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…)

Epiphany

DoubleLine’s famed Jeff Gundlach says we’ll take out March lows in stocks because the market is dysfunctional.

Karen and I have money at DoubleLine through managed accounts with advisors.  Mr. Gundlach is a smart man. Maybe it’s splitting hairs if I say the stock market isn’t dysfunctional but reflecting its inherent structural risks.

We know as much as anyone including Mr. Gundlach about market mechanics. And I still learn new stuff daily.  Matter of fact, I had an epiphany over the weekend. I compared market behaviors during the Great 2020 Market Correction.

Wow is that something to see.  We might host a webcast and share it.  If you’re interested, let us know.

Over the past decade, the effort to produce returns with lower risk has spread virally in the US stock market.  Call it alpha if you like, getting more than you’re risking.  Hedge funds say it’s risk-adjusted return.

The aim is to protect, or insure, everything against risk, as we everyday people do. We protect our homes, cars, lives, appliances, even our entertainment expenditures, against risk by paying someone to replace them (save for our lives, where beneficiaries win at our loss).

Stock traders try to offset the cost of insurance by profitably transacting in insured assets. That’s the holy grail.  No flesh wounds, no farts in our general direction (for you Monty Python fans).

It works this way. Suppose your favorite stock trades for $20 and you’re a thousand shares long – you own 1,000 shares. For protection, you buy 20 puts, each for 50 shares. You’re now long and short a thousand shares.

If the stock rises, the value of your puts shrinks but you’re up. If the stock declines, your long position diminishes but your puts are worth more.  Say the stock rises to $23. The value of your puts declines, making you effectively long 1,300 shares, short 700.

To generate alpha (I’m simplifying, leaving out how options may decrease in value near expiration, the insurance-renewal date, so to speak), you need to offset the cost of insurance. With a good model built on intraday volatility, you can trade the underlying stock for 20 days, buying high and selling low, going long or short, to mitigate costs.

Everybody wins. Your counterparty who sold you the puts makes money.  You make money trading your favorite stock. You have no fear of risk. And because more money keeps coming into stocks via 401ks and so on, even the losers get lucky (thank you Tom Petty, rest in peace, for that one).

One big reason this strategy works is the rules.  Regulation National Market System requires all stocks to trade at a single daily average price in effect. Calculating averages in a generally rising market is so easy even the losers can do it.

Now, what would jack this model all to hell?

A virus (frankly the virus is an excuse but time fails me for that thesis today).

Understand this:  About 80% of all market volume was using this technique. Quants did it. Active hedge funds. Fast Traders. Exchange-Traded Funds (ETF) market-makers.

Big volatility doesn’t kill this strategy. It slaughters the parties selling insurance. Observers are missing this crucial point. Most active money didn’t sell this bear turn.  We can see it.  Again, a story for later via webcast if you’re interested.

What died in the great 2020 Coronavirus Correction was the insurance business.

Casualties litter the field. The biggest bond ETFs on the planet swung wildly in price. Big banks like Dutch giant ABN Amro took major hits. Twenty-six ETFs backed by derivatives failed. The list of ETFs ceasing the creation of new units keeps growing and it’s spilling into mainstream instruments. Going long or short ETFs is a fave hedge now.

The Chicago Mercantile Exchange auctioned the assets of a major high-speed trader that sold insurance, Ronin Capital (around since 2006. If its balance sheet and leverage can be believed, it may have imputed a loss of $500 billion to markets.

Just one firm. How many others, vastly bigger, might be at risk?

Forget stock-losses. Think about how funds mitigate volatility. How they generate alpha. We’ve been saying for years that if the market tips over, what’s at risk is whatever has been extended through derivatives. ETFs are derivatives. That’s 60% of volume.

And now key market-makers for stocks, bonds, ETFs, derivatives, commodities, currencies, are tied up helping the Federal Reserve. Including Blackrock. They can’t be all things to all people at once.

The market isn’t dysfunctional.  It’s just designed to function in ways that don’t work if insurance fails. And yes, I guess that that’s dysfunctional. That was my epiphany.

I’ll conclude with an observation. We shouldn’t shut down our economy. Sweden didn’t. This is their curve. Using a population multiplier, their curve is 27% better than ours – without shutting down the economy, schools, restaurants. We are the land of the free, the home of the brave. Not the land of those home, devoid of the brave. I think it’s time to put property rights, inalienable rights, above the government’s presumption of statist power.

The End

In crises I think of Winston Churchill who said, “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Let’s start now with lessons from a health crisis that became a market crisis and proceeded to an economic crisis.

This last leg is yet murky but with hotels at 15% occupancy and the great American service industry at a standstill in an economy 70% dependent on consumption, it’s big.

First, the stock market. Intraday volatility in the S&P 500 averaged 10% the past week – a daily market correction between mean high and low prices by component.

Volatility is unstable prices, and big money needs stability to move. If the market exists for public companies and investors, it has served them poorly. Short-term machines have dominated. Investors were unable to get in or out without convulsing the whole construct of a $30 trillion edifice now smashed a third smaller.

Energy companies should be the first ones knocking at the SEC because the sector was 22% volatile the past week amid losing vast value. Sure, oil prices fell. Should it be the worst month ever for oil? The sector was battered more than in the maw of 2008.

Market structure is the hubris of equities. We’ve said it for years. We warned that Exchange Traded Funds, derivatives, had pervaded it, spreading the viral threat of severe inflation and deflation if stocks and ETFs move in unison.

There’s another basic problem. I’ll give you an analogy. The local grocery store down the street in Steamboat was denuded of wares as though some biblical horde of incisor-infested critters had chewed through it. I guess in a sense it was.

If there’s no lettuce, you can’t buy it. The price of lettuce doesn’t carom though. Demand ceases until supply arrives.

And it did. We later found lettuce, carrots, onions, eggs in abundance, but no limes (drat! A vital gin-and-tonic component).

We bought what they had.

In the stock market as with groceries there is no limitless supply of XOM or AAPL or whatever. But rules permit machines to behave as though lettuce and carrots always exist on the shelves when they don’t (a majority of volume was shorting and Fast Trading the past week – phantom products).

It’s why prices bucked and seized like a blender hucked into a bathtub. Investors would reach a hand for the proverbial lettuce and it would vanish and lettuce prices would scream smoking off like bottle rockets on July 4.

We don’t do that with groceries. Why in stocks? Energy companies, are you happy that machines can manufacture a crisis in your prices (that rhymes) and destroy the bulk of your value in days?

Look at Utilities. Producing energy to heat and cool American homes is vulnerable to tornadoes. Not viruses. Why did a preponderance of Utilities lose half their market capitalization in days – and then get 20% back yesterday?

These are questions every public company, every investor, should ask.

(Here’s what happened: Utilities were overweight – we warned of it! – in “low volatility” investments. Those blew up, taking Utilities with them.)

And they jumped on options bets. Volatility as an asset class lapses today around VIX expirations, and resets. Tomorrow index options expire, Friday is the first quad-witch of 2020. Derivatives have demolished swaths of equity capital like a runaway Transformer in one of those boom-boom superhero movies trampling through a trailer park.

It should be evident to the last market-structure skeptic – whoever you are – that market structure overwhelms reason, fundamentals, financials. If you’re in stocks, you need to get your head around it (we have, removing that burden for you).

If you want to be prepared and informed, ask us. We have a product that will fit your budget and put you in with the – socially distanced – cool kids who make market structure part of the investor-relations and investing processes.

Speaking of social distancing, there are 71 million American millennials (meaningful numbers living paycheck-to-paycheck). Viral mortality rate for them globally: 0%. There are two million hoary heads over 90. Covid-19 mortality is 19% (and most over 80 have chronic medical conditions).

I’m a data guy. How about keeping oldsters out of bars and youngsters out of nursing homes? I don’t mean to be insensitive and I know the concern is healthcare facilities. But destroying the finances of millennials over sequestering the vulnerable is troubling.

Last, central banks once were lenders of LAST resort taking good collateral at high cost. I would be pulling out all stops too, were I leading. I’m casting no aspersions. But governments are funded by people, not the other way around, and cannot carry the freight by idling productive output. That’s cognitively dissonant, intellectually incongruous.

This may be the last time we get away with it. Let’s stop that before it ends us. Find a new plan.

And investors and IR people, understand market structure. This is a beginning. It’ll again roar in our faces with slavering fangs.

SPECIAL CORONAVIRUS EDITION: Halting

My email inbox took such a fusillade of stock volatility halts yesterday that I set two rules to sort them automatically. Emails rained in well after the close, girders triggered hours before and stuck in an overwhelmed system.

As I write, volatility halts Mon-Thu this week total 2,512.  Smashing all records.

You need to understand these mechanisms, public companies and investors, because high-speed trading machines do.

On May 6, 2010 the market collapsed and then surged suddenly, and systems designed then to interdict volatility failed.  They were revamped. Finalized and implemented in 2013, new brackets sat dormant until Mar 9, 2020.

Wham!

They were triggered again yesterday, the 12th. At Level 1, the market in all its forms across 15 exchanges and roughly 31 Alternative Trading Systems stops trading stocks when benchmarks fall 7% from the reference price in the previous day’s closing auction.

To see exchanges, visit the CTA plan and exclude Finra and CBOE (17 members becomes 15 exchanges). You can track ATS’s (dark pools) here.

The Level 1 pause lasts 15 minutes and trading then resumes.  Say the reference price was 2,400 for the S&P500 the day before. At 2,242, it stops for 15 minutes.  Down 13% to 2,123, it halts again for 15 minutes. At 20% down, the markets close till the next day (that would be SPX 2,000 in our example).

Here’s the kicker: Levels 1-2 apply only till 3:25p ET. If the market has been off 5% all day till 3:25p ET and then it swoons, it won’t stop falling till it’s down 20% – SPX 2,000.  Girders apply only down, not up. Stocks could soar 30% in a day but couldn’t fall 21%.

Then there are single-stock guards called Limit Up/Limit Down (LULD) halts (the stuff inundating my inbox). When a Russell 1000 stock (95% of market cap), or an ETF or closed-end fund, moves 5% away from the preceding day’s reference price in a five-minute span, the security will be halted.

Russell 2000 stocks (add the two and it’s 99.9% of market cap) halt on a 10% move from the reference price in five minutes, applicable all the way to the close. Prices for all securities must be in the LULD range for 15 seconds to trigger halts.

For perspective, high-speed machines can trade in microseconds, millionths of a second (if machines can find securities to trade). Machines can game all these girders.

Boeing (BA) was volatility-halted three times yesterday (market cap $87 billion, over $220 billion of market cap in April last year) and still declined 18%, 80% more than the DJIA (and it’s a component).

Our friends at IEX, the Investors Exchange (the best market, structurally, for trading) tracked the data. Full-service broker-dealers handle customer orders, as do agency brokers (like our blood brothers at Themis Trading). Proprietary traders are racing their own capital around markets.  Look at this.

It matches what we see with behavioral analytics, where machines outrace any indication that rational money is coming or going. It’s why real money struggles to buy or sell.

How have stocks lost 25% of value in two weeks with no material change to shareholdings (widely true)? This is how. Machines are so vastly faster than real money that it’s like shooting fish in a barrel.

A word on futures:  The Chicago Mercantile Exchange triggers halts overnight if futures move 5%. But that tells machines to bet big on the direction prices were last moving.

Let’s bring in Exchange Traded Funds (ETFs). They depend on predictable value in ETF shares and the underlying stocks. If ETFs have risen above the value of underlying stocks, market-makers short ETF shares (borrow them) and return them to ETF sponsors to get stocks worth less than ETF shares. And vice versa.

With a low VIX, this trade is easy to calculate. When volatility soars and ETFs and stocks move the same direction, market-makers quit. They can’t tabulate a directional gain. The market loses roughly 67% of its prices, which come from ETF market-makers. Machines then yank markets up and down thousands of points without meaningful real buying or selling.

Which leads us to next week.  Options expire. This pandemonium began with Feb options-expirations, where demand plunged.  If the market puts together two solid days, there will be an epochal rush to out-of-the-money call options before Mar 20. Stocks will soar 15%.

I’m not saying that’ll happen. It’s remotely possible. But we’re on precarious ground where ETFs subtracted from stocks suggest another 35% of potential downside.

Last, here’s my philosophical thought, apolitical and in the vein of Will Rogers or Oscar Wilde on human nature. A primitive society ignorant of the Coronavirus would blithely pursue food, clothing and shelter. Life going on.

Now our global self-actualized culture in one breath proposes we change the climate, and in the next paralyzes over a tiny virus.  I think Will and Oscar would suggest we learn to live (with viruses and the climate).

Whether we lose 35% or gain 15%, market structure is crushing human thought and shareholder behavior, and that fact deserves redress after this crisis.

Canary Prices

We’ve written of risks in stocks from proliferating Exchange Traded Funds (ETFs).

We’ve talked long about liquidity risks, here last October with CNBC’s Brian Sullivan.

So what, right?

The market has functioned well in this Coronavirus Pandemonium, argue regulators and reporters (WSJ subscription required).

What’s the definition of functioning?  Volume?  You longtime users of Market Structure Analytics rely on them so as not to confuse busy – volume – with productive – liquidity (and to know when story drives price, and doesn’t, and much more).

Refinitiv Lipper says some $20 billion left US equities the week ended Mar 6. Sounds big but it’s 1% of volume.

Add up shorting (borrowed stock) at 45.2% of daily S&P 500 trading the past week, and Fast Trading (machines hyper-trading intraday and ending flat), 53.3% of volume, and it’s 98.5% of market volume but not liquidity.

There’s your 99% (the difference is a rounding error).

This is why you should care about market structure, if you haven’t yet.

Volatility Monday triggered a marketwide stock circuit-breaker halting trading when stocks drop 7%. First time since the rule was implemented in 2013.

Volatility halts also stopped futures trading Monday. Both events derailed reads of VIX volatility, which depend on futures contracts and put/call pricing for freely trading S&P 500 components.

Maybe the VIX was over 100 Monday. We don’t know, as components stopped trading.

What’s more, volatility halts for stocks and ETFs cascaded to more than a thousand Monday and Tuesday, including pauses in large caps like OXY, stopped eight times. I think we surpassed the record-setting currency-driven (as is this) frenzy of Aug 24, 2015.

Many directional ETFs in energy, commodities, market vectors, bonds, leveraged instruments, were halted too.  Volatility halts are coal-mine canaries.

And we’re led to believe investors are panicking over the Coronavirus, and getting out, because markets are working. Anybody but ModernIR writing about volatility halts, paucity of liquidity? Do tell.

Market Structure Analytics exist, public companies and investors, to know what headlines don’t say.

It’s egregious disservice to tell everyone “the market is working great!” when volatility halts explode, most volume is transient trading, and nobody can get in or out.

Canaries falling in waves.

Active Investment declined in the S&P 500 from early Feb until Mar 6 and Mar 9, then ticked up 3% on selling – less than the 5.4% daily intraday volatility (spread between highest and lowest average prices) in components of the S&P 500.

Responding, the market suffered one of its greatest collapses.

People don’t care about insurance – a canary in the coal mine – until it’s needed. And then it’s too late.

Investors and public companies, if you’re lulled by quiescence like last autumn, you’ll be shocked by its departure regardless of the Coronavirus. You shouldn’t be.

ETFs are a principal cause for both market volatility and vanishing liquidity. Investors can sit on stocks – meaning they don’t circulate – and trade ETFs.  When the market lurched, ETF market-makers withdrew, as we’d reasoned from data.

Then investors wanted to sell.

Without the ETFs driving some 67% of trading volume normally, nobody was there to calculate prices. Markets spun crazily like a fighter jet hit by a missile.

And regulators tell us the market is working fine. What about these dying canaries everywhere?

Here is liquidity simply. Trade-size is down to 132 shares in the S&P 500. If you’re an investor trying to sell 100,000 shares, you fill 1% of it and the price gyrates away from you as Fast Traders jump ahead.

Now your pre-trade analytics are wrong. You can pull your trade. Or try to blitzkrieg it in a thousand 100-share trades “at the market,” the best bid.

Wham!

The market implodes a thousand points. Try to buy 10,000 shares and the market skyrockets, rising a thousand points.

Investor-relations people for Energy companies, how do your executives feel about this market?

Technology IR people, what if you’re next?  Tech is the biggest sector. Shorting rose 12% last week in the FAANGs (FB, AAPL, AMZN, GOOG/GOOGL, NFLX) and Active money was selling. FAANGs lead the market up and down. They topped Feb 14, bottomed Mar 3. And now?

(We have the answer. Ask us.)

Investors, is a market that can’t accommodate 1% of the audience into and out of the exits without shuddering the whole stadium and threatening its foundations okay?

Sentiment by our measures is the lowest we’ve ever recorded. Yesterday it was still falling but a day or two from bottom. Uncharted territory, yes. But ModernIR is continuously mapping behaviors, trends, spreads, more.  We have that data, right here.

What if markets zoom? Or don’t?

What’s it worth, public companies and investors, to know what the headlines don’t tell you?  What’s the price of a canary? Ask us. You’ll be surprised.

Viral Market

I fear the Coronavirus may cause us to miss the real clanging claxon the past two weeks: The stock market cannot handle any form of truth.  The viral threat is market structure.

That the market plummeted on yesterday’s surprise (shocking) Federal Reserve rate-cut, the first non-meeting central-bank move since 2008, is to be expected in context of the continuum that created pressure in the first place.  Let’s review:

1.      Week of Feb 16. Options expired, Market Structure Sentiment topped, demand for derivatives bets fell 5% rather than rose, on a fast-appreciating US dollar.

2.      Feb 24.  New options for March expiration began trading. March brings the first “quad-witching” period of 2020, with rafts of derivatives tied to currencies and interest rates recalibrating.  Against a soaring dollar and plunging interest rates, uncertainty flared and implied derivatives demand vanished, tanking stocks.

3.      Intraday volatility (spreads between high and low prices) zoomed in the S&P 500 to the highest level we’ve recorded, averaging a searing 4.9% daily. Market-makers for Exchange-Traded Funds could not calculate successful trades between stocks and ETFs and withdrew.  Fast Trading rose to 53% of volume. Markets corrected by Feb 28 at the fastest pace ever.

4.      Bets jumped to 100% that the Fed would cut rates at its Mar 17 meeting in response to mounting economic concern over the Coronavirus.  On Mar 2, with a new month beginning, traders bet big with swaps (swap volumes crushed records) paying on a rate cut.

The Fed cut rates yesterday instead.

They might as well have trafficked in infectious diseases. The change rendered Monday’s bets void by pulling forward all implied returns. It’s effectively the same thing that happened Feb 24 when bets never materialized. The market imploded.

Somebody should be on TV and in the newspapers explaining these mechanics, so the public stops incorrectly supposing the market is a barometer for virus fears.

It’s worse in fact. During the whole period of tumult in the market from Feb 24 to present, Active money at no point was a big seller.  Patterns show a collapse for passive investment – especially ETFs – that didn’t change till Monday on rate-cut bets (that were chop-blocked yesterday).

There’s more. Trade-size in the S&P 500 plummeted to a record-low 132 shares. While volume exploded, it was repeated movement of the same shares by Fast Trading machines, which were 53% of volume. Daily trades per S&P 500 component exploded from a 200-day average of 27,000 to over 58,000.

What does it all mean?  Without any real buying or selling, the market gyrated in ways we’ve never seen before. That’s the shriek of metal, the scream of inefficiency. Rightly, it should raise hair.

We wrote about this looming liquidity threat last year (more than once but we’ll spare you).

Regulators should prepare now for the actual Big One yet to come.  Because the next time there will be real selling. It could make February’s fantasia look like a warmup act.  I’m not mongering fear here. I’m saying public companies and investors should demand a careful assessment from regulators about recent market turmoil.

My suggestion:  If the market moves more than 5% in a day, we should suspend the trade-through rule, the requirement that trades occur at the best national price. Let buyers and sellers find each other, cutting out the Fast Trading middlemen fragmenting markets into a frenzy of tiny trades and volatile prices.

And we’d better develop a clear-eyed perspective on the market’s role as a barometer for rational thought.  The truth is, market structure is  the real viral threat to the big money exposed to stocks.

The Mock

Does it matter where stock-trades occur, investors and public companies?

It does to the stock exchanges.  The explosion in passive investing has driven trades toward the last price of the day, found in stock-exchanges’ closing auctions.

Why?

Index and Exchange-Traded Funds need to track a benchmark in most cases. The bane of passive investing is skewing from the mean, called a tracking-error. The last price of the day is the reference price, the official one.  Money pegging a benchmark wants it.

It’s been profitable business for the big exchanges because they charge the same price to buy or sell into the close. Often at other times there’s a fee to buy but a credit to sell (they say “adding and removing” but don’t get lost in the jargon).

Orders to buy or sell may be “market-on-close,” (we’ll call it “the mock”) meaning at the best bid to buy or offer to sell as determined by matching up supply and demand, or “limit-on-close,” orders buying or selling at a specific price or better to end the day.

If you’re nodding off now or looking for the latest news on who might’ve won the Iowa Caucus, stay with me. There’s an important market-structure lesson coming.

Cboe (the erstwhile Chicago Board Options Exchange) operates four stock markets and just received SEC approval to be part of the closing auction, formerly controlled by the NYSE for stocks listed there, and the Nasdaq for stocks listed there.

The auction will occur at Cboe’s BZX market, likely at a set fee per share. It’s important to know that BZX encourages orders to sell, paying $0.30 per hundred shares, or even $0.32 if the shares first came from retail traders.  That means firms like Two Sigma might buy trades for $0.15 from Schwab and sell them at BZX for $0.32.

Why would an exchange pay so much for a trade?  Because it sets the price – and that’s valuable data to sell, worth more than the cost of paying for the trade.

But I digress.

So the Cboe will now use prices from the NYSE and the Nasdaq to match trades market-on-close for reference purposes.  No short trades, no limit orders. Only what the market giveth or taketh away.

Naturally, the NYSE and the Nasdaq opposed the Cboe plan. We wrote about it all the way back in Aug 2017, describing the cash at stake then.  The biggies argued expanding access to the closing auction would fragment liquidity.

Anyone can use order types from all the exchanges to fill trades. What difference does it make where trades occur if the rules from the SEC say the behavior must be uniform?

It’s like those heist movies where the robbers huddle beforehand and say “synchronize watches.” The market is a collection of synchronized watches at the close.

But overlooked amid the market mumbo-jumbo are the effects on trading the rest of the time – and we need to understand, investors and public companies.

Phil Mackintosh, now chief economist at the Nasdaq and always an interesting read, says, “The data show there are a lot of other investors, traders and hedgers who are also using the close because it’s a cheap way to get sizable liquidity with minimal market impact.”

True enough, it’s not all passive. By the way, MSCI indexes rebalance for the quarter today. The issue to us is the way that much of the trading throughout the rest of the day is an effort to change the prices of big measures into the close.

Traders know money chases reference prices.  So they change prices the rest of the day by running stocks up or down, and trading index futures, options, options on futures, or baskets of ETFs, creating divergences to exploit.

This becomes the market’s chief purpose – skewing prices and bringing them back to the mean (the hubris here is a story for next time).  Everyone thinks it’s fundamentals when the behavioral data show how pervasive this short-term pursuit has become.

How to solve it? Disconnect markets. That alone would halve the arbitrage opportunity.

Since that won’t happen, the best defense is a good offense. Know what all the money is doing, all the time (we can help), and you won’t be fooled. Or mocked.

The Truth

You know it’s after Groundhog Day?  We passed Feb 2 and I don’t recall hearing the name Punxsutawney Phil (no shadow, so that means a reputed early spring).

Reminds one of the stock market. Things change so fast there’s no time for tradition.

We have important topics to cover, including the implications of the SEC’s recent decision to approve closing-auction trading at the CBOE, which doesn’t list stocks (save BATS).  Circumstances keep pushing the calendar back.

We said last week that the Coronavirus wasn’t driving stocks. It was market structure – measurable, behavioral change behind prices.

The Coronavirus is mushrooming still, and news services are full of dire warnings of global economic consequence.  Some said the plunge last Friday, the Dow Industrials diving 600 points, reflected shrinking economic expectations for 2020.

Now the market is essentially back to level in two days. The Nasdaq closed yesterday at a new record.  Did expectations of Coronavirus-driven economic sclerosis reverse course over the weekend?

It’s apparent in the Iowa caucuses that accurate outcomes matter.  The Impeachment odyssey, slipping last night into the curtains of the State of the Union address, is at root about interpretations of truth, the reliability of information, no matter the result.

We seem to live in an age where what can be known with certainty has diminished. Nowhere is it manifesting more starkly than in stocks.  Most of what we’re told drives them is unsupported by data.

A business news anchor could reasonably say, “Stocks surged today on a 10% jump in Fast Trading and a 5% decline in short volume, reflecting the pursuit of short-term arbitrage around sudden stock-volatility that created a broad array of cheap buying opportunity in derivatives.”

That would be a data-backed answer. Instead we hear, “Coronavirus fears eased.”

Inaccurate explanations are dangerous because they foster incorrect expectations.

The truth is, behavioral volatility exploded to 30% Feb 3, the most since Aug 2019. To understand behavioral volatility, picture a crowd leaving a stadium that stampedes.

Notice what Sentiment showed Feb 3. Sentiment is the capacity of the market to absorb higher and lower prices. It trades most times between 4.0-6.0, with tops over 7.0  The volatile daily read dropped below 4.0 Feb 3.

Cycles have shortened. Volatility in decline/recovery cycles is unstable.

Here’s the kicker. It was Exchange Traded Funds stampeding into stocks. Not people putting money to work in ETFs.  No, market makers for ETFs bought options in a wild orgy Monday, then caterwauled into the underlying stocks and ETFs yesterday, igniting a searing arc of market-recovery as prices for both options and ETFs ignited like fuel and raced through stocks.

That’s how TSLA screamed like a Ford GT40 (Carroll Shelby might say stocks were faster than Ferraris yesterday).  Same with a cross-section of stocks up hundreds of basis points (UNH up 7%, AMP up 6%, VMW up 4%, CAT up 4%, on it goes).

These are not rational moves. They are potentially bankrupting events for the parties selling volatility. That’s not to say the stock market’s gains are invalid.  We have the best economy in the world.

But.

Everyone – investors, investor-relations professionals, board directors, public-company executives – deserves basic accuracy around what’s driving stocks.  We expect it everywhere else (save politics!).

We’ll have to search out the truth ourselves, and it’s in the data (and we’ve got that data).