavior, trading behavior.

Do you know that OXY and ETSY have exactly the same amount of volume driven by Active Investment?  About 9%. Etsy is profitable, too.  But its short volume – percentage of trading from borrowed or manufactured stock – has been over 50% all year and at times over 70%.

And 52% of Etsy’s trading volume comes from machines that don’t own anything at day’s end. Well, there you go. Heavily short, heavily traded. Recipe for declines.

Occidental?  About 44% of its trading volume ties to ETFs and derivatives.  Just 47% is machines wanting to own nothing. Short Volume in OXY had been below 50% until last week, when it jumped to 60% right before price dropped from $70 to $55.

Small variances in market structure are reasons why one is down 65%, the other up 92%. 

In sum, value in the stock market is about Supply and Demand, as it is in every market.  And Supply and Demand are driven by MONEY. And 90% of the money is trading things, leveraging into things via derivatives, allocating according to models.

And it pays to be big.  Occidental is among the 20 largest Energy sector stocks by market capitalization, Etsy is on the small side of a sector dominated by Amazon, Tesla, Home Depot, Alibaba, McDonald’s, Nike.

Callon Petroleum is a darned good company too, but where OXY is over $50 billion of market cap, CPE is under $3 billion, in the Russell 2000 instead of the Russell 1000 where all the money is. It’s down 7% this year.

How about Campbell Soup, Kellogg, General Mills?  Similar companies in Consumer Staples. Which is biggest?  GIS.  Which stock is up most the last year? GIS.

So Occidental did it right.  It got bigger. 

If Kellogg splits into three companies, there will be three choices rather than one for asset-allocation models.  In case you missed that news.  Maybe that’s good for business. It’s bad for size, and size matters (I think increasing operating costs and decreasing synergies is stupid but the bankers don’t).

Mondelez?  Big company. But it was bigger before shedding Kraft. It trades about where it did three years ago.

Lesson? Be the biggest thing in your industry that you can be.  If you’re Energy, become one of the 20-25 largest.

If quitting beer didn’t cut my weight, why would I do it? I love CO beer.  I want to do things that count, not things that go through the motions, form over substance.

Here are your essentials, public companies.  If you want to be in front of as much money as possible, become the biggest in your business.  You can tell your story till you’re blue in the face and it won’t matter if you’re $2 billion and the big dogs are $50 billion.

Another essential to shareholder value, public companies, stop reporting earnings during options expirations, because three times more economic value ties to derivatives paired with your stock than tie to your story.

Are we playing at being public, or taking it seriously? Stop drinking beer and expecting to lose weight.  So to speak.

And Essential #3.  Know your market structure. Investors, understand where the money is going (if you don’t know, use EDGE. It’ll show you. And it works.).  Market Structure, not story, interprets enthusiasm and determines your value.

Do those things, and you’ll be a serious public company, just like it takes three things for me to seriously lose weight. And it’s not that hard. 

Elasticity

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?

Illustration 164670867 © Adonis1969 | Dreamstime.com

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.

Snapped

SNAP broke yesterday. I’ll explain two reasons why.

Yes, the company blew the quarter. Dramatic swings in guidance don’t instill joy.

But the losses occurred before anybody talked about them.  SNAP closed Monday at $22.47 and opened Tuesday for trading at $14.49 and closed at $12.79.

It lost 36% when most couldn’t trade it and shed just $1.30 during official market hours.

Illustration 135866583 © Jm10 | Dreamstime.com

How is that fair?

Regulations are meant to promote a free, fair and open stock market. I think premarket trading should be prohibited because it’s not a level playing field.

Who’s using it? Big institutions with direct access to brokers who operate the markets running around the clock. Hedge funds could dump shares through a prime broker, which instantly sells via so-called dark pools.

And the hedge funds could buy puts – and leverage them – on a whole basket including the stock they dumped, peers, ETFs, indices.  All outside market hours.

Something unfair also happens DURING market hours. I’ll explain with my own experience as a retail trader using our decision-support platform, Market Structure EDGE.

It’s not that my trade was unfair.  I understand market structure, including how to use volatility, trade-size, liquidity and stock orders to best effect.  I made money on the trade.

But it’s instructive for public companies, traders, investors.

I sold 50 shares of NXST. Small trade, with a reasonable return. I pay a modest commission at Interactive Brokers to observe how trades execute.

Most times I buy and sell 100 or fewer shares, often 95 or 99. The average trade-size in the market is less than 100 shares so I don’t want to be an outlier. And you’re looking for blocks? Forget it. The market is algorithmic.

And I know the rules require a market order, one accepting the best offer to sell, to execute immediately at the best price if it’s 100 or fewer shares.

Stay with me – there’s a vital point.

NXST trades about $7,300 at a time (a little under 50 shares), the reason for my trade-size. And it’s 2.1% volatile daily. Since it was up 2% during the day, I knew it was at the top of the daily statistical probability, good time to sell.

I checked the bid/ask spread – the gap between the best bid to buy and offer to sell.  Bid was $176.01, offer was $176.25. A spread of $0.25. That’s big for a liquid stock.

So I used a marketable limit order – I picked a spot between them, aiming to the lower side to improve the chance it filled: $176.05. I was wanting to leave.

The trade sat there for a bit, and then filled.  I checked. It split into two pieces, 45 shares at “Island,” which is Instinet, the oldest Electronic Communications Network, now owned by Nomura. I paid a commission of $0.19.

And the other piece, five shares, also executed at Instinet at the same price.  And I paid $1.02 in commission. For five shares!

What the hell happened? 

This is how the ecosystem works.  And this rapid action can smash swaths of shareholder value, foster wild and violent market swings – especially during options-expirations (yesterday was Counterparty Tuesday, when banks square monthly derivatives books, and it was a tug-of-war) – and, sometimes, work masterfully.

It’s market structure.

My broker sent the trade to Instinet, determining by pinging that undisplayed shares there would fill it.

And one or more Fast Traders hit and cancelled to take a piece of it, permitting my broker to charge me two commissions, one on five shares, another on 45 shares.

And now my one trade became ammo for two. The going rate at stock exchanges for a trade that sets the best offer is around $0.25 per hundred shares – the exact spread in NXST.

Yes, that’s right. Exchanges PAY traders to set prices. I traded 50 shares, but since the order split, it could become the best national offer two places simultaneously, generating that high frequency trader about $0.15.

What’s more, my order originated as a retail trade, qualifying for Retail Liquidity Programs at stock exchanges that pay an additional $0.03.

So my intermediary, Interactive Brokers, made $1.21. Some high-frequency trader probably made another $0.18 for breaking the trade up and buying and selling it at the same price two places. Zero risk for an $0.18 return.

Do that 100,000 times, it’s big, risk-free money.

It didn’t cost me much. But suppose it was 500,000 shares or five million?  Every trade navigates this maze, public companies and investors, getting picked and pecked.

Not only do costs mount for moving any order of size but the market BECOMES this maze. Its purpose disappears into the machination of pennies. Oftentimes it’s tenths of pennies in liquid stocks.

And you’re telling your story, spending on ESG reports, a total approaching $10 billion for public companies complying with rules to inform investors.

And the market is the mass pursuit of pennies.  Yes, there are investors. But everybody endures this withering barrage that inflates on the way up, deflates on the way down.

And it’s wrong that the mechanics of the market devolve its form into the intermediated death of a thousand cuts. Is anyone going to do anything about it?

Create and Destroy

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

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

Illustration 247279717 / Cryptocurrency © Vladimir Kazakov | Dreamstime.com

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

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

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

Here’s the 2022 calendar.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Hysteresis

You never know where you’ll hear a new vocabulary word. 

It’s not the word that matters but what it connotes.  And the context in which one hears it.  In this case, it was hedge-fund billionaire Paul Tudor Jones on CNBC Squawk Box yesterday, talking about stocks and bonds.

He said you don’t want to own them. He said, paraphrasing, there’s hysteresis at work in markets. 

Now, I think I’ve got a decent vocabulary. I read Allan Bloom’s “The Closing of the American Mind” in college and recorded roughly 32% of its entire contents as words I didn’t know.  Like palimpsest.

And I didn’t know hysteresis. It’s the delayed effect of causes. The relationship between an outcome and the history preceding it.

Illustration 27944908 © Mopic | Dreamstime.com

I guess it’s good news he didn’t say “there are no words to describe how bad things are in markets.” Warren Buffett, speaking this past weekend to the Berkshire masses gathered in Omaha, called financial markets “a gambling parlor.”

By the way, did you know Berkshire Hathaway holds no earnings call?  They just put out a Saturday press release. Hm, one wonders if we’re all confusing busy with productive.

Anyway, Mr. Buffett said he finds the amount of speculative betting “obscene.”

I’m reminded of a vignette from David Mamet’s book, Recessional. He’s in New York and observing street experts working suckers with Three Card Monte.

You know it? Somebody turns three cards up and says follow the queen, or whatever.  Then he turns them over and shuffles them.

Mamet says Three Card Monte is not a game of chance.  Not a game of skill.  It’s not a game.

And that’s the stock market. It is not a game for those setting most prices. I told traders using our quant decision-support platform that all the middlemen, the toll-takers like money managers, ETF sponsors, market-makers, brokers, exchanges, make money while investors and traders struggle.  Look at Citadel’s great April.

For intermediaries, it’s a job, and the rules and processes are well-known to them. The purpose of the stock market is to facilitate a continuous auction of everything in tiny bits. So the SEC has decreed.

That is, there must always be prices for all stocks, even if the prices are wholly disconnected from supply/demand reality.

Public companies, consider the chasm between Mr. Buffett’s statement and what you want.  You’re after shareholder value, not stimulating the “gambling parlor.”

What are you going to do to sort the one from the other? You can’t do it with “settlement data.”

Bill Gurley, guru of venture capital in Silicon Valley at Benchmark Capital tweeted that earnings multiples have always been a “hack proxy.” He said there’s a lot of what he called “unlearning” coming to the multitude too young to know a bear market.

I know looking at the numbers coming out of Robinhood and other parts of the market that retail traders have taken a drubbing by not understanding what’s happening.

The stock market functions exactly as its rules specify. It’s the system. The word “hysteresis” says the system reflects the state of its history.

And the history of the market, as with money, credit, labor, is about increasingly pervasive government control. Which means market forces lose control.

Bonds and equities are for the first time in decades falling at the same time.  The dollar is at levels one finds during crises when money rushes to it for capital-preservation. The economy doddered into a GDP decline last quarter.

We may be in a financial crisis already. We don’t see it because the credit-overextension causing it isn’t emanating from some part of the economy but from the government itself.

What about jobs, openings, strong consumer credit and balance sheets? They’re part of hysteresis, the milieu resulting from what came before it. They reflect what was stimulated into existence, not what can survive without stimulation.

I’m not saying everything is about to fall apart. The stock market could go on a tear again, although supply/demand trends need big change to make that hold.

Rather, I think the trouble is all the effort to manage outcomes. A handful of members of government, and central bankers and regulators are trying to run everything. The few are not smarter than the many. Hysteresis for any cultural experiment shows it.

Stenosis is a word describing the consequences of narrowing neural passages. Stentorian means loud, thundering.

I think hysteresis in our financial markets is breeding economic stenosis that will lead to stentorian tumult.  We best get prepared (we have the navigational data).

For the Birds

Did you know the Caribbean is full of brown boobies? 

The blue-footed brown booby, about the size of a seagull.  We’re just back from sailing St Martin and St Barts, where the critters of both sea and sky delighted.

Unlike the stock market, apparently, which has gone to, um, the birds. 

By the way, best food in the islands?  Grand Case on St Martin. It’s French. Need I say more?  On our boat, we had French food, French wine, French chef.

It’s a wonder we left. I gained five pounds. You can see it in the photo, aboard our catamaran in St Barts (more trip photos if you’re interested).

Tim and Karen Quast aboard Norsegod in St Barts Harbor (courtesy Tim Quast).

Back to stocks, we should have expected cratering markets because fundamentals have deteriorated dramatically.

Oh no, wait. They haven’t. 

Zscaler (ZS), which has been crushing expectations every quarter, is up just 6.7% the past year now after rising over 500% the past five years. It’s down 33% the last six months.

Philip Morris (PM), which is not growing, is down 7% the past five years but up 8% the past six months.

The popular explanations for why these conditions exist have reached such shrieking insanity that I might be forced to return to the sea.  And French food.

First, let’s understand how stocks go up.  Not the “more buyers than sellers” version but the mechanics. 

There is demand.  It can come from investors, traders or counterparties. Active investors buy opportunity, Passive investors buy products – growth, value, etc. Traders chase arbitrage (different prices for the same thing). Counterparties buy or sell to meet or mitigate demand for derivatives like options.

When all converge, prices explode. 

And there are compounding factors. Many investors now prefer Exchange Traded Funds (ETFs), which don’t increase the SUPPLY of stocks, just the DEMAND for them.

And traders buy or sell short-term prices with connection only to previous prices, leading to spiraling short-term gyrations.

And derivatives as both implied demand and supply magnify moves.

Are you with me still? Think this is for the birds?

The Tetris of the stock market, the arranging of these blocks, distorts perceptions of supply and demand and fosters absurd explanations.

And over time, it erodes realized returns.  All the toll-collectors – money managers, ETF sponsors, trading intermediaries, stock exchanges, counterparties – get rich.

As of yesterday, the Nasdaq is up about 6.5% annually since March 2000, before taxes and inflation and without respect to risk premia. Tech stocks move 3.5% intraday daily.

You see? Daily price-moves are more than half the average expected pre-tax returns. That’s because of what happens when all the Tetris blocks start falling.

Here’s how. Active investors stop buying equities. Passive investors slow allocations and see redemptions.  Speculators stop setting prices. ETFs have to redeem shares so compounding demand is suddenly replaced by a vacuum. Implied demand via derivatives vanishes.

And prices implode.

This is how the DJIA drops 800 points in a day.

And we haven’t even talked about short volume.  The SEC permits intermediaries to create stock when no real supply exists to satisfy it. That is, they can short stocks without borrowing.

That works great on the way up as it provides supply to rising prices that would otherwise go unsatisfied. On the way down, we become aware that the implied demand in created stock just doesn’t exist.

So, Tim. What can we do in this market?  

You can’t control it.  We could fix it if we stopped letting shilling Fast Traders set prices and create stock.

If we junked the continuous auction market and returned to periodic auctions of real demand and supply. No real buyers or sellers, no prices.

And stock markets should actually compete by offering separate “stores” that aren’t connected electronically and forced to share prices. As it is, markets are just a system.

Alas, none of this will happen anytime soon.

So.

We can continue as companies, investors and traders fooling ourselves that fundamentals drive markets.  Or we can learn how markets work. The starting point.

Otherwise, we’re like somebody reading the opening line today. “Did he just say ‘boobies’?”

I was talking about birds.

We need to understand the topic. The market (ask us, we’ll help).

Suspended

Shocking.

No other word for it.

Yesterday as VIX volatility futures settled on an odd Tuesday, Barclays suspended two of the market’s biggest Exchange Traded Notes (ETNs), VXX and OIL.

Let me explain what it means and why it’s a colossal market-structure deal.

VXX is the iPath Series B S&P 500 VIX Short-Term Futures ETN. OIL is the iPath Pure Beta Crude Oil ETN (OIL). iPath is a prominent Barclays brand. Barclays created the iShares line that Blackrock bought.  It’s an industry pioneer.

Illustration 76839447 © Ekaterina Muzyka | Dreamstime.com

These are marketplace standards, like LIBOR used to be.  This isn’t some back-alley structured product pitched from a boiler room in Bulgaria (no offense to the Bulgarians).

Let’s understand how they work. ETNs are similar to Exchange Traded Funds (ETFs) in that both trade like stocks.  But ETNs are unsecured, structured debt.

The aim of these particular notes is to pay the return via trading reflected in crude oil, and volatility in the S&P 500 stock index. 

OIL uses quantitative data to select baskets of West Texas Intermediate oil futures that the model projects will best reflect the “spot” market for oil – its immediate price.  But nobody owning OIL owns anything. The ETN is just a proxy, a derivative.

VXX is the standard-bearer for trading short-term stock-volatility. It’s not an investment vehicle per se but a way to profit from or guard against the instability of stock-prices.  It’s recalibrated daily to reflect the CBOE Volatility Index, the VIX.

In a nutshell, a security intended to give exposure to volatility was undone by volatility.

I loved this phrase about it from ETF.com: “Volatility ETPs have a history of erasing vast sums of investor capital over holdings periods as short as a few days.”

ETP is an acronym encompassing both ETFs and ETNs as Exchange Traded Products.

It’s not that Barclays shut them down. They continue trading for now. The bank said in a statement that it “does not currently have sufficient issuance capacity to support further sales from inventory and any further issuances of the ETNs.”

ETF industry icon Dave Nadig said, “The ‘Issuance Capacity’ thing is a bit of a get out of jail free card, so we can interpret that as ‘we no longer feel comfortable managing the implied risk of this product.’”

Barclays said it intends to resume supporting the funds at some future point. But we’ll see.  Credit Suisse ETNs that failed in Mar 2020 amid Pandemic volatility were stopped temporarily too but suspensions became permanent.

The lesson is clear. The market is too unpredictable to support single-day bets, which these instruments are principally designed for. 

I’ve long written about the risks in ETPs. They’re all derivatives and all subject to suddenly becoming worthless, though the risk is relatively small.

And it’s incorrect to suppose it can happen only to ETNs. All tracking instruments are at risk of failure if the underlying measure, whatever it is, moves too unpredictably.

You might say, “This is why we focus on the long-term.  You can’t predict the short-term.”

Bosh. Any market incapable of delivering reliable prices is a dysfunctional one.  It’s like saying, “I don’t know what to bid on that Childe Hassam painting but I’m sure over the long-term it’ll become clear.”

Bluntly, that’s asinine. Price is determined by buyers and sellers meeting at the nexus of supply and demand.  If you can’t sort out what any of that is, your market is a mess.

It remains bewildering to me why this is acceptable to investors and public companies. 

It’s how I feel about empty store shelves in the USA. No excuses. It reflects disastrous decisions by leaders owing a civic duty to make ones that are in our best interests.

Same principle applies. We have a market that’s supposed to be overseen in a way that best serves investors and public companies. Instead it’s cacophony, confusion, bellicosity, mayhem.

At least we at ModernIR can see it, measure it, explain it, know it.  We’ve been telling clients that it’s bizarre beyond the pale for S&P 500 stocks to have more than 3% intraday volatility for 50 straight days. Never happened before.

Well, now we know the cost.

Oh, and the clincher? VIX options expired yesterday. Save for four times since 2008, they always expire on WEDNESDAY. Did one day undo Barclays?  Yes.

That’s why market structure matters. Your board and c-suite better know something about it.

Eyes Wide Open

Here’s my grand unified theory on the world. We stopped following the rules.

Not that humans don’t color outside the lines routinely. But in the last two years we jettisoned restraint. That gave rise to chaos in the stock market, imperialism in Ukraine.

Here’s what I mean. The Pandemic prompted a reversal of the relationship between people and governments. Governments derive their purpose and support from the people.

Even in tyrannies.  French Nobel-Prize-winning writer Albert Camus who coincidentally wrote a book called The Plague said, “The welfare of humanity is always the alibi of tyrants.”

We did it for the people.

During the Pandemic, governments uniformly, whether free or autocratic, assumed supreme authority and bullied everybody into submission. Rules be damned.

That’s a bullhorn to brigands, cretins and miscreants.  If the rules don’t apply, then what’s to stop me?

Everybody started taking other people’s stuff.

Here in the USA, the country’s system of production and distribution through free-market capitalism was crushed by a tsunami of manufactured money. Businesses were unevenly and forcibly shuttered (some essential, others not, for no reason save an opinion) when the cornerstone of the rule of law is uniform justice.

And the money whooshed away from commerce into financial assets and real estate. There was a geyser drenching everything.

Waves come in, waves go out. 

I told users of our trading decision-support platform Market Structure EDGE last May that the long Pandemic Money momentum arc might have ended. The data signaled it (see image).

Market Structure EDGE data. Sentiment (Demand) changed in May 2021. Price has returned there, and Demand is ever more volatile.

The market doesn’t suddenly recede.  The tsunami comes in.  Reaches a zenith. Goes back out. You can see it in the sea but the ebb and flow is deceitful in asset markets.

Plus, human attention spans are short. We think that whatever is happening at this moment is reflected in the mirror of capital markets, forgetting the most basic economic principle besides Supply and Demand: Cause and Effect.

The tripwires might be immediate. Somebody coughs in a quiet theater. Russia invades Ukraine. Jay Powell says, “We’ll raise rates…” and everybody stampedes. And then he adds, “By and by.”

The stock market is now trading where it was in May 2021 when Pandemic Momentum died. Sure, there was a carryover. (We wrote about the changes here and here.)

But the wave that advanced for more than a year is receding. We’re experiencing the consequences of monetary actions that smashed every concept of good behavior.

We shouldn’t have thrown the rules out.

The roiling waters now may calm and settle and return to a regular tidal cadence. The data suggest a surge in Tech stocks in particular is possible and maybe in the whole market.

But we’ve done damage that may be far longer-lasting ultimately.

There are bigger reasons why Russia invaded Ukraine and no excuses for thuggery (though thuggery is a timeless imperialist trait).  But what greenlights bad behavior is evidence the rules don’t apply anymore.

And so here we are at the crossroads of geopolitics and markets in a world where anything goes. Russia ETFs are cratering. Nickel was halted. Wheat doubled in a day. Oil is at 2008 weak-dollar pre-Financial-Crisis prices as the dollar hits Pandemic highs.

Half the S&P 500 is down 20% or more. Half the Nasdaq stocks are down by half, and the Nasdaq Composite is now down 2% for the trailing year!

Consequences.

Now, throw in market mechanics. Market Structure. The reason the trouble from Ukraine is so cataclysmic for asset markets isn’t rational but structural.  I wrote about volatility last week in a post called Rise and Fall. I think it’s worth reading.

By the way, did you see John Stewart is the new Market Structure expert?

The stock market is volatile because 53% of trading volume derives from participants with better data and faster prices and shorter horizons than the investors and companies who depend on the market.

They magnify markets up and down.

Once we thought markets should be free, fair and open, and rules should level the playing field for all. We’ve thrown those rules out.  Now rules promote specific outcomes.

How do we get back to good? Stop doing all that stuff. And in case that’s awhile coming, our best defense is understanding what’s happening.

The great international relations classicist Hans Morgenthau said all politics are the pursuit of power defined by self-interest, and human nature doesn’t change.

That’s a good lens for seeing the world.

And in the stock market, understand that 10% of volume is rational. The rest is reactive, leveraged, constantly evolving, changing prices, hedging. It’s all measurable, though.

Eyes wide open is always the best strategy. 

It begins with understanding what’s going on. In the stock market, we can help you.  In life, my advice is biblical: The prudent foresee evil and hide themselves.