“This is Not Your Father’s Stock Market”
Kerr Financial Group
Kildare Asset Mgt.
Jeffrey J. Kerr, CFA
October 9, 2023 – DJIA = 33,407 – S&P 500 = 4,308 – Nasdaq = 13,431
Once upon a time, economic news and business headlines were big stock market influences. Such things as inflation news, earnings reports, employment data, and merger announcements moved markets. Things have changed. New securities, new trading strategies, and advanced technology have combined to change the landscape on Wall Street.
Certainly, fundamental developments still matter. Economic awareness is essential and understanding the corporate landscape remains critical. But these factors have a much lower effect on day-to-day activity as new trading vehicles have grown in both size and trading volume.
Reportedly, JP Morgan has estimated that 90% of the market trading is not based on fundamentals. This trading is partially based on such things as algorithms, fund flows, periodic/systematic investing, and index arbitrage. An important point is that the financial media’s economic narrative has no influence on these approaches.
There are estimates that 80% to 85% of 401k contributions are invested in target dated mutual funds. Target date funds are mutual funds or ETF’s that invest in a mix of stocks, bonds, and other securities. The fund periodically rebalances and shifts the portfolio from aggressive to conservative investments over time. At the target date of the fund, the investments should be in a money market or other similar positions.
Looking under the hood at these funds, it’s crucial to understand that contributions to target funds are immediately invested. There is no judgement on whether it’s a good time to invest. There is no analysis if an investment is an overvalued security. The money is put to work as soon as it is received by the fund.
Target dated investments are not the only funds that act this way. Index funds do the same thing. As soon as an S&P 500 index fund receives money, it buys shares in Apple, Microsoft, Amazon, Nvidia, etc. Combining index and target dated funds, there is a sizable and steady flow of money into the market, and it is invested automatically regardless the economic backdrop.
Beyond these systematic investing programs, derivative trading, and dealer flows have grown in stock market trading. These have been more in focus since the addition of daily options on the SPY and QQQ ETFs in 2022. These options have exploded in usage in 2023.
Again, these strategies are very short term and have little to do with economic fundamentals. 0 DTE options (the daily options or zero days to expiration options) have partially replaced use of S&P futures as a trading tool. These options cost a lot less and can provide the same level of exposure for a portfolio.
The mechanics of these trades result in the options dealers with unwanted risk which they hedge through buying and selling the market. This is a complex strategy that looks at both the option price and the SPY. These are non-linear relationships which require many constantly changing mathematical calculations to measure the rapidly shifting landscape. Despite these intricacies, it has not prevented 0 DTE trading from being a force in the stock market throughout 2023.
The main conclusion is that these strategies are a large piece of the capital markets and have very limited connection with economic data. A recent example of how the day’s trading can be separated from the news flow was last Friday (October 6, 2023).
The Department of Labor released September’s employment data and the report was stronger than forecast and the stock market fell. Any sign of an expanding economy (such as a healthy job market) is a negative because it will likely force the Fed to keep interest rates higher for longer.
Last Friday, the morning retreat reversed by midday and stocks rallied the rest of the afternoon. There were no headlines behind the market’s direction change but short dated call option buying played a significant role. The financial media were forced to change the narrative from ‘too strong of a report’ to ‘moderate wage pressures’ which equals everything is fine.
For those who were too busy to follow Friday’s market and were only able to check the closing prices, it was another good day in the stock market. These types of rallies on seemingly bad news have been happening all year. And there have been plenty of selloffs on good news as well.
The biggest danger within this environment is that risk becomes camouflaged and mispriced. When markets rise, it’s easy and natural to conclude that it’s a sign of a good economy. But what if the rally is not a reflection of any fundamental data? This is what an algorithm or dealer flow can do.
Wall Street is continually looking for an edge to make money and developing new trading strategies to accomplish this. 0 DTE option trading and the related algorithms is the latest chapter in the story. And as these new products are implemented it can breakdown established correlations especially in short term durations. Over the long term, the economic data and fundamentals will direct the capital markets. In the meantime, the adjustment period could be volatile.