Yearly Archives: 2018


Our good friends at Themis Trading wrote last week about a $14 million settlement between the NYSE and the SEC over a series of violations.

Why care, issuers and investors? Suppose nobody told you the road you take daily to work sat atop a growing sink hole. We’re all responsible for the market that serves us and as such we have a duty to understand it. Do you know how it works?

Credit Haim Bodek for research leading to SEC action. Had not Mr. Bodek, one of the great market-structure experts of the modern era, blown the whistle, we might not know of these problems. Follow him on Twitter: @haimbodek.

Picking up from Joe and Sal at Themis (Note: With permission.  We’ve edited some for length):

The SEC Case Against NYSE

The NYSE case involves five serious violations.  We will list them all here but we want to focus on the fifth violation since we think it is the most egregious one:

1) On July 8, 2015, NYSE and American Negligently Represented That Their Quotations Were Automated When They Were Not.  NYSE and American Negligently Marked Quotations as Automated When They Had “Reason to Believe” They Were Not Capable of Displaying Automated Quotations

2) Arca Improperly Applied Price Collars to Reopening Auctions During August 24, 2015 Market Volatility.  Arca’s failure to have an effective exchange rule regarding the application of price collars to reopening auctions violated Section 19(b)(1) of the Exchange Act.

3) On March 31, 2015, Arca Erroneously Implemented a Regulatory Halt and Failed to Publish Closing Order Imbalance Information. Although Arca intended to suspend trading only on Arca, which would allow trading of Arca-listed securities to continue on other exchanges, Arca inadvertently implemented a “regulatory halt” that stopped trading in the 134 Arca-listed securities on all exchanges.

4) NYSE and American Failed to Comply with Reg SCI’s Business Continuity and Disaster Recovery Requirements. From November 3, 2015 through November 23, 2016, NYSE and American were in violation of the requirements in Rules 1001(a)(1) and 1001(a)(2)(v) of Reg SCI that each SCI entity have policies and procedures reasonably designed to ensure operational capability.

5) NYSE and American’s Rules Failed to State That Pegging Interest Orders Created Possibility of Detection of Prices of Non-Displayed Depth Liquidity.

While we have noted many examples in the past about information leakage by the stock exchanges, this is the first time that the SEC has fined an exchange for leaking confidential client information:

– Floor brokers were permitted to enter “pegging interest” orders (PI) which allowed them to peg their order to the best NYSE quote. They could specify a range of prices for this PI order to be active. If the best NYSE quote was outside the PI range, then the PI order would price at the next level closest to the quote.

– According to the SEC, “A PI’s ability to peg to the price level of a NDRO (non-displayed reserve order) created the possibility that a floor broker, or a customer who submitted a PI through a floor broker, that sent the PI, would be able to detect the presence of same side non-displayed depth liquidity if certain circumstances were present.”

***Notice that the SEC says “a floor broker or a customer who submitted the order through a floor broker”.  This is because it is widely known that some HFT firms rent out the pipes of certain floor brokers and route orders through them to gain parity which is a benefit that floor brokers enjoy.

– PI orders could peg their price to a non-displayed NYSE order that was not part of their best bid or offer.

– The SEC explained how the initiator of the PI order could find out about hidden interest: “the submitter of the PI could potentially use identifying characteristics of its PI to locate it in the market data feed displayed at a price that did not previously have any displayed liquidity (because the NDRO was undisplayed), and if so located, conclude that there was same side non-displayed depth liquidity at that price level.”

NYSE was notified of the information leakage issue in 2013 by a client and chose to do nothing about it.  According to the SEC, “in 2013, NYSE received a complaint from a trader that the price levels of his NDROs, which were entered at prices inferior to the quote and unoccupied by any displayed liquidity, were being joined upon entry, as the trader observed in the exchange depth of book market data feed, by a displayed order.”

Apparently sensing that they had a problem, NYSE submitted a rule change in March 2015 which “modified the functionality of PIs so that they only pegged to price levels occupied by displayable interest.”  The SEC approved this rule change and didn’t appear to take any further action.

What made the SEC go back and take another look at this issue?  It looks like our old friend Haim Bodek was responsible for this with another whistle blower case. According to this press release, Haim continues to protect investors and haunt the exchanges.

Themis Concludes: The question now becomes what do we, as investors and clients of NYSE, do about this?  Should NYSE simply get away with neglecting their regulatory responsibilities?  Should they be able to pay the $14 million and just continue doing business like nothing happened? Or, should issuers and long-term investors shift their business to an exchange like IEX which seeks to protect them and not favor one class of client over another?

MODERNIR EDITORIAL NOTE:  Thanks, Joe and Sal! Issuers, you should expect honest markets free of predatory practices that distort your stock price and create risk. Two of the instances producing fines occurred in the summer of 2015 when ETFs nearly imploded. The stock market is overly dependent on intermediaries that during crises may vanish.  By then it’s too late.  We need an Issuer Advisory Committee for markets.

Green and Purple

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.


“It’s like the market has become some uncontrollable machine lurching around,” said friend Pat at the NIRI Rocky Mountain chapter meeting last week.

I spoke there about Exchange Traded Funds and how they contribute to market instability through the slow adjustment of collateral for creating ETF shares and the very rapid setting of prices for stocks and ETFs. If you want the presentation, send me a note and I’ll share it in pdf.

But first, breaking news from Steamboat Springs: Ski conditions are superb and you can snowshoe in deep champagne powder atop Rabbit Ears between the Yampa Valley and Grand County. We took in WinterWonderGrass too, mass musical ode to banjo, mandolin and upright bass. Blurring genres and maybe the event’s best was Fruition. They might be giants.

Back to Pat’s point that the market seems like a giant robot with the humans inside desperately fiddling with buttons and levers as it swings around destroying furniture, wouldn’t that suggest something awry in the mechanics of the market rather than human irrationality?

While you ponder, the blame may be going unfairly to new SEC chair Jay Powell. Whatever he said to Congress yesterday, the markets had from 8:30a ET to read the text.

Maybe he blew the Q&A. He used the word “strong.” Durable goods were terrible and he thinks the economy can absorb more rate-hikes. GDP may come in lighter still for Q4 in today’s revision.

We’re casting about for rational explanations where there may be none. What you never seem to hear is an investor saying “the reason I sold Powell’s testimony is because of” blah blah blah. What you hear are investors trying to explain why other investors are selling.

What if it’s the machines?

In a terrific interview with the New Yorker last December, Jim Simons said, “I looked at the price charts and analyzed them, and they didn’t look random to me.” Simons, a mathematician, founded hedge fund Renaissance Technologies and is today worth $20 billion.

The firm’s flagship Medallion Fund has generated 80% annually before fees for almost thirty years. It’s size-constrained because big money can’t be moved quickly, and longer-term trading makes algorithms less useful. “It’s like the weather,” says Simons. The nearer in, the higher the certainty.

So think about that. Humans and their fundamental models are trying to produce returns years in the making – which is highly uncertain. Machines focus on the moment. A high-speed trader told me they think of stocks in real time as moving from 5s to 6s, or 6s to 5s. “Buy the 5s that are becoming 6s, and short the 6s that are becoming 5s, and never take your eye off the book – the money at risk.”

I can tell you we rarely see arbitrary scatterplots in the behavioral trends we track. There’s a mathematical symmetry everywhere that defies the idea of a random walk down Wall Street.

It would make sense if the rules required machines to set—wait a minute.  The rules DO require machines to set prices.

Every “marketable” order that wants to be the best bid to buy or offer to sell must by law be on an algorithm, a machine, so it can move fluidly around the market, much faster than humans can react.

The spreads are regulated, to the penny. The bid to buy can’t be higher than the offer to sell, nor can it be the same as the offer to sell.

That’s math. Machines can be programmed to adapt to rapidly changing prices. Simons told The New Yorker he “never overrode the model.”

And maybe that’s your answer. Nobody overrode the model.

So, then? First, investors and public companies have to stop thinking rational thought is responsible for all prices, and boards and management teams better know. Both investors and companies should become better at data analysis if they’re to compete with machines.

Second, there is irreconcilable conflict between humans focused on fundamentals and machines fixated on data patterns – and the machines have the advantage because the market has been handed to them by rules.

Third, should there be different markets for the two? We’ll have opportunity to grapple with that idea when next machines drive the market somewhere it wasn’t prepared to go.

Collateral Recovery

Who remembers EF Hutton?

When EF Hutton talks, people listen.  That slogan crafted by Hutton’s William Clayton, who died in 2013, and now-defunct advertising agency Benton & Bowles, wasn’t about a man but a firm. Ads ran in the 70s and 80s where characters would shout “EF Hutton!” over a din, and all clamor would stop as people leaned in to hear.

Edward Francis Hutton died in 1962. But his firm touched history via its brand, its merger with Shearson Lehman, and its subsequent mutations through Smith Barney, Citigroup and Morgan Stanley. The name lives today, in fact, through HUTN Inc., which owns the EF Hutton moniker.

In a sense the Hutton Effect today in capital markets is Amazon. Every time Amazon speaks, the market holds its breath.  From athletic apparel, to groceries, to pharmaceuticals and healthcare, the market has stopped midsentence, transfixed. Investors realize Amazon is so leviathan (searching for a synonym for “Amazon”) that it can sway the fortunes of industries.

Another mammoth in our midst seems to go unnoticed, a sort of antonym to EF Hutton and Amazon. Exchange Traded Funds.

NOTE: I’m on a panel tomorrow for the NIRI Virtual Chapter on Passive vs Active Investing and will serve as warmup or foil Thursday Feb 22 for NIRI CEO Gary LeBranche here in Denver at the Rocky Mountain chapter, on ETFs.  We’ll talk about ETFs.

ETFs have been loud about attracting $4.8 trillion of global assets and 50% of US trading volume, but dead quiet about what they really do. Were sellers of groceries thrown in a pit with a hulking sword-swinging Amazon, the cries would be shrill. A market tossed together with this beast called ETFs offers not a whimper, let alone a silence-deafening EF Hutton listen.


I’ve come to an answer.  We know how Amazon works.  Whatever you think of the Bezosian Beast, we understand its manners.  It’s among us without guile.

But I don’t think investors and public companies get what ETFs do. They are a permeating market presence of epochal significance and yet an idea persists that their influence is invisible. It’s not true with Amazon, or ETFs.

Suppose ETFs through the use of collateral drove these recent gyrations?  There’s a swamp around the way they work. Read the prospectus – not the summary but the full document – for SPY. Tell me what you learn.  Half of it is about taxes.

But I know this: ETFs don’t invest your money. They manage collateral. Big investors gather up shares in large blocks from who knows where, because there’s no transparency, and exchange them for ETF shares.

They then sell those ETF shares at a profit. Don’t believe me? Read an ETF prospectus.  What’s this got to do with market volatility?  Suppose big investors had pledged stocks belonging to others as collateral to gain access to ETF shares expected to rise in value – and then the collateral dropped sharply in value.

They’d have to sell assets to raise money to buy ETF shares to trade back for collateral that might well belong to somebody else (never pledge the mob’s donkey on your personal horse race).

Boy would that process produce volatility if it were Amazonian in scope. And volatility was leviathan. Collateral damage.

Theorizing this way, we warned clients last week (as those of you reading know): If this is sorting out who owns what, we’ll take a hit Tue-Wed Feb 20-21.

Okay, well, that happened yesterday.  A glancing blow but it was there. If collateral is sorted out, markets zoom anew now. If not, you’ll see trouble again today.

Lesson? We can see what Amazon is doing. ETFs are another story.  We don’t know what they use for collateral. That alone should make us more watchful. ETFs don’t behave like EF Hutton stilling the noisy room.

So stay tuned. If this is a collateral recovery, confidence may be shaken. And we all need to understand the Amazon of the capital markets, ETFs.

Shaun White Market

The market’s Valentine’s Day gift is VIX expirations today. It might be no more than a flirtatious glance toward investors but there’s reason for wariness.

It kicks off the February series of expirations for derivatives today through Friday, with then a market holiday next Monday, new options and futures (and vast derivatives thus date-stamped) next Tuesday, and banks sorting out imbalances Feb 21.

It matters because leverage lately failed in epic fashion – like snowboarding the halfpipe at the Olympics and putting the toe of your board into the lip and faceplanting at high speed.

Michael Batnick of Ritholtz Wealth Management writing yesterday for Marketwatch said the market has rarely given so little warning. He says it’s the first time ever back to 1900 that the Dow closed at all-time highs and nine days later was down 10%.  It’s the largest momentum decline on record for the S&P 500.  It’s the biggest freefall we’ve seen in our Sentiment Index since launching it in 2012.

In his graphs, it’s a “Told You” theory. As in “I told you” it wasn’t over. Until it is.

There could be a crisis of confidence for everyone who buys and sells volatility, as with an Olympic athlete who suddenly fell before competing. Anyone besides Shaun White, that is, who wrecked last October and got 62 stitches for it and this week in PyeongChang laid near-perfection on the halfpipe, winning a comeback third lifetime Games gold.

We’ve seen the market get back up. In Dec 2015 after the Federal Reserve lifted rates for the first time in ten years, stocks fell apart after expirations that month. From a low in early January the market then roared toward expirations like a wounded beast in great throes, swooned to February expirations, and finally launched a burning contrail into May, pulling a Shaun White comeback.

Today marks the first expirations after low-volatility strategies crashed. This is when damage shakes out, traders signal if they’ll try again, and banks and their customers as counterparties tell us with actions if costs have risen. We’ll learn if volatility traders have some Shaun White in them.

Since this temblor started in late January, each big up day – Feb 6, 9, 12 – has brought a rash of Active buying. Contrary to my own expectations that investors might sell the rallies, investors have done the opposite. There’s a foundation of economic enthusiasm.

But it also fits with Michael Batnick’s “Told You” theory that can mean the end of market cycles. See his images in the piece above.  In our Sentiment Index we’ve added a straight line at 5.0 – mean-reversion, the chief characteristic of this post-crisis market – and a trendline.  The trend is weakening.

It says the bull market dies ahead. I said a week ago it wasn’t over. I still don’t think it is. But maybe it’s the beginning of the end, the bear a far distant dot.  The trend could run another two years before gravity pulls it into the white line and it burns like space junk.

Maybe the white line doesn’t matter. But supposing it does, we need some Shaun White from the market.

Vapor Risk

One definition of “volatile” is “passing off readily in the form of vapor.”

Through yesterday, XIV, the exchange-traded security representing a one-day swap from Credit Suisse and offered by VelocityShares, had seen 94% of its value vaporized. It triggered a technical provision in the fund’s prospectus that says Credit Suisse may redeem the backing notes if the fund loses more than 80% of its value. It’s shutting down.

By mixing exposure to futures and other derivatives of varying lengths tied to the S&P 500, XIV aims to let investors capture not the appreciation of stocks or their decline if one shorted them, but instead the difference between current and future prices. Volatility.

The fund says in sternly worded and repeating fashion things like: The ETNs are riskier than securities that have intermediate or long-term investment objectives, and may not be suitable for investors who plan to hold them for longer than one day.

The idea for investors is hitting the trifecta – long rising stocks, short falling stocks, and with things like XIV, capturing the difference between prices to boot.

The problem for “synthetic” exchange-traded notes (ETNs) like XIV backed by a Credit Suisse promissory note is they hold no assets save commitment to replicate an outcome. They are for all intents and purposes vapor.

They have proved wildly popular, with several volatility ETNs routinely in the top 25 most actively traded stocks. In a low-volatility environment, differences in prices between short-term and long-term options and futures can mean returns of 5-10% on a given day, without particular risk to either party.

But if volatility renders futures and options worthless because prices have changed too much, all the investor’s capital vanishes.

Is this what rocked stocks globally? No. There is, however, a lesson about how global financial markets work that can be drawn from the demise of XIV.  Everyone transfers risk. Investing in volatility is in a sense a hedge against being wrong in long and short positions. If you are, you still make money on the spread.

The biggest risk-transfer effort relates to currencies and interest rates. As with stocks, the transference of unexpected fluctuations through swaps – which the Bank for International Settlements says have $540 trillion of notional value (but precious little actual value, rather like XIV) – only works if the disturbances are small.

In the past month, the US Treasury was laying in dry powder before the debt ceiling. The size of auctions exploded by about 50%. Getting people to buy 50% more of the same thing caused interest rates to shoot up. The rise in debt devalued the dollar, a double whammy. Hedges fell apart.

Counterparties for these hedging swaps also transfer the risk, often with short-term Exchange-Traded-Fund (ETF) or ETN hedges that lapse on Fridays. They are the same banks like Credit Suisse making markets in stocks. This is what caused stocks to swoon, not a strong jobs number or higher wages. On Friday, Feb 2, stocks imploded. I suspect counterparties were selling assets to cover losses.

Now we come to a warning about ETFs. Their original creators, who were in the derivatives business, likened ETF shares to commodity warehouse receipts, a representation of something physically residing elsewhere.

In this long bull market, money has poured into ETFs. The supply of things in the warehouse has not kept pace with the exposure to it via ETFs.  We have written over and over about this problem. The way ETFs trade and the way underlying assets increase or decrease are two different processes.  Investors buy and sell the warehouse receipts. The fund and its Authorized Participants in large block transactions occasionally adjust underlying warehouse assets.

We can see by tracking the amount of money flowing to big ETFs from Blackrock, Vanguard and State Street and counter-checking those flows against reported fund turnover that insufficient warehouse commodities (stocks) back ETF shares.

Why? Because buying and selling things incurs transaction costs and tax consequences, which diminishes fund performance. Shaving those is a gutsy strategy – sort of like dumping fuel in a car race to give yourself an advantage in the last flaps by running light and on fumes.

But you can run out of fuel. If the value of the stuff in the warehouse plunges as everybody tries to sell, we’ll find out what part of those warehouse receipts are backed by vapor.

So far that has not happened. But we don’t know what damage has been done to market makers short ETF shares and long stocks or vice versa. The next week will be telling. If a major counterparty was irreparably harmed, we could be in a world of vapor.

If not, the hurt will fade and we’ll revert to normal. Right now, forecasts for stocks in our models say vapor risk is small. But let’s see what happens come Friday, another short-term expiration for derivatives.

Currency Volatility

 We interrupt the white-hot arc of the stock market for this public-service announcement: Watch the dollar.

While any number of factors might be selected as reason for the DJIA’s 360-point drop yesterday, one macro factor correlates well: The relative buying power of the US dollar, the world’s reserve currency.

Give me two minutes, and I’ll show you.

Sure, one can say the market is due for a pullback. But randomly? Donald Trump’s first inaugural address is an easy target. Do we call investors schizophrenic if the market regains yesterday’s losses today or tomorrow?

How the US dollar fares versus other global currencies remains a barometer for US stocks. It’s been especially true since 2008 because the Financial Crisis marked a stark turn for central banks toward coordinated global policy.

But all the way back to 1971 when the United States left the gold standard for the 20th century’s version of a cryptocurrency experiment, a floating-rate dollar, shocks to equities trace to gyrations in the currency (the economy’s risk assets like stocks and bonds have replaced gold as the backing commodity but that’s another story).

Black Monday, the October 19, 1987 global stock crash that hacked 508 points or 23% of blue-chip value off the Dow Jones Industrial Average (DJIA) followed a stretch of currency volatility (and interest-rate volatility as the two are intertwined).

For perspective, the DJIA lost a greater number of points just now, Jan 29-30 (533), than it did Oct 19, 1987 (508). Heights today are so lofty that past ravines are wrinkles.

The collapse of the Internet Bubble in 2000 came after a sharp acceleration for the dollar on rate hikes by Fed chair Alan Greenspan to slow what he famously called “irrational exuberance.” He recognized the stock market reflected inflation, which as Milton Friedman said, is always and everywhere a monetary phenomenon.

Inflation is more money than an economy can readily deploy, not rising prices, which is a consequence. Stuffing money into economies is like squeezing a balloon. You don’t know where the air pockets will form.  Prices rise, but not always how or where central bankers suppose.

On May 6, 2010, market seams split fleetingly in the Flash Crash, the DJIA first plunging down and then bucking back up about a thousand points.  Before it, volatility was rattling the euro/dollar trade, a product of 2009’s massive “quantitative easing” by the Federal Reserve as the US central bank gave the global money balloon a giant squeeze and the dollar went into a steep dive.

In latter August 2015 the DJIA lost more than 6% over a series of days following a sudden currency-devaluation in China that tripped the delicate global balance.  And remember the Fed’s first post-crisis rate hike – a buck-booster – in Dec 2015? Near catastrophe for stocks (most for energies as oil plunged when the dollar rose) in January 2016.

We come to yesterday. What came before it? Last week the dollar plummeted about 3% as traders interpreted comments by US Treasury Secretary Steven Mnuchin to mean he wanted a weaker dollar.

Sure, there’s a sort of Clockmaker God quality to the idea that if we can pan back in the mind’s eye, the financial markets are all perched atop a giant dollar bill that occasionally flutters and spills something into the abyss.

On the other hand, it could be fixed. The dollar, that is. If the dollar wasn’t always fluctuating, we could better concentrate on, say, saving more, or investing capital without worrying about the corrosive effects on returns of a depreciating currency.

So, Jay Powell.  You’ll be steering the Fed after Janet Yellen bids us adieu this week. Imagine how much easier everything would be if the dollar wasn’t one of the things gyrating like stock-prices.

Arbitrage Mechanism

Arbitrage Mechanism would be a great name for a rock band.

Of course, when bands are named for market terms – Call Option, Factor Model, Shiller PE – the bull market may be ending (let me know if your kid’s garage band is called Flash Crash).

The arbitrage mechanism we’re talking about today is the key to how the most popular investment vehicle of the modern era works. Not bitcoin.  Exchange Traded Funds (ETFs).

Arbitrage means “taking advantage of differing prices for the same asset.” Arbitrage isn’t evil. It’s an opportunity. ETFs are not evil any more than derivatives of any kind including mortgage-backed securities are evil.

But we should know how things work. Why is an arbitrage mechanism essential to ETFs? It’s not obtuse to ask the question.

ETF sponsors say the arbitrage mechanism permits ETFs to price throughout the day instead of once as with mutual funds, and it keeps ETF shares near the net asset value (NAV) of the ETF, in contrast to closed-end funds, where NAV and share-price can veer.

That sounds good. Until you reflect on it.  Why would it be helpful for something other than actual investor interest to set price?

As you ponder, here’s how ETF shares are born. Big brokers called Authorized Participants (APs) exchange securities with an ETF sponsor like Blackrock for ETF shares, which they can then sell to the public. The Investment Company Institute says (page 8 here):

APs play a key role in the primary market for ETF shares because they are the only investors allowed to transact directly with the fund. APs generally do not receive compensation from an ETF or its sponsor and have no legal obligation to create or redeem the ETF’s shares.

APs typically derive their compensation from commissions and fees that clients (such as registered investment advisers and various liquidity providers, including market makers, hedge funds, and proprietary trading firms) pay for creating and redeeming ETF shares on their behalf and from any profits the AP earns while engaging in arbitrage between the ETF’s NAV and its market price.

On one hand it’s ingenious. ETFs trade away the risk of buying and selling real assets to third parties (the APs). Like magic, they then can beat stock pickers, who still must buy or sell stocks in the real world.

On the other, it’s rigged.  Select friends of Blackrock get inside information on ETF demand, which they can share with customers like hedge funds and prop traders for a chance to profit, in exchange for a commission.

Wait, isn’t that what gets you thrown in jail for insider trading? So why is it okay for passive money but not active money?  Is that a level playing field for investors seeking great companies – and the companies courting them?

I want to know why journalists and regulators are mute about this disparity sitting like a naked emperor in the room.

Because it’s working, that’s why. So why worry?

Understand this: ETFs are not buying and selling your shares in the open market, creating demand and supply. They are trading ETF shares to APs for a basket of assets of equal value, thus avoiding transaction and tax costs.

Suppose these assets handed back and forth to facilitate the creation of ETF shares are not unique but the same assets used other places.

When real buying or selling occurs, assets are volatile. They rise, and fall.  Right now assets are only rising.  That alone should tell us that money is leveraged to the underlying assets – and ETFs provide the avenue.

The capacity to understand supply and demand has always supported investment decisions. Without that information, bad companies are rewarded like good companies. And who’s ultimately accountable for market risk? You and me. Investors, public companies. We can’t rely on someone else, such as regulators.

Bad Company is a good name for a rock band.  So is Good Company. We want to be in good company, in a good market. Investment built around an “arbitrage mechanism” should make us seek answers. Smart people always ask why.

Day to Day

Here in CO we can count on sun much of the time but we still watch the weather forecast.

It would be a real pain to drag the skis out and drive up the mountain only to find the resorts bereft of snow.  For one, it’s an hour and a half on I-70 through the Eisenhower Tunnel to Summit County and the Arapahoe Basin, Keystone, Breckenridge and Copper Mountain ski resorts (and double that to our fave, Steamboat).

“You could use social media, Tim.  You can have the resorts text you about conditions.  You can go to,,—”

Right, I know that. I’m making a point about dealing with things as they come without thinking about the future. What’s called living day-to-day.  Some of us might want to do that. Get away from the schedule, the rat race. But it’s not a life strategy.

How come we do it with stocks?

Let me explain. Investor-relations folks, for the moment I’m talking to you.  (Investors, listen and see how it applies.) This is typically what you’ll get if you ask an exchange what’s happening with your stock:

The stock opened just above the blah blah blah level then broke out to the upside before basing around noon as profit-takers took over. The bulk of the volume occurred in the morning hours. There was one block, the opening trade, and BAML led most actives (880k), along with Interactive Brokers (615k), GSCO (325k) and JPM (70k).  IBKR often handles retail while the rest generally trade for institutions.

I’m not picking on exchanges. I’m asking what this tells you? It’s the same information I was getting fifteen years ago. No comparative forecast, no indication of what behavior set price, no trends, patterns. It’s a narrative suggesting the day is an end unto itself.

This is lugging skis to Breck on a shorts and flip-flops day.

Compare to the oft-maligned weatherperson.  They’re not always right but they give reliable forecasts. It’s math.  The weather keeps changing but we don’t stop reading forecasts. Right?

Like the weather, the stock market is continually changing. And like weather it’s got measurable patterns because it too is governed by mathematical principles.

Patterns abound. We give Wall Street general expectations of financial trends and patterns through guidance. The Peloton stationary web-connected exercise bike we love gives us troves of trend and pattern data on our performances (sometimes to our chagrin).

I know executives love trends and patterns because they tell me. They like to know what’s coming because they’re people responsible for outcomes and it’s how they think. They appreciate seeing patterns behind price-moves.

We have your trends, patterns and forecasts.  If you’d like to see them, let me know.

The stock market isn’t a set of disconnected events one upon the next called trading days that begin at zero, crescendo, and conclude at a finish line. It’s impossible for everything material to investment behavior to wrap by 4:00 p.m. Eastern Time each day. There’s a pattern at work you can be sure. The average stock trades 13,000 times per day in 200-share increments (and the last price of the day is the 13,000th then).

I’ll share some patterns and trends to finish. Broadly, the key behavior the past week driving big gains and yesterday’s intraday volatility is Risk Mgmt – the use of derivatives to protect and leverage portfolios. Second is Passive Investment. That combination means ETFs are responsible (passive money, plus a risk-transfer effort by market-makers).

Options expire tomorrow through Friday. The Sentiment trend in the market is white-hot growth behavior slamming into a ceiling, based on past trends and patterns. Shorting is rising, intraday volatility is rising.

While the market has persistent upside fervor, near-term volatility is baked in via behavior and options-expirations regardless of a government shutdown. Trends and patterns show it. It may change again next week. That’s how the market works.

If you’re an observer it’s nice to know what’s coming. If you’re an investor, it’s very material to know patterns and trends because your money is on the line. And if you’re in investor-relations, it’s your job.  You don’t want to live it day-to-day. That’s not a strategy.

Can It Last?

It’s the number one question.  Tack “how long” on the front.

I’m asked all the time: “Tim, do you think the stock market is sustainable? Are fundamentals driving it or is this a bubble? Stock buybacks?  The Fed is behind it, right? Isn’t bitcoin proof of irrational exuberance?”

And everybody with an opinion is asked, and answers. I’ve offered mine (read The 5.5 Market from last week) and I’ll add today what we’ve further learned about the behavior of money.

Speaking of money, Karen and I joke that we miss the recession. Hotels were a bargain.  They gave you free tickets to shows if you just came to Las Vegas. Vacations were affordable (I’m not making light of great stock returns but if we give it all back, how is that helpful?).

Now suppose at the same time interest rates would rise. People and companies with too much debt would suffer, sure. But society would save money and take on less debt. That’s what higher interest rates encourage. From Hammurabi in Babylon until fairly recently we understood this to be the formula for prosperity.

“Quast, do you know nothing about contemporary behavioral economics? What kind of idiot would think it’s better to save money and avoid debt?  Economists agree that debt and spending drive the global consumption economy.”

Ask your financial advisor if you should borrow money and spend more, or save money and invest it.  So how come the Federal Reserve encourages borrowing and spending?

Recessions have purpose – and they’re packed with opportunity!  Seriously. They reset the economic calculus.

I’ll give you an example from the Wall Street Journal yesterday, which reported that here in Denver we have 16,000 vacant metro apartments, most in the luxury category. And 22,000 more are being built. Since they’re unaffordable, the city has launched a program to subsidize rents.

This is the kind of warped outcome one gets from promoting debt and spending, and it’s influencing our stock market too. I’m not the least worried because I know boundless opportunity awaits when prices reset, and that’s the right way to see it.  Warren Buffett said it’s unwise to pay more for a thing than it’s worth.  All right, I look forward to attractive prices ahead.

And prices are products of the behavior of money.  Last week we described how the market could not correctly be credited with rational valuation because stock-picking was not the principal behavior. Over the past ten years, all the NET new inflows into US equities have gone to index and exchange-traded funds. They follow a benchmark. They don’t pick stocks.

They also rarely sell them. If things are bought and not sold, prices rise.  There is a paucity of stocks for sale. In its 2016 prospectus for the S&P 500 ETF SPY, State Street said its turnover – proportion of holdings bought and sold – was 4%.  The fund that year, the latest available, had $197 billion in net asset value. Four percent is about $8 billion.

Yet SPY traded $25 billion daily in 2016 (still does!), about three times the entire annual fund turnover. Explanation? Right there on page 2 of the prospectus: The Trust’s portfolio turnover rate does not include securities received or delivered from processing creations or redemptions of Units.

On page 30 we learn this:  For the year ended September 30, 2016, the Trust had in-kind contributions, in-kind redemptions, purchases and sales of investment securities of $177,227,631,568, $167,729,988,725, $7,783,624,798, and $6,444,954,759, respectively.

Translating to English, it means brokers called Authorized Participants created $177 billion worth of new ETF shares by exchanging assemblages of stocks for them that were not counted as sales by SPY. It counted sales of only about $8 billion – as I said above.

The functional turnover rate for SPY is closer to 100%. If it really was, the market would be volatile. Prices would fall as shares hit the market. SPY drives 10% of the entire stock market’s dollar volume.

But what trades is ETF shares. The creation and redemption process occurs away from the market in some secretive block-transaction fashion that means the natural buying or selling that would otherwise be done is not happening.

Selling lowers prices. The absence of selling, the replacement of selling with trading in ETF shares predicated primarily on price-differences – arbitrage – produces a market that relentlessly rises with very little volatility.

And which notably means investors don’t actually own anything when they buy ETF shares. If they did, that $177 billion SPY exchanged for ETF shares would carry a taxable ownership interest, and transaction costs. It doesn’t.

Think about that.

When the recession comes because of this bizarre displacement of actual buying and selling by derivatives, I look greatly forward to all the bargains, the affordable vacation homes in desirable places, the cheap stocks, and the free show tickets in Las Vegas.

I just can’t tell you when. The wise are always prepared.