October 19, 2022

What the Hell?

ModernIR has seen a surge of interest from companies perplexed by the stock market. They see that stocks don’t move with fundamentals, don’t move as expected.

They move with each other.

An October 12 Wall Street Journal article described “lock-step” moves in stocks ranging from technology to household goods to utilities.

Growth and Value should diverge. It’s not happening.

At ModernIR, we’re observing other divergences, though. Broad measures diverge from underlying stocks.  The average stock in the S&P 500 the past five days ranged 3.7% from intraday high to low.  But SPY, the State Street Exchange Traded Fund (ETF) tracking those stocks had 3% intraday volatility, variance of more than 20%.

An ETF should diverge less than 2% from its basket. 

Year to date, our Market Structure Bands forecasting SPY five days out are 95% correlated to actual SPY price, meaning our forecasts are more closely tracking SPY than SPY is tracking the stocks it mimics.

What the hell is going on?  Math is pricing stocks.

Let’s consider another thing. Premarket moves are either evaporating the possibility for gains by investors during market hours or turning out to be opposite of what they signal.

Institutions trading baskets of futures outside market hours are in and out of those derivatives before adjustments are made to underlying stocks. That means retail money and the rest of us trying to track the broad market with our long-term retirement accounts often don’t see the gains.

The advantage accrues only to the small group able to trade when everybody else can’t.

Would someone from the SEC explain how that’s fair for retail investors, buy-and-hold retirement money, public companies?

Anyone?  Gary Gensler?  Hester Peirce?  Mark Uyeda?

I see these people are concerned about the secular decline in IPOs.  I find it startlingly tone-deaf. The market is a morass of short-term prices, disadvantages for investors and issuers, arbitrage, and volatility. That’s the SEC’s fault.

And it wants the Small Business Capital Formation Advisory Committee to figure out why more companies leave the stock market than join it.

Which brings us back to our title.  What the hell is going on?  Three big things.

Death Valley Illustration 113183050 © Diana Coman | Dreamstime.com

First, stocks now often move together because Passive Investment isn’t picking “superior companies.” Index funds and ETFs need SIZE.  Since there aren’t enough public companies – thus the SEC’s concern – the lines between, say, Value and Growth blur.

As I’ve often noted, about 95% of market capitalization, and thus investment assets, resides in the Russell 1000, the thousand largest stocks.  There’s not enough market cap for money to shift to Utilities when markets are rocky.

Instead it concentrates in the same stocks but ones with the least movement versus the benchmark.

We track that.

What we call “Big and Stable” stocks – ones from the Russell 1000 with liquidity and low volatility – average $185 billion of market cap. Passive money shifts from Growth in size, to Value in size. Not by story or sector but by market cap.

Second, derivatives are the tail wagging the dog. They drive premarket moves. Especially near options-expirations. The market plunged Sep 13, the trade date plus two more (T+2) to expirations starting Sep 15.

And the market dropped 8% from there to quarter-end Sep 30 when futures contracts expired.

And the market SURGED Monday and Tuesday this week ahead of expirations Wednesday through Friday.

Lesson? Machines trade stocks to move derivatives, which gyrate before assets catch up.

Third and last, the machines driving over 50% of market volume are motivated by short-term divergences between stocks, derivatives and benchmarks. 

Time is risk and trading machines incur the least by committing to the smallest increments of time. The whole market is geared by SEC rules toward giving advantages to money that spends the least amount of time in it.

That’s not fair.

The SEC permits it because the stock market would stop giving us prices and trades in everything in 100-share increments unless the machines providing them had an advantage.

What if the market couldn’t give you a price but could signal whether real factors, real investment, were pricing stocks?

Ponder that.

As I write, the S&P 500 is trading at 3,715 after closing near 3,560 just five days ago. Market structure data five days ago predicted it. But those signals have vanished now.

Portents of sudden swoons after big surges? I told traders using our decision-support platform EDGE that this week is “the valley of the shadow of death.”

I’m not saying the bottom will drop out the next five days as options lapse and reset. But I’ll fear no evil only if thou art with me. And God doesn’t speculate.

The stock market is not a barometer for rational thought. It meters the behavior of machines. And that’s why you find yourself saying, “What the hell?”

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