Three Days

Some energy-sector clients lost 40% of market-capitalization in three days last October.

A year and a half cultivating share-appreciation and by Wednesday it’s gone.  How so?  To get there let’s take a trip.

I love driving the Llano Estacado, in Spanish “palisaded steppe” or the Staked Plains. From Boise City, OK and unfolding southward to Big Spring, TX lies an expanse fit for nomads, an unending escarpment of mottled browns and khakis flat as iron rail stretching symmetric from the horizon like a sea.

Spanish explorer Francisco Coronado wrote, “I reached some plains so vast that I did not find their limit anywhere I went.” Here Comanches were dominating horse warlords for hundreds of years. Later sprouted first the oil boom early last century around Amarillo and again in the 21st century a neoclassical renaissance punctuated by hydraulic fracturing in the Permian Basin.

The air sometimes is suffused with mercaptan, an additive redolent of rotten egg that signals the otherwise invisible presence of natural gas. But the pressure of a relentless regimen silts away on a foreshortened compass, time seeming to cease and with it the pounding of pulses and devices.  It’s refreshing somehow.

And on a map one can plot with precision a passage from Masterson to Lampasas off The Llano and know what conquering that route demands from clock and fuel gauge.

Energy stocks in August 2014 were humming along at highway speed and then shot off The Llano in October, disappearing into the haze.

(Side note: If you want to discuss this idea, we’re at the NIRI Tristate Chapter in Cincinnati Wed Mar 18 and I’m happy to entertain it!)

What happened?  There are fundamental influences on supply and demand, sure. But something else sets prices. I’ll illustrate with an example. Short interest is often measured in days-to-cover meaning shares borrowed and sold and not yet bought and returned are compared to average daily trading volume. So if you move a million shares daily and your short interest is eight million, days-to-cover is eight, which may be good or bad versus your average.

Twice in recent weeks we’ve seen big blocks in stocks, and short volumes then plunged by half in a day. Both stocks declined. Understand, short interest and short volume differ. The former is shares borrowed but not yet covered. It’s a limited measure of risk.  Carry a big portfolio at a brokerage with marginable accounts and you can appropriate half more against it under rules.

Using a proxy we developed, marketwide in the past five days short volume was about 44%, which at 6.7 billion total shares means borrowed shares were 2.95 billion. Statistically, nearly 30% of all stocks had short volume above 50%.  More shares were rented than owned in those on a given day.

In an apartment building, everyone could leave in a day and vacancy would explode. In your shares, renters can leave fast but it takes another step:  Derivatives.

Surrounding data say that in these recent instances where short volume imploded,  directional ETFs, exchange-traded funds betting short-term moves will compound through leverage, borrowed shares through swap agreements and then extended reach in portfolios with options and futures.

When a change occurs an ETF might suddenly exit its contracts, returning rented shares to a counterparty such as a big broker, which in turn restores them to discretionary liquidity and reports the transactions to the tape as blocks.

We don’t fully understand mechanics or constraints. But we observe process and consequences and we comprehend what’s happening mathematically and structurally. There is an appearance of vital demand just as the pre-crisis real estate boom extrapolating the same mortgages through tranches of derivatives masked hollowness.

There’s a domino effect when stock-direction changes. First traders stop buying. Then leveraged instruments drop rights to shares, skyrocketing supply seen by intermediating machines, which in turn flee market-making to avoid getting caught long.

That’s how in three days sectors drop from the flat iron of predictability to the vertigo of freefall.  These features of modern markets are at work in all your shares, not just energy stocks, whether you trade a few thousand or tens of millions.  We measure it.

Today are VIX expirations and a vital Fed meeting. Tomorrow come index futures expirations.  And Friday brings index-rebalances and quadruple-witching, the quarterly sovereign of derivatives shuffles.

Three days can change everything.  We don’t expect it yet. Our Sentiment gauge says the market has bottomed.  But it’s impossible to know in a rental world what’s owned. Risk from borrowing and leverage, as in finance, abounds below the equity surface.

So. Be informed. Know your answers. And maybe take a road trip soon.