Stock reactions from news vs underlying cash flows

The stock market reacts to events in funny ways. Usually the headline news events have nothing to do with market movements at all, but the press will just say “stocks went up on optimism about vaccines” or occasionally “stocks went down on (insert negative news headline here)”.

This Thursday at 1pm, an announcement about congress increasing capital gains taxes went out on capital hill, and the S&P 500 immediately dropped. The next day the S&P gained that all back and then some. There is a significant amount of algorithmic trading or other trading styles that quickly react to news events which are supposed to move markets, but they only move prices in the very short term.

There are very powerful cash flows that move markets over the intermediate term, driven by their own considerations which often have little to do with daily news events. Here are some of the major sources of these cash flows affecting stocks:

  • 1. Employee retirement plans like 401k’s, which keep buying stocks at current market prices week after week as long as these employees keep getting paychecks.
    • This category hasn’t been affected much by the pandemic lockdowns because most of the job losses hit lower end employees who don’t have these retirement plans.
    • 401k’s became common in the 1980’s, and have had a powerful effect increasing the P/E multiples of the stock market ever since.
    • 401k stock flows are increased by low interest rates over the longer term, as the fraction of money allocated to bonds has steadily decreased.
    • As you can see from the chart below, retirement contributions have had a rapidly growing influence on the US stock market over the last decade. Unfortunately it is incredibly difficult to find data on the combined annual contributions, so this survey on tax credits for retirement contributions, discontinued in 2016, was the only indication I could find on this critically important cash flow.
  • 2. Stock buyback programs from big US corporations relentlessly borrow money on their balance sheets to purchase their own shares at current market prices.
    • Share buybacks had an enormous impact on the stock market this past decade, often representing the largest flows of money into the US stock market. The spike in 2016 had to do with the corporate tax change, followed by an enormous “repatriation” of cash held outside the US into share buyback programs.
  • 3. Increases in margin lending, available in small amounts to retail investors and enormous amounts to hedge funds, put enormous amounts of borrowed money into the stock market.
    • As you can see in the chart below, large flows into margin accounts often occur during recessions. This is in part because the federal reserve tends to lower interest rates and generally encourage banks to lend. Many large funds are always willing to take on more leverage to boost their returns and their market impact. When large funds plow money into illiquid assets, the underlying asset valuation skyrockets and they can look like geniuses – think of the thinly traded tech names that funds like ARKK and Archegos purchased large stakes of. These funds tend to shut down and get liquidated all the time to minimal fanfare, unless they are big enough to make a significant dent in bank earnings. Margin flows then reverse later on due to margin calls and/or efforts at risk reduction.
  • 4. Rotations from large funds from one sector of the stock market into another are extremely important in how real money is made over time. Big investment funds will rotate out of one sector and into another for various reasons, such as the often talked about rotation from growth into value, large caps into small caps, tech into energy and finance, and so on.

The most important part of the above flows when it comes to market tops is from margin accounts. This is because market crashes always involve forced selling – initially from margin calls, and later from mutual funds or index funds that have redemptions when people who are worried about their 401k’s reallocate the money into funds they consider safer.

Very few of the fund flows above are affected by headline news. The one segment that is most affected is market rotations, as investment managers look for narratives that encourage fund flows into one sector or another. Unexpected events like wars can quickly shift the narrative stream, while expected events like the tax increases last week just feed into existing narrative streams.

Note that investment narrative streams from the mainstream news should always be viewed with skepticism. Big investment firms tend to feed the financial press their narratives, so they tend to have news about everything going wrong in a sector while they accumulate a position and everything going right in a sector when they strategically sell out of that position. Think of the oil fears from demand collapse culminating in a large negative spot price, followed by the inflation narratives pumping everything energy related.

Here’s my latest portfolio:

  • DOWNSIDE BETS (37.6%)
    • 29.8% TLT Calls
    • 4.6% IWM Puts
    • 2.0% EEM Puts
    • 1.2% Short dated puts
  • GOLD (22.2%)
    • 7.1% FNV, WPM, GOLD & NEM Calls (Large gold miners)
    • 7.9% EQX (Small gold miner)
    • 7.2% SAND Calls (Small gold streamer)
  • SILVER (19.8%)
    • 10.3% AG (Small silver miner)
    • 0.8% AG Calls
    • 5.1% SILV (Small silver miner/explorer)
    • 1.2% MTA (Small silver miner/explorer)
    • 0.8% RSNVF (Really small silver miner/explorer)
    • 1.7% SILVRF (Really small silver miner/explorer)
  • COMMODITIES (14.7%)
    • 9.4% CCJ shares
    • 2.0% ALB (Lithium)
    • 1.4% NMGRF (Graphite)
    • 1.9% NOVRF (Nickel/Copper)
  • CANNABIS (5.6%)
    • 5.6% split between CRLBF, GTBIF & TSSRF (companies with significant US footprints)
  • CASH (0.1%)

I did some trading this week, picking up additional shares of SILVRF and NOVRF. I also sold off last week’s short dated puts for a decent gain on Tuesday, then picked up new short dated puts on Friday. It seems a common pattern for the stock market to hit new highs on Friday and then struggle Monday thru Wednesday. These are mainly timing moves, as some of the chartists I follow on twitter have Elliott wave charts on the S&P 500 showing a pullback to 4100 followed by a breakout to new highs around 4250. Perhaps I’ll swap out the short dated puts for short dated calls when it hits my target there. It’s a good exercise to get a feel for timing market moves in general and seeing how reliable these charts are. On the other hand, a significant correction is expected following this top in May and these moves can always come earlier than planned so I won’t be risking a lot.

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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