Outcomes are culminations, not events.

Denver bid farewell this week to retiring Broncos quarterback Peyton Manning who for eighteen years accumulated the byproducts of focus, discipline and work, twice culminating in Super Bowl victories.

The idea that outcomes are culminations translates to the stock market. What happens today in your stock-trading is a product of things preceding today’s culmination just as our lives are accumulations of decisions and consequences.

Rewind to Feb 11, 2016. The S&P 500 hit a 52-week low of 1829. Recession fears were rippling globally. European banks were imploding, with some pundits predicting another 2008 crisis. China was lowering growth views and weakening its currency to pad the landing (word since is some 5-6 million workers will be laid off through 2017).

In apparent response, the US stock market soared, recovering to November levels. If the market is a proxy for the economy, it’s a heckler hurling eggs. Wiping away yolk, pundits said markets expecting monetary tightening from the Federal Reserve saw stasis instead. Recession fears were overblown and an overly reactive market rebounded.

But headlines don’t buy or sell stocks, people and machines do.  Markets move on money. This is what we’ve learned from more than a decade of market lab work, repeating behavioral measurements with software, servers, algorithms and models.

Follow the money.  The most widely traded equity in the world, SPY, is a derivative. It’s an Exchange-Traded Fund (ETF) tracking the S&P 500.  Nearly 50% of all options volume ties to it.  In 2016 so far almost every trading day at least 12 of the 25 most actively traded stocks were ETFs.

Why do we say ETFs are derivatives? Because derivatives extend access to assets, exactly the thing ETFs do. They’re securities trading on underlying stocks without owning them. The sponsor owns assets, yes. But ETF investors hold only a proxy.

ETFs depend on arbitrage. Rules the SEC approved for ETFs effectively sanction use of information the rest of the market doesn’t know about demand by the big brokers who produce ETF shares for trading.  These brokers are continually shorting index components and derivatives or ETF shares to close the gaps that form between the value of the ETF and what it represents (stocks, sectors, commodities, bonds, indices).

In the stock market, the price-setters are primarily short-term traders (high-frequency firms) arbitraging small price-divergences in many things simultaneously. ETFs are stocks that provide exposure to other stocks, sectors, commodities, bonds and indices. For arbitragers, they’re a massive additional layer of arbitrage permutations:  How might this financial ETF vary with that energy futures contract, and this basket of energy stocks?

What develops in this market is a disregard for fundamental factors. Prices are mathematical facts. Spreads drive directional-change. The market’s purpose devolves from economics to how to price a stock, sector, commodity, bond, futures contract, option or index relative to things associated with it or its value at a point ranging from fractions of seconds to next month before a derivatives contract expires.

It’s not investment but arbitrage of such scale and size that few recognize it. Yesterday, the most actively traded stock was the VelocityShares 3x Long Crude ETN linked to the S&P GSCI Crude Oil Index Excess Return (UWTI).  Yes, that its name! It’s an exchange-traded product backed by Goldman Sachs, and it dropped 13.3%. Offsetting, the eighth most active stock was DUST, the Direxion Daily Gold Miners Index Bear 3x Shares, which rose 13.7%.

Neither DUST nor UWTI owns tangible assets. Their returns depend on derivative contracts held by banks or other counterparties. Now step back. Look at stocks. They are moving the same way but over longer periods. Market moves are a culmination of whichever directional trade is winning at the moment, plus all the tiny little arbitrage trades over ETFs, stocks, commodities, bonds and indices, tallied up.

There are two links back to fundamentals. First, banks back this market. Some of them are losing badly and this is what European bank trouble last month signaled. And this IS a consequence of Fed policy.  By artificially manipulating the cost of capital, the Fed shifted money from scrutinizing economics to chasing arbitrage opportunities.

When arbitrage has exhausted returns, the market will change direction again. It’s coming soon.  The bad news is the market has not yet considered economic threats and is ill-equipped to do so.