5 Years Of Dark Liquidity And Central Bankers

Includes: R, SPY
by: SqueezeMetrics


We can often look at dark pool data to see what sophisticated investors think about a stock.

Can we extrapolate this information to the scale of the S&P index to predict where the market is going?

Five years of dark pool sentiment tells a story of the primary importance of monetary policy.

Central bankers still rule the day.

Last time we talked about market sentiment from the perspective of short selling, we looked specifically at the ratio of short to long dark pool transactions in the SPDR S&P 500 ETF (NYSEARCA:SPY).

We found, unsurprisingly, that a higher ratio of short selling is correlated with greater uncertainty. Sort of like in the VIX - higher number, more fear.

(Catch up: What's all this about dark pools?)

One of the useful things about looking exclusively at dark pool transactions (as reported by FINRA's TRFs) is that we get a sense of what more well-informed and well-connected investors are thinking about any given security.

Since over a third of equities volume trades in dark pools, and do not immediately affect the market price when traded, dark pool short sales often have a delayed - but substantial - effect on the market.

In individual stocks...

The effect is often very easy to spot. Take Ryder (NYSE:R) for example.

On July 23rd, Ryder reported not-terribly-exciting earnings with moderately weak guidance. In dark pools, 528k shares were shorted. To put that in terms of dark pool short ratio, it was 67% short - pretty heavy.

But despite that, the price pretty much stayed the same.

On August 7th (the biggest red bar) over 750k shares ($67M) were sold short in dark pools. In terms of dark pool short ratio, that's 0.89, or 89% short. That's pretty rare in an S&P 500 stock.

Why the persistence? Well, it seems that the market failed to react to one sneaky little line in the press release, and dark pool short sellers took advantage of that:

Due to the increase in leverage, the Company elected to temporarily pause the anti-dilutive share repurchase program early in the year.

"Ryder suspends buyback program" never made it into the news, but apparently, someone caught it anyway. Finally, reality set in and the price started dropping rapidly.

(By the way, we published an article about this on July 24th, the day after the first short, so you have no excuse to be holding Ryder unhedged right now.)

Shares have fallen 42.3% since then.

Does this happen on a larger scale?

We'd like it if we could see "leading indicators" like this when we look at the whole market through the lens of dark pools, but it's an open question whether that's possible. Some readers were still skeptical about it after reading our first analysis of the SPY ETF.

So this time, we dug deeper.

Instead of just looking to a single instrument to get a broad view, this time we

  • aggregated five years of daily dark pool volume data across the entire S&P 500 (taking into account additions and subtractions over the years),
  • weighted the volume by stocks' market capitalization (updated daily),
  • and charted it all out.

So it basically looks just like the chart from last time... except it's way cooler.

The first thing that we notice here...

Is that there's a lot more detail, which is what we were hoping for. The other thing is that the series fluctuates between 35% short on the low end and 50% short on the high end, which is a pretty wide range considering that we're talking about such a substantial proportion of the stock market.

Also - and most exciting - is that nobody would mistake this for a random series. Whether predictive, reactive, choleric, or affable, there is clearly something here that we can call "sentiment" here, and sometimes, it swings rapidly.

Taking a not-so-random walk.

I remember 2011 like yesterday - not very clearly at all. That's why I had to go back in time to see what people were saying and worrying about at the left side of this chart.

It's quaint to read things like "Could The S&P Hit 1250?" in five-year-old SA articles, especially alongside seemingly more familiar concerns like "Greek debt crisis," "Fed tapering," and "end of QE?"

Bad jobs data, double-dip recessions, Eurozone default scenarios, Bernanke giving bad vibes - it's all here in a report from September 2nd, which is where short-selling peaked in 2011.

Looks pretty analogous to the VIX, right? But when we look at this slice of the chart, we wonder if the real story isn't contained in the few months prior, where the average short ratio steadily rose 4%.

Is this the real "shift" in sentiment that we should be looking for?

A change of pace.

If "rate of change" in the dark pool ratio is a good proxy for shifts in clever investors' sentiment, then the next large-scale move we should turn to is late 2012, when the short ratio quickly and definitively dropped below its moving average.

Some of you will probably remember very clearly what brought on this revival of good feelings and happy thoughts in the market: The third round of "Quantitative Easing." And this time, it was a very open-ended plan to buy $40 billion in agency MBS every month for as long as it took, alongside a guaranteed federal funds rate of ~0% "until at least 2015."

A raging bull market.

Everything looked pretty boring and happy until we see a scramble to short in mid-June. We'll bet you can't guess that it had something to do with the Fed.

Tapering the asset-buying program and raising the funds rate came up in conversation on June 19th, 2013. Dark pool traders, hearing this, kicked off several day's worth of market-wide losses. The end of that August - the Friday before Labor Day - featured more of the same fears.

And then, the unthinkable.

Dark pool traders, up to this point very in-tune with global macro and central bank policy - hedging or shorting opportunistically - surprise us in October 2014 as a huge chunk is taken out of the index.

The surprise? They don't flinch. Not at anything. Not even at a VIX above 30 (mid-month)!

And then the Fed actually tapered at the end of the month. No shorting.

Well, apparently they were right to not care, as the index surged from a low of 1820 to new highs above 2000 within the month.

This is the second time that a lack of shorting is a clearly bullish signal, and the first time that we realize that dark pool sentiment is definitely not just a mirror image of the VIX. This seems important.

What are we experiencing right now?

If "rate of change" is still what we're looking for, sentiment definitely shifted in late August, and with fear at least equivalent to the height of the pre-QE3 sovereign debt crisis in 2011.

Some people ask "Is the market overvalued?" Others, "Is it safe?" Let me rephrase that question on your behalf to save us all some trouble and misunderstandings. What you really want to know is:

"Up, down, or sideways?"

With this history as our guide the answer is

"sideways, until a catalyst from the Fed"

Why? Because this is a lot like 2011.

The only thing that got us past the S&P 500's two-time ceiling at 1500 in 2012 was the Fed committing to flattening the yield curve and keeping the federal funds rate ~0%. It had nothing to do with Greece "fixing itself" or employers being awesome and "improving jobs data." It was simply the guarantee that the funds rate will stay at 0% until 2015, and if you want to retire, America, you'll put your money into risk assets - or else.

Note that it was when Bernanke mentioned raising the funds rate a bit earlier than anticipated on June 19th, 2013 that we saw our first anomaly - the dark pool traders protested.

What about late 2014, when the market dropped to 1820 on no news from the Fed? The reason that dark pool traders didn't care is because they know all that matters is rates, and guarantees from the Fed about rates.

And now? Well, 2016 is here, and the dominance of risk assets might very well be over. It's like 2011, deja vu. Will we get a guarantee that rates go lower and stay lower? That's the real question.


As long as a negative interest rate policy (NIRP) is on the table, the Fed has a trump card. As long as that card is not played, however, "organic" growth (without coercion or stimulus) appears to be the only upside in stocks (and hey, nobody wants plain old growth).

So no, it's not about "growth," or GDP, or ISIS, or Russia, or oil, or dollars, or anything else.

It's about monetary policy.

And if this big-picture view of the market sounds somewhat similar to that silly Ryder example from the beginning of this article, that's because it is. Ryder's share buyback program is essentially the microeconomic equivalent of macroeconomic central bank policy.

The somewhat counterintuitive lesson to learn from this sophisticated subset of nimble investors? Whether it's the Federal Reserve, company management, earnings, trends, or whatever, don't fight reality. Whether at the company level or the country level; effective funds rates or share buybacks, always figure out who controls the purse-strings and check with them first (whether that means going long or short).

In the case of the broad equities market, the purse-strings are still controlled by the Fed, and the game is still monetary policy. Don't fight that.

Whenever the next big shift (or lack thereof!) occurs in dark pool sentiment, we'll make a point of updating our readers, so please follow us for more.

Referenced dark pool data comes from your friendly market regulators at FINRA. Charts and the SqueezeMetrics service reside at sqzme.co.

Want to know more? Get in touch here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.