September 2, 2020

The Little Short

In Michael Lewis’s The Big Short, a collection of eccentrics finds a flaw in real estate securities and shorts them.  The movie is great, the book even better.

Somebody will write a book about the 2020 stock market (anyone?) flaw.

The flaw? Depends who you ask. Writing for Barron’s, Ben Levisohn notes ZM is worth more in the market on $660 million of sales for the quarter than is IBM on $18 billion.

TSLA is up a thousand percent the last year, sales are up 3%. NVDA is trading at a hundred times quarterly revenue. AAPL is up 160% on 6% sales growth.

I know a lot about fundamental valuation after 25 years in investor relations. But 20 of those years were consumed with market structure, which our models show mechanically overwhelms fundamentals.

Why is market structure irrational?

Because most of the money in the market since Reg NMS isn’t rational. And still investor-relations professionals drag me to a whiteboard and sketch out how the performance of the stock – if it’s up – can be justified by prospects, or if it’s down is defying financials.

Market structure, rules governing how stocks trade, is agnostic about WHY stocks trade. The flaw is process has replaced purpose. Money inured to risk and reality can do anything. Just like government money from the Federal Reserve.

And yet that’s not what I’m talking about today.  The market is the Little Short.  Nobody is short stocks. I use the term “nobody” loosely.

Let me give you some history.

First, ignore short interest. It’s not a useful metric because it was created in 1975 before electronic markets, ETFs, Reg NMS, Fast Traders, exchange-traded derivatives, blah, blah. It’s like medieval costumes in Tom Cruise’s redux of Top Gun. It doesn’t fit.

After the financial crisis, rules for banks changed. The government figured out it could force banks to own its debt as “Tier 1 Capital,” and the Fed could drive down interest rates so they’d have to keep buying more.

Voila! Create a market for your own overspending. The Basel Accords do the same thing.

Anyway, so big banks stopped carrying equity inventories because they couldn’t do both.  Meanwhile the SEC gave market-makers exemptions from limitations on shorting.

Presto, Fast Traders started shorting to provide securities to the market. And that became the new “inventory.” Ten years later, short volume – borrowed stock – averages 45% of trading volume.

It was over 48% this spring.  And then it imploded in latter August, currently standing at 42.6%. The FAANGs, the giant stocks rocketing the major measures into the stratosphere, show even more short paucity at just 39%.

Realize that the market was trading $500 billion of stock before August, about 12 billion shares daily. So what’s the point? Short volume is inventory today, not mainly bets on declining stocks. It’s the supply that keeps demand from destabilizing prices, in effect. A drop from 48% to 43% is a 10% swoon, a cranial blow to inventory.

Higher short volume restrains prices because it increases the available supply. If demand slows, then excess supply weighs on prices, and stocks decline. We’ve been measuring this feature of market structure for a decade. It’s well over 80% correlated.

So the absence of inventory has the opposite impact on prices. They rise.  If the whole market lacks inventory, stocks soar. And the lowest inventory right now is in the FAANGs, which are leading the stampeding bulls.

Thinking about prices as rational things is wholly flawed. It’s not how the market works, from supply-chain, to routing, to quotes, prices, execution.

We thought temporal tumult in behaviors two weeks ago would derail this market. It didn’t. Or hasn’t yet. The big drop in shorting followed, suggesting those patterns included largescale short-covering by market-makers for ETFs.

When the market does finally reverse – and it will, and it’s going to be a freak show of a fall too, on market structure – low short volume will foster seismic volatility. Then shorting will explode, exacerbating the swoon as supply mushrooms and prices implode.

The good news is we can measure these data, and the behaviors responsible, and the impact on price. There’s no need to ever wonder if your stock, public companies, or your portfolio, traders, is about to step on a land mine.  We’re just waiting now to see how the Little Short plays out.

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