The moderating influence of mutual and hedge funds, the proliferation and rising popularity in ETFs and the expanding role of passive, risk adjusted (risk parity), momentum-based (CTAs) and quant trading have contributed to a crowding out of discretionary trading over the last few years.
This phenomenon and changing market structure coupled with a halving of the number of publicly traded stocks over the last two decades are important contributors to the historic rise since the March, 2020 lows. The remaining publicly traded stocks have reduced their float by over 20% following the liberal use of buybacks since The Great Decession.
The icing to the market's cake has been monetary and fiscal stimulus.
Importantly, changing market structure perpetuates the strength of the largest companies (read: FANG) as they become more influential market and ETF components in their weightings.
As well, speculative bottom fishing (of a Robinhood-kind) has, because of the changing demand conditions, summarized above, combined with a limited supply of equities, have resulted in the conspicuous pursuit of shiny objects like Kandi Technologies (KNDI) and Eastman Kodak (KODK) .
Some are skeptical of Robinhood's role, in the belief that "surely the Robinhood guys cannot be causing this, it is a tiny amount of $s in the whole scheme of things." Well, although correlation is not always causality, it is happening. Here is my guess how:
* Robinhood, and other retail and commission free traders, are not price sensitive. I have watched videos of these guys. They just hit the buy button, and often at that. No limit orders. Just buy. Like pushing the buttons on a slot machine.
* Before those trades are executed, their order flow is sold and routed to a few select firms. Those firms effectively can front run the Robinhood trader. They are going in and grabbing stock efficiently and for all intents and purposes flipping it right back to the market - Robinhood buyer - at an exaggerated higher price as the buy orders are placed with no limits.
* As professional investors, one is always petrified of this stuff happening and is careful about how they place orders, and who they place them with. I always used to wonder how certain prop trading desks at big banks with order flow always made a ton of money. And then when their "superstars" left and started their own firms and didn't have theoretical access to order flow, most of them underperformed!
* Robinhood traders also seem to be pretty active in the options market, which turbocharges these spikes.
* This effect just causes stock prices to jump. Oftentimes there is not a lot of real liquidity in a lot of these stocks too. Not a lot of natural buyers and sellers, even for some of the bigger companies like Apple (AAPL) . Seems more like a smaller group kiting stock back and forth, higher and higher.
* Then the real money follows behind these moves. The actual CTA's that have tons of dollars to play with. Short covering. All the other investors that are just price chasers. That is many and most these days.
There is a chicken and an egg. Might not be a big chicken, but it is finding a way to lay a lot of eggs. (Side note, I am still stunned it is legal for the commission free guys - and potentially others - to sell off their order flow and allow third parties to execute on it before their own customers do):
* This feels like the definition of insider trading. It is also information not broadly available to everyone.
* We know from the last filing Robinhood was collecting $100 million in fees per quarter by doing this. I am sure the number is larger now. Firms like Citadel Securities who are buying the order flow are many things, but one thing they are not is the Red Cross. If Robinhood is collecting $100 million in fees per quarter, I bet the guys buying the order flow are making many multiples of that per quarter by using that information. Per my second point above, I bet there is quite a big spread involved. Robinhood should be taking up their price!
* If the notion of this is acceptable because it is disclosed somewhere in the brokerage agreement (in small print that nobody reads or understands) that Robinhood sells their order flow off, what is the point of a regulatory body? For example, is it okay to put cyanide in food, and then disclose in small print on the label that nobody reads that said food will kill you?
The evolution of market structure is underappreciated especially with regard to how it perpetuates and leads to a "one way" stock market - effectively reducing natural price discovery.
In favorable periods (now), it results in buyers buying higher.
In unfavorable periods (in March, 2020), it results in sellers selling lower.
It is my strong view that this evolution artificially accentuates short term (daily/weekly/monthly) market moves - providing intermediate opportunities for those with a sense of "intrinsic value" that are willing to buck the tape and consider the contrary.
(This commentary originally appeared on Real Money Pro on August 3rd. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)