The fact that the major stock market indexes are at or near all-time highs despite glaring red flags in the labor market and other areas of the economy seems like a massive contradiction.
We know the stock market is not the economy—but how can the two be so seemingly disconnected right now? There are many theories why this could be the case, among them stronger-than-expected corporate earnings, encouraging signs of a vaccine, or simply an old school technical breakout.
But according to Tim Quast, founder and CEO of ModernIR and MarketStructureEdge, the reason that stocks are rallying in the face of a shaky global economy is simple: stocks are driven by prices and nothing more.
“You have behavior that seems to disconnect from the underlying economy, it’s just a reflection of the fact that the market isn’t motivated by rational thought,” he said on Wednesday’s PreMarket Prep. “It’s motivated by prices. The way we look at the market...it all comes back to what the surrounding prices are. And the market has reflected that very well.”
In other words, the market is behaving in a way that is consistent with how the structure of the market and its participants—the brokers, exchanges, and traders—enable it to behave.
According to Quast, about 85% of volume in the stock market is the result of something other than orders placed with conviction to buy or sell a specific stock. Most of the time, it comes from high-frequency traders and market makers who act as intermediaries between exchanges and broker-dealers.
Retail brokers will route orders from their clients to computers controlled by these high-frequency traders, who will then execute these orders at the exchange for a slightly lower price and profit the difference. This system is known as payment for order flow, and is a primary driver of revenue for brokers and exchanges.
Quast said the massive influx of retail traders into the market over the past several months has contributed to a corresponding increase in trading from firms like Citadel and Virtu Financial (NYSE:VIRT), which has in turn enabled them to control more of the market and dictate prices with their split-second trades.
“Citadel and Virtu buy 70% of all retail order flow. So if you’re a Robinhood trader, your trade will never ever ever ever get to the market. What that means is retail flow does not directly affect the market, but it does induce arbitrage,” he said.
This can also affect the options market he said.
“People should understand this. When there is a raft of retail flow, it will affect the derivatives market. And that, in turn, is implied demand, and it causes the market to move in ways it wouldn’t otherwise.”
Watch to the full interview with Tiim Quast in the clip below, or listen to the podcast here
PreMarket Prep is a daily trading show hosted by prop trader Dennis Dick and former floor trader Joel Elconin. You can watch PreMarket Prep live every day from 8-9 a.m. ET Benzinga's YouTube channel, and the podcast is on Spotify, iTunes, Google Play, Soundcloud, Stitcher and Tunein.