Yearly Archives: 2018

Moon Rules

We spent last week in Summit County, famous for Breckenridge and Keystone. With windows open and the sun set, the temperature at 9,000 feet drops fast, great for sleeping.

It’s not great for staying awake reading a Kindle but I worked through some exciting pages of Artemis, the new novel by Andy Weir, who wrote The Martian, made into a Ridley Scott movie starring Matt Damon.

And yes, Artemis got me thinking about market structure. Not because of the profanity, the ripping pace, the clever characters, the exotic settings.  It’s a book set on the moon, where scientific rules matter.

Weir’s genius is the application of science to clever storylines. On the moon, if you want to commit a crime to save the community, you better understand how to blend acetylene and oxygen in zero atmosphere. Fail to follow or understand the rules, you die.

It’s not life and death in the stock market but rules play the same supreme role in dictating outcomes. If as public companies you think your story will determine the outcome for your stock, the rules will humble you.  How much of your trading volume comes from Active Investment? You can and should know – and it’s not what you’d think. But that’s not the point of being public, is it.  So don’t be afraid.

If you’re an investor and you think fundamentals will pace you to superior results, think again. The amount of money choosing company financials has plunged, while funds indexing to markets has mushroomed. Rules helping models will eat your lunch.

What rules? Start with Regulation National Market System. It creates a marketplace that forces revenue-sharing among intermediaries. Professional sports like basketball in the USA also operate with rules that shift focus from playing the sport to managing salary cap (Denver just traded three Nuggets for that reason).

If you don’t know this, you’ll have a false understanding of what drives the sport. The “haves” must distribute funds to the “have nots.” Some owners in money-losing markets might choose to skimp on salary to scrape mandated distributions from teams making bank (I wonder what the NBA Cavaliers will do now?).

Right now, stock market sentiment reflecting not the opinions of humans but the ebb and flow of money and the way machines price stocks (the rules, in other words) is topping again as it did about June 12. Options expire today through Friday.  So, no matter what you expect as earnings commence, the market will have a propensity to decline ahead.

It’s like the rules on the moon.  In one-sixth of earth’s gravity, harsh sun, no atmosphere, success depends on knowing how stuff works. Investors and public companies, welcome to the moon. You can’t treat it like earth. Rules determine outcomes. If your actions don’t account for the rules that govern how markets function, outcomes will reflect it.

But it’s fun on the moon once you know what you’re doing. It’s fun knowing when the market is topped, and bottomed, on rules. It’s fun doing investor-relations when you know what all the money is doing.  So, come on up to zero atmosphere! It’s not scary.

Block Monopoly

This year’s rare midweek July 4 prompted a pause for the Market Structure Map to honor our Republic built on limited government and unbounded individual liberty. Long may it live.

Returning to our market narrative: Did you know that 100% of Exchange Traded Fund creations and redemptions occur in block trades?

If you’ve got 48 minutes and a desire to understand ETFs, catch my podcast (you can get our ETF White Paper too) with IR Magazine’s Jeff Cossette.

In stocks, according to publicly reported data, three-tenths of one percent (0.03%) of NYSE trades are blocks (meaning 97.7% are non-block).  The Nasdaq compiles data differently but my back-of-the-envelope math off known data says blocks are about the same there – a rounding error of all trades.

Blocks have shrunk due to market regulation. Rules say stock trades must meet at a single national price between the best bid to buy and offer to sell.  That price relentlessly changes, especially for the biggest thousand stocks comprising 95% of volume and market cap (north of $2.5 billion to make the cut) so the amount of shares available at the best price is most times tiny.

We track the data.  At July 9, the average Russell 1000 stock traded 13,300 times per day in 160-share increments.  If you buy and sell shares 200 at a time like high-speed traders or algorithmic routers that dissolve and spray orders like crop-dusters, it’s great.

But if you buy cheese by the wheel, so to speak, getting a slice at a time means you’re not in the cheese-wheel buying business but instead in the order-hiding business. Get it? You must trick everybody into thinking you want a slice, not a wheel.

The cause? Market structure. Regulation National Market System, the regime governing stock trades, says one exchange must send to another any trade for which a better price exists there (so big exchanges pay traders to set price. IEX, the newest, doesn’t).

Put simply, exchanges are forced by rules to share prices. Exchanges cannot give preference to any customer over another.

ETFs get different rules. Shares are only created in blocks, and only traded between ETF creators and their only customers, called Authorized Participants.

I’m not making this up. When Blackrock wants more ETF shares, they create them in blocks only.  From Blackrock’s IVV S&P 500 ETF prospectus: Only an Authorized Participant may engage in creation or redemption transactions directly with the Fund. The Fund has a limited number of institutions that may act as Authorized Participants on an agency basis (i.e., on behalf of other market participants).

Why can ETFs offer preference when it’s against the law for exchanges? Fair question. There is no stated answer. The unstated one is that nobody would make markets in ETFs if a handful of firms didn’t have an unassailable competitive advantage, a sure chance to make money (why ETF fees are so low).

Again from the IVV prospectus:

Prior to trading in the secondary market, shares of the Fund are “created” at NAV by market makers, large investors and institutions only in block-size Creation Units of 50,000 shares or multiples thereof.

Each “creator” or authorized participant (an “Authorized Participant”) has entered into an agreement with the Fund’s distributor, BlackRock Investments, LLC (the “Distributor”), an affiliate of BFA. A creation transaction, which is subject to acceptance by the Distributor and the Fund, generally takes place when an Authorized Participant deposits into the Fund a designated portfolio of securities (including any portion of such securities for which cash may be substituted) and a specified amount of cash approximating the holdings of the Fund in exchange for a specified number of Creation Units.

And down a bit further (emphasis in all cases mine):

Only an Authorized Participant may create or redeem Creation Units with the Fund. Authorized Participants may create or redeem Creation Units for their own accounts or for customers, including, without limitation, affiliates of the Fund.

Did you catch that last bit? The creator of ETF shares – only in blocks, off the secondary market (which means not in the stock market) – may create units for itself, for its customers, or even for the Fund wanting ETF shares (here, Blackrock).

And the shares are not created at the best national bid to buy or offer to sell but at NAV – Net Asset Value.

Translating to English: ETF shares are created between two cloistered parties with no competition, off the market, in blocks, at a set price – and then sold to somebody else who will have to compete with others and can only trade at the best national price, which continually changes in the stock market, where no one gets preference and prices are incredibly unstable.

It’s a monopoly.

Two questions:  Why do regulators think this is okay? The SEC issued exemptive orders to the 1940 Investment Company Act (can the SEC override Congress?) permitting it.

We wrote about the enormous size of ETF creations and redemptions. Which leads to Question #2: Why wouldn’t this process become an end unto itself, displacing fundamental investment?

The Actionable Hoax

What’s actionable?

It’s a buzzword of business and the investor-relations profession. And, yes, my title violates a rule of grammar because you can’t tell if the topic is a hoax about actionability or if a hoax out there has proved actionable.

We’ll answer using the market. Like this: Trade-war threats are wrecking markets!  Right?

Wrong.  Pundits tying moves in the market to headlines don’t understand market structure. Suppose you’re getting “actionable” information from pundits who don’t know how the market works. Are the recommended actions reliable?

While you ponder that, consider this: If trade concerns for tech stocks caused the correction in February, why did the Nasdaq hit an all-time high June 20? Did the same money that rejected the market back then on trade fears three months later without resolution to those concerns pay more?

You can say, “No, they were sellers.” Okay, so who bought?

Market experts are often offering actionable intelligence based on outdated ideas. But they have a duty to understand how the market works and what the money is doing.

In fact, these two pillars – how the market works, what the money is doing – should be the bedrock for understanding markets.

What’s the money doing?  It’s not choosing to be directed by rational thought. We know  because a vast sea of data on fund flows tells us so. If we as investors or investor-relations practitioners continue doing what we did before fund flows surged to passive money, who is the bigger fool?

Exchange Traded Funds (ETFs) are driving 50% of market volume now. They are passive vehicles. But they uniquely among investment products permit ETF creators like Blackrock and Vanguard a step-up in tax basis through creation and redemption.

How? Say NFLX is up 100% in three months, imputing tax costs to ETF shares. Creators of ETFs collateralized by NFLX shares will put it in redemption baskets exchanged to brokers for returned ETF shares.  (NOTE: If you don’t know how ETFs work, ask us for our ETF whitepaper.)  NFLX then plunges as brokers sell and short it.

Five days later, the ETF creator can bring NFLX back now in a creation basket of new ETF shares that it will issue only in exchange for NFLX – laundered of tax consequences.

Apply this to the Technology sector (or the whole market for that matter).  We just had Russell index rebalances, and Technology is a big part of market cap.  S&P indices rebalanced June 22 and Technology is over 25% of the S&P 500 now.

This week is quarter-end window-dressing. ETFs are trying to bleed taxes off runups in Tech stocks.  We could see it coming in Sentiment by June 14, when it topped, signaling downside, and when behavioral volatility indicated big price-swings. Data say we have another rough day coming this week.

Headlines may help prioritize what gets tax-washed, so to speak, but the motivation is not investment. It’s aiming at picking gains and packing off tax consequences.

The market is driven far more by these factors than rational thought, which we know by studying the data. ETF creations and redemptions are hundreds of billions of dollars monthly. Inflows and outflows from buy-and-hold funds are nonexistent by comparison.

Ergo, it can’t be rational thought driving the market no matter the talking heads declaiming trade threats.

It’s what lawyers call a “fact pattern.” ETFs dominate passive investment, drive 50% of market volume, depend on tax efficiency, which process is an arbitrage trade that involves a continual shift of hundreds of billions monthly in underlying assets, and a corresponding continual shift in collateralizing assets called stocks – with market-makers profiting, and ETF creators profiting – without regard to market direction.

It’s poor fodder for a 24-hour news cycle. But it explains market behavior. Moves have become more pronounced because money stopped pouring into US equities via ETFs this year. Volatility exploded because getting tax efficiency got harder.

Which brings us to the “actionable” hoax. The word “actionable” says consumers of products or services are fixated on a prompt, a push, an imprimatur.

Fine. But flinging the word around causes investors and IR professionals to miss what matters more, and first.  Investors and public companies should be asking: “How does this service or that tool help me understand what the money behind stocks is doing?”

Ask your service provider to explain how your stock trades. Then ask us to explain it.

If they don’t match, ask why. The beginning point of correct action is an understanding of what you can and cannot control, and how the environment in which you operate works.

Take the weather. We can’t control it. But it determines the viability of our actions. The same applies to understanding market structure. It determines the viability of actions.

If you want to learn market structure, ask us how, IR professionals and investors.  It’s the starting point. What you think is actionable may be a hoax. Compare how the market works to what you’re doing. Do they match? If not, change your actions. We’ll help you.

Big Pillow Fight

I hope you enjoyed summer vacation from the Market Structure Map!

We skipped last week while immersed in NIRI National, the investor-relations profession’s annual bash, this year at the Wynn in Las Vegas, where at the ModernIR booth these passersby in feathers joined us for a photo (and Sammy Davis, Jr., whom I’d mistakenly thought had expired some time ago).

Speaking of feathers, a “big league” (bigly?) pillow fight has erupted over the SEC’s proposed Access Fee Pilot Program – we’ll explain – and the exchanges are stuffing the digital airwaves with nasal-clogging goose down over it.  How to blow the air clear?

Before we answer, you may be thinking, “Tim, didn’t you write about this June 6?” Yes. But I’ve had relentless questions about what the exchanges are saying.

The IR industry’s biggest annual event last week had nothing on market structure. Never has there been a session at NIRI National called “How Stocks Trade Under Reg NMS.”  You can earn an Investor Relations Charter designation, our version of the CFA, without knowing how stocks trade, because the body of knowledge omits market structure.

As one IR officer said to me, “It’s become acceptable today to not know how our stock trades, and that ought not be.”

No wonder our profession has officially taken a neutral position on something the listing stock exchanges generally oppose, and investors support – this latter lot the audience for IR, and ostensibly the buyers and sellers exchanges are knotting in matrimony.

Do you see?  We’re told the stock market matches investors with investments. Yet exchanges and investors have opposing views, and public companies, the investments of the market, are neutral. What could be more bizarre?

Well, okay. There are beings walking the hallways of casinos on the strip more bizarre than that. But follow me here.

As we explained last week, this trading study is intended to assess how fees and incentives affect the way stock-prices are set and how trades are circulated around the data network that our stock market has become today.

In 2004, when the current market structure was still being debated, the NYSE’s then CEO said trading incentives should be prohibited. The Nasdaq thought requiring a national best price would lead to “flickering quotes” and “quote shredding,” terms that describe unstable prices resulting purely from effort to set the price.

Step forward.  The exchanges are paying some $3 billion of combined (that includes amounts from CBOE, operator of four erstwhile BATS equity markets) incentives aimed at setting prices, and we have flickering and shredded quotes all over the market as evidenced by the SEC’s own data (Midas) on ratios of quotes to trades.

And both exchanges want these conditions to persist because both make money selling data – which is the byproduct of a whole bunch of prices.

This is the key point: Exchanges pay traders to set prices. Picture a table with marbles on it.  Exchanges are positioned at the corners. Consider incentives called trading rebates a weight that exchanges can lean on the corners to cause marbles to roll toward them.  The more rolling marbles, the more data revenue they capture.  So you see why exchanges want those payments to continue – and why they are pressing issuers hard for support.

Investors are the marbles. The incentives cause marbles to roll AWAY from each other, the opposite of what investors want. They want orders with big size and stable prices, a big marble pool.

The problem for issuers is that prices are set to create data revenues, not to match investors.  The culprit is a market that behaves like a flat table with marbles on it, when a market ought to encourage the formation of a big pool of marbles.

That the SEC wants to examine an aspect of this structure is itself encouraging, however.

Regulation National Market System, the Consolidated Tape Association Plan, and exchange order types coalesce to create the market we have now. We understand them.  Do your trusted sources of market information explain these things to you?  You cannot interpret the market without first understanding the rules that govern its function.

I don’t blame our friends at the exchanges for clinging to current structure. They have their own revenue streams in mind. Human beings are self-interested, the cornerstone of international relations from the beginning of time. But you should not count on unbiased information about your trading to come from trading intermediaries.

You can count on unbiased analytics from ModernIR, because we are the IR profession’s market structure experts.  If you want to see how your stock trades, ask us.

Piloting Fees

What do these pension funds below have in common?

All (over $1.3 trillion of assets), according to Pensions & Investments, periodical for retirement plans, endorse the SEC’s Fee Pilot program on stock-trading in US equities.

The California State Teachers’ Retirement System
The California Public Employees Retirement System (CalPERS)
The Ontario Teachers Pension Plan (Canada)
The New York City Retirement Systems
The State of Wisconsin Investment Board
The Alberta Investment Management Corp. (Canada)
The Healthcare of Ontario Pension Plan (Canada)
The Alaska Permanent Fund Corp.
The Arizona State Retirement System
The San Francisco City & County Employees’ Retirement System
The Wyoming Retirement System
The San Diego City Employees’ Retirement System

In case you missed the news, we’ll explain the study in a moment. It will affect how stocks trade and could reverse what we believe are flaws in the structure of the US stock market impeding capital formation. But first, we perused comment letters from other supportive investors and found:

Capital Group (parent of American Funds) $1.7 trillion
Wellington Management, $1 trillion
State Street Global Advisors, $2.7 trillion (but State Street wants Exchange Traded Products, ETPs, its primary business, excluded)
Invesco, $970 billion
Fidelity Investments, $2.4 trillion
Vanguard, $5.1 trillion
Blackrock, $6.3 trillion (with the proviso that equal ETPs be clustered in the same test groups)
Assorted smaller investment advisors

By contrast, big exchange operators and a collection of trading intermediaries are either opposed to the study or to eliminating trading incentives called rebates.  We’ll explain “rebates” in a bit.

That the views of investors and exchanges contrast starkly speaks volumes about how the market works today.  None of us wants to pick a fight with the NYSE or the Nasdaq. They’re pillars of the capital markets where we’re friends, colleagues and fellow constituents. And to be fair, it’s not their fault. They’re trying to compete under rules created by the SEC. But once upon a time exchanges matched investors and issuers.

Let’s survey the study. The program aims to assess the impact of trading fees, costs for buying and selling shares, and rebates, or payments for buying or selling, on how trading in stocks behaves.  There’s widespread belief fees distort how stock orders are handled.

The market today is an interconnected data network of 13 stock exchanges (four and soon five by the NYSE, three from the Nasdaq, and four from CBOE, plus new entrant IEX, the only one paying no trading rebates), and 32 Alternative Trading Systems (says Finra).

The bedrock of Regulation National Market System governing this market is that all trades in any individual stock must occur at a single best price:  The National Best Bid to buy, or Offer to sell – the NBBO.  Since exchanges cannot give preference and must share prices and customers, how to attract orders to a market?  Pay traders.

All three big exchange groups pay traders to set the best Bid to buy at one platform and the best Offer to sell at another, so trades will flow to them (between the NBBO).  Then they sell feeds with this price-setting data to brokers, which must by rule buy it to prove to customers they’re giving “best execution.” High-volume traders buy it too, to inform smart order routers.  Exchanges also sell technology services to speed interaction.

It’s a huge business, this data and services segment.  Under Reg NMS, the number of public companies has fallen by 50% while the exchanges have become massive multibillion-dollar organizations.  No wonder they like the status quo.

The vast majority of letters favoring the study point to how incentive payments from exchanges that attract order flow to a market may mean investors overpay.

One example: Linda Giordano and Jeff Alexander at BabelFish Analytics are two of the smartest market structure people I know. They deal in “execution quality,” the overall cost to investors to buy and sell stocks. Read their letter. It explains how trading incentives increase costs.

Our concern is that incentives foster false prices. When exchanges pay traders not wanting to own shares to set prices, the prices do not reflect supply and demand. What’s more, the continuous changing of prices to profit on differences is arbitrage. The stock market is riven with it thanks to incentives and rules.

The more arbitrage, the harder to buy and sell for big investors. Arbitrage is the exact opposite motivation from investment. Why would we want a market full of it?

The three constituents opposing eliminating trading payments are the parties selling data, and the two principal arbitrage forces in the market:  High-frequency traders, and ETFs.

What should matter to public companies is if the stock market is a good place for the kind of money you spend your time targeting and informing. Look at the list above. We’ve written for 12 years now about how the market has evolved from a place for risk-taking capital to find innovative companies, to one best suited to fast machines with short horizons and the intermediaries selling data and services for navigating it.

Today, less than 13% of trading volume comes from money that commits for years to your investment thesis and strategy. All the rest is something else ranging from machines speculating on ticks, to passive money tracking benchmarks, to pairing tactics involving derivatives.

So public companies, if your exchange urges you for the sake of market integrity to oppose the study, ask them why $22 trillion of investment assets favor it? When will public companies and investors take back their own market? The SEC is offering that opportunity via this study.

Are there risks? Yes. The market has become utterly dependent for prices on arbitrage. But to persist with a hollow market where supply and demand are distorted because we fear the consequences of change is the coward’s path.

Liar’s Poker

We’re back! We recommend Barbados but we didn’t see Rihanna.

We also endorse floating around the Grenadines on a big catamaran turning brown and losing track of time. We had rum off the shore of Petit Tabac where Elizabeth set Captain Jack Sparrow’s rum store afire.

Meanwhile, back in reality the dollar rose and interest rates fell, and Italy slouched into confusion, and Argentina dodged a currency crisis for now, and Venezuela…well, Venezuela is like that rum fire Elizabeth set in Pirates of the Caribbean.

I at last read Liar’s Poker, Michael Lewis’s first book (and also Varina, by Charles Frazier, a lyrical novel that sighs like wind through live oaks, imagining life in the eyes of Mrs. Jefferson Davis).

With the boat and the sea taking us far from cell towers, we hit the power buttons and blinked out and I with cold Carib at hand, the beer of the Caribbean, sailed through Mr. Lewis’s time at Salomon Brothers in the bond frenzy of the 1980s.

Mr. Lewis explains how a Federal Reserve decision in Oct 1979 by then chairman Paul Volcker to fix the supply of money and float interest rates stuffed the turkey for Salomon. Overnight, bonds moved from conservative investments held to produce income, to speculative instruments driven by bets on big swings in prices.

For Salomon, the money was in toll-taking. They bought bonds from those selling at incorrect prices and sold them to others willing to buy at incorrect prices. They kept a middleman’s sliver. Do it enough and you’re rich. If you’ve not read the book, do so. There’s verisimilitude for today’s stock market.

The Fed abandoned floating interest rates in 1982, reverting to influencing the Fed Funds rate as it still does today (setting interest rates and flexing the money supply). But speculation on price-changes is now rampant, having spread into everything from currencies to equities.

It matters because anytime supply and demand are not the principal price-setters, a market cannot be depended on to offer reliable fundamental signals. The US stock market thanks to Exchange Traded Funds now may be the most arbitraged in human history.

You might be thinking, Tim, did time on the boat not dump your ETF cache? Also, why do I care?

I return to the ETF theme because investors and public companies continue to assign the market disproportionately fundamental interpretations. You should care because Salomon is gone, swept away on the tides of history because it didn’t keep up. Are we keeping up?

The motivation behind the two parties to every ETF creation and redemption – and neither one of them is you – is capturing a price-spread.  It’s not investment.  Yes, you as an investor may buy ETFs as an investment. But the parties creating and redeeming them are doing so to make money on how prices change.

That’s arbitrage. And what determines the value of investments isn’t who holds them but who buys or sells them (this is the flaw in thinking your stock reflects value assigned by buy-and-hold investors).

In a way, it’s what Mr. Lewis describes in Liar’s Poker, where Salomon merchandised the market’s ignorance about what priced bonds.

How many people understand that ETFs are not managing the money they spent buying ETF shares? ETFs have everyone believing they’re buying a pooled investment when it’s not. Whose fault is it?  Don’t we all bear a responsibility to understand what we’re buying, or what’s affecting the value of our traded shares, companies?

ETFs are the dominant stock financial vehicle of this very long bull market. What matters to those behind trillions of dollars of ETF share-creations and redemptions isn’t the objective of the ETF – but how the prices of ETFs change versus the underlying assets used to collateralize their creation.

Thus a fundamental tremor like trouble in Italy becomes volcanic, spewing molten lava all over stocks. The true driver is arbitrage. Bets. Liar’s Poker. Let’s not be fooled again.

BEST OF: Green and Purple

EDITORIAL NOTE:  We are on a big catamaran with Painkillers in hand watching the sun dissolve into an aqua Grenadine sea. So while we all float on, here’s Part Two of our return to the past to learn today’s lessons. The piece below originally ran Mar 7, 2018. If we’re going to understand today’s market, we must wrap our minds around the vastness of the ETF Effect:  

I can’t find a team (men’s or women’s) headed to March Madness, the annual collegiate sports fete in the USA, wearing green and purple. But the market’s awash in them.

Don’t you mean red and green, Tim?  Buy and selling?

No, green and purple.  See this image?  Green and purple are Passive Investment and Risk Management, a combination revealing how arbitrage in Exchange Traded Funds (ETFs) is taking over the stock market.

In the first circle, green and purple coincide with short covering (lower bar graph) and a surge in price.  In the second, green and purple again, shorting up, price falls.  It’s an anonymous stock exemplar but we see these patterns everywhere.

Monday, a friend sent me a note: “First thing I heard today when I got in the car to go to work and turned on the news is ‘Dow is down on fears of Trump tariff.’  Now I see the market is up 400 points. Should it say: ‘Markets up on Trump tariff?’”

Some pundits, coughing in advance, said it was reduced fears of tariffs on Canada and Mexico. It may be the green and purple gang and not rational thought at all.

I’ve written before about the “arbitrage mechanism” for ETFs.  Google “ETF arbitrage mechanism.” It’s presented as a good thing – the way ETFs can closely track an index.

Yet apart from ETFs, regulators, congresspersons, pundits, investors, all rail at “the arbitragers” for distorting prices and manipulating markets.  Isn’t it cognitively dissonant to say it’s good for ETFs but bad elsewhere?

If we don’t know what’s pricing the market because a pervasive “arbitrage mechanism” – green and purple going long and short – trumps Trump tariffs or any other fundamental consideration, the market cannot serve as a reliable barometer for corporate effort or economic activity.  I’m surprised it’s not troubling to more.

For every trade executed in the stock market in December, 19 were cancelled before matching according to Midas data from the SEC.  Of those that completed, 30% were odd lots – less than 100 shares (no wonder average trade size is about 180 shares).

Trade-cancellations in ETFs run about four times higher than in stocks, near 80-to-1, Midas shows. If trading motivation is changing the price, cancellations will run high.  Investors don’t do it. Profiting on price-differences is arbitrage. Only 5% of US stock orders execute, suggesting a lot of arbitrage. It’s rampant in ETFs. Green and purple.

Here’s what I think. Brokers trade collateral like stocks and cash at a fixed, net-asset-value to ETF sponsors tax-free for ETF shares. They cover borrowed stock-shares, bet long in futures and options on the indexes and components and sell ETF shares to investors.

When the group or index or sector or market-measure has appreciated to the point the ETF sponsor will incur taxes on low-basis stocks in the collateral the brokers provided, the brokers short those stocks and the options and futures and buy the ETF shares and return them to receive the collateral back in exchange.

Headlines may create entries and exits. This process repeats relentlessly, prompting investors and pundits and companies to draw widespread false correlations between market behavior and fundamental or economic factors.

It’s a genius way for brokers, traders and fund sponsors to make money. One could say we all benefit by extension. To a point, yes. So long as more money comes into the market than leaves it, stocks rise.

Volatility mounts on over-correction, where the arbitragers cover at the wrong time, short at the wrong time or exchange collateral for ETF shares in ill-timed ways, leaving puzzled people watching the tape.

Upon reflection, I guess it’s a good thing no team is wearing green and purple. The rest of us would do well to get as good at pattern-recognition as we are at PE ratios, because the patterns are setting prices. Watch the green and purple.

Best Of: The Housing ETF

Editorial note:  We looked at market Sentiment topping into this week’s options expirations cycle and said to ourselves, “Selves, we should be cheeseburgers in paradise instead of hanging around here waiting for the market to fall!”  So we are somewhere on Barbados, not searching for Rihanna but chasing tranquility. You all are in charge. We’ll catch you up May 30!  But this below to me is the most important thing to know at the moment in the stock market:  How ETFs work. 

 

Recent market volatility is, we’re told, investors one day saying “let’s sell everything because of tariffs and a trade war” and two days later “let’s buy in epic fashion because the USA is negotiating with China.”

That conforms market behavior to a fundamental explanation but omits the elephant: Exchange Traded Funds. They are 50% of market volume. They’re no side show.

Today you’ll see the way wild swings trace to how ETFs work, by creating an ETF that lets people trade houses. Sound fun?

Let’s name our ETF company after a color and something from nature. How about WhiteTree? WhiteTree is in Denver. We make Big Broker Inc., our Authorized Participant (AP) responsible for creating ETF shares, and we advertise: “Want to own residential real estate but trade it like stocks? Buy PADS!”

There’s demand (Editorial note: ETFs like STWD offer this exposure) and we tell our AP, Big Broker Inc., to provide a “Creation Basket” of titles to Denver homes as collateral, and in exchange BBI can create ETF shares to sell to the public.

We get deeds to real estate tax free. Cool! Why? It’s an “in-kind” exchange under IRS rules and SEC exemptive orders. One thing of equal value is exchanged for another. No fund turnover, no commissions (and we can charge BBI to boot!).

We don’t manage any money, just the collateral, the houses.  Demand is great for PADS and analysts say, “It’s a boom in residential real estate.”  We need more PADS to sell.

So we ask BBI for more collateral and BBI says, “We’re out of Denver homes. Will you take some in Minot, ND?” Sure. It’s collateral. More PADS shares, investor demand is strong, and The Housing Index, the benchmark PADS is tracking, rises.

We can’t keep up with PADS demand. We tell BBI the Creation Basket will take any housing deeds they’ve got. “We’re out,” BBI says. “How about a check for the amount of a house in Minot?”

Done! More ETF shares created. The media says WhiteTree is managing billions of investments in housing. No, we manage collateral. And we’re now writing futures on The Housing Index to boost reported ETF returns.

Home prices in Minot, ND soar. Pundits are saying, “Minot is an economic model for the nation. Everybody wants to live in Minot!”

But at WhiteTree, we’ve got a problem. Home values nationwide are rising and those capital gains taxes will be imputed to PADS shares, hurting our performance versus the benchmark. We need to get rid of capital gains, something ETF Redemption permits.

So we survey the collateral and Minot deeds have risen most.  We offer a Redemption Basket to BBI: PADS shares for equal value in Minot deeds (or a cash substitute).

BBI shorts The Housing Index, borrows PADS shares from another broker, gives them to WhiteTree, which delivers Minot deeds, and BBI dumps them.

Real Estate in Minot implodes.  Pundits are saying, “The economy turned. Nobody wants to live in Minot!”

This is precisely how ETFs work. Replace housing with stocks. It’s how they expand beyond the asset base and become an engine for the asset class.

Take the last two weeks. Bad times for Facebook (FB). The Tech Sector is over 25% of the S&P 500, and FB is the third largest Tech holding. It WAS the Redemption Basket, with brokers trading S&P 500 ETFs like SPY and IVV for FB and shorting FB and buying puts on Tech and FB. The market imploded.

But now ETF funds have removed capital gains via the Redemption process and instead with the Mar 31 quarter-end looming they need to true up tracking versus benchmarks.

On Monday Mar 26, the Creation Basket was full of stocks that had declined, capital gains wrung out. Brokers bought calls, bought futures on indexes, and the market before the open was set to rise over 300 points on the Dow.  It gained about 700 points.

But the REASON is arbitrage opportunity between COLLATERAL for ETFs, and trading the components, and ETF shares, and options and futures on indexes. Do you see?

Yesterday, nobody showed up to buy the new ETF shares. Investors are skittish. Thus as Tuesday wore on, brokers were worried that the ETF shares they had collateralized could lose value along with the collateral they had supplied to create them. Big trouble!  The market rolled over as they began selling and shorting Tech again to raise cash.

While we have theorized with PADS, what I’ve described about stocks is what we saw in the analytics we invented to track Passive Investment. Everything in the theoretical PADS scenario describes what I’ve read in ETF regulatory documents.

ETFs are like a currency backed by gold. After awhile there’s no more gold and you start backing the currency with something else – or nothing, as is the case today.  The creation of money drives up prices, the rise of which is misconstrued to be economic growth.

ETFs are not rights to stocks via pooled investments. They are substitutes you buy from brokers. As WhiteTree manages no ETF money, so it is with the big ETF sponsors.

The good thing about ETFs is they allow more money access to a finite asset class. But that’s the bad news too. Overextension of assets inevitably leads to bubbles which leads to popping bubbles.

Volatility since February has roiled the value of ETF collateral. Managing collateral exposure is wholly different than investing, and why inexplicable behavior is becoming more common in stocks.  You can see with PADS how complicated resolving this tangle might prove to be.  It’s the age-old lesson about derivatives.

Westworld

The smash HBO series Westworld is a lot like the stock market: It has the appearance of reality but is populated by machines (which are trying to take over in both places).

What the market lacks in gratuitous nudity it more than compensates for with a veneer that far exceeds what the Westworld operators call “the narrative.”  Most think the market’s narrative is headlines and fundamentals.  Examine what the money is doing, the rules of the market, the way exchanges match trades today, and it’s the opposite.

Fundamentals are the sideshow. The sellside has imploded. Blackrock, Vanguard and State Street cut costs by cutting them out. Index and exchange-traded funds (ETFs), dominating investment the past decade, don’t follow fundamentals.  We just hired a person from Janus because stock-picking is like the androids in Westworld: subject to repeated obliteration.

JP Morgan and Goldman Sachs both have said publicly that 10% of their trading volumes now are active investment. Sellside analysts in droves are trying to get investor-relations jobs. Why then is IR spending 85% of its effort on the buyside and sellside?

And the earnings-versus-expectations model is misdirection. It’s not for buy-and-hold investors. It’s for arbitragers. It’s an opportunity to bet. Investors don’t change their minds that way.

What’s exploded is the use of derivatives. The same handful of banks from Goldman Sachs to UBS that perpetuate earnings vs. expectations execute 90% of customer equity orders and handle 95% of the derivatives market.  They know the direction of equity flows so they can hedge long or short. Their best customers are hedge funds and high-speed firms profiting on price-changes.

These same big firms are ETF authorized participants, which have created and redeemed some $2 trillion of ETF shares already this year, contributing to whopping market volatility. Actual inflows to equities are 2% of that figure! It’s arbitrage.

We’ve become the hosts – as the androids in Westworld are called. Unwitting contributors to a storyline. What if we suspended all our effort at outreach to the buyside and sellside…and nothing happened?

Berkshire Hathaway doesn’t hold an earnings call. Tesla’s Elon Musk went off over banal analyst questions, but questions don’t buy or sell stocks and TSLA is right where the math signaled (about $301), up on – you guessed it – ETF creations, arbitrage.

You don’t want to hear this? Do you prefer to live in Westworld, hosts for a narrative not of your design? Don’t do that.  IR is the chief intelligence function. You’re supposed to know what’s going on.  We rarely stress it here, but I’m saying it today. Market Structure Analytics, which we invented, can tell you everything you need to escape Westworld:

-What’s setting your price every day

-The demographic composition of your volume by behavior

-The trends of behavioral change

-When Active money buys or sells, and if it’s growth, GARP or value

-If your investors are engaged

-The risk from directional bets and whether they’re long or short

-The presence of deal arbitrage, Activism and short attacks (and likely success)

-Borrowing trends in your shares

-How passive investment affects stock performance

-Visual indications of short-term market cycles including how ETFs work

-Key trends and drivers

-Key metrics for knowing if your equity is healthy or not

-Forecasted prices (with 95% accuracy five days out)

-Earnings expectation models

-Predictive Sentiment for Overbought and Oversold conditions

-Why your shares behave differently than peers or the market

You might say, “So?”

Public companies have a fiduciary responsibility to act in the best interest of shareholders, which includes understanding how the market is using those shares.  If IR was a business division, we’d expect nothing less than a full SWOT disposition. IR is the equity product manager – arguably as vital as any business division. You need data.

Analytics should first enable you to see important trends and drivers – in consumer behavior, in a business, in your equity.  That’s the starting point for actions. IR has fallen into a rut of saying it wants actionability – but without first understanding equity drivers.

Public companies have over the past 20 years let intermediaries make rules that work well for intermediaries like exchanges selling data and technology services but poorly for ourselves and long-term money. The problem is IR behaves still like it’s 20 years ago.

We remedy that deficiency.  If you want to see how, give us 15-30 minutes by web meeting to show you why Market Structure Analytics should be considered a vital part of being public today (and you investors, we’ll soon have a solution for you too!).

The Matrix

FactSet says quarterly earnings are up 23% from a year ago. Why have stocks declined?

There’s an inclination to grasp at fundamental explanations. Yet stock pickers generally don’t reactively sell because most times they must be fully invested (meaning to sell, they must buy).

Blackrock, Vanguard and State Street claim for Exchange-Traded Funds tracking the S&P 500 or Russell 1000 that turnover is 3-5%. (Editorial note: Those figures exclude creations and redemptions of ETF shares totaling trillions annually – a story we’ve told exclusively in the Market Structure Map.)

If investors are not responsible, who or what is?  Machines. By market rule all trades wanting to set the best bid to buy or offer to sell are automated – running on an algorithm. Why? Because the best price can be anyplace at anytime in the market system, and trades must move fluidly to it.

Thus, machines have become hugely influential in determining how prices are calculated. An amalgam of broker algorithms, smart routers and exchange order types are continually calculating the probability of higher or lower prices and completing a trade.

By our measures, back on Apr 19 the probability of calculating higher prices dropped. Why? Perhaps risk calculations for asset managers ordered rotation from overweighted equities or a need to slough off capital gains from ETFs (stuff mathematical models routinely do).

We have a mathematical representation for it: The market was Overbought. It doesn’t mean people are overpaying for fundamentals. It says machines will lack data to arrive at higher prices.  What follows this condition is nearly always a flat or lower market.

We know then that math arising from market rules is more powerful than a 23% increase in earnings. That should disturb stock pickers and public companies. If the market is The Matrix (if you’re younger than the movie, watch it to understand the reference), what are we all doing straining so hard to be outliers?

And why do machines possess the capacity to trump value-creation?

Good question.

By the way, the math is now changing. It’s resolving toward a mean.  We measure these price-setting propensities with a 10-point scale, the ModernIR Behavioral Index. Most of the time the stock market trades between 4.0 and 6.0, mean-reverting to 5.0 or thereabouts.

It returns to the middle because rules propel it there. Stocks must trade between the best bid or offer. What lies there? The average price. What do indexes and ETFs hew to? Averages.  We’ve explained this before.

When the market slops beyond 6.0, a mean-reversion is coming.  When it drops below 4.0, it signals upward mean-reversion. The market has descended from about 6.5 a week ago to 5.2 yesterday. The market will soon level off or rise as it did microcosmically yesterday, a day of extremes that ended back near midway (but it’s not down to 4.0, notice).

If math is a more reliable indicator of the future than earnings, why is everybody fixated on earnings versus expectations? What if that model is obsolete? And is that a bad thing?

I don’t think so. The earnings-versus-expectations convention promotes arbitrage. Shouldn’t capital-formation power the market?