Together with

Good afternoon,

Business optimism is the highest since May 2022, the Fed is skeptical inflation falls back to 2% before 2025, and mortgage demand fell to a fresh 28-year low. 

Equity markets began the short trading week with their worst one-day performance in 2023, as Treasury yields drove rate-sensitive tech firms to unwind almost all of their month-to-date gains. Home Depot earnings disappointed the retail sector while Nvidia excited retail traders and surged during after hours trading. 

Let’s dive in.

Economy Heat Check

As of 2/21/23 market close, unless otherwise stated.

But first, a message from today's sponsor: Gridline

You don’t have to be a billionaire to invest like one. 

Top-tier private market fund managers outperform public markets, but there’s just one problem: access has been almost impossible (unless you have at least $50M in capital to deploy).

Gridline is opening up that access to investors like you.

Gridline users gain access to a curated selection of rigorously vetted managers and up-to-date information about the most compelling investment opportunities.

The result? You can construct a fully diversified private market portfolio with lower capital minimums and a fee structure 50% lower than comparable offerings. 

And the best part? Membership to the platform is free and access is instant.

So what are you waiting for? Upgrade your portfolio with Gridline now.

Briefings

• Wells Fargo lays off mortgage bankers days after rewarding some with California retreat (CNBC)

• JPMorgan is attempting to curb its staff’s use of ChatGPT (BBG)

• Microsoft will give Nintendo and Nvidia access to “Call of Duty” games for a decade if its $75B deal to buy the developer, Activision Blizzard, gets approved (WSJ)

• Nvidia surged in after hours after beating EPS by $0.08, reporting revenues in-line, and guiding Q1 revenues above consensus (Barchart)

• A Pimco-owned office manager has defaulted on $1.7 billion of mortgage notes (BBG)

• The SEC charged the Mormon Church for failing to disclose $32B in assets hidden in shell corps (AP)

• McKinsey to cut up to 2,000 jobs in back-office restructuring (FT)

Expectations Reset

The week in review.

FOMC minutes released yesterday revealed the Fed doesn’t see inflation moving back to 2% until 2025. Keep in mind, these minutes did not take into account the historically strong January jobs numbers, where the U.S. added 517,000 jobs. The Fed seems to be pivoting, but in the hawkish direction. Highlights from the meeting include:

• Almost all Fed officials backed a 25 bps hike in Feb.

• Expect "restrictive policy" until inflation hits 2%.

• The Fed sees an elevated risk of recession.

• "A few" officials backed a 50 bps hike in Feb. 

The US services and manufacturing index from S&P Global had its best reading since June 2022. Manufacturing PMI came in at 47.8 vs. 46.9 prior. The composite PMI came in at 50.2 vs. 46.8 prior. Flash services PMI came in at 50.5 vs. 46.8 in January.

The PMI data revealed business optimism is at its highest since May 2022. Despite headwinds from higher interest rates and the cost of living squeeze, supply constraints have alleviated to the extent that delivery times for inputs into factories are improving at a rate not seen since 2009.

Don’t get too excited. There are some caveats to the good news. The upturn is being driven by the services sector, which in part reflects unseasonably warm weather. Although the manufacturing survey data shows signs of improvement, the factory sector remains in contraction and focused on inventory reduction. The improved supply situation has taken price pressures out of manufacturing supply chains, but the upward driving force on inflation has now shifted to wages amid the tight labor market.

Existing home sales for January fell for a 12th straight month, down -0.7%. The national median home price for existing homes is now $359,000, a +1.3% increase year-over-year.

Further data in the report revealed that 31% of January purchases were first-time buyers (same as December). 29% of total sales were cash. Investors, who often purchase with cash and are therefore less sensitive to mortgage rates, make up 16% of the market. Sales of single-family homes dropped to 0.8%, marking their lowest level since 2010.

The MBA's Mortgage Purchase Application Index (seasonally adjusted) recorded its lowest weekly reading since 1995. Mortgage rates rose by almost 0.5 percentage point during the first two weeks of February. The data is being carefully watched by policymakers trying to get inflation under control.

With mortgage rates so inflated, someone must’ve told them Adam Neumann was getting into real estate.

DEEP DIVE: OpEx Week Drowned by Dark Pools

$1.8 trillion of options notional expired last Friday. But the majority of that volume wasn’t on public exchanges. 

Thanks to dark pools. Let’s dive in. 

The stock market allows the public to access the most fractional of slices of the American economy, by buying fractional ownership of companies. Once a company goes public, their financials and ownership composition are subject to reporting requirements and regulation. Technically speaking.

The above statement is about as deep as you’d get on any TikTok tutorial about retail trading. But when it comes to trading, what you don’t know will almost certainly hurt you.

As a rule of thumb, complexity, “sophistication” and secrecy are tools in any Wall Street starter pack as advantages over retail investors. And as much as we’d love to spend 50,000 more words in this newsletter dicing into some examples of “complex” and “sophisticated” techniques, we’ll leave those to FINRA. 

Instead, let’s examine the avenue banks are going down that’s quietly taking over the options market: dark pools. 

OpEx Week: A Play-by-Play

OpEx week refers to the week during which options contracts expire. During this week, you can expect significant trading activity as traders look to close out or roll over their options positions. Last Friday, over $1.8 trillion of options expired. 

Options that are traded on public exchanges are typically counted in OpEx week, as they are included in the open interest figures reported by the exchanges. Open interest refers to the total number of outstanding options contracts, which includes both the number of contracts held by traders and the number of contracts sold short by traders.

During OpEx week, there can be increased trading activity in options contracts as traders close out their positions or roll them over to new contracts. This increased activity can potentially lead to greater volatility in the underlying stocks as well. If a large institutional investor decides to trade a significant block of stock through a dark pool during OpEx week, it could have an impact on the options market as well, particularly if the stock is one that is heavily traded in options.

For example, if a large block of stock is sold through a dark pool during OpEx week, it could create downward pressure on the stock price, potentially causing the price of options contracts to decrease as well. On the other hand, if a large block of stock is purchased through a dark pool, it could create upward pressure on the stock price and potentially cause the price of options contracts to increase.

Dark pools can have an impact on options expiration (OpEx) week, although the extent of this impact may depend on a number of factors such as the size of the dark pool and the specific stocks and options being traded.

Dark pools are private trading venues that do not publicly report trading activity. As a result, options traded in dark pools may not be counted in OpEx week. But everything gets reported back to FINRA eventually. So let’s examine their impact. 

A Briefer on Dark Pools

In general, dark pools are private exchanges where institutional investors can buy and sell large blocks of stocks without revealing their intentions or the specific prices they are willing to pay or receive. This allows them to avoid the market impact of large trades and maintain greater anonymity.

Those that do have access to their murky waters are able to trade privately and directly with other participants. While dark pool volume is reflected “on the tape,” whether the trade was a buy or sell is not.

Dark pools do have some reporting requirements. Every week, the total Alternative Trading System (“ATS”) activity is listed by security on FINRA’s website.

However, by the time the data goes public, it is already out of date. Remember, this is coming from the industry that has the infrastructure to check multiple exchanges for prices in nanoseconds and execute billions of trades per day. But when it comes to basic transparency reporting…expect a 30-day latency.

Retail investor orders often get filled in dark pools through the payment-for-order-flow business model. Remember GameStop? In the GameStop run Reddit won’t let you forget about, it was revealed that Robinhood was routing its order flow to marker maker Citadel for fulfillment. That means Citadel essentially had exclusivity in processing Robinhood investor orders.

The way a healthy public market would work is that all participants – regardless of how deep their pockets – would be able to see the same pre-trade data, also known as the order book. This information is key to calibrating the buy and sell pressure on stocks to determine where their price is heading.

That is exactly why it is hidden from public view.

Why Do Institutional Investors Use Dark Pools?

Institutional investors trade in dark pools for two primary reasons:

• Find buyers and sellers for large orders without publicly revealing intentions

• Obtain better pricing for executed trades

Dark pools allow institutional investors to quietly find buyers and sellers for large orders without causing large swings in the market (typically against them). How? Dark pools are not required to make the order book available to the public. Instead, transactions executed through dark pools are released to the consolidated tape after a delay.

For example, let’s say an investment bank is trying to sell 400,000 shares on a public exchange like the New York Stock Exchange. As soon as institutional investors or high-frequency traders see a large sell block hit the order book, the markets react, and the security would likely decrease in value by the time the investment bank was able to find enough buyers to fill the entire order. But if the trade is disclosed only after it has been executed, the news has a much smaller impact on the market.

Another reason to fill large equity orders in dark pools is to obtain better pricing. Trades made on dark pools can have lower transaction costs in two ways:

1. Dark pools typically offer lower exchange fees

2. The lack of price transparency may result in trades filled closer to the midpoint of the quoted bid-ask spread

A common criticism of dark pools is that enough volume traded through dark pools could result in stock prices on public exchanges not reflecting the actual market value. While the above scenario may work out well for the investment bank selling the shares, consider a retail investor who just purchased shares of the company the investment bank just sold 400,000 shares of on a dark pool. Once the sale of those 400,000 shares becomes public knowledge, the stock price could tank, and the retail investor who just bought shares paid too much.

How Long Are Dark Pool Trades Delayed?

In case you are studying for a Series exam, we’ll try to stop triggering you – this is the last time we’ll bring up FINRA. According to FINRA’s reporting requirements for dark pools, trades executed between 8:00 am and 8:00 pm EST must be reported within 10 seconds of being executed. Trades executed between 8:00 pm and 8:00 am EST have until 8:15 am the following day to be reported.

An important caveat is that a trade is not considered “executed” until the order is filled in its entirety. Due to the inherently large nature of trades made on dark pools, it may be several hours until the trade is fully filled and reported to FINRA. If the trade is filled outside market hours, the reporting can be delayed even further. In some cases, it may be up to 24 hours before a trade is made public.

To add to the delay, institutional investors found a loophole by executing trades on European dark pools to get around reporting them right away. Trades executed on European dark pools may not be reported until hours later or the next trading day.

Why Are Dark Pool Prints Important for Traders?

Understanding dark pool prints is critical for identifying upcoming market movements, changes in trends, and support and resistance levels.

Dark pool prints are a leading indicator of upcoming market movements.

This is especially true for major indexes like SPY. Historically, SPY dark pool prints have proved to be a powerful leading indicator of large upcoming market movements. A pattern of multiple large trades with bullish characteristics has predicted very large bullish swings in the overall market, and the opposite pattern has predicted major downturns.

Dark pool prints can signal the beginning of a trend or a change in trend.

Dark pool prints have proved just as powerful at indicating the beginning of a trend or a reversal for any ticker. A pattern of multiple large trades with bullish characteristics on a ticker with otherwise bearish characteristics can indicate a change in trend, or the same pattern can indicate the beginning of a trend on a ticker otherwise trading sideways.

Dark pool print accumulation can identify support and resistance levels.

Tracking the price level that dark pool prints are trading over time helps identify support and resistance levels.

If a ticker is trading down, identifying large dark pool print accumulations below the current price will uncover support levels where a reversal may occur. The more volume that was transacted at that price, the stronger the support level is likely to be.

The same is true for large accumulations above the current price. The price with the most volume accumulated can signal the resistance level at which the ticker may consolidate and reverse down.

Dark pool prints provide the full picture of market value.

Without the full picture of dark pool prints, traders could end up paying too much for an equity security. Consider the retail trader in the example above who was unaware of a large dark pool trade that would have impacted the share price had it been traded through a public exchange.

Dark Pool Trading is Going Parabolic 

More than seventy percent of all shares that changed hands in the stock market at large in 2021 did so in dark pools. Interestingly, the percentage of shares traded in dark pools isn’t the only thing ramping up.

The number of shares traded in the market overall exploded.

The ten quarters between Q1 2018 and Q2 2020 collectively averaged approximately 71B shares traded per quarter.

The second quarter of 2021 saw over 500 billion shares change hands. That’s a 700% increase compared to the historical average. Of those trades, almost 70% were executed in dark pools.

Wall Street tries to frame retail for frenzied activity, but can’t in this case considering 70% of the activity is happening in Wall Street insider exchanges. Here’s one window in. 

The Dark Index (DIX)

The Dark index provides a way of dipping into dark exchanges. It is calculated as an aggregate value of many dark pool indicators (another type of release provided by squeeze metrics) and measures hidden market sentiment. When the values of this indicator are higher than usual, it means that more buying occurred in dark pools than usual. 

In short, the DIX represents a trail of liquidity providers. To achieve this, it is negatively correlated with the market it follows due to hedging activities. 

Then again, unless you enjoy having nightmares about Citadel, GameStop or the SEC’s Gary Gensler, maybe just stick with following Treasuries.

STILL TO COME: PCE

According to your aunt’s favorite news anchor, the CPI print was the most significant economic data release of our lifetimes…until tomorrow’s PCE. All eyes will be on the Personal Consumption Expenditures price index — the Fed's most closely watched assessment of how quickly prices are rising across the economy. 

Since the beginning of February, markets have been pricing in a more hawkish Fed. The strong Labour market, rebounding service sector, and hawkish US retail sales print have all led to more hawkish rate expectations. This has been supporting the USD, weakening stocks, and weighing on precious metals. 

In the short-term, traders are hoping for opportunities that would come from any sense that the core PCE price index is falling more rapidly than markets expected. The prior core reading for December was 4.4%.

January’s print is expected to come in at 4.3% for another fall, but any moves lower at 4.1% or lower will encourage hopes of a Fed pause once again. If there happens to be a miss of 4.1% or lower, and the headline and month-over-month comes in at 0.1% or lower, then you can expect a knee-jerk reaction from intraday traders acting on a USD weakness, S&P 500 strength, and gold upside. 

Meme Bank

Advertise with us // Visit our merch store // Invest alongside Lit Ventures