Search Results for: ETFs

ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

Let me frame that statement with backstory. I consider it our mission to help you understand market behavior. The biggest currently is arbitrage – taking advantage of price-differences. Insert that phrase wherever you see the word.  We mean that much of the money behind volume is doing that.  Yesterday eleven of the 25 most active stocks were Exchange-Traded Funds (ETFs). Four were American Depositary Receipts (ADRs).

Both these and high-frequency trading turn on taking advantage of price-differences. Both offer the capacity to capitalize on changing prices – ADRs relative to ordinary-share conversions, and ETFs relative to the net asset value of the ETF and the prices of components. In a sense both are stock-backed securities built on conversions.

For high-speed traders, arbitrage lies in the act of setting prices at different markets. Rules require trades to match between the best bid to buy and offer to sell (called the NBBO). Generally exchanges pay traders to sell and charge them to buy.

In fact, the SEC suspended an NYSE rule because it may permit traders to take advantage of price-differences (something we’ve long contended). We’ll come to that at the end.

Next, ETFs are constructed on arbitrage – price-differences. Say Blackrock sponsors an ETF to track a technology index. Blackrock sells a bunch of ETF shares to a broker like Morgan Stanley, which provides Blackrock with either commensurate stocks comprising the tech index or a substitute, principally cash, and sells ETF shares to the public.

If there’s demand, Morgan Stanley creates more ETF shares in exchange for components or cash, and then sells them. Conversely, if people are selling the ETF, Morgan Stanley buys the ETF shares and sells them back to Blackrock, which pays with stocks or cash.

The trick is keeping assets and stock-prices of components aligned. ETFs post asset positions daily. Divergences create both risk and opportunity for the sponsor and the broker alike. Blackrock cites its derivatives-hedging strategies as a standard risk associated with ETF investing. I’m convinced that a key reason why ETFs have low management fees is that the components can be lent, shorted, or leveraged with derivatives so as to contribute to returns for both the sponsor and the broker.

On the flip side, if markets are volatile as they have been post-Brexit and really since latter 2014, either party could lose money on unexpected moves. So both hedge.

For arbitragers, a perfect market is one with little direction and lots of volatility. Despite this week’s move to new market highs, there remains statistically little real market movement in the past two years. If a market is up or down 2% daily, does it over time gain, lose or stay the same?

Run it in Excel. You’ll see that a market declines over time. Thus arbitragers short securities using rapid tactics to minimize time-decay. If you want a distraction, Google “ETF arbitrage shorting” and read how traders short leveraged ETFs to make money without respect to the market at large.

In fact, this is the root problem: Taking advantage of price-differences is by nature a short-term strategy. Sixteen of the most actively traded 25 stocks yesterday (64% of the total!) were priced heavily by arbitrage, some by high-speed traders and some by investors and the market-makers for ETFs.

Offering further support for arbitrage ubiquity, the market is routinely 45-50% short on a given day. Short volume this week dipped below 45% for the first time since December, perhaps signaling an arbitrage squeeze and certainly offering evidence that arbitragers hate a runaway market.

If the market rises on arbitrage, it means parties SUPPLYING hedges are losing money. Those are big banks and hedge funds and insurance companies. Who’d take the market on a run to undermine arbitrage that’s eating away at balance sheets (big banks and hedge funds have suffered)?  Counterparties.

In our behavioral data Active investment is down and counterparties have been weak too, likely cutting back on participation. That comports with fund data showing net outflows of $70-$80 billion from US equities this year even as the market reverts to highs. The only two behaviors up the past 50 trading days are Fast Trading (arbitrage) and Asset Allocation (market-makers and brokers for ETFs and other quantitative vehicles). Yet more evidence. And both are principally quantitative.

Assemble these statistics and you see why the market seems oblivious to everything from US racial unrest, to a bankrupt Puerto Rico, to foundering global growth and teetering banks.  The market is running on arbitrage.

What’s the good news, you ask?  The SEC is aware of rising risk. It suspended an NYSE rule-filing on fees at the exchange’s Amex Options market after concluding the structure may incentivize arbitrage.  The SEC is scrutinizing leveraged ETFs and could end them.

But most important is the timeless self-regulation of knowledge. If we’re all aware of what’s driving the market then maybe the arbitragers will be their own undoing without taking the rest of us with them.

Janus ETFs

Everybody adapts, including institutional investors like Janus.

Rattle off a top-ten list of the best active stock pickers visited by teams of company execs and investor-relations pros trundling through the airports and cities of America, and Denver’s Janus likely makes the cut.

Ah, but.  In 2014 Janus bought VelocityShares, purveyor of synthetic exchange-traded products.  Just as a drug manufactured in a laboratory rather than from the plant that first formed its mechanism of action is a replica, so are these lab-made financial instruments. They replicate the act of investment without actually performing it.

It’s neither good nor bad per se, as I explained yesterday to the NIRI San Diego chapter. But synthetics are revolutionizing how public stocks trade – without owning public stocks. Describing its effort at adaptation, Janus says on its website that it’s “committed to offering distinctive strategies for today’s complex market environment. Leveraging almost a half century of investment experience, we are now pleased to make our expertise available through Exchange Traded Funds.”

Janus says it’s intending to offer a range of returns beyond simple capital-appreciation, including “volatility management” and “uncorrelated returns.” Janus’s VelocityShares directed at volatility aim to produce enhanced or inverse returns on the VIX, an index called the “fear gauge” for reflecting volatility in forward rights to the S&P 500.

But traders and investors don’t fear volatility. They invest in it.  On Monday May 16, four of the top 20 most actively traded stocks were exchange-traded products leveraging the VIX.  Those offered by Janus aren’t equity investments but a debt obligation backed by Credit Suisse. Returns derive from what is best described as bets using derivatives.

The prospectus for the most active version is 174 pages, so it’s hard to decipher the nature of wagers. It says: “We expect to hedge our obligations relating to the ETNs by purchasing or selling short the underlying futures, listed or over-the-counter options, futures contracts, swaps, or other derivative instruments relating to the applicable underlying Index…and adjust the hedge by, among other things, purchasing or selling any of the foregoing, at any time and from time to time, and to unwind the hedge by selling any of the foregoing, perhaps on or before the applicable Valuation Date.”

Got that?  Here’s my attempt at translation: “We’ll do the exact opposite of whatever return we’ve promised you, to keep from losing money.”

During the mortgage-related financial crisis there was a collective recoil of horror through media and into Congress that banks may have been betting against their clients. Well, come on.  It’s happening in equities every day!  Exactly how do we think somebody who says “sure, I’ll take your bet that you can make double the index without buying any assets” can possibly make good without farming the risk out to someone else?

In the mortgage crisis we learned about “credit default swaps” and how insurers like AIG were on the hook for hundreds of billions when real estate stopped rising. Who is on the hook for all these derivatives bets in equities if stocks stop rising? It’s the same thing.

Last Friday the 13th, five of the top 20 most actively traded instruments on the Nasdaq and NYSE were synthetic exchange-traded products attempting to produce outsized returns without correlating to the market. That’s 25% of the action, in effect.

For stock-picking investors and public companies it means a significant contingent of price-setting trades in the stock market are betting on moves uncorrelated to either fundamentals or markets. You’ll find no explanation in ownership-change.

What do you tell management and Boards about a market where, demonstrably, top price-setting vehicles like TVIX owned by conventional stock-pickers aren’t buying or selling stock but betting on tomorrow’s future values using derivatives?

In fact, everyone is betting against each other – traders, banks, investors. I take you back to the mortgage-backed securities crisis. The value of underlying assets was massively leveraged through derivatives the values of which bore no direct connection to whether mortgages were performing assets.  That by any definition is credit-overextension. A bubble.  A mania. Then homes stopped appreciating. The bubble burst two years later.

Look at stocks. They’ve not risen since Nov 2014. Is anyone out there listening or paying attention to the derivatives mess in equities?

ETFs and Divine Creation and Redemption

There’s a saying: It’s easier to keep the cat in the bag than to get it back in there once you’ve let it out. Nobody is likely to stuff the Exchange Traded Fund (ETF) cat back in the bag.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea. (more…)

Why Traders Trade

Albert Einstein reputedly quipped that compounding was the 8th wonder of the world. What would he think of negative interest rates?

The 10-year German government bond yield is -0.61%. The Rule of 72, which nobody mentions now, says dividing 72 by the expected rate of investment return tells you when it’ll double. At 6%, that’s 12 years. At 2%, 36 years. Try compounding negative rates.

Believe it or not, the stock market is weirder still.

Volatility in US stocks averaged 3.4% daily the past week, 55% higher than the risk-free return of 2.2% for 30-year US Treasurys.

Plug those figures into an equity cost of capital calculation where the expected return is 8%.  You with me?  It’s 22%!  So, the interest you earn on cash has vanished while the cost of raising it in public markets has exploded.

You may say, investor-relations professionals, there’s no way my equity costs 22%.  The truth is, volatility introduces value-uncertainty, which both increases what you pay for money, and on the other side, decreases returns on it.

University of Chicago professors Eugene Fama, who won a Nobel Prize in 2013, and Kenneth French, who also serves as head of investment policy for quant investor Dimensional Fund Advisors, co-authored a paper describing how equity-market volatility diminishes the apparent superiority of equities over bonds.

To wit, three-month Treasury Bills are returning 2% annualized. The S&P 500 since Sep 20, 2018 is down 0.4% even after yesterday’s gains. What if you’d sold Monday when the Dow Industrials dropped 391 points and bought yesterday when they rose 372? One day can make or break returns for investors.

Same for public companies. Say you issued stock in Dec 2018 and implemented an aggressive buyback in Jan 2019.  On the wrong side of the market, cost of capital skyrockets.

Rather than rationalizing market behavior, we should be asking why it’s become so volatile. And yes, it’s vastly more so now than during earlier epochs.

The answers? Rules. Stocks must trade between the best bid to buy and offer to sell, which cannot be the same. Thus, machines change prices. They’re 45% of volume.

On top of that, stock exchanges give firms economic incentives to trade stocks and derivatives simultaneously, accelerating the rate of change for prices.

For instance, the Nasdaq pays traders with more than 0.6% of sell volume (they call it adding liquidity but it’s paying traders to set the offer, the highest price for a stock) $0.29 per hundred shares.

Sell 1.75% of Nasdaq volume, with 0.6% in derivatives like options and futures, and if that amount is 0.1% of total Nasdaq derivatives volume, the exchanges pays $0.32 per hundred shares. That’s a 10% kicker for more prices.

Now add Exchange Traded Funds, which have no intrinsic value and depend for prices on the stocks that collateralize them. The two – stocks, and ETFs – are always a bit out of step.

Take Energy stocks last week.  XLE, a big Energy ETF, was down 2.2%. But composite Energy stocks were down 5.5% – a spread of 150%!

Capture half that by buying the ETF and selling the stocks, and it’s a 75% return.  No wonder traders trade.

ETFs drive what we estimate is 60% of total market volume now. ETFs exist via a regulatory exemption from the Investment Company Act of 1940 permitting them to trade as stock substitutes around an “arbitrage mechanism.”

That is, they depend on changing prices. There are thousands of ETFs, worth trillions of dollars. It’s a mania.

I’ll summarize: Market rules and investment behavior built on continually changing prices have transformed the market from a place where long-range horizons are the objective, to one where continuously changing prices are the objective.

Changing prices is the definition of volatility. Traders trade to profit on it. They rule.

What we expect from the stock market should derive from these facts. Public companies and investors alike should adapt. How? Understand the ebbs and flows and surf them like waves (we have that data). Modulate your buybacks, your stock issuances, your tactical investor-outreach, your investment decisions, to reflect behavioral facts.

Investors and public companies could also band together to petition the SEC to stop giving arbitrage a leg up.  The first step toward that goal is understanding how and why the market’s focus is now today’s spread, not tomorrow’s capital appreciation. I’ve explained it.

Mark Twain would say: Is the market run by smart people who are putting us on or imbeciles who really mean it?

Yet Arrived

Bula!

That’s Fijian for “greetings!” You say it “boo-lah.” Fiji is among the friendliest places on the planet. Karen and I are just back from the South Pacific, as this compilation illustrates.  Do you know it’s traditional in Fiji to invite anyone passing by to breakfast?

Maybe that’s the answer to the world’s woes.

And maybe we should have stayed out to sea!  Our first day back the market tumbled.

We left you July 18 with our concern that the market had become a runaway train. In a private client note Jul 19 as options expired we said, “Right now, the data say the market will next tick up. If it’s a weak top – check page 3 of your Market Structure Reports – we could have trouble. At this moment, I don’t think that’s set to occur. Yet.

Well, “yet” arrived.

Is it possible to know when yet is coming?

Yes. At least the way one knows a storm front is forming. It’s not mystical knowledge. It’s math. Weather forecasters track patterns because, as it turns out, weather is mathematical.  It follows rules that can be modeled.

We put a man on the moon 50 years ago because escaping gravity and traveling four days at predictable velocity will get you there. It’s math – which smart people computed on devices less powerful than your smart phone.

Even human behavior, which isn’t mathematical, can often be predicted (somebody needs to develop a model for mass-shooting nutcases). For instance, in the stock market rational people predictably buy weakness and sell strength.

What kind of money sells weakness and buys strength? We’ll come to that.

Conventional wisdom says stocks imploded because a) people wanted the Federal Reserve to cut rates Jul 31 more than it did, b) President Trump tweeted about Chinese tariffs, c) and the Chinese retaliated by letting the yuan slide.

Relative currency values matter. We’ve written often about it. The pandemonium routing equities Aug 24, 2015 followed a yuan devaluation too. Stocks inversely correlate with the dollar because currencies have no inherent value today.

So if the supply of dollars rises, the value of the dollar falls, and the prices of assets denominated in dollars that serve as stores of value, such as stocks, rise. Value investor Ron Baron said he puts depreciating assets, dollars, into appreciating assets, stocks.

With dollars increasing, the relative value of other currencies like the euro and the yen rises, so prices of goods denominated in them fall – which governments and central banks interpret as “a recession,” leading to interest-rate cuts, negative bond yields, banks buying stuff to create money, and other weirdness.

Makes you wonder if these central planners actually understand economics.

I digress. That’s not the root reason why stocks rolled over. Headlines, Fed actions and currencies don’t buy or sell stocks. People and machines do.

The majority of the money in the market pegs a benchmark now – machine-like behavior. Market Structure Sentiment, our index for short-term market-direction, has been above 5.0 for an extended period without mean-reversion.

That matters because money tracking a measure must rebalance – mean-revert. If it goes an unusual stretch without doing so, risk of a sudden mean-reversion rises.

We saw the same condition before stock-corrections in Jan 2016, June 2016 around Brexit, ahead of the US election in late Oct 2016, in Jan 2018, and in Sep 2018. Each featured an extended positive Sentiment run with a weak top, as now.

The week ended Aug 2 also had another mathematical doozy: Exchange Traded Fund flows as measured not by purchases or sales of ETFs but market-making by brokers plunged 20%.  In some mega capitalization stocks it was the largest decline in ETF flows since early Dec 2018.

Passive money buys strength, until it stops. When it stops, weakness often follows. And if it has not rebalanced, it sells weakness because weakness means deteriorating returns.

The last day of trading every month is the most important one for money tracking benchmarks. That was July 31. Stocks deteriorated in the afternoon. Pundits blamed Jay Powell’s comments. What if it was long overdue rebalancing on the last trading day?

That selling coupled with a big overall decline in ETF flows converged with a currency depreciation Monday, and whoosh! What yet we feared arrived.

And yet. It’s not fundamental. Why does that matter? Monetary policy, portfolio positioning, and economic predictions may be predicated on a false premise that rational people had unmet expectations.

I think that’s a big deal.

So. Since yet has arrived, is yet over?  Data say no. It’s a model with predictiveness that may be a step ahead or behind. But a swoon like this should produce a mean-reversion. That’s not – yet – happened.

With that, I say Bula! And if you’re in the neighborhood, drop by for breakfast on us.

Unstoppable

Any of you Denzel Washington fans?

He starred in a 2010 movie loosely based on real events called Unstoppable, about a runaway freight train (I have Tom Petty’s “Runaway Train” going through my head).

In a way, the market has the appearance of an unstoppable force, a runaway train.  On it goes, unexpectedly, and so pundits, chuckling uncomfortably, try to explain why.

Tellingly, however, in the past month, JP Morgan said 80% of market volume is on autopilot, driven by passive and systematic flows.  Goldman Sachs held a conference call for issuers on what’s driving stock-prices – focusing on market structure. Jefferies issued a white paper called When the Market Moves the Market (thank you, alert readers, for those!).

We’ve been talking about market structure for almost 15 years (writing here on it since 2006). We’re glad some big names are joining us. You skeptics, if you don’t believe us, will you believe these banks?

Market structure has seized control. Stock pickers say the market always reflects expectations.  Well, stocks are at records even as expectations for corporate earnings predict a recession – back-to-back quarterly profit-declines.

There’s more. Last week the S&P 500 rose 0.8%, pushing index gains to 9.3% total since the end of May. But something that may be lost on most: The S&P 500 is up less than 2.5% since last September. The bane of stock-investing is volatility – changing prices.

Hedge funds call that uncompensated risk. The market has given us three straight quarters of stomach-lurching roller coasters of risk. For a 2.5% gain?

We all want stocks to rise!  Save shorts and volatility traders.  The point is that we should understand WHY the market does what it does. When it’s behaving unexpectedly, we shouldn’t shrug and say, “Huh. Wonder what that’s about?”

It’s akin to what humorist Dave Barry said you can do when your car starts making a funny noise:  Turn the radio up.

Let me give you another weird market outtake.  We track composite quantitative data on stocks clustered by sector (and soon by industry, and even down to selected peers).  That is, we run central tendencies, averages, for stocks comprising industries.

Last week, Consumer Discretionary stocks were best, up 1.5%. The sector SPDR (XLY, the State Street ETF) was up 2% (a spread of 33% by the way). Yet sector stocks had more selling than buying every day but Friday last week.

You know the old investor-relations joke:  “Why is our stock down today?”

“Because we had more sellers than buyers.”

Now stocks are UP on more selling than buying.

An aside before I get to the punchline:  ETF flows are measured in share creations and redemptions. More money into ETFs? More ETF shares are created.  Except there were $50 billion more ETF shares created than redeemed in December last year when the market fell 20%.

The market increasingly cannot be trusted to tell us what’s occurring, because the mechanics of it – market structure – are poorly understood by observers. ETFs act more like currencies than stocks because they replace stocks. They don’t invest in stocks (and they can be created and shorted en masse).

With the rise of ETFs, Fast Trading machines, shorting, derivatives, the way the market runs cannot be seen through the eyes of Benjamin Graham.

Last week as the S&P 500 rose, across the eleven industry groups into which it’s divided there were 28 net selling days, and 27 net buying days (11 sectors, five days each).

How can Consumer Discretionary stocks rise on net selling? How can the market rise on net selling? Statistical samples. ETFs and indexes don’t trade everything. They buy or sell a representative group – say 10 out of a hundred.

(Editorial note: listen to five minutes of commentary on Sector Insights, and if you’re interested in receiving them, let us know.)

So, 90 stocks could be experiencing outflows while the ten on which this benchmark or that index rests for prices today have inflows, and major measures, sector ETFs, say the market is up when it’s the opposite.

Market Structure Sentiment™, our behavioral index, topped on July 12, right into option-expirations today through Friday.  On Monday in a flat market belying dyspepsia below the surface, we saw massive behavioral change suggesting ETFs are leaving.

Stay with me. We’re headed unstoppably toward a conclusion.

From Jan 1-May 31 this year, ETFs were less volatile than stocks every week save one. ETFs are elastic, and so should be less volatile. Suddenly in the last six weeks, ETFs are more volatile than stocks, a head-scratcher.

Mechanics would see these as symptoms of failing vehicle-performance. Dave Barry would turn the radio up.  None of us wants an Unstoppable train derailing into the depot.  We can avoid trouble by measuring data and recognizing when it’s telling us things aren’t working right.

Investors and public companies, do you want to know when you’re on a runaway train?

The Canary

For a taste of July 4 in a mountain town, featuring boy scouts serving pancakes, a camel amongst horses, sand crane dancers, and Clyde the glad hound, click here.  Americana.

Meanwhile back in the coal mine of the stock market, the canary showed up.

We first raised concern about the possible failure of a major prime broker in 2014. By “prime,” we mean a firm large enough to facilitate big transactions by supplying global trading capacity, capital, advice and strategy.

We homed in on mounting risk at HSBC and Deutsche Bank.

Last weekend Deutsche Bank announced an astonishing intention:  It will eliminate global equity trading and 18,000 jobs. It’s a long-range effort, the bank says, with targeted conclusion in 2022.

But will a bank erasing the foundation of investment-banking, cash equities, retain key people and core customers? Doubtful. In effect, one of the dozen largest market-makers for US stocks is going away.

It matters to public companies and investors because the market depends on but a handful of firms for market-efficiency in everything from US Treasurys, to stocks, to derivatives, and corporate bonds.

And Exchange Traded Funds.  Industry sources say over 80% of creations and redemptions in ETF shares are handled by ten firms. We don’t know precise identities of the ten because this market with over $300 billion of monthly transactions is a black box to investors, with no requirement that fund sponsors disclose which brokers support them.

We know these so-called “Authorized Participants” must be self-clearing members of the Federal Reserve system, which shrinks the pool of possibilities to about 40, including Deutsche Bank, which hired an ETF trading legend, Chris Hempstead, in 2017.

It’s possible others may fill the void. But you have to be an established firm to compete, due to rigorous regulatory requirements.

For instance, brokers executing trades for customers must meet a stout “best execution” mandate that orders be filled a large percentage of the time at the best marketwide prices. That standard is determined by averages across aggregate order flow dominated in US markets by yet again ten firms (we presume the same ones), including Deutsche Bank.

It’s exceedingly difficult to shoulder in.  The great bulk of the 4,000 or so brokers overseen by Finra, the industry regulator, send their trades to one of these ten because the rest cannot consistently achieve the high required standard.

So the elite club upon which rests the vast apparatus of financial markets just shrank by about 10%.

Already the market is susceptible to trouble because it’s like a soccer stadium with only a handful of exits.  That’s no problem when everyone is inside.  But getting in or out when all are in a rush is dangerous, as we saw in Feb 2018 and Dec 2019, with markets swooning double digits in days.

Let’s go back to a basic market-structure concept.  The “stock market” isn’t a place. It’s a data network of interconnected alcoves and eddies.  What’s more, shares don’t reside inside it.  The supply must continuously be brought to it by brokers.

Picture a farmers’ market with rows of empty stalls. When you move in front of one, suddenly products materialize, a vendor selling you goat’s milk soap. You go to the next blank space and instantly it’s a bakery stand with fresh croissants.  As you move along, contents vanish again.

That’s how the stock market works today under the mandatory market-making model imposed by Regulation National Market System. High-speed traders and gigantic brokerage firms are racing around behind the booths and stands at extreme speeds rushing croissants and goat’s milk soap around to be in front of you when you appear.

The network depends on the few.  We have long theorized that one big threat to this construct is its increasing dependency on a handful of giant firms. In 2006, a large-cap stock would have over 200 firms making markets – running croissants to the stand.

Today it’s less than a hundred, and over 95% of volume concentrates consistently at just 30 firms, half of them dealers with customers, the other half proprietary trading firms, arbitragers trading inefficiencies amid continuous delivery of croissants and goat’s milk soap – so to speak – at the public bazaar.

We said we’ll know trouble is mounting when one of the major players fails. Deutsche Bank hasn’t failed per se, but you don’t close a global equity trading business without catastrophic associated losses behind the scenes. The speedy supply chain failed.

Why? I think it’s ETFs. These derivatives – that’s what they are – depend on arbitrage, or profiting on different prices for the same thing, for prices. Arbitrage creates winners and losers, unlike investment occurring as growing firms attract more capital.

As arbitrage losers leave, or rules become harder to meet, the market becomes thinner even as the obligations looming over it mount.

We are not predicting disaster. We are identifying faults in the structure. These will be the cause of its undoing at some point ahead.  We’ve seen the canary.

 

Flying Machines

While France roasts on both the heat of the US women’s soccer strikers and mother nature’s summertime glow, in Steamboat Springs Lake Catamount sits alpine serene, and it was 46 degrees Fahrenheit (about the same read in Celsius in France) on our early bike ride yesterday.

In the USA, we join figurative thankful hands with you across the fruited plain to mark this amazing republic’s 243rd birthday.  Long may the stars and stripes fly.

What’s flying in markets are a bunch of machines.

Joe Saluzzi, one of our marquee panelists at the NIRI Annual Conference last month, spoke to IR Magazine on how the market works and why investor-relations professionals need to educate themselves. As Joe says, much of your volume isn’t investment but trading. It distorts perceptions of real supply and demand.

Why does that matter?  Because your board, your executive team, your investors, see your stock as a barometer of fundamentals. You need to know when that’s true – and when it’s not.  Misunderstanding what the market is doing can lead to big mistakes.

What if your stock declines sharply with results and management believes it has miscommunicated key messages (and blames you)?

Suppose market structure shows Active money bought in the preceding two weeks – because you’ve been talking regularly over the quarter about what you’re trying to do strategically. Then before the call, they stop buying to pay attention to what you say.

The absence of what had been present will be patently apparent to Fast Traders. They will sell and short you.  Whoosh! The flying machines take you down.

Every IRO should understand, and observe, and report internally to the executive team and the board, the starkly apparent data demonstrating these facts. We have that data. For anyone traded in US markets.  Including your peers. And yes, you can see that data.

Story is vital, sure.  But the way we think about the influence of story, fundamentals, strategy, should be predicated on facts, not a perception diverging from reality.

Illustratively, CNBC ran a headline last Saturday reading “80% of the stock market is now on autopilot.”  Referencing a JP Morgan client note, the reporter said about 60% of assets are in passive indexes and Exchange-Traded Funds (ETFs), with another 20% following systematic strategies.

An aside, I think Morningstar is behind the curve on measuring the pervasive and endemic shift to passive in stocks. It’s not just assets under management but the composition of volume.

A WSJ article (registration required) last December describing the “herdlike behavior of computerized trading” also quoted JP Morgan officials estimating that 85% of market volume was something other than Active investing.

Those of you using our analytics know we track the facts with precision. Currently, it’s 87%, with just 13% of market volume the past week from Active investment.

Does it render IR obsolete?  Of course not!  Stop thinking your job consists of talking to investors.

That’s part of the job, sure. But IR is a strategic management function. Your job is to know what all the money is doing, all the time, and communicate important facts about trends and drivers to the board and executives so they’ll have realistic expectations.

And your job is to manage the market for your shares, which includes sorting out what’s controllable and what’s not, and providing important metrics on equity health and drivers around news, earnings, and non-deal road shows – and on a regular basis, proactively, as all good business managers do.

That’s IR today. The market is not full of “noise.” It’s full of flying machines, amazing sensors feeding back vital data to observers like us, who in turn help you take command of the equity-market battlefield as trusted strategic advisor to your executive team.

Ponder that with a cold beer (or a cold Rose from Provence!) and a flag this holiday week.  Happy birthday, USA!

In Control

This is what Steamboat Springs looked like June 21, the first day of summer (yes, that’s a snow plow).

Before winter returned, we were hiking Emerald Mountain there and were glad the big fella who left these tracks had headed the other way (yes, those are Karen’s shoes on the upper edge, for a size comparison).

A setup for talking about a bear market?  No.  But there are structural facts you need to know.  Such as why are investor-relations goals for changes to the shareholder base hard to achieve?

We were in Chicago seeing customers and one said, “Some holders complain we’re underperforming our peers because we don’t have the right shareholder mix. We develop a plan to change it.  We execute our outreach. When we compare outcomes to goals after the fact, we’ve not achieved them.”

Why?

The cause isn’t a failure of communication. It’s market structure.  First, many Active funds have had net outflows over the last decade as money shifted from expensive active management to inexpensive passive management.

It’s trillions of dollars.  And it means stock-pickers are often sellers, not buyers.

As the head of equities for a major fund complex told me, “Management teams come to see my analysts and tell the story, but we’ve got redemptions.  We’re not buying stocks. We’re selling them. And getting into ETFs.”

Second, conventional funds are by rule fully invested.  To buy something they must sell something else.  It’s hard business now.  While the average trade size rose the past two weeks from about 155 shares to 174 shares, it’s skewed by mega caps.  MRK is right at the average.  But FDX’s average trade size is 89 shares.  I saw a company yesterday averaging 45 shares per trade.

Moving 250,000 shares 45 at a time is wildly inefficient. It also means investors are continually contending with incorrect prices. Stocks quote in 100-share increments. If they trade in smaller fractions, there’s a good chance it’s not at the best displayed price.

That’s a structural problem that stacks the deck against active stock pickers, who are better off using Exchange Traded Funds (ETFs) that have limitless supply elasticity (ETFs don’t compete in the market for stocks. All stock-movement related to creating and redeeming ETF shares occurs off-market in giant blocks).

Speaking of market-structure (thank you, Joe Saluzzi), the Securities Traders Association had this advice for issuers:  Educate yourself on the market and develop a voice.

Bottom line, IR people, you need to understand how your stock trades and what its characteristics are, so you and your executive team and the board remain grounded in the reality of what’s achievable in a market dominated by ETFs.

Which brings us to current market structure.  Yesterday was “Counterparty Tuesday” when banks true up books related to options expiring last week and new ones that traded Monday.  The market was down because demand for stocks and derivatives from ETFs was off a combined 19% the past week versus 20-day averages.

It should be up, not down.

Last week was quad-witching when stock and index options and futures lapsed. S&P indexes rebalanced for the quarter. There was Phase III of the annual Russell reconstitution, which concludes Friday. Quarterly window-dressing should be happening now, as money tracking any benchmark needs to true up errors by June 28.

Where’d the money go?

If Passive money declines, the market could tip over. We’re not saying it’s bound to happen.  More important than the composition of an index is the amount of money pegged to it – trillions with the Russells (95% of it the Russell 1000), even more for S&P indices.

In that vein, last week leading into quad witching the lead behavior in every sector was Fast Trading.  Machines, not investors, drove the S&P 500 up 2.2%, likely counting on Passive money manifesting (as we did).

If it doesn’t, Fast Traders will vanish.

Summing up, we need to know what’s within our control.  Targeting investors without knowing market structure is like a farmer cutting hay without checking the weather report.  You can’t control the weather. You control when you cut hay – to avoid failure.

The same applies to IR (and investing, for that matter) in modern markets.

Rate of Change

Every investor and public company experiences volatility – the rate of change in prices.

So every investor and public company should come to the market with a baseline grasp on what others do about the rate of change in prices.

Notwithstanding how Rate of Change would be a good name for a rock band, let’s think about the kinds of money that would be concerned about rate of change, volatility.

Hedge funds. Though as we learned in the hedge-fund panel at NIRI Annual a couple weeks ago (with the help of my good friend Rich Barry, I assembled the group on the stage), hedge funds may have longer horizons than you think.

One of those folks said, however, putting emphasis on rate of change, “Whatever assets we’ve got under management, put a multiplier of 5-8 times on it, because that’s our economic impact on markets.”

You’ve got pension funds, commodity funds, insurance companies.  All are impacted by the rate of change in prices.

There are Fast Traders – machines in the markets driving about 45% of trading volume in US stocks that continuously calculate recovering and deteriorating prices. They’ll want to extend their influence in a way that profits from these rates of change.

Am I going somewhere with this?  Yes. And it’s happening right now. Stay with me.

Mutual funds too, especially indexers.  Index funds are the biggest consumer of options and futures because they track the mean, a benchmark. Volatility causes tracking errors.

They can adjust for index errors by buying or selling options (or futures, or repurchase agreements, or forwards, and so on). Most prospectuses include provisos for using about 10% of funds toward these ends.

Only one asset class, however, owes its existence to the rate of change: Exchange Traded Funds. They’re the only financial instrument ever created that was imbued with special regulatory dispensation to pursue arbitrage.  Which is…anyone?  Anyone?

Profiting on the rate of change in prices.

Arbitrage cannot exist if prices don’t change. There was almost no currency arbitrage before the USA left the gold standard in 1971. Exchange rates were fixed. Today, there are $544 TRILLION of over-the-counter derivatives swaps, most tied to currencies and interest rates designed to compensate for continual rates of change.

You know the VIX, the fear gauge?  Instruments tied to it expire today. It’s a way to profit on the rate of change.

Heard of the VVIX?  It tracks the annualized presence of volatility. It was created in 2006 and closed that year over 71%. It’s never been sustainably lower. It’s currently at 96%, about where it was in December last year.

Volatility is rising, not muted as the VIX suggests. Why? Blame can be spread around but it concentrates in ETFs. ETFs aren’t compensating for it. They’re depending on it.

ETF volatility – we track it – averaged 11% PER WEEK between Dec 14, 2018-Jun 14, 2019. Annualized, that’s nearly 600%. In fact, volatility between ETFs and the underlying stocks they’re supposed to track was 23% in April 2019 but a staggering 481% in May when stocks were down for six straight weeks. It suggests low spreads (April) triggered weak markets (May).

Maybe the Dow Jones would be at 50,000 if so many didn’t feed on the rate of change.

Is it good for investors and companies that the focus of the stock market has shifted from what rises or falls to what the gaps are between those items?

We get to today. Options expire today through Friday. These instruments tie to the rate of change in prices.  S&P indices, the benchmarks, true up quarterly this week. Russell indices are in phase three, the penultimate, of annual reconstitution, and they depend on the absence of a rate of change.

New options trade Monday, Jun 24. Counterparties will true up exposure Tuesday the 25th. We’ll see reality around Jun 26-27.

The bigger the money tracking a benchmark, the bigger the assets pegged to ETFs, the more consequential the rate of change of prices becomes.

And it warps any interpretation of fundamentals.

We cannot suppose that fundamentals price stocks when 100% of NET new inflows to stocks the entire past decade have gone to instruments attempting to mitigate the rate of change by tracking some measure.

I hope I’ve made the point.

The data tell us the rate of change could take a stomach-jerking step. Why? Too much money depends on preventing it or fostering it. Tug of war.  It may not happen. But be ready.