November 14, 2018

When Oil Swoons

How is it that stocks and oil fall if no one is selling them? There’s an answer. Tim Tebow once famously sent a one-word tweet: “Motivation.”

For Tebow (Karen and I were downtown years ago when Tim was a Denver Broncos quarterback, and we passed a handsome youngster who offered a friendly hello and seemed familiar and had shoulders so wide they covered most of the sidewalk…and we realized seconds later we’d passed Tim Tebow.), the word meant a reason to try.

Motivation in markets is money.

Whatever your ticker, investor-relations professionals (or investors, whatever the composition of your portfolios), your price is often set by trading firms.

How do we know? Floor rules at the exchange prohibit using customer orders to price NYSE-listed stocks at the open. Designated Market Makers (DMMs) must trade their own capital to set a bid and offer for your shares. Now all DMMs are proprietary traders.

Investors:  If you don’t know how stock prices are set, you deserve to be outperformed by Exchange Traded Funds (ETFs). ETFs don’t even buy and sell stocks!  They are collateralized stock derivatives (let’s call them CSDs).

Don’t know what I mean? Stop, and listen:

If you’re in Dallas Fri Nov 16, hear my presentation on ETFs at The Clubs at Prestonwood.  Clients in Dallas: Ask your CFO and Treasurer and VP of Finance and Controller to learn what the money is doing behind price and volume, and why.

What if you’re Nasdaq-listed?  The first and fastest machines set all offers to sell (the primary price) and bids to buy (the secondary price) when stocks open for trading, and chances are traders (not IEX, the only exception) have been paid to set bids and offers.

It’s not your fundamentals. Machines set prices all day long.

And the price of oil most days is not determined by fundamentals either. It’s set by a currency. The US dollar.  Oil is denominated in dollars. Big dollar, smaller oil price. Small dollar – say 2007, or much of 2017 – big oil price.

Back to stocks. Under Regulation National Market System, there is a spread between the best bid to buy and offer to sell for your shares.  They can’t be the same ($15.01 buy, $15.01 to sell). That’s a locked market. Against the law.

The Bid cannot be higher than the Offer (e.g. Bid, $15.02, Offer $15.01). That’s a crossed market. Can’t happen. Why? So there’s an audit trail, a way to trace which firms set every bid, every offer, in the market. And a crossed market cannot be controlled by limit-up/limit-down girders that govern stocks now. (You can bid more than what’s asked for art, houses, cars, companies, etc. But not stocks.)

If demand from money wanting to buy shares exactly matched supply, stocks would decline. Brokers, required by rule to set every bid and offer, have to be paid.

That means stocks can rise only if demand exceeds supply, a condition we measure every day for you, and the market. Do you think your board and executive team might like to know?  (Note: If you want to know if supply exceeds demand in your stock, or your sector, ask us. We’ll give you a look gratis.)

Knowing if or when supply exceeds demand is not determined by whether your stock goes up or down. Were it so, 100% of trades would be front-run by Fast Traders. So how can it be that no money leaves stocks and they fall, and no money sells oil and it falls?

Do you own a house? Suppose you put it up as collateral for a loan to start a business you believed would be more valuable than your house. This is the bet ETF traders make daily. Put up collateral, create ETF shares, bet that ETF shares can be sold for more ($12.1 million) than the cost of the collateral offered for the right to create them ($12.0 million).

Then suppose you can sit between buyers and sellers and make 10 basis points on every trade in the ETF, the index futures the ETF tracks, and the stocks comprising the index.  Another $120,000 (a 20% margin over collateral). Do that every day and it’s meaningful even to Goldman Sachs for whom this business is now 90% of equity trading.

Reverse it. When stock-supply exceeds demand, ETF creators and market-makers lose money. So they sell and short, and the whole market convulses.  Spreads jump. Nobody can make heads or tails of it – until you consider the motivation. Price-spreads.

Oil? Remember our time-tested theme (you veteran readers). If the dollar rises, oil falls. It happened in Sep 2014 when the Federal Reserve stopped expanding its balance sheet.

Now it’s worse. The Fed is shrinking its balance sheet. Oil is denominated in dollars no matter what Saudi Arabia does. If the dollar gets bigger – stronger – oil prices shrink. Look at the chart here for the Energy sector. ETFs? Devalued collateral?

ETFs, the greatest investment phenomenon of the modern era, behave like currencies. We’ve not yet had a BIG imbalance. It’s coming. We’ll see it.  Subscribe. It’s motivating.

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