Search Results for: creations

Growth vs Value

Are you Value or Growth?  

Depends what we mean, I know. S&P Dow Jones says it distinguishes Value with “ratios of book value, earnings and sales to price.”

It matters because Growth is terrorizing Value.  According to data from the investment arm of AllianceBernstein, Growth stocks outperformed Value stocks by 92% between 2015-2020.  Morningstar says it’s the biggest maw on record, topping the 1999 chasm.

If you’re in the Growth group, you’re loving it.  But realize.  By S&P Dow Jones’s measures, anybody could be a Value or Growth stock at any time.  It’s all in the metrics.

The larger question is why the difference?  AllianceBernstein notes that the traditional explanation is earnings growth plus dividends paid.  That is, if your stock is up 50% more than a peer’s, it should be because your earnings and dividends are 50% better.

If that were the case, everybody would be a great stock-picker. All you’d need do is buy stocks with the best earnings growth. 

Well, turns out fundamentals accounted for just ten percentage points of the difference.  The remaining 82% of the spread, as the image here from AllianceBernstein shows, was multiple-expansion.  Paying more for the same thing.

Courtesy AllianceBernstein LP. https://www.alliancebernstein.com/corporate/en/insights/investment-insights/whats-behind-the-value-growth-performance-gap.html

Put differently, 90% of the time Growth stocks outperform Value stocks for no known reason. No wonder stock-picking is hard.

Take Vertex (VRTX) and Fortinet (FTNT), among the two very best and worst stocks of the past year.  I don’t know fundamentally what separates them. One is Tech, the other Healthcare.

I do know that running supply/demand math on the two, there’s a staggering behavioral difference.  FTNT spent 61 days the past year at 10.0 on our ten-point scale measuring demand called Market Structure Sentiment.  It pegged the speedometer 24% of the time.

VRTX spent five days at 10.0.  Two percent of the time.  You need momentum in today’s stock market or you become a Value stock.

We recently shared data with a client who wondered why there was a 20-point spread to the price of a top peer.  We ran the data.  Engagement scores were about the same – 85% to 83%, advantage to our client. Can’t say it’s story then.

But the peer had a 20% advantage in time spent at 10.0.  The behavioral patterns were momentum-style. Our client’s, GARP/Value style.

Okay, Quast.  Suppose I stipulate to the validity of your measure of supply and demand, whatever it is.  Doesn’t answer the question. Why do some stocks become momentum, propelling Growth to a giant advantage over Value?

I think it’s three things. I can offer at least some data, empirical or circumstantial, to support each.

Let’s call the first Herd Behavior.  The explosion of Exchange Traded Funds concentrates herd behavior by using stocks as continuously stepped-up collateral for ETF shares.  I’ll translate.  ETFs don’t invest in stocks, per se.  ETFs trade baskets of ETF shares for baskets of stocks (cash too but let’s keep it simple here). As the stocks go up in value, ETF sponsors can trade them out for ETF shares. Say those ETF shares are value funds.

The supply of Value ETF shares shrinks because there’s less interest in Value.  Then the ETF sponsor asks for the same stocks back to create more Growth ETF shares.

But the taxes are washed out via this process. And more ETF shares are created.  And ETFs pay no commissions on these transactions. They sidestep taxes and commissions and keep gains.  It’s wholly up to traders and market-makers to see that ETF shares track the benchmark or basket.

The point? It leads to herd behavior. The process repeats. Demand for the same stuff is unremitting.  We see it in creation/redemption data for ETFs from the Investment Company Institute. ETF creations and redemptions average over $500 billion monthly. Same stuff, over and over. Herd behavior.

Second, there’s Amplification.  Fast Traders, firms like Infinium, GTS, Tower Research, Hudson River Trading, Quantlab, Jane Street, Two Sigma, Citadel Securities and others amplify price-moves.  Momentum derives from faster price-changes, and Fast Traders feed it.

Third is Leverage with derivatives or borrowing.  Almost 19% of trading volume in the S&P 500 ties to puts, calls and other forms of taking or managing risk with derivatives. Or it can be borrowed money. Or 2-3x levered ETFs. The greater the pool of money using leverage, the larger the probability of outsized moves.

Summarizing, Growth beats Value because of herd behavior, amplification of price-changes, and leverage.

By the way, we can measure these factors behind your price and volume – anybody in the US national market system.

Does that mean the Growth advantage is permanent?  Well, until it isn’t. Economist Herb Stein (Ben’s dad) famously said, “If something cannot last forever, it will stop.”

And it will. I don’t know when. I do know that the turn will prompt the collapse of leverage and the vanishing of amplification. Then Growth stocks will become Value stocks.

And we’ll start again.

What’s In It

We rode the Colorado National Monument this week with our good friends from Sun Valley. There’s a lesson in it about life and stocks both.

We would’ve been riding bikes in Puglia with them now, if not for this pandemic.  Oh, and part of the lesson learned is in Telluride.

Stay with me.  I’ll explain.

So we learned Sun Valley is comprised of four towns.  Sun Valley, Ketchum, Hailey and Bellevue. Each has its own mayor, own government.  It could be one united town, but no.

There’s a point.  While you ponder that, let me give you some background.

Karen and I wandered from Denver to Glenwood Springs (rode bikes, ate great food, soaked in hot springs, at this energetic little burg favored by Wyatt Earp and Doc Holliday), and on to Grand Junction (pedaled the Monument and bunked at the lovely Hotel Maverick on the campus of Colorado Mesa University).

We then migrated to Moab and hiked Canyonlands and cycled the Potash Highway where evidence remains of a civilization once living in paradise on the Colorado River (if your etched recreations of yourselves in sandstone reflect jewelry and wildly stylish hair, you’re well up the actualization hierarchy from basic sustenance).

We next traversed the remote stretch from there to Telluride, a dramatic geological shift. The little city in a box canyon lighted by Nikola Tesla and robbed by Butch Cassidy is a swanky spot at the end of the road.  Wow.  I get it.  Oprah. Tom Cruise. Ralph Lauren. It looks like their town.

Or towns, rather.  Because here too as in Idaho there are cities a couple miles apart with two mayors, two governments. There’s Telluride, CO, in the valley. There’s Mountain Village, CO, up above (where no expense has been spared – you cannot find a tool shed that’s a shack).

And that’s the lesson. People talk about coming together.  Sun Valley can’t.  Telluride can’t.  Could it be humans are motivated by their own interests?

And how about money behind stocks?

More on that in a moment.

NIRI, the association for investor-relations professionals, has a 50-year history.  I’m on the national board representing service providers.  We were blindsided by the SEC this summer, which abruptly proposed changing the threshold for so-called 13Fs, named for the section of the Securities Act creating them.

Our profession depends on those filings to understand shareholdings.

The SEC said funds with less than $5 billion of assets would no longer have to file.  There goes insight into 90% of funds. The SEC never asked us.

You’re thinking, “There’s a hammer here, and a nail. Perhaps I’ll just pound it through my hand rather than continue reading.”

Don’t quit! You’re getting close.

Tip O’Neill and Ronald Reagan made deals. You youngsters, look it up.  There were “pork barrel politics,” a pejorative way to describe a quid pro quo.  Wait, is that a double negative?

Let me rephrase. Politicians used to do deals.  Give me something, I’ll give you something.  You can decry it but it’s human nature.  We don’t “come together” without a reason.

Sun Valley. Telluride. They haven’t yet found a reason to unite.

NIRI could learn. We can talk for ten years about why we deserve better data. There’s nothing in it for the other side. I bet if we said to the bulge bracket, the Goldman Sachses, the Morgan Stanleys, “You lose your corporate access until you help us get better data.”

Now both have skin in the game. Stuff gets done.

Most of us outside Jesus Christ, Mother Theresa, Martin Luther King, Jr and Mahatma Gandhi are motivated by what benefits us.

Shift to stocks.  Money with different purposes and time-horizons drives them.  The motivation for each is self-interest, not headlines or negotiations between Nancy Pelosi and Steven Mnuchin.

Let’s call it, “What’s In It for Me?” All the money is motivated by that.  Humans are similarly animated.  For most of the money in the market, what’s in it is a short-term return.

If you want to understand what motivates the money, you must understand self-interest.  You can learn it in Sun Valley or Telluride.  You can learn it watching politics. And it applies to stocks. Money wants returns. When that opportunity wanes, it leaves.

That’s it. No more complex. And ModernIR measures that motivation.  Ask us, and we’ll show you what’s in it for the money behind your shares.  Too bad we can’t figure it out in politics. It’s not that hard.

Hummingbird Wings

I recall reading in high school that the military’s then new jet, the FA-18 Hornet, would fall out of the sky if not for computers.

Could be that’s exaggerated but the jet’s designers pushed the wings forward, creating the probability of continual minute turbulence events too frequent for human responses.  Why do that? Because it made the plane vastly nimbler in supersonic flight.

You just had to keep the computers on or the craft would go cartwheeling to earth.

As we wrap a remarkable year for stocks in a market too fast for humans and full of trading wings whipping fleeting instances of turbulence, we’re in a curious state where the machines are keeping us all airborne.

I don’t mean the market should be lower.  Valuations are stretched but not perverse. The economy is humming and the job market is great guns. And while the industrial sector might be spongy, the winds in the main blow fair on the fruited plain.

So why any unease about stocks, a sense the market is like an FA-18 Hornet, where you hope the computers keep going (ironic, right)?

It’s not just a feeling.  We at ModernIR as you longtime readers know are not touchy-feely about data. We’re quantitative analysts. No emotion, just math.  Data show continual tweaking of ailerons abounds.

You see it in fund flows. The WSJ wrote over the weekend that $135 billion has been pulled from US equities this year. Against overall appreciation, it’s not a big number. But the point is the market rose on outflows.

And corporate earnings peaked in real terms in 2014, according to data compiled by quantitative fund manager Julex Capital. We’ve got standouts crushing it, sure.  But if earnings drive stocks, there’s a disconnect.

I’m reading the new book on Jim Simons, the “man who solved the market,” says author and WSJ reporter Greg Zuckerman. Simons founded Renaissance Technologies, which by Zuckerman’s calculations (there’s no public data) has made more than $100 billion the past three decades investing in stocks. Nobody touches that track record.

It’s a riveting book, and well-written, and rich with mathematical anecdotes and funny reflections on Simons’s intellectually peripatetic life.

Renaissance is not a stock-picking investment firm. It’s a quant shop. Its guys and gals good at solving equations with no acumen at business or income statements proved better at investing than the rest.

It’s then no baseless alchemy to propose that math lies at the heart of the stock market.

And son of a gun.

There’s just one kind of money that increased the past year.  Exchange Traded Funds (ETFs). This currency substituting for stocks is $224 billion higher than a year ago and about a trillion dollars greater the past three years.  As we learned from Milton Friedman and currency markets, more money chasing the same goods lifts prices.

Stocks declined in 2018, yet ETF shares increased by $311 billion, more than this year.  In 2017, ETF shares increased by $471 billion.

Behind those numbers is a phantasmagorical melee of ETF creations and redemptions, the ailerons keeping the market’s flight level through the turbulent minutia flying by.

I’ve explained it numerous times, so apologies to those tiring of redundancy. But ETFs are substitutes for stocks.  Brokers take a pile of stocks and give it to Blackrock, which authorizes the brokers to create and sell to the public a bunch of ETF shares valued the same as the pile of stocks.

If you sell ETF shares, the reverse happens – a broker buys the ETF shares and gives them to Blackrock in trade for some stocks of equal value.

This differential equation of continuous and variable motion doesn’t count as fund-turnover. But it’s massive – $3.2 trillion through October this year and $10.7 trillion, or a third of the market’s total value, the past three years.

Why the heck are there trillions of ETF transactions not counted as fund flows? Because our fly-by-wire stock market is dependent on this continuous thrum for stable harmonics.

That’s the hummingbird wings, the Butterfly Effect, for stocks.

We can see it.  In July a seismic ripple in behavioral patterns said the market could tumble. It did. Dec 3-5, a temblor passed through the movement of money behind prices. The market faltered.

If the ETF hive goes silent, we’ll cartwheel.  It won’t be recession, earnings, fundamentals, tariffs, Trump tweets, blah blah.  It will be whatever causes the computers to shut off for a moment.  It’s an infinitesimal thing.  But it’s why we watch with machines every day.  And one day, like a volcano in New Zealand, it’ll be there in the data.

Jim Simons proved the math is the money. It’s unstable. And that’s why, investor-relations pros and investors, market structure matters.

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.