Search Results for: creations

Hot Air

Balloons rise on hot air. Data suggest there’s some in stocks.

Lipper says about $25 billion left US equities in October, $15 billion if you weed out inflows to Exchange Traded Funds (ETFs). Bond flows by contrast were up $21 billion. So how did stocks rise 5%?

In September 2019 when the S&P 500 closed roughly unchanged for the month, the Investment Company Institute reported a net increase in ETF shares of over $48 billion, bringing total YTD ETF creations and redemptions to $2.96 trillion.

For what?  More money has gone than come in 2019, so why more ETF shares?

And should we be concerned that stocks are rising on outflows?

Drawing correct conclusions about stocks depends on a narrative buttressed by data.  If we stay “stocks are up on strong earnings,” and earnings are down, it’s incorrect.

With about 80% of S&P 500 components having reported, earnings are down (FactSet says) about 3% year-over-year, the third straight quarterly contraction. Analysts currently expect Q4 2019 earnings to also contract versus 2018.

I’m not bearish. We measure behavioral data to see WHY stocks act as they do, so we’re not surprised by what happens.  It was simpler when one could meter inflows and outflows to explain ups and downs. More buyers than sellers. Remember those good old days?

Some $70 billion has exited US equities in 2019 yet stocks are at records. If holdings are down while stocks are up, the simplest explanation left to us now is it’s hot air – balloons lifted on heated atmosphere.

What’s heating the air? Well, one form of inflow has risen in 2019: The amount of ETF shares circulating. It’s up $200 billion.

The industry will say it’s because more money is choosing ETFs.  Okay, but is a dollar spent on ETFs hotter than one spent on underlying stocks, or mutual funds? There shouldn’t be more ETF shares if there are less invested dollars.

And if ETFs are inflationary for equities, how and why?

The reason investors are withdrawing money from stocks is because the market cannot be trusted to behave according to what we’re told is driving it. Such as people withdraw money and stocks rise.

Now ahead in the fourth quarter, if indeed rational money is forward-looking, we may see rising active investment on an expected 2020 pickup in earnings.

But measuring the rate of behavioral change from Jan-Nov 2019, the biggest force is ETFs. It’s not even close.  That matches ETF-creation data.

The inflationary effect from ETFs is that the market is hitting new highs as earnings decline and money leaves stocks.

The bedrock of fundamental investment is that earnings drive the market. Apparently not now.  What’s changed? ETFs.

How do they create inflation? Arbitraging spreads between stocks and ETFs has become an end unto itself. The prices of both are thus relative, not moored to something other than each other. And with more ETF shares chasing the same goods, the underlying stocks, the goods inflate.

We see it in the data. Big spreads periodically develop between stocks and ETFs, and stocks rise, and spreads wane, and stocks fall. In the last six weeks, correlation between the movement of stocks and ETFs has collapsed to 39% from over 91% YTD.

That’s not happened since we’ve been tracking the data. If ETFs are substitutes, they should move together (with periodic gaps), not apart. That they are indicates a fever-pitch in the focus on profiting on stock-ETF spreads.

That’s hot air.  The chance to trade things that diverge in value.

The problem with inflation is deflation, and the problem with rising on hot air is falling when it cools. We’re not predicting a collapse. But the risk in a market levitating on hot air is real.

Knowing the risks and how they may affect your stock, investor-relations people, or your portfolio, investors, is pretty important. We have the data to demystify hot air.

Wholesale Profits

CNBC’s Brian Sullivan invited me to discuss shrinking market liquidity last Friday. Riveting, huh!

Well, it is to me! Unraveling the mystery of the market has turned out to be a breathtaking quest. I had another aha! moment this weekend.

Jane Street, a big Exchange Traded Funds (ETF) Authorized Participant, commissioned a study by Risk.net on ETF liquidity.  As a reminder, APs, as they’re called, are essential to the ETF supply chain.  They’re independent contractors hired by ETF sponsors such as State Street to create and redeem ETF shares in exchange for collateral like stocks and cash.

Without them, ETFs can’t function. In fact, they’re the reason why ETFs have been blanket-exempted from the Investment Company Act of 1940 under SEC Rule 6c-11, recently approved.

Exempted from what? The law that all pooled investments be redeemable for a portion of the underlying assets. There is no underlying pool of assets for ETFs, as we’ve explained before.

If you’re thinking, “Oh, for Pete’s sake, Quast, can you move on?” stay with me. If we don’t understand how ETFs are affecting equities and what risks they present, it’s our own darned fault.  So, let’s learn together.

As I was saying, ETFs don’t pool assets. Instead, firms like Jane Street gather up baskets of stocks and trade them straight across at a set price to ETF sponsors, which in turn “authorize” APs, thus the term, to create an equal value of ETF shares wholesale in large blocks and sell them retail in small trades.

I explained to Brian Sullivan how the math of the stock market shows a collapse in stock-liquidity. That is, the amount of stock one can buy before the price changes is down to about 135 shares (per trade) in the S&P 500. Nearly half of trades are less than 100 shares.

Block trades have vanished. The Nasdaq’s data show blocks are about 0.06% of all trades – less than a tenth of a percent. Blocks are defined as trades of $200,000 in value and up. And with lots of high-priced stocks, a block isn’t what it was. For BRK.A, it’s 1.5 shares.  In AMZN, around 130 shares.

Yet somehow, trade-sizes in the ETF wholesale market have become gigantic. Risk.net says 52% of trades are $26 million or more.  A quarter of all ETF trades are over $100 million. Four percent are over $1 billion!

And almost $3 TRILLION of ETF shares have been created and redeemed so far in 2019.

Guess what the #1 ETF liquidity criterion is?  According to the Risk.net study, 31% of respondents said liquidity in the underlying stocks. Another 25% said the bid-offer ETF spread.

Well, if stock liquidity is in free-fall, how can ETF liquidity dependent on underlying stocks be so awesome that investors are doing billion-dollar trades with ETF APs?

We’re led to believe APs are going around buying up a billion dollars of stock in the market and turning around and trading it (tax-free, commission-free) to ETF sponsors.

For that to be true, it’s got to profitable to buy all the products retail and sell them wholesale. So to speak. My dad joked that the reason cattle-ranching was a lousy business is because you buy your services retail and sell the products wholesale.

Yet the biggest, booming business in the equity markets globally is ETFs.

We recently studied a stock repurchase program for a small-cap Tech-sector company.  It trades about 300,000 shares a day. When the buyback was consuming about 30,000 shares daily, behaviors heaved violently and Fast Traders front-ran the trades, creating inflation and deflation.

That’s less than a million dollars of stock per day.  And it was too much. Cutting the buyback down to about 10,000 shares ended the front-running.

I don’t believe billions in stocks can be gobbled up daily by ETF APs without disrupting prices. Indeed, starting in September we observed a spiking breakdown in the cohesion of ETF prices and underlying stock-prices and a surge in spreads (not at the tick level but over five-day periods).

But let’s say it’s possible. Or that big passive investors are trading stocks for ETF shares, back and forth, to profit on divergence. In either case it means a great deal of the market’s volume is about capturing the spreads between ETFs and underlying stocks – exactly the complaint we’ve made to the SEC.

Because that’s not investment.

And it’s driving stock-pickers out of business (WSJ subscription required) with its insurmountable competitive lead over long-term risk-taking on growth enterprises, which once was the heart of the market.

The alternative is worse, which is that ETF APs are borrowing stock or substituting cash and equivalents. We could examine the 13Fs for APs, if we knew who they were. A look at Jane Street’s shows its biggest positions are puts and calls.  Are they hedging? Or substituting derivatives for stocks?

Public companies and Active investors deserve answers to these questions. Market regulation prohibits discriminating against us – and this feels a lot like discrimination.

Meanwhile, your best defense is a good offense:  Market Structure Analytics. We have them. Ask us to see yours.  We see everything, including massive ETF create/redeem patterns.

Suppy Chain Trouble

If you go to the store for a shirt and they don’t have your size, you wait for the supply chain to find it.  There isn’t one to buy. Ever thought about that for stocks?

I just looked up a client’s trade data. It says the bid size is 2, the ask, 3.  That means there are buyers for 200 shares and sellers of 300.  Yet the average trade-size the past 20 days for this stock, with about $27 million of daily volume, is 96 shares.  Not enough to make a minimum round-lot quote.

That means, by the way, that the average trade doesn’t even show up in the quote data. Alex Osipovich at the Wall Street Journal wrote yesterday (subscription required) that the market is full of tiny trades. Indeed, nearly half are less than 100 shares (I raised a liquidity alarm with Marketwatch this past Monday).

Back to our sample stock, if it’s priced around $50, there are buyers for $10,000, sellers of $15,000. But it trades in 96-share increments so the buyer will fill less than half the order before the price changes. In fact, the average trade-size in dollars is $4,640.

The beginning economic principle is supply and demand. Prices should lie at their nexus. There’s an expectation in the stock market of endless supply – always a t-shirt on the rack.

Well, what if there’s not? What if shares for trades stop showing up at the bid and ask?  And what might cause that problem?

To the first question, it’s already happening. Regulations require brokers transacting in shares to post a minimum hundred-share bid to buy and offer to sell (or ask). Before Mr. Osipovich wrote on tiny trades, I’d sent data around internally from the SEC’s Midas system showing 48% of all trades were odd lots – less than 100 shares.

Do you see? Half the trades in the market can’t match the minimum. Trade-size has gone down, down, down as the market capitalization of stocks has gone up, up, up.  That’s a glaring supply-chain signal that prices of stocks are at risk during turbulence.

Let’s define “liquidity.”

I say it’s the amount of something you can buy before the price changes. Softbank is swallowing its previous $47 billion valuation on WeWork and taking the company over for $10 billion. That’s a single trade. One price. Bad, but stable.

The stock market is $30 trillion of capitalization and trades in 135-share increments across the S&P 500, or about $16,500 per trade.  Blackrock manages over $6.8 trillion of assets. Vanguard, $5.3 trillion. State Street. $2.5 trillion.

Relationship among those data?  Massive assets. Moving in miniscule snippets.

Getting to why trade-size keeps shriveling, the simple answer is prices are changing faster than ever.  Unstable prices are volatility.  That’s the definition.

I’ll tell you what I think is happening: Exchange Traded Funds (ETFs) are turning stocks from investments to collateral, which moves off-market. As a result, a growing percentage of stock-trades are aimed at setting different prices in stocks and ETFs. That combination is leading to a supply-chain shortage of stocks, and tiny stock-trades.

ETFs are substitutes dependent on stocks for prices. The ETF complex has mushroomed – dominated by the three investment managers I just mentioned (but everyone is in the ETF business now, it seems) – because shares are created in large blocks with stable prices. Like a WeWork deal.

A typical ETF creation unit is 50,000 shares.  Stocks or cash of the same value is exchanged in-kind. Off-market, one price.

The ETF shares are then shredded into the stock market amidst the mass pandemonium of Brownian Motion (random movement) afflicting the stocks of public companies, which across the whole market move nearly 3% from high to low every day, on average.

Because there are nearly 900 ETFs, reliant on the largest stocks for tracking, ever-rising amounts of stock-trading tie back to ETF spreads. That is, are stocks above or below ETF prices? Go long or short accordingly.

Through August 2019, ETF creations and redemptions in US stocks total $2.6 trillion.  From Jan 2017-Aug 2019, $10.1 trillion of ETF shares were created and redeemed.

ETFs are priced via an “arbitrage mechanism” derived from prices in underlying stocks. Machines are chopping trades into minute pieces because the smaller the trade, the lower the value at risk for the arbitragers trading ETFs versus stocks.

ETFs are the dominant investment vehicle now. Arbitrage is the dominant trading activity. What if we’re running out of ETF collateral – stocks?

It would explain much: shrinking trade-sizes because there is no supply to be had. Rising shorting as share-borrowing is needed to create supply. Price-instability because much of the trading is aimed at changing the prices of ETFs and underlying stocks.

Now, maybe it’s an aberration only. But we should consider whether the collateralization feature of ETFs is crippling the equity supply-chain. What if investors tried to leave both at the same time?

All public companies and investors should understand market liquidity – by stock, sector, industry, broad measure. We track and trend that data every. Data is the best defense in an uncertain time, because it’s preparation.

Spread Spoofing

I’ve never bet on sports, but the bulk of wagers is on the spread – whether the outcome will be above or below a range.

In the stock market spreads rule too, and data suggest market-makers are gambling on which things will move. The most shocking spread is the one between assets flowing to Exchange Traded Funds and the dollar-volume of ETF shares.

Wall Street Journal writer Akane Otani reported last weekend (subscription required) using data from Strategas that US equity ETFs saw about $36 billion of inflows to date this year, the majority into low-volatility strategies favoring defensive plays like large-caps and Utilities.

To accommodate these flows, ETF shares must be created. Data from the Investment Company Institute through August 2019 (the latest available) show a staggering $2.6 trillion of ETF shares have been created and redeemed this year.

Put another way, actual increases in ETF assets are 1.4% of total ETF share-transactions.  Talk about a spread.

I wonder what effect that’s having on the stock market?

First, let’s understand “creations” and “redemptions.”  We’ve written about them before and you can read our ETF white paper for more.  ETF shares are manufactured by brokers, which receive that right from Blackrock and other ETF sponsors in (tax-free) exchange for stocks and cash of equal value.

Say investors are buying Utilities ETFs because they want to avoid volatility. Communication Services sector stocks like Facebook and CBS are 84% more volatile on average over the past 50 trading days (we study that data) than Utilities stocks like Southern Co. and Duke Energy.

Brokers will find (buy, borrow, substitute) Utilities stocks worth, say, $12 million, and receive in trade from an ETF sponsor like State Street (XLU is the Utilities sector ETF) authority to create $12 million worth of ETF shares to sell to the eager investing public.

The data are saying the process of creating and redeeming ETF shares is vastly more peripatetic behind stocks than the actual dollars coming from investors.

Why? We’ll come to that.

Continuing the explanation, ETF shares are created off the market in giant blocks typically numbering 50,000 or more. The price does not move.  These shares are then sold in tiny trades – about 130 shares at a time – that move wildly, as do the prices of stocks exchanged for ETF shares.

There is, as the statistics folks would say, mass Brownian Motion (random movement) amid stocks – and the pursuit of profits via instability is leviathan.

We’ve done the math. An average of $325 billion of ETF shares are created and redeemed every month.  Barely more than a tenth of that has been invested in equity ETFs en toto in 2019.

What’s going on? What we’ve been telling financial reporters and the SEC for the last three years – to withering recrimination from ETF sponsors and resounding silence from the press and regulators.

ETF shares are being created and redeemed so short-term money can profit on the spreads that develop between stocks and ETFs (ironically, the same parties doing this are decrying short-termism).

Create ETF shares, and prices of ETFs will deteriorate versus stocks. Redeem (remove them) and prices firm. Contraction/expansion is relentless and way bigger than flows.

That’s not investing.  It’s gambling on (and fostering) spreads.  The math on its face says nearly 99% of creation/redemption volume is a form of gambling, because it doesn’t match investment-flows.

No doubt now there’s epithet-riddled screaming and shouting occurring across ETF trading rooms and ETF boardrooms.  Perhaps some part of the spread is legitimate.

But I’ll say again, regulators:  You owe the investing public a look into why trillions of dollars of ETF shares are created to serve billions of dollars of investment-flows. And we don’t know who the parties to creations and redemptions are, or what’s being exchanged.

It feels like spoofing – issuing and canceling trades to distort supply and demand. What effect is it having on the prices of stocks that both public companies and investors think reflect investment behavior?

I’ll wager there’s an answer.  Do you want to take the over or under?

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.

 

Melting Up

Blackrock CEO Larry Fink sees risk of a melt-up, not a meltdown for stocks.

Speaking of market structure, I’m a vice chair for NIRI’s Annual Conference – the 50th anniversary edition.  From the opening general session, to meeting the hedge funds, to a debate on how ETFs work, we’ve included market structure.  Catch a preview webcast on So-So Thursday, Apr 18, (before Good Friday) at 2pm ET (allow time to download Adobe Connect): https://niri.adobeconnect.com/webinar041819

Back to Larry Fink, is he right?  Who knows. But Blackrock wants to nudge record sidelined retail and institutional cash into stocks because revenues declined 7%.

Data tell us the market doesn’t need more buyers to melt up. Lipper said $20 billion left US equities from Jan through Apr 3, more than the $6 billion Bloomberg had earlier estimated. Stocks rallied 16%.

We wrote April 3 that no net cash fled equities in Q4 last year when the market corrected. If stocks can plunge when no money leaves and soar when it does, investors and public companies should be wary of rational expectations.

We teach public companies to watch for behavioral data outside norms.  Investors, you should be doing the same. Behavioral-change precedes price-change.  It can be fleeting, like a hand shoved in a bucket of water. Look away and you’ll miss the splash.

Often there’s no headline or economic factor because behaviors are in large part motivated by characteristics, not fundamentals.

Contrast with what legendary value investor Benjamin Graham taught us in Security Analysis (1934) and The Intelligent Investor (1949): Buy stocks discounted to assets and limit your risk.

The market is now packed with behaviors treating stocks as collateral and chasing price-differences. It’s the opposite of the Mr. Market of the Intelligent Investor. If we’re still thinking the same way, we’ll be wrong.

When the Communication Services sector arose from Technology and Consumer Discretionary stocks last September, the pattern of disruption was shocking. Unless you saw it (Figure 1), you’d never have known markets could roll over.

Larry Fink may think money should rush in (refrains of “fools rush in…”) because interest rates are low.  Alan Greenspan told CNBC last week there’s a “stock market aura” in which a 10% rise in stocks corresponds to a 1% increase in GDP. Stocks were down 18% in Q4, and have rebounded about 16%. Is the GDP impact then neutral?

To me, the great lesson for public companies and investors is the market’s breakdown as a barometer for fundamentals.  We’ve written why. Much of the volume driving equities now reacts to spreads – price-differences.

In a recent year, SPY, the world’s largest and oldest Exchange Traded Fund, traded at a premium to net asset value 62% of the time and a discount 38% of the time. Was it 2017 when stocks soared?  No, it was 2018 when SPY declined 4.5%.

Note how big changes in behavioral patterns correspond with market moves. The one in September is eye-popping. Patterns now are down as much as up and could signal a top.

SPY trades 93% of the time within 25 basis points of NAV, but it effectively never trades AT net-asset-value. Comparing trading volume to creations and redemptions of ETF shares, the data suggest 96% of SPY trading is arbitrage, profiting on price-differences.

This is the stuff that’s invaded the equity market like a Genghis Kahn horde trampling principles of value investment and distorting prices.

So, what do we DO, investors and public companies?

Recognize that the market isn’t a reliable barometer for rational thought. If your stock fell 40% in Q4 2018 and rebounded 38% in Q1, the gain should be as suspect as the fall.

Ask why. Ask your exchange. Ask the regulators. Ask the business reporters. These people should be getting to the bottom of vanishing rationality in stocks.

It may be the market now is telling us nothing more than ETFs are closing above net asset value and ETF market-makers are melting stocks up to close that gap.  That could be true 62% of the time, and the market could still lose 20% in two weeks.

When you hear market-behavior described in rational terms – even during earnings – toss some salt over a shoulder.  I think the market today comes down to three items: Sentiment reflecting how machines set prices, shorting, and behavioral change.

Behavioral patterns in stocks now show the biggest declines since September. Sentiment reflecting how machines set prices is topped ahead of options expirations that’ll be truncated by Good Friday. Shorting bottomed last week and is rising.

(Side note: patterns don’t vary during earnings. They fluctuate at month-ends, quarter-ends and options-expirations, so these are more powerful than results.)

Nobody knows the future and we don’t either. Behaviors change. But the present is dominated by characteristics, powerful factors behind behavioral patterns.

Beating Hearts

As the Dow Jones Industrials surged over 300 points on April Fools Day, the behavior driving it was Exchange Traded Funds, not rational thought reacting to economic data.

But aren’t ETFs manifestations of rational thought? Investors see, say, good Chinese manufacturing data, and pump money into them?

I’m not talking about fund flows.  I’ll explain.

CNBC reported that investors withdrew about $6 billion from stock funds during the first quarter’s epic equity rally. How can stocks soar when money is leaving?

We wrote Mar 20 that tallying fund-flow data in Q4 2018 when the market fell about 20% showed net static conditions. That is, $370 billion left stock-picking portfolios and the same amount shifted to passive funds. If no money left, why did stocks crater?

We should ask why fund flows don’t match market-performance. It seems like everyone is running around with fingers in ears going, “La la la la!” amid these uncomfortable realities.

Bloomberg wrote a wildly compelling piece on “heartbeat trades” Mar 29, taking a cue from FactSet’s Elisabeth Kashner, who first wrote about this ETF phenomenon in late 2017.

The gist is that ETFs somehow get short-term cash or stocks to finance creating ETF shares, which go to the provider of the loan as collateral, and then days later the ETF sponsor provides the bank with high capital-gains stocks equal to the value of the ETF shares, which it receives back.

Follow that?  Money is traded for ETF shares, which in turn are traded for stocks.

(Note: We should also wonder where those stocks came from if the market doesn’t suddenly take a selling hit afterward. Were they borrowed to start?)

The result of this trade is that taxes associated with the stocks are washed out of the ETF portfolio, ostensibly benefiting ETF investors.

Except ETF investors don’t own a share of pooled assets carrying tax liabilities. ETFs are not backed by any assets. The assets moving back and forth between, say, Blackrock and Goldman Sachs in these heartbeat trades belong to Blackrock, not to investors.

So Blackrock gets a tax benefit.

If you as an investor sell appreciated ETF shares, you owe taxes. That is, if you bought ETFs for $20 per share and they go to $30, and you sell them, you have $10 of gains and you’ll owe either ordinary-income or capital-gains taxes.

Not Blackrock et al.  They don’t own ETF shares.  They own collateral. Washed of taxes through processes such as what Bloomberg describes.

Bloomberg acknowledges that the same event – washing capital gains – occurs through the process of creating and redeeming ETF shares in ordinary course. Vanguard says in its ETF FAQs: “Vanguard ETFs can also use in-kind redemptions to remove stocks that have greatly increased in value (which trigger large capital gains) from their holdings.”

That by the way can hit a stock, undermining great fundamentals.

Creations and redemptions are huge. We had an estimated $1 trillion of ETF “gross issuance,” it’s called, in the time ordinary investors yanked $6 billion from stocks.

Might that $1 trillion have SOMETHING to do with how the stock market has behaved?  Read anything about it?

I’ll give you an example of the impact: the April Fools Day’s stock tirade. Brokers knew ETFs were undercollateralized. That is, if ETFs are supposed to, say, hold 500 S&P components in proportion as collateral, the rate of increase of markets in Q1 has meant they’re sampling only – using a handful of the same liquid stocks repeatedly to create and redeem ETF shares.

But they have to square books sometime. Usually month-ends, quarter-ends.

Fast Traders tipped us to it last week by buying and covering shorts.  So the market surged not on investors buying economic news but on ETF bookkeeping, in effect.

What has not happened yet is washing out capital gains. We saw smatterings only at March options-expirations. That shoe awaits, and ETF horizons in the wholesale market where shares are created and redeemed – again, $1 trillion in Q1 2019 – are fleeting.

These facts – not suppositions – matter because financial punditry is describing the market in fundamental terms when it’s being driven by leviathan tax-avoidance and arbitrage around a multi-trillion-dollar ETF creation-redemption process.

For public companies and investors, that means it’s nearly impossible to arrive at reliably fundamental expectations for stocks.

Manufactured Spreads

Did Exchange Traded Funds drive the recent market rollercoaster?

The supply of ETF shares moved opposite the market. The S&P 500 fell about 16% in December and rose around 19% from Dec 24 to March 5.  In December, says the Investment Company Institute, US ETFs created, or introduced, $260 billion of ETF shares, and redeemed, or retired, $211 billion.

So as the market tumbled, the number of ETF shares increased by $49 billion.

We saw the reverse in January as the market soared, with $208 billion of ETF shares created, $212 billion redeemed, the supply shrinking a little.

If ETFs track indexes, shouldn’t available shares shrink when the market declines and increase when the market rises?  Why did it instead do the opposite?

One might point to the $46 billion investors poured into equity ETFs in December at the same time they were yanking $32 billion from Active funds, says Morningstar.

Again a contradiction. If more money flowed to equities than left, why did the S&P 500 fall?  Don’t stocks rise when there are more buyers than sellers, and vice versa?

The fact that data and market behavior are at loggerheads should cause consternation for both investors and public companies. It means we don’t understand supply and demand.

One explanation, the folks from the ETF business say, is that inflows to ETFs may have been short. That is, when ETF shares increase while stocks are falling, ETF creators are borrowing stocks and trading them to Blackrock and Vanguard to create ETF shares for investors, who borrow and sell them.

These people explain it in a tone of voice that sounds like “aren’t we geniuses?”

But if true, the unique characteristics of ETFs that permit them limitless supply and demand elasticity contributed to the market correction.

We cannot manufacture shares of GE to short.  But ETF market-makers can manufacture ETF shares to short. How is that helpful to long-only investors and public companies?  The behavior of stocks separates from fundamentals purely on arbitrage then.

Here’s another statistical oddity: The net shrinkage in January this year marks only the third time since the 2008 Financial Crisis that the monthly spread between ETF creations and redemptions was negative. The other two times were in February and June last year, periods of market tumult.

And still the ETF supply is $45 billion larger than it was when the market corrected (near $55 billion if one adds back market-appreciation).

We conducted an experiment, tracking week-over-week gains and losses for stocks comprising the eleven General Industry Classification System (GICS) sectors and comparing changes to gains and losses for corresponding sector ETFs from State Street, called SPDRs (pronounced “spiders”) from Dec 14 to present.

Startlingly, when we added up the nominal spread – the real difference between composite stocks and ETFs rolled up across all eleven sectors – it was 18%, almost exactly the amount the market has risen.

What’s more, on a percentage basis the spreads were not a penny like you see between typical best bids to buy and offers to sell for stocks. They averaged 5% — 500 basis points – every week.  The widest spread, 2,000 basis points, came in late December as stocks roared.

Now the spread has shrunk to 150 basis points and markets have stopped rallying.  Might it be that big spreads cause traders to chase markets up and down, and small spreads prompt them to quit?

Now, maybe a half-dozen correlated data points are purely coincidental. False correlations as the statistics crowd likes to say.

What if they’re not?  Tell me what fundamental data explains the market’s plunge and recovery, both breath-taking and gravity-defying in their garishness? The economic data are fine. It was the market that wasn’t. What if it was ETF market-making?

The mere possibility that chasing spreads might have destroyed vast sums of wealth and magically remanufactured it by toying with the supply of ETF shares and spreads versus stocks should give everyone pause.

Investors, you should start thinking about these market-structure factors as you wax and wane your exposure to equities.  If fundamentals are not setting prices, find the data most correlated to why prices change, and use it.  We think it’s market structure. Data abound.

And public companies, boards and executives need a baseline grasp on the wholesale and retail markets for ETFs, the vast scope of the money behind it — $4.5 TRILLION in 2018, or more than ten times flows to passive investors last year – and what “arbitrage mechanism” means. So we’re not fooled again (as The Who would say).

What do data say comes next?  Sentiment data are the weakest since January 7 – and still positive, or above 5.0 on our ten-point Sentiment scale. That’s a record since we’ve been tracking it.

So. The market likely stops rising.  No doom. But doom may be forming in the far distance.

Flowing

The Investment Company Institute (ICI) says US equities saw net outflows of $5.1 billion Jan 2-23, the latest data. Add the week ended Dec 26 and a net $26.2 billion left.

So how can stocks be up?

Maybe flows reversed after the 23rd?  Okay, but the S&P 500 rose 12.2% from Dec 24-Jan 23.  It’s now up about 16%, meaning 75% of gains occurred during net outflows.

Is the ICI wrong?  In a way, yes.  It treats redeemed Exchange Traded Fund (ETF) shares as outflows – and that’s not correct.

Let me explain. The stock market is up because of whatever is setting prices. We measure that stuff. The two big behaviors driving stocks Dec 26-Feb 4 were Passive Investment, and Risk Mgmt, the latter counterparties for directional bets like index options.

That combination is ETFs.

ETF shares are redeemed when brokers buy or borrow them to return to ETF sponsors like Blackrock, which exchanges them for stocks or cash of equal value.

If ETF shares are removed from the market, prices of ETFs tighten – and market makers bet long on index and stock options. That’s how derivatives rally underlying assets.

See, ETFs depend on arbitrage – different prices for the same things. And boy do prices differ. We track that data too.  When ETFs rise more than underlying stocks, the spreads are small. Stocks are far less liquid than ETFs because share-supplies don’t continually expand and contract like ETFs.

As an example, Consumer Discretionary stocks were up 1.6% last week (we meter 197 components for composite data on behaviors, shorting, Sentiment, etc.).  But the State Street Sector SPDR (pronounced “spider,” an acronym for S&P Depository Receipts, an ETF) XLY was up just 0.2%.

XLY is comprised of 65 Consumer Discretionary stocks. As we’ve explained before, ETFs are not pooled investments.  They’re derivatives, substitutes predicated on underlying assets.

So it really means State Street will take these stocks or similar ones in exchange for letting brokers create ETF shares, and vice versa.

You can’t short a mutual fund because it’s a pooled investment.  You can short ETFs, because they’re not. In fact, they’re a way to short entire sectors.

Want to pull down a swath of the market? Borrow key components correlated to the ETF and supply them to a big broker authorized to create ETF shares, and receive off-market blocks of a sector ETF like XLY. Then sell all of it on the open market.

It happened in December.

Here’s how. A staggering $470 BILLION of ETF shares were created and redeemed in December as the market plunged, putting the Nasdaq into bear territory (down 20%) and correcting major indices (down 10% or more).

And guess what?  There were $49 billion more creations than redemptions, which means the supply of ETF shares expanded even as the market declined.

I doubt regulators intended to fuel mass shorting and supply/demand distortion when they exempted ETFs from key provisions of the Investment Company Act of 1940 (and how can they do that, one wonders?).

But it’s happening. More proof: shorting in stocks topped 48% of all volume in December.

Returning to spreads, we’ve since seen the reverse of that trade. Stocks are being arbitraged up in value to reflect the supply of ETF shares outstanding, in effect.

And shorting has come down, with 5-day levels now below 20- and 50-day averages.

We’ve showed you ETF patterns before. Here’s the Industrials sector, up 5% the past week. Those purple and green bars?  ETFs. Stocks, plus leverage.  The purple bars are bigger than the green ones, meaning there is more leverage than assets.

That was true Jan 8-15 too, ahead of expirations the 16th-18th, the only period during which the sector and the market showed proportionally flat or down prices (see linked image).  Traders used their leverage (options volumes in 2018 crushed past records – but the culprit is short-term ETF leverage, arbitrage. Not rational behavior).

Why should you care about this stuff, investor-relations professionals and investors? We should know how the market works and what the money is doing. With ETF-driven arbitrage pervasive, the market cannot be trusted as a barometer for fundamentals.

Your boards and executive teams deserve to know.

What can we do? Until we have a disaster and the SEC realizes it can’t permit a derivatives invasion in an asset market, we must adapt. Think ahead.

For companies reporting results next week or the week after, risk has compounded because this trade is going to reverse. We don’t know when, but options expire Feb 14-16. Will bets renew – or fold?

Whenever it happens, we’ll see it coming in the data, by sector, by stock, across the market, just as we did in late September last year before the tumult.