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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…)

Big Blanket

The US stock market trades about $500 billion of stock daily, the great majority of it driven by machines turning it into trading aerosol, a fine mist sprayed everywhere. So tracking ownership-changes is hard. And unless we speak up it’s about to get a lot harder.

In 1975 when the government was reeling like a balloon in the wind after cutting the dollar loose from its anchoring gold, Congress decided to grant itself a bunch of authority over the free stock market, turning into the system that it now is.

How?  Congress added Section 11A to the Securities Act, which in 2005 became Regulation National Market System governing stock-trading today – the reason why Market Structure Analytics, which we offer to both public companies and investors, are accurately predictive about short-term price-changes.

And Congress decided to create a disclosure standard for investors, amending the Securities Act with section 13F. That’s what gave rise to the quarterly reports, 13Fs, that both investors and public companies rely on to know who owns shares.

I use the phrase “rely on” loosely as the reports are filed 45 days after the end of each quarter, which means the positions could be totally different by the time data is released. It’s a standard fit for the post office. Mail was the means of mass communication in 1975.

Currently, the standard applies to funds with $100 million or more in assets. Many managers divide assets into sub-funds to stay below that threshold.  So most companies have shareholders that show up in no reports. But at least they have some idea.

Well, out of the blue the Securities and Exchange Commission (SEC) has decided to lift the threshold to $3.5 billion to reflect, I guess, the collapse of dollar purchasing power.

But nothing else changes!  What would possess a regulatory body ostensibly responsible for promoting fairness and transparency to blanket the market in opacity while keeping in place time periods for reporting that have existed since 1975?

I’m reminded of a great line from the most quotable movie in modern history, Thank You For Smoking: I cannot imagine a way in which you could have $#!!@ up more.

Public companies have been asking the SEC for decades to modernize 13F reporting. Dodd Frank legislation passed in 2010 included a mandate for monthly short-position reporting. It’s not happened because the law put no timeframe on implementation.

But how stupid would it be to require monthly short-position reporting while letting long positions remain undisclosed till 45 days after the end of each quarter?

Much of the world has stricter standards of shareholder disclosure.  Australian markets empower companies and stock exchanges to require of investors full disclosure of their economic interest, on demand.

Our regulators appear to be going the opposite direction.

Australia offers an idea, SEC. If you’re going darken the capital markets with a new (non) disclosure standard, then how about empowering companies to demand from holders at any time a full picture of what they own and how they own it?

Investors, I get it. You don’t want anyone knowing what you have.  Well, it seems to work just fine in Australia, home to a vibrant capital market.

And let’s bring it around to market structure.  There is a woefully tilted playing field around ETFs.  A big investor, let’s say Vanguard, could give a billion-dollar basket of stocks to an Authorized Participant like Morgan Stanley off-market with no trading commissions and no taxes, in exchange for a billion dollars of ETF shares.

None of that counts as fund-turnover.

It could happen by 4p ET and be done the next day.  No trading volume. And then Vanguard could come right back with the ETF shares – again, off-market, doesn’t count as fund-turnover – and receive the stocks back.

Why would investors do that? To wash out capital gains. To profit on the changing prices of stocks and ETFs. This is a massive market – over $500 billion every month in US stocks alone.  It’s already over $3 TRILLION in total this year.

What’s wrong with it?  All other investors have to actually buy and sell securities, and compete with other forces, and with volatility, and pay commissions, pay taxes, alter outcomes by tromping through supply and demand.  Oh, and every single trade is handled by an intermediary (even if it’s a direct-access machine).

So how is that fair?

Well, couldn’t all investors do what Vanguard did?  No. Retail investors cannot.  Yes, big investors could take their stock-holdings to Morgan Stanley and do the same thing. But trading stocks and ETF shares back and forth to profit on price-changes while avoiding taxes and commissions isn’t long-term investment.

That the ETF market enjoys such a radical advantage over everything else is a massive disservice to public companies and stock-pickers.

And after approving the ETF market, you now, SEC, want to yank a blanket over shareholdings to boot?  Really?  Leave us in 1975 but 35 times worse?

Market Structure Analytics will show you what’s happening anyway. And nearly in real time. But that’s not the point. The point is fairness and transparency. Every one of us should comment on this rule.

Power of Two

We’re coming to the end of two Coronavirus quarters. What happens now?

In a word, July.  As to what July brings, it’s summer in the northern hemisphere, winter down under.

It’s also the end of a remarkable period in stocks. I don’t mean rising or falling, volatility, the invincible-Alexander-the-Great-Macedonian-phalanx of the stock market (your history tidbit…you can look it up).

By “end” we don’t mean demise.  Though a demise is probably coming. More on that later. We mean the end of epic patterns.

We wrote last week about index-rebalances delayed since December.  In patterns observable through ModernIR behavioral analytics, the effort to complete them stretched unremitting from May 28 to June 18.

Yes, June 19 was a muscular volume day with quad-witching and we saw BIG Exchange Traded Fund (ETF) price-setting that day in many stocks. (Note: ETFs are substitutes for stocks that are easily traded but entitle owners to no underlying assets save the ETF shares.)

But the patterns strapping May to June like a Livestrong bracelet (wait, are those out?) ended almost everywhere June 18.  The effort reflected work by about $30 trillion, adding up money marked to MSCI, FTSE Russell and S&P Dow Jones, to match underlying construction.

Funds moved before rebalances. And the biggest components, ETF data indicate – really, they dwarf everything else – are AAPL and MSFT. Patterns show money piled like a rugby scrum into AAPL call options in early June, and then plowed headlong into AAPL equity between June 12-18.

It’s good business if you can get it, knowing the stock will inevitably rise because of its mass exposure to indexes and how its price then when last money square-danced into an Allemande Left with indexers in December 2019 was about $280.

How many of you remember when AAPL was down to about 5% of the computing market, most of that in academia, and it looked like MSFT would steamroll it right out of business?  And then MSFT was yesterday’s news, washed up, a boomer in a Slack world.

Today both say, Ha! Suckers!

MSFT patterns are like AAPL’s but less leveraged, explaining the divergence in performance over the past year. AAPL is up 84%, MSFT about half that.  You can see here how both have performed versus the Tech-heavy QQQ (Nasdaq 100 from Invesco) and the SPY, State Street’s proxy for the S&P 500.

AAPL and MSFT have pulled the market along like Charles Atlas (and his doppelganger) towing a Pennsylvania railcar (more arcane and anachronistic history for you).

That ended, at least for now.  The Russell reconstitution continues through Friday but in patterns at this point it appears money has already changed mounts, shifted chairs.

The marvel is the magnitude of the effects of these events, and the power of two – AAPL and MSFT.

You’re thinking, “What about the rest of the FAANGs?”

MSFT isn’t one but we include it, and oftentimes now TSLA and AMD.  FB, AMZN, NFLX, GOOG – incisors dripping less saliva than AAPL – are massive, yes. But they don’t pack the ETF power of the two.

Let me give you some data. There are 500 Financials stocks, about 400 Healthcare, around 300 Consumer Discretionary.  Tech is around 200.  Most of these sectors are Oversold, and there’s a lot of shorting. The FAANGs are Overbought and more than 50% short, collectively.

The few outweigh the many.

And meanwhile, Market Structure Sentiment™ is both bottomed and lacking the maw it signaled. Either we skip across the chasm for now, or it trips us soon (stocks love to render fools of soothsayers).

The salient point is that the market can’t be trusted to reflect views on Covid19, or trade with China, or the election in November, or economic data, or actions of the Federal Reserve (curiously the Fed’s balance sheet is tightening at the moment). It’s right now defined by the power of two.

Two legs.

We humans stand fine on two. Can the market?  We’re about to find out.  And the degree to which your shares are at risk, public companies, to those two legs, and your portfolio, investors, is measurable and quantifiable. Ask us, and we’ll show you.

Squid Ink

Is retail money creating a Pandemic Bubble? Sort of. Really, it’s Fast Traders turning those orders into clouds of squid ink.

There are 47 million customer accounts at Schwab, Fidelity, Ameritrade, E*Trade and Robinhood.  These big online brokers sell their flow to Citadel, Two Sigma, Susquehanna’s G1X options platform, Virtu, UBS, options trader Wolverine, and others.

Nearly all of the orders are “non-directed,” meaning the broker determines where to send them.  Also, more than three paragraphs of market structure goop and people grab a bottle of tequila and go back to day-trading.

So, let me explain.

Do you know CHK?  A shale-oil play, it’s on the ropes financially. In May it was below $8. Yesterday CHK was near $70 when it halted for news. Which never came, and trading resumed. (Note: A stock should never, ever be halted for news, without news.)

It closed down hard near $24. Rumors have flown for weeks it’ll file bankruptcy.  Why was it at $70? People don’t understand that public equity often becomes worthless if companies go bust. Debtholders convert to equity and wipe out the old shareholders.

Hertz (HTZ) went bankrupt May 26 and shares closed at $0.56.  Monday it was over $5.50, up about 900%. HTZ debt is trading at less than 40 cents on the dollar, meaning bondholders don’t think they’ll be made whole – and they’re senior to equity.

This is bubble behavior. And it abounds. Stocks trading under $1 are up on average 79% since March, according to a CNBC report.

ABIO, a Colorado biotech normally trading about 10,000 shares daily with 1.6 million shares out made inconsequential reference to a Covid preclinical project (translation: There’s nothing there). The stock exploded, trading 83 million shares on May 28, or roughly 50 times the shares outstanding.

Look at NKLA.  It’s been a top play for Robinhood clients and pandemic barstool sports day-trading. No products out yet, no revenue. DUO, an obscure Chinese tech stock trading on the Nasdaq yesterday jumped from about $10 to $129, closing above $47.

Heck, look at Macy’s.  M, many thought, was teetering near failure amidst total retail shutdown. From about $4.50 Apr 2, it closed over $9.50 by June 8.

W, the online retailer that’s got just what you need, is up 700% since its March low despite losing a billion dollars in 2019.

When day traders were partying like it was 1999, in 1999, stocks for businesses with no revenues and products boomed.  Then the Nasdaq lost 83% of its value.

About 95% of online-broker orders are sold to Fast Traders – the Citadels, the Two Sigmas, the Virtus.  They’re buying the tick data (all the prices) in fractions of seconds. They know what’s in the pipeline, and what’s not.

Big online brokers sell flow to guarantee execution to retail traders.  I shared my experience with GE trades. The problem is retail prices are the ammunition in the machine gun for Fast Traders. They know if clips are being loaded, or not. And since retail traders don’t direct their trades (they don’t tell the broker to send it to the NYSE, Nasdaq, Instinet, IEX, etc., to hide prices from Fast Traders), these are tracer rounds stitching market prices up and down wildly.

The Fast Traders buying it can freely splatter it all over the market in a frenzy of rapidly changing prices, the gun set on Full Automatic.

This is how Fast Traders use retail trades to cause Wayfair to rise 700%. The order flow bursts into the market like squid ink in the Caribbean (I’ve seen that happen snorkeling), and everyone is blinded until prices whoosh up 30%.

A money manager on CNBC yesterday was talking about the risk in HTZ. She said there were no HTZ shares to borrow. Even if you could, the cost was astronomical.

Being a market structure guy with cool market structure tools (you can use them too), I checked HTZ.  Nearly 56% of trading volume is short. Borrowed. And the pattern (see here) is a colossus of Fast Trading, a choreographed crescendo into gouting squid ink.

How? Two Sigma, Hudson River Trading, Quantlab, etc., Fast Trading firms, enjoy market-making exemptions. They don’t have to locate shares. As high-speed firms “providing liquidity,” regulators let them do with stocks what the Federal Reserve does with our money. Digitally manufacture it.

Because they buy the flow from 47 million accounts, they know how to push prices.

That’s how ABIO traded 83 million shares (60% of the volume – nearly 50 million shares – was borrowed May 28, the rest the same shares trading many times per second).

It’s how CHK exploded up and then imploded as the manufactured currency vanished. And when stocks are volatility halted – which happened about 40 times for CHK the past two trading days – machines can game their skidding stop versus continuing trades in the ETFs and options and peer-group stocks related to the industry or sector.

This squid ink is enveloping the market, amid Pandemic psychology, and the economic (and epic) collapse of fundamental stock-pricing.


You gotta know market structure, public companies (ask us) and investors (try EDGE).

Benjamin Graham

A decade ago today, stocks flash-crashed.  I’m reminded that there are points of conventional market wisdom needing reconsideration.

It’s not because wisdom has diminished. It’s because the market always reflects what the money is doing, and it’s not Ben Graham’s market now. I’ll explain.

There are sayings like “sell in May and go away.”  Stocks fell last May. You’ll find bad Mays through the years. But to say it’s an axiom is to assert false precision.

Mind you, I’m not saying stocks will rise this month. They could plunge. The month isn’t the reason.

Graham protégé Warren Buffett told investors last weekend that he could find little value and had done the unthinkable: Reversed course on an investment. He dumped airlines. Buffett owned 10% of AAL, 11% of DAL, 11% of LUV and 9% of UAL.

Buffett and Berkshire Hathaway, sitting on $137 billion, believe in what Buffett termed “American Magic.” But they’ve sold, and gone away in May.

There are lots of those sayings. As January goes, so goes the market.  Santa Claus rallies come in December.  August is sleepy because the traders are at the Cape, the Hamptons.

These expectations for markets aren’t grounded in financial results or market structure.

Blackrock, Vanguard and State Street own 15-20% of the airlines, all of which are in 150-200 Exchange Traded Funds (ETF).  Passive money holds roughly half their shares.

Passives don’t care about the Hamptons, January, or May.  Or what Warren Buffett does.

In JBLU, which Buffett didn’t own, the Big Three own 20%, and Renaissance Technologies and Dimensional Fund Advisors, quants with track records well better than Buffett’s in the modern era, invest in the main without respect to fundamentals.

Unlike Buffett, RenTech and DFA continually wax and wane.

It’s what the money is doing now.  Its models, analysis, motivation, allocations, are not Benjamin Graham’s (he wrote Security Analysis, The Intelligent Investor, seminal tomes on sound stock-picking from the 1930s and 1940s).

And that’s only part of it.  New 13fs, regulatory details on share-ownership, will be out mid-May. Current data from the Sep-Dec 2019 quarters for DAL show net institutional ownership down 17m shares, or 3%.

But DAL trades over 70 million shares every day. Rewinding to the 200-day average before the market correction exploded volumes, DAL still traded over 16m shares daily.  The total net ownership change quarter-over-quarter was one day’s trading volume.

Since there are about 64 trading days in a quarter, and 13fs span two quarters, we could say DAL’s ownership data account for about 1/128th of trading volume. Even if we’re generous and measure a quarter, terribly little ownership data tie to volume.

Owners aren’t setting prices.

Benjamin Graham was right in the 1930s and 1940s.  He’s got relevance still for sound assessment of fundamental value.  But you can’t expect the market to behave like Benjamin Graham in 2020.

The bedrock principle in the stock market now is knowing what motivates the money that’s coming and going, because that’s what sets prices.  Fundamentals can’t be counted on to predict outcomes.

In DAL, Active Investment – call it Benjamin Graham – was about 12% of daily volume over the trailing 200 days, but that’s down to 8% now. Passive money is 19%, Fast Traders chasing the price long and short are 62% of the 73m shares trading daily. Another 11% ties to derivatives.

Those are all different motivations, reasons for prices to rise or fall.  The 11% related to derivatives are hoping for an outcome opposite that of investors. Fast Traders don’t care for more than the next price in fractions of seconds. They’re the majority of volume and will own zero shares at day’s end. You’ll see little of them in 13fs.

The airline showing the most love from Benjamin Graham – so to speak – is Southwest.  Yet it’s currently trading down the most relative to long-term performance. Why? Biggest market cap, biggest exposure to ETFs.  It’s not fundamental.

If you’re heading investor-relations for a public company or trying to invest in stocks, what I’ve just described is more important than Benjamin Graham now.

The disconnect between rational thought and market behavior has never been laid so bare as in the age of the pandemic.  It calls to mind that famous Warren Buffett line:  Only when the tide goes out do you discover who’s been swimming naked.

Might that be rational thought?

How airlines perform near-term depends on bets, trading, leverage. Not balance sheets.  It’s like oil, Energy stocks – screaming up without any fundamental reason.  And market structure, the infinite repeating arc from oversold to overbought, will price stocks. Not Ben Graham.  Though he was wise.

Roll Call

Apr 21, yesterday, is Texas A&M Aggie Muster.  Aggies everywhere gather to say “here” for Aggies lost in the past year, a roll call. It’s more poignant this time for my Aggie, Karen, and the many friends and family hailing from College Station.  Gig’em, Aggies.

Speaking of Texas, let’s talk oil.  We’ve been saying for years that volatility during the next crisis, whenever it came, would be exacerbated by Exchange Traded Funds (ETFs) and lead to large failures.  It’s now happened in oil, which freakishly settled Monday at $37 below zero.

Oil prices are predicated in the USA on futures contracts for West Texas Intermediate (WTI). Overflowing storage facilities mean few parties want to take delivery of oil. That pressures prices.

But oil isn’t worth nothing. It’s not worth less than nothing. That futures went south of zero is a product of the supply/demand distortions ETFs introduce.

Futures are themselves derivatives that obligate one to action only if held to settlement. ETF investors are not buying barrels of oil. They’re buying the PRICE of oil.

But they’re really buying derivatives that represent derivatives that represent the price of oil.  The massive oil ETF, USO (always among the most active stocks, it yesterday traded a billion shares, one of every twelve, leading the market), currently claims assets of $3 billion comprised heavily of June and July WTI contracts.  It’s down 80% in a year.

We’ve explained before that ETFs work similarly to, say, buying poker chips.  You pay cash to the house and receive chips of equal value. The chips represent the cash.  The difference with ETFs is there’s an intermediary between you and the house.

So the intermediary, the broker, pays the house for the chips and sells them to you.  Suppose the intermediary, the broker, gave energy futures as payment for the chips, rather than cash.

Then the value of the futures plunged. ETFs compound the damage. The broker is out the value of it collateral, futures, and you’re out the value of your chips, which also collapse.

The broker may stop transacting in the ETF because it’s out a lot of money. Now you can’t find a buyer – and you suffer even more damage.

This happened.  Interactive Brokers said it lost $88 million, its portion of the excess losses by its customers, some of whom lost everything in their accounts. The firm’s CEO said in a CNBC interview yesterday it had exposure to about 15% of the May WTI futures contracts behind the damage, meaning some $500 million more exists.

And the damage yesterday to the June WTI contract, the next in the series, was as impactful.  Massive Singapore futures broker Hin Leong, which moves physical commodities, filed for bankruptcy. It had been in business since 1963.

Banks most exposed to Hin Leong’s billions in obligations:  HSBC and ABN Amro.  We’ve long said we thought HSBC was a counterparty at risk in a financial crisis, on exposure to derivatives.  ABN Amro lost big already, on Ronin Capital’s March failure.

The biggest derivatives counterparties though are all names you know: JP Morgan, Goldman Sachs, Morgan Stanley, BofA, Citi (which has vastly more derivatives exposure via swaps than anyone).  They may be fine – but the world relies on these firms to make every meaningful market, from helping the Fed, to trading ETFs.

We’re leaving out a key piece of the story. The big way ETFs cause trouble is by distorting the market’s perception of supply and demand. In 2008, securitized mortgage derivatives bloated the appearance of demand for real estate.

USO owned some 25% of the subject oil futures contract. Yes, we’ve got too much oil (remember peak oil? Cough, cough.) because travel died. Sure, we know supply exceeds demand.


Demand from derivatives of derivatives is extended reach to an asset class – which inflates its price.  I submit:  WTI May futures traded to -$37 Apr 20 because ETFs grossly inflated the price despite its apparent weakness. When books were squared and inflationary “financial” demand from ETFs removed, oil was worth 200% less than zero.

Said another way, when money in ETFs not wanting to take delivery of oil didn’t even want its price, we discovered that demand implied in futures misrepresented reality.

Thank you, ETFs.

Barclays shuttered two oil instruments. A dozen more are at risk.  USO is at risk. The roll call of the threatened is lengthening.

Where else are ETFs inflating prices relative to underlying demand? Well, the greatest instance of asset-class extension is in US equities. Especially the FAANGs – FB, AAPL, AMZN, NFLX, GOOG (and the pluses are MSFT, AMD, TSLA, a handful of others).

These bellwethers have weathered better than the rest in a global shutdown.  But they all depend on consumer-discretionary income. People have to be working to pay for subscriptions, and businesses must be operating to spend advertising dollars.

The drums are drumming. I expect we’ll see some even more surprising ETF failures before the roll call is done.  The sooner we’re back to work, the quicker the drumbeat ends.


I rest my case, and it only took 15 years.

On Dec 29, 2009, we wrote in this very blog we’d then been clattering off the keyboard since 2006: “Now, why would you care about Iron Condors, IROs and execs? Because once again something besides fundamentals affected market prices.

Has the market ever offered more proof than now of the absence of fundamentals?  SPY, the S&P 500 Exchange Traded Fund (ETF), is up 27.3% since Mar 23 after falling 34.1% from a Feb 19 peak.  It’s still 19% down but, boy.  That’s like a Patriots Super Bowl comeback.  And what happened?


I’ll explain.

Note: We’re going to discuss what’s happened to the market in the age of the virus at 2p ET today, and it’s free and open to anyone. Join us for an hour:

What I mean by nothing is that the virus is still here, the economy is still shut down.  Quarterly earnings began with the big banks yesterday and they were bad and Financials fell.  The banks are the frontlines of the Viral Response (double entendre intended).

Many say the market’s expectations are improving. But we have NO IDEA what sort of destruction lies beyond the smoky wisps floating up from quarterly reporting. Future expectations are aspirational. Financial outcomes are rational facts.

And do they even matter?

Consider the Federal Reserve. Or as people are calling it on Twitter, the Freasury (Fed merged with Treasury).  The Fed is all-in, signaling that it’ll create plenty of money to replace shrunken consumption (why is that good if your money buys less?). It’s even buying bond-backed ETFs, which are equities (we’re Japan now).

The market’s reaction to Fed intervention cannot be said to reflect business fundamentals but rather the probability of asset-price inflation – or perhaps the analogous equivalent of enough poker chips for all the players including the losers to stay in the game.

It’s a reason for a 27% rally in equities. But it’s confusing to Main Street, as it should be.  We’ll have 20 million unemployed people (it’s coming) and capital destruction in the trillions of dollars when we sort out the mess in our consumption-driven society.

Yet the market doesn’t seem to depend on anything. That’s what I mean by nothing.  The market does its thing, rises and falls, shifts money from Real Estate to Tech and back, without respect to the virus or fundamentals. As investors flail to describe the unexpected.

Stocks dependent on consumption like Consumer Discretionary, Energy, Materials, led sector gainers the last month.  These include energy companies like Chevron, Exxon and Valero that sell gasoline to commuters. Chipotle, Starbuck’s, Royal Caribbean, selling stuff to people with discretionary income. Dow, Dupont and Sherwin-Williams selling paint, chemicals, paper.

They’ve soared, after getting demolished. And nothing has changed. Sure, Amazon, Zoom, Netflix, the chip companies powering systems behind all our stay-at-home video-use are up, and should be.

But the central tendency is that the market plunged down and bucked up, without data to support either move.  That’s what I’ve been talking about so long. The market is not a barometer for rational thought.

It IS a barometer for behaviors, one of which is rational.  And we’ll explain what this image means when you tune to the webcast. (Click here for larger version.)Active Investment - Mar 2020 Correction

Think of the risk in a market motivated by nothing.  In Dec 2019 when we described the market as surly furious, the steep decline had no basis. During it, pundits tried to explain the swoon as expectation of a recession. Stocks roared to epic gains after Christmas 2018.

Nothing motivated either move.  That was a stark illustration of market structure form trumping capital-formation function.

Now stocks have zoomed back up 27% off lows, and everything is still wrong, and the wrongness doesn’t yet have defined parameters.

I don’t know which instance is most stark. Maybe it doesn’t matter. Come ask questions today at 2p ET at our webcast on market structure during the age of the virus.  I would love nothing more!


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.