Finance – Page 20

Robinhood and overactive retail trading

Globe and Mail had an interesting article on the advent of Robinhood.

Robinhood is not currently available in Canada, but I’ve seen enough videos to come to an easy conclusion – it is the financial brokerage equivalent of crack cocaine.

There’s two items I’d like to discuss. One is commission-free trading, and the other is the psychological aspects of trading.

Robinhood allows commission-free trading of various products. The company’s business model makes money on payment for order flow, where the entity sells order flow to market making entities (such as Virtu – VIRT on the Nasdaq). The market makers execute on the trades and they pocket money buying on the bid, selling at the ask, and also making some informed speculation on the very short term future prices of securities depending on the order flow coming in (which is why you tend to see discontinuities on intraday trading – it is the market maker pulling away from the bid when there is a crush of supply pressure or pulling away at the ask when there is a crush of demand pressure).

For each share of stock traded, Robinhood made four to 15 times more than Schwab in the most recent quarter, according to the filings. In total, Robinhood got US$18,955 from the trading firms for every dollar in the average customer account, while Schwab made US$195, the Alphacution analysis shows.

I would suspect this magnitude difference (US$18,955 for a Robinhood dollar to $195 for a Schwab dollar) is a mis-print, but the 4-15 times magnitude of payment for order flow would intuitively sound like it is in the ballpark – reflecting the fact that customers purchase the most profitable type of items (call and put options) with large spreads. A market maker isn’t going to make much money if you buy 100 shares of Microsoft, but if you purchase 50 call options of some medium-capitalization security, it is virtually guaranteed that they will be paying at least a 25 cent (if not 50 cent or 1 dollar) spread on the trade.

In essence, there are two components to the cost of a trade. One is the commissions and fees associated with the trade – and for the most part, this is fairly transparent. The other less transparent cost of trading, which is much higher than the commission, is the slippage you pay for execution. If you want immediate execution, you must pay the spread. This is more costly than most commissions unless if you are trading the most liquid of securities.

There is a more subtle aspect to trading which applies when you have to take larger positions in companies, and that is how to acquire enough of the stock without materially impacting the stock price, but this is usually an institutional concern. This concern does sometimes happen at the retail level, especially in lower capitalization/volume stocks (e.g. my frustrations with trading Torstar, where it didn’t take much money to affect the stock price!).

So as a result of Robinhood’s price structure, they have an incentive to have their customers trade as much as possible, and ideally trade securities that will generate higher payment for order flow margins (i.e. high bid-ask spread options, especially multi-leg option positions such as Iron Condors!).

As a result, they make trading as easy as opening up an app on your iPhone and tapping a few keys and you’ve suddenly made a trade. You can trade on the bus, trade in bed, trade at the gym, etc, etc.

Clearly they’re trying to turn it into a legalized version of casino gambling, without telling the consumer that the expected value of their transactions are probably going to be higher at a casino.

So this leads me to the second item of this post, and this is psychology. There is a book called Nudge which you should read and Robinhood employs many of these tricks.

Just viewing the plethora of Youtube videos of people “minting coin” (e.g. “How I Made $30,000 in 1 Week Stock Trading on Robinhood“), and the general “millennial” attitude of these market participants, makes it definitely a herd mentality atmosphere, coupled with the “missing out” psychological sentiment – other people are making money, seemingly by tapping buttons on their phone in bed, why can’t I??? Robinhood couldn’t purchase this type of marketing. Contrast this with Interactive Brokers, where you get some very dry videos that few people in relation will click on.

The other phenomena is the advent of more sophisticated “trading rooms”, which has existed since the dawn of time (yes, pre-digital world), where people with their Robinhood accounts can band together to pumping up securities and purchasing and selling the hot tip of the day, just like a huckster at a horse racing track. There is so much rich history in herd mentality in stock trading that it would fill volumes, but for example, I’m going through a book called “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds“, which was published in 1841, and its first chapter is about after Louis the 14th bankrupted France, eventually there was a mania in paper currency and the corporation that was created to exploit the Louisana Territory – people were lined up to subscribe and shares were bidded up to the roof. It didn’t end well.

Another great example is the “bucket shops” of the late 19th and early 20th century. A book written on behalf of Jesse Livermore is a good chronicle of this form of legalized gambling (in the name of speculating on the prices of securities), but it basically has the same rhythm to it.

There are all sorts of stories of financial malfeasance, and they all prey on the same human psychological ‘nudges’ that we see today. The only difference is the medium, and our digital age. Our psychological failures are the same and have not evolved with technology.

Robinhood is indeed marketing brilliance, and the net asset value in these accounts gets transferred to the shareholders of Robinhood, the market makers, and the counterparties to the trades that get executed on the platform. I generally do not have much sympathy for those that lose money in this manner. I just hope they do not ruin their lives in the process.

The COVID quarter where everything gets written off

Most companies have a fiscal year corresponding with the calendar, and most of them will be reporting April to June results in the last week of July and in early August.

Q1’s results were in the onset of COVID-19, so results were only partially affected (the sanctions required due to the pandemic really only took effect in the middle of March).

Q2 will contain the full brunt of the economic consequences of COVID-19.

The results posted are going to be horrible for a lot of companies, especially on a GAAP basis. You’re going to see a whole bunch of write-downs of various assets that have been lingering on balance sheets for far too long, but Q2 will be the best time to formally impair them and get past mistakes out of the public consciousness.

The markets are not going to care. This has long since been baked in.

The next consequence of this is that you’re going to see headline computer generated metrics from company financial statements (price to earnings, EPS, etc.) over the next twelve months get wildly misstated due to the inevitable Q2 reporting of losses. This will also affect ROE/ROA, growth percentages, and almost anything relating to earnings in the calculation.

As a result, stock screens looking for value will be twisted unless if forward-looking adjustments can be made. A common forward-looking metric is “consensus analyst estimates”, but this figure is what an investor is looking as a rough short-term measuring stick in relation to the price the market is offering (indeed, if something looks ‘cheap’ solely on the basis of price to consensus analyst estimates, I’d view that much more as an alarm bell than a reason to buy).

The contamination of financial data coming from the COVID quarter will be the worst since the 2008-2009 financial crisis. While individual stock selection is always important, the COVID quarter should create an even better environment for stock selection than other times.

A great money-making ETF vessel is closing

Retail holders of the TVIX exchange-traded product were getting ripped off by institutional investors for years. Sadly this product, which has a market capitalization of $1.2 billion dollars (and a management expense ratio of 1.65%, so not a trivial money-maker for the issuer) will cease trading on a public exchange on July 10. The notes themselves will still exist, but operate in a “wind-down” state which means that there is going to be quite a bit of havoc in terms of its market value vs. the underlying index it is supposed to track.

TVIX leveraged its asset value into futures contracts of the two front-end months of VIX. As of June 23, 2020, 79% of its notional value was in July VIX futures and 21% in the August month. This gyration of selling the short-month and longing the second month was an excuse for institutional shareholders to siphon money from ETF holders that were silly enough to hold onto it for more than a one day period. Incidentally, other futures-linked ETFs (e.g. commodity ETFs such as USO) exhibit the same characteristics.

To put an amount on this, at a VIX value of 34, to maintain a double exposure to $1.2 billion notional value of volatility, the TVIX fund would have had to hold about 55,700 contracts of July VIX futures, and 14,800 contracts of August VIX futures. 111,000 futures contracts in July traded today.

The effective closure of the TVIX ETF, which was the largest volatility ETF, might work for the benefit of other volatility ETFs. It might also increase the volatility of volatility futures (wrap your head around that one).

My guess is that Credit Suisse is getting skittish on this product blowing up on them in a catastrophic manner.

Back to normal – and re-indexing

Examining the price action of the past couple business days, I think there is a better chance than not that we have received the “flush-out” that I wrote about last week. The morning was packed with market selling before everything went up again. S&P 500 volatility spiked up to the 40% level. The trading was a bit panicky in two waves (how appropriate for COVID-19!). For the most part, I have been content to watch. There might be another ‘wave’ but I think the slow and gradual force exhibited by the central banks will force more capital into the markets.

I have been mildly tweaking my portfolio here and there, but in very minor ways. I’ve lightened up my USD portfolio concentration slightly.

Finally, I note that the TSX will be re-indexing their TSX 60 and Composite indexes next week. I always look at the entrails of index discards because typically if a company is getting trashed out of the index, the stock price tanks because of the automatic supply that gets sent to the market. However, if the underlying company has value, this is a better time than not to add. The only problem is a bunch of other institutional investors do exactly the same thing (reducing the effectiveness of this technique). Needless to say, there is a lot of money passively tracking the TSX 60 and TSX Composite, but most of it is concentrated in the top names.

How do you get into the TSX Composite? (I’ll just do a cut-and-paste job here):

To be eligible for inclusion in the S&P/TSX Composite, a security must meet the following two criteria:

1. Based on the volume weighted average price (VWAP) of the security on the Toronto Stock Exchange over the last 10 trading days of the month-end prior to the Quarterly Review, the security must represent a minimum weight of 0.04% of the index, after including the Quoted Market Value (QMV) of that security in the total float capitalization of the index. In the event that any Index Security has a weight of more than 10% at any month-end, the minimum weights for the purpose of inclusion are based on the S&P/TSX Capped Composite.

2. The security must have a minimum VWAP of C$1 over the past three months and over the last 10 trading days of the month-end prior to the Quarterly Review.

… and to get kicked out:

For Quarterly Review deletions the following buffer rules apply.

1. To be eligible for continued inclusion in the index, a security must meet the following two criteria:
a. Based on the volume weighted average price (VWAP) over the last 10 trading days of the month-end prior to the Quarterly Review, the security must represent a minimum weight of 0.025% of the index, after including the QMV for that security in the total float capitalization for the index. In the event that any Index Security has a weight of more than 10% at any month-end, the minimum weights for the purpose of inclusion are based on the S&P/TSX Capped Composite.
b. The security must have a minimum VWAP of C$1 over the previous three calendar months.

2. Liquidity is measured by float turnover (total number of shares traded in Canada and U.S. in the previous 12 months divided by float-adjusted shares outstanding at the end of the period). Liquidity must be at least 0.25. For dual-listed stocks, liquidity must also be at least 0.125 when using Canadian volume only.

In case if you were wondering, for the overall composite Index, Royal Bank is still 6% of the TSX and Shopify is currently around 5%, so no fears of over-concentration. I remember at one point Nortel was above 20% of the TSX.

Deleted out of the TSX Composite are:
AFN – Ag Growth International
AD – Alaris Royalty
BTE – Baytex Energy
BBD.B – Bombardier
CHE.UN – Chemtrade Logistics
CHR – Chorus Aviation
EFX – Enerflex
EXE – Extendicare
FRU – Freehold Royalties
FEC – Frontera Energy
HEXO – HEXO
MTY – MTY Food Group
SES – Secure Energy Services
SCL – Shawcor

I will offer some mild and not-so-useful commentary – some of these are compelling values. Some of them I’ve written about here before. I’ve looked at the inclusions and don’t like any of them.

What, markets can go down too?

Today is the start of these newly-found daytraders getting flushed out of the market.

What has happened is that apparently half of the cohort of unemployed people have entered into the casino known as the stock market with their unemployment/CERB cheques (this is a bit hyperbole – $2k isn’t going to move the market too much, but when you consider $43 billion in CERB has been handed out so far, not a trivial amount of money!), signed for accounts on RobinHood and WealthSimple, and suddenly turned into stock market geniuses buying shares of companies in Chapter 11. This is a by-proudct of many factors but very loose monetary policy is one of them. When you couple this with every institution on the planet trying to get into equities because they can’t make a return on their fixed income portfolios anymore, you will have days like today where the people with less conviction get flushed out.

Throw in a spooky headline like this:

Second wave! Second wave! Fear the second wave! Must sell because the news is bad!

Anyhow, this is why I suggested to lighten up last Friday and take some chips off the table.

This isn’t going to be a one day thing, the effect of flushing people out of the market involves having sharp down days (people getting caught long), and sharp up days (people getting caught in cash). This process rinses and repeats until monetary policy eventually kicks in, swamps the whole system with liquidity, and this gets pumped into the asset markets once again. Things are a lot faster than they were 22 years ago when this sort of thing happened in 1998 after the LTCM bust, but I’d guesstimate a week or two before the flush is completed.

I’m going to use Hertz as an example.

Visualize this. The equity of a company like Hertz (Chesapeake, Pier 1, etc., you name it) is fundamentally going to zero after it restructures out of Chapter 11. They have a fixed number of shares outstanding that are trading, and they have to be somewhere. Just because people sell it doesn’t mean the shares vanish – they are transferred to somebody else. The same goes for the cash. The only difference is that the asset value (the stock) changes.

Any sane institutional manager (I am not talking about the day traders, or high frequency traders that would have a rational reason to be purchasing the stock, but this would be for a very short term period) would have dumped out on Hertz equity if not on May 26th when Chapter 11 was announced, but they would have been guaranteed to bail out by June 8th, where there were 523 million shares traded and the stock topped out at over $5/share. Keep in mind that Hertz has 142 million shares outstanding!

So this leaves the question of – who the hell would want to own the stock after this? The institutional demand for Hertz equity will be zero – they are all cashed out and not interested in getting in. The answer has to be retail investors, where currently (at a share price of $2.10 as I write this) US$300 million of client capital is locked up. There will be some other retail investors that look at the chart, not even realizing what Chapter 11 means, and purchase the stock, and some of these retail investors will be able to get out, but you can be sure that the only bids you will be receiving will be of other retail investors, or short sellers covering the trade. (Edit: Or perhaps the RobinHood/WealthSimple brokerages simply are making a mint speculating off of their clients by selling any Hertz their customers buy and then they have a very cheap borrow!)

In these ‘flushing’ processes is that after it is done, the garbage of the market will lose asset value, while the entities that have value will later receive a wave of demand – aided in part with the cash from their sales of Hertz at US$5! The people remaining will be true bagholders, and will eventually flip the stock around to a diminishing pool of demand until it gets cashed out at zero once the Chapter 11 process is completed. The inevitable result – wealth gets transferred – from the buyers of worthless Hertz to the sellers, who will move the asset value into something (presumably) more productive.