Yearly Archives: 2018

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?

Substitutes

Substitutes were responsible for yesterday’s market selloff.

Remember back in school when you had substitute teachers? They were standing in for the real deal, no offense to substitutes.  But did you maybe take them a little less seriously than the home room teacher?

The market is saturated with substitutes. The difference between stocks and the home room back in grammar school is nobody knows the difference.

If shares are borrowed they look the same to the market as shares that are not borrowed.  If you use a credit card, the money is the same to the merchant from whom you just bought dinner or a summer outfit. But it’s a substitute for cash you may or may not have (a key statistic on consumption trends).

Apply to borrowed stock. The average Russell 1000 stock trades $235 million of stock daily, and in the past 50 trading days 46%, or $108 million, came from borrowed shares. The Russell 1000 represents over 90% of market capitalization and volume. Almost half of it is a substitute.

Why does it matter?  Suppose half the fans in the stands at an athletic event were proxies, cardboard cutouts that bought an option to attend a game but were there only in the form of a Fathead, a simulacrum.

The stadium would appear to be full but think of the distortions in player salaries, costs of advertisement, ticket prices.  If all the stand-ins vanished and we saw the bleachers were half-empty, what effect would it have on market behavior?

Shorting is the biggest substitute in the stock market but hardly the only one.  Options – rights to buy shares – are substitutes. When you buy call options you pay a fee for the right to become future demand for shares of stock.  Your demand becomes part of the audience, part of the way the market is priced.

But your demand is a Fathead, a representation that may not take on greater dimension. Picture this:  Suppose you were able to buy a chit – a coupon – that would increase in value if kitchen remodels were on the rise.

Your Kitchen Chit would appreciate if people were buying stoves, fridges, countertops, custom cabinets.  Now imagine that so many people wanted to invest in the growth of kitchen remodels that Kitchen Chits were created in exchange for other things, such as cash or stocks.

What’s the problem here?  People believe Kitchen Chits reflect growth in kitchen remodels. If they’re backed instead by something else, there’s distortion.  And buying and selling Kitchen Chits becomes an end unto itself as investors lose sight of what’s real and focus on the substitute.

It happens with stocks. Every month options expire that reflect substitutes. This kitchen-chit business is so big that by our measures it was over 19% of market volume in the Russell 1000 the past five days during April options-expirations.

It distorts the market.  Take CAT.  Caterpillar had big earnings. The stock was way up pre-market, the whole market too, trading up on futures – SUBSTITUTES – 150 points as measured by the Dow Jones Industrial Average.

But yesterday was Counterparty Tuesday, the day each month when those underwriting substitutes like options, futures, swaps, balance their books.  Suppose they had CAT shares to back new options on CAT, and they bid up rights in the premarket in anticipation of strong demand.

The market opened and nobody showed up at the cash register. All the parties expecting to square books in CAT by selling future rights to shares at a profit instead cut prices on substitutes and then dumped what real product they had.  CAT plunged.

Extrapolate across stocks. It’s the problem with a market stuffed full of substitutes. Yesterday the substitutes didn’t show up to teach the class. The market discovered on a single day that when substitutes are backed out, there’s not nearly so much real demand as substitutes imply.

Substitution distorts realistic expectations about risk and reward. It’s too late to change the calculus. The next best thing is measuring substitutes so as not to confuse the fans of stocks with the Fatheads.

Big Movers

You can’t expect the stock market to reflect earnings. I’ll explain.

By week’s end, 20% of the S&P 500 will have reported, and earnings are up 17% over the same period last year so far (normalized to about 7% sans federal corporate tax reform legislation).

Yardeni Research, Inc. reports that price-to-earnings ratios in various categories of the market are not misaligned with history.  The S&P 500 trades just over 16 times forward expected earnings, about where it did in 2015, and in 2007 before the financial crisis, and well below levels before Sep 11, 2001.

Sure, by some measures valuations are extreme. Viewed via normative metrics, however, the market is as it’s been. From 1982-2000, PE ratios were generally rising.  From there to 2012, they were generally falling. Yet between we had multiple major market corrections.

Which returns us to my incendiary opening assertion that earnings today don’t drive stocks. What does? The money setting prices. Let me explain.

Buy-and-hold money tends to buy, and hold. Most conventional “long” equity funds must be fully invested, which means to buy something they must sell something else.  Buying and selling introduces tax, trading-commission, and volatility costs, which can cause stock-picking investors to underperform broad indexes.

The Investment Company Institute reported that 2016 turnover rates among equity funds averaged 34%, or about a third of positions annually. Passive index and exchange-traded funds tout low turnover. State Street, sponsor for the world’s largest ETF, SPY, claimed 2017 turnover was 3%.

We’ll come to the fallacy of low turnover in ETFs.

First, Big Reason #1 for the movement of stocks is arbitrage. Follow the money. Using our proprietary statistical measures of behavior in stock trades, nearly 46% of market volume (20-day ave.) in the Russell 1000 (which is over 90% of market cap) came from high-speed traders.

They are not investors. These machines trade tick data in baskets, aiming most times to own nothing at day’s end. The objective is to profit on intraday price-moves.  For instance, 52% of Facebook’s daily trading volume is high-speed machines. Less then 9% is Active investment by stock-pickers.

Viewed another way, there’s a 46% chance that the price of stocks reflects machines trading the tick. Since less than 12% of Russell 1000 volume was fundamental, there is but a one-in-eight chance that earnings set prices. High-speed trading is arbitrage – profiting on price-differences.

Don’t fundamentals price the market long-term? Again, that would be true if the majority of the money setting prices in the market was motivated by fundamentals. That hasn’t been true this century.

How about fund flows?  Assembling data from EPFR, Lipper and others and accounting for big outflows in February, about $40 billion has come into US stocks this year.

Using Investment Company Institute data and estimates for Mar and Apr this year, ETFs have by comparison created and redeemed some $1.5 TRILLION of shares. Fund flows are less than 3% of that figure.

These “in-kind” exchanges between ETF creators and big brokers that form the machinery of the ETF market are excluded from portfolio turnover. If they were counted, turnover rates in ETFs would dwarf those for conventional funds. And the objective behind creations and redemptions is not investment.

ETF creators make money by charging brokers fees for these transactions (which are tax-free to them) and investing the collateral. Brokers then trade ETFs and components and indexes to profit on the creations (new ETF shares sold to investors) and redemptions (returning ETF shares to ETF creators in exchange for collateral to sell and short).

Neither of these parties is trying to produce an investment return per se. They are profiting on how prices change – which is arbitrage (and if ETF creations are greater than redemptions, they permit more money to chase the same goods, lifting markets).

Summarizing: The biggest sources of movement of money and prices are machines trading the tick, and ETF creators and brokers shuttling tax-free collateral and shares back and forth by the hundreds of billions. If pundits describe the market in fundamental terms, they are not doing the math or following the money.

And when the market surges or plunges, it’s statistically probable that imbalances in these two behaviors are responsible.

Ticking Down

In 2016 to much fanfare, the SEC and the stock exchanges smashed a bottle of champagne on the looming bow of a tick-size study and launched that battleship into the markets.  Two years later the tick study is limping into port in a lifeboat.

For those of you thinking what the heck is a tick-size study, the US stock market is top-heavy.  The weighted average market capitalization of the Wilshire 5000 Total Market Index is $165 billion, yet the median is $1.1 billion.  The market is skewed massively large.  We mentioned these data in our 2014 comment letter on the SEC’s tick study.

Over 90% of the Wilshire 5000’s market cap is concentrated in less than 750 companies – with the bulk of trading volume, inclusion in indexes, Exchange Traded Funds. Seen another way, the Russell 1000 is about 92% of market cap, the Russell 2000, 8%.

The SEC looked across the sea of the market and determined that small caps were marooned in forgotten eddies and byways.  How to remedy it?  Hike the spread.

Historic backdrop is needed to appreciate the irony. Today the market trades in mandated penny spreads, thanks to SEC-led decimalization of markets in 2001.  Why? Back then, many thought intermediary brokers were gouging investors by buying low and selling way too high.

By reducing spreads to a penny, computerized trading systems were able to compete with brokers. The cost to trade plunged.  Regulators cheered their own brilliance.

But sellside research imploded. Without a trading spread to fund cost centers like analysts poring over data and penning reports, the number of firms supporting small stocks with market-making operations tumbled.

The average IPO before decimalization had 66 underwriters, which wrote research on the many thousands of traded stocks. Today’s IPOs have on average six underwriters. Of the 3,500 individual companies comprising the Wilshire 5000 Index, about 2,500 have little or no analyst coverage, and wan trading.

Regulators thought, “Maybe we should widen the spreads?”

When you’re through laughing, I’ll resume the story.

So in 2014, the SEC directed exchanges to run a study grouping stocks – comprising virtually all small caps by our count – in control and variable buckets to see if lifting the spread from one penny to more, such as five cents, would lead to more market-making.  It took two years to hash out details, and the study commenced in October 2016.

The plug will be pulled in October now because the study has produced scant measurable change.  By my reading, market capitalization has become even more concentrated during the study, and the number of public companies continues to shrink.

If wider spreads worked before, why didn’t they work this time?  Four words: Regulation National Market System. Before decimalization, stock markets were not connected to each other electronically and forced to share prices and customers and trade at a single best national price – across all platforms – called the National Best Bid or Offer.

Reg NMS gave us that market. Hike the spread from one penny to five where all trading is still electronic, markets interconnected around the BBO, all you’ve done is widen the step into the same building, and the same behaviors that run up and down the steps – high-speed machines – still set the price.

Nothing has been done to change the economics of brokerage, which still won’t support research.  Plus, rules, not economics, determine spreads.

Suppose you were in the banana business, and you flew back and forth from Belize buying bananas and selling them here. Then the government said you could only make a penny per banana. You cannot predict from time to time if a penny spread on bananas will work for you. And nearer banana growers would put you right out of business.

That is exactly what happened to small caps. They’ve been ticked down to uneconomical. You can’t expect to succeed now as a new public company in US markets unless you land among the thousand largest. The cutoff? About $2.5 billion.

Could we fix this problem? Of course!  But the forces wanting a thousand liquid low-spread stocks to support everybody’s index, ETF, trading, and stock-picking portfolios are powerful.  Until we realize we’ve no longer got a capital formation battleship and it’s instead adrift on a raft, we best love low ticks and big stocks.

Streaming Market

Spotify ditched convention yesterday with its direct listing on the NYSE. It didn’t raise money or ring the opening bell.  It gave shareholders a way out.  It’s a touchstone for the state of the capital markets.

CrunchBase says Spotify has raised $2.6 billion in 22 funding rounds in private markets where you don’t have to file 10-Ks and 10-Qs and fight proxy battles, meet a rising sea of disclosures from the impact of your business on the environment to how much more the CEO makes than the janitor.

No high-frequency traders. No passive investors ignoring your fundamentals but browbeating you over governance. No worrying about meeting expectations that somebody will game by spread-trading you versus the VIX.  No analyst models to tussle over.  No scripts or contentious Q&A over quarterly results. No Activists.

Spotify cut out all the banks save two to help with pricing and a bit of secondary market-making and let holders sell shares through a broker via the NYSE node on the market’s network and now they can trade anywhere.  Welcome to the new age.

It’s more proof of the decline and fall of the sellside, source of brokerage research. In the past 20 years, it’s been buffeted by a series of body blows:

-The Order Handling Rules in the late 1990s commenced a shift from valuable information to speed in trading markets.

Decimalization in 2001 gutted the intermediary margin paying for sellside analysts.

-Elliott Spitzer’s 2003 Global Settlement forcibly separated research from trading and with it went the glory era of the all-star sellside analyst and in its place came the age of trading technology.

-In 2007, Regulation National Market System transformed the stock market into a frenetic, automated blitzkrieg where competing markets are forced to share customers and prices, and market structure overtook story as price-setter, dealing another dire setback to analyst research.

-Over the ensuing decade with now prices made to trade at averages (the mandatory best-bid-and-offer model from Reg NMS imposed midpoints, averages, on the stock market), trillions of dollars dropped the sellside, shifting from information as key to beating benchmarks, to technology for tracking benchmarks, and average became better than superior.

Today Exchange Traded Funds, derivatives of underlying stock assets, drive 50% of market volume and have no connection to differentiating research. Blackrock, Vanguard and State Street have slashed active investment (and brokerage research), and most of their $13 trillion in combined assets follow models tracking benchmarks.

What’s all this got to do with Spotify?  If form follows function, Spotify is the future.  The function of the stock market isn’t capital formation anymore. That happens in private equity. Public markets are an exit strategy, where stocks go to trade. It’s what you do at the end of the beginning, so to speak, to give the first money in a way out.

Private equity is still built on vital information and differentiation, not averages. There is a vibrant and thriving capital market out there, but it’s not the stock market.

The stock market is a place to trade things. It’s what ETFs facilitate – arbitraging everything toward a mean. You don’t need banks and bells and big road trips to make things tradable. You just need a node on the network.  We’ll see more of it, I’m sure.

I wonder why we’re consuming so much time and energy on corporate disclosure if so much of the money ignores it.  ETFs offer Summary Prospectuses because nobody reads the prospectuses.  What about a Summary 10-Q? What about a slimline 10-K?

Let me be blunt: Why are public companies spending billions on disclosure if half the market volume is machines trading things? Isn’t that a waste of money?

These are questions somebody should be answering.

It should affect how we think about the skill set for investor relations in the future. Everything is data today. If you ride a bike, you’ve got data analytics. Post a job via LinkedIn? Data analytics. The IR people of tomorrow should be data analysts, not just storytellers. Quantify, track and trend the money, whether it follows the story or not.

We can’t stay back in the 1990s talking to a failing sellside. Spotify didn’t. And it’s the future, a streaming market.

The Housing ETF

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.

Three Ways

Jakob Dylan (he of Pulitzer lineage) claimed on the Red Letter Days album by the Wallflowers that there are three ways out of every box.  Warning: Listen to the song at your own risk. It will get in your head and stay there.

Something else that should get in the heads of every investor, every executive and investor-relations professional for public companies, is that there are three ways to make money in the stock market (which implies three ways to lose it too).

Most of us default to the idea that the way you make money is buying stuff that’s worth more later. Thus, when companies report results that miss by a penny and the stock plunges, everybody concludes investors are selling because expectations for profits were misplaced so the stock is worth less.

Really? Does long-term money care if you’re off a penny? Most of the time when that happens, it’s one of the other two ways to make money at work.

Take Facebook (FB) the past two days.

“It’s this Cambridge Analytica thing. People are reconsidering what it means to share information via social media.”

Maybe it is.  But that conclusion supposes investors want a Tyrion Lannister from Game of Thrones, a mutilated nose that spites the face. Why would investors who’ve risked capital since New Year’s for a 4% return mangle it in two days with a 9% loss?

You can buy stocks that rise in value.  You can short stocks that decline in value. And you can trade the spreads between things. Three ways to make money.

The biggest? We suppose buying things that rise dominates and the other two are sideshows.  But currently, 45% of all market trading volume of about $300 billion daily is borrowed. Short.  In January 2016, shorting hit 52% of trading volume, so selling things that decline in value became bigger than buying things that rise.  That’s mostly Fast Trading betting on price-change over fractions of seconds but the principle applies.

Facebook Monday as the stock plunged was 52% short. Nearly $3 billion of trading volume was making money, not losing it.  FB was 49% short on Friday the 16th before the news, and Overbought and overweight in Passive funds ahead of the Tech selloff.

The headline was a tripwire but the cause wasn’t investors that had bought appreciation.

But wait, there’s a third item. Patterns in FB showed dominating ETF market-making the past four days around quad-witching and quarterly index-rebalances. I say “market-making” loosely because it’s a euphemism for arbitrage – the third way to make money.

Buying the gaps between things is investing in volatility. Trading gaps is arbitrage, or profiting on price-differences (which is volatility).  ETFs foster arbitrage because they are a substitute for something that’s the same: a set of underlying securities.

Profiting on price-differences in the same thing is the most reliable arbitrage scheme. ETF trading is now 50% of market volume, some from big brokers, some from Fast Traders, nearly all of it arbitrage.

FB was hit by ETF redemptions.  Unlike any other investment vehicle, ETFs use an “in-kind exchange” model. Blackrock doesn’t manage your money in ETFs. It manages collateral from the broker who sold you ETF shares.

To create shares for an S&P 500 ETF like IVV, brokers gather a statistical sampling of S&P stocks worth the cost of a creation basket of 50,000 shares, which is about $12 million. That basket need be only a smattering of the S&P 500 or things substantially similar. It could be all FB shares if Blackrock permits it.

FB is widely held so its 4% rise means the collateral brokers provided is worth more than IVV shares exchanged in-kind. Blackrock could in theory make the “redemption basket” of assets that it will trade back for returned IVV shares all FB in order to eliminate the capital gains associated with FB.

So brokers short FB, buy puts on FB, buy a redemption basket of $12 million of IVV, and return it to Blackrock, receive FB shares, and sell them. And FB goes down 9%.  The key is the motivation. It’s not investment but arbitrage profit opportunity. Who benefited? Blackrock by reducing taxes, and brokers profiting on the trade. Who was harmed? Core FB holders.

This is 50% of market volume. And it’s the pattern in FB (which is not a client but we track the Russell 1000 and are building sector reports).

The next time your stock moves, think of Jakob Dylan and ask yourself which of the three ways out of the equity box might be hitting you today. It’s probably not investors (and if you want to talk about it, we’ll be at NIRI Boston Thursday).