FINANCE

THAT'S ODD

How a Simple Indicator Tells Us Where " Max Pain" Will Hit Next

ANDY SNYDER, MANWARD PRESS

 

The market is a mean beast.

If you know me, you've heard me say this before... It likes to hurt the greatest amount of people, the greatest amount of the time.

It's called the "maximum pain" theory.

Where the most money is going, the most pain is likely to erupt. It's why we see bubbles blow up in devasting ways. It's why we see bubbles blow up in devasting ways. It's why meme stocks hurt more folks than they help. And it's why a stock that's making all the headlines...has likely already made its investors all the money it ever will.

But what if there were a way to take advantage of all this?

What if there were a way to force and quietly put it in your favor?

Contrarians rejoice. There is...and it's quite controversial.

Rounding Errors

Way back when I was a young lad, I applied for my securities licenses. I can still remember the very first question on the test...

"What are groups of 100 shares called?

The answer, of course, is "round lots."

Trades made in round lots often get favorable treatment from market makers.

And back when fees were a bigger part of the equation, they often got better pricing.

Here's the important part...Most institutional trades (the moves coming from the big boys of Wall Street) are made in round lots.

They're more efficient and simpler to manage. Even a junior trader can do the math in his head.

But when was the last time you - the retail investor - bought 100 shares of something like, say, Tesla? It's been one of the strongest stocks, so lots of folks want in. But a round lot would cost you more than $840,000.

Few retail investors buy round lots of an $800+ stock. Instead, they buy in "odd lots" - or any number of shares that's not 100.

Separating deals into those made in round lots versus those made in odd lots creates a very easy and effective easy of tracking who is buying what. And as long terms readers of my Alpha Money Flow know, breaking down trading volume is one of my favorite ways to dissect the market and uncover winning trades.

Who's Buying?

That's where the "odd-lot indicator" comes in.

Take a look at this chart from our friends at the SEC...

It offers some beautiful insight into the market... and it shows us just how powerful the lowly retail investor has become in recent years. The ratio of odd-lot trades to round-lot trades has surged in the past three years.

In the simplest of terms, the chart divides the market's stock trades into 10 unique categories based on price. Instead of showing all 10 here, I broke it down by the first decile (the cheapest 10% of stocks), the fourth decile, the seventh decile, and the 10th decile (the most expensive 10% of stocks).

It makes sense to do it this way because we'd expect round lots to make up a much larger percentage of trades for cheap stocks. After all, it's a lot easier to buy 100 shares of a $5 stock than it is to buy 100 shares of a $500 stock.

That's why we see the 10th decile at the top of the chart. Nearly 40% of trades in that high-priced category are in odd lots.

But it's not the percentage I'm interested in. It's the trend.

Getting Dumber

 

Remember, the market likes to hurt the greatest amount of people.

Therefore, when odd lots are becoming more popular, it tells us that retail investors (aka the "dumb money") are pouring in...and pain is likely on the horizon.

Through the end of last year, we can see that while round lots were still the majority in all deciles, the number of odd-lot trades more than doubled for all groups.

This ties to our Modern Asset Portfolio theory perfectly.

When interest rates are low and investors are looking for a return, they put more of their money into stocks. That explains why we saw odd-lot volume declines as a percentage of trades in later 2018...when the Fed was raising rates at nearly each of its meetings.

It also shows - in a huge nod to the contrarian nature of the idea - why odd-lot sales dipped to near-term lows around January 1, 2019...which was one of the best buying opportunities the market has seen in nearly two years.

The "dumb money got out of the market just when it should have been piling in.

Folks who saw nadir in odd-lot trades as a buying indicator (which clearly was counter to the logic of the time) could have taken advantage of a rabid 40% gain in the S&P in just 12 months.

But like I said, the odd-lot indicator does come with some controversy.

Knowledge Debate

In fact, the greater technology's role in investing becomes, the more the naysayers fight back by saying the odd-lot investor has just as much information as the big, round-lot buyer.

Yes, in a sense, that's truer than ever. But do today's Robinhood investors really know as much as the fellas at Goldman Sachs? Are the folks piling in from the Reddit boards really using the same tools and technology as the deep-pocketed analyst on Wall Street?

They may access to the same information...but do they use it?

No.

So how do we best use the odd-lot indicator?

First, understand that it's not an end-all, be-all solution to timing the market. Nothing is. But it is a powerful tool for our toolbox.

Just as a microscope allows a doctor to see what's happening at a much smaller scale, this indicator allows us to break the market down into smaller chunks and see who's buying what.

That's critically important.

It means we don't have to look at just the major indexes and try to guess why things are moving the way they are. We can make much more educated moves...and play the contrarian game.

When the retail investor is buying in gobs, it tells us to pay attention. It begs us to ask whether the buyers know why they're buying...or if they're just buying to buy.

If it's the latter - as it has been of late thanks to low interest rates - it tells us to pay close attention. Once the catalyst of the day (in this case interest rates) goes away, so, too, may the gains.

The market is a hungry beast. It'll take a bite out of everybody it can.

With the indicator in our toolkit, we can do our very best to avoid the pain.