The Vital Day

Which is the most important trading day of the month?

“The one when my company reports results,” you say.

Good guess, and you’re usually right. Not this time. It’s the last day.  Yesterday was it, the vital day of April, the benchmark for monthly fund-performance.

All funds want to clock results, punch the timer when the sprinter hits the tape. But it’s most true for money tracking a measure like the S&P 500.

CBOE, the giant derivatives and equities market operator, began in 2014 offering an options contract to “allow asset managers to more precisely match SPX option expirations to end-of-month fund cycles and fund performance periods.” SPX is the S&P 500. CBOE offers many ways for investors to improve tracking or profit on variances.

CBOE describes SPX securities as “flexible tools that allow investors to synthetically adjust their positions to a 500-stock portfolio.”

All three big exchange groups (NYSE, Nasdaq, CBOE) operate equity and derivatives markets, and all promote pricing advantages for firms trading equities and derivatives simultaneously.

That means, public companies and investors, these exchanges are encouraging traders to speculate. How often are prices of stocks affected by the prices of derivatives ranging from options on individual stocks to futures on indexes and ETFs?  (Heck, there are options on futures.)

Answer: Behavioral analytics ModernIR developed show that about 19% of volume marketwide the last five days ties to derivatives. By sector, Communication Services was highest at 20.6%; Industrials the lowest, 17.7%.

Active Investment by comparison was 11.2% of volume in Communication Services stocks, and 12.6% in Industrials (sellers, however).

AAPL, trading today on results, had 23% of volume on Apr 29 – $1.03 billion! – driven by derivatives-related trades. About 150 S&P 500 components, and hundreds of others, release this week.

Derivatives are bigger than investment. Do stocks then reflect fundamentals?

BK plunged Apr 17 – index options expired that day – and the biggest behavioral change was in Risk Mgmt, reflecting derivatives. Shorting peaked Apr 17. Bets preceding results were quantitative, and big. Math.  Active money then bought the dip.

SIRI dropped on results like a diver off a cliff, and over 23% of its trading volume beforehand traced to counterparties for derivatives bets.

TWTR exploded from about $34 to over $40 intraday on long (not short) derivatives bets made with new options that traded Apr 22, driving more than 20% of TWTR volume. Active money played no price-setting role and was a profit-taker on the move.

INTC rag-dolled down Apr 26 with results, on volumes approaching 80 million shares, and the biggest behavior was Risk Mgmt – counterparties to derivatives bets.

CHRW was 70% short and 25% of its trading volume tied to derivatives – a resounding bear bet – before shares blinked out this week to December levels.

Imagine the value you’d add – what’s your name, IR professional? Portfolio manager? – if you knew the behaviors behind price and volume BEFORE stocks went wild.

A lesson: 

Fast Traders arbitrage the tick. That is, computerized trades profit by churning many securities long and short fleetingly, netting gains. The more money seeks a measure – indexes, ETFs, closet indexers, money trying to beat a benchmark – the more machines change prices. Fast Trading is 42% of volume the past five days.

Passive investment must track the benchmark. ETFs need variance versus the index to price shares. That combination is 27% of volume.

Active money chasing superior stories defined by fundamentals is 12% of market volume the five days ended Apr 29. So, during earnings season stocks had a 1-of-8 chance of being priced by story.

Derivatives (Risk Mgmt to us at ModernIR) used by indexes to true up tracking and traders to profit on volatility are 19% of volume.

Got bad news to dump, companies? Do it the last three trading days of the month. You’ll get hammered. But then it’s done. Money will return in the new month. Investors, in the new month the stuff hammered to finish the last month could win.

There’s a vital day: The last trading day each month. It trumps story. You should understand it. We can help you.

Driverless Market

Suppose you were human resources director for a fleet of driverless taxis.

As Elon Musk proposes streets full of autonomous autos, the market has become that fleet for investors and investor-relations professionals.  The market drives itself. What we measure as IR professionals and investors should reflect a self-driving market.

There’s nothing amiss with the economy or earnings. About 78% of companies reporting results so far this quarter, FactSet says, are beating expectations, a tad ahead of the long-term average of 72%.

But a closer look shows earnings unchanged from a year ago. In February last year with the market anticipating earnings goosed by the corporate tax cut of 2017, stocks plunged, and then lurched in Q3 to heights we’re now touching anew, and then nosedived in the fourth quarter.

An honest assessment of the market’s behavior warrants questioning whether the autonomous vehicle of the market has properly functioning sensors. If a Tesla sped down the road and blew a stop sign and exploded, it would lead all newscasts.

No matter the cacophony of protestations I might hear in response to this assertion, there is no reasonable, rational explanation for the fourth-quarter stock-implosion and its immediate, V-shaped hyperbolic restoration. Sure, stocks rise and fall (and will do both ahead). But these inexplicable bursts and whooshes should draw scrutiny.

Investor-relations professionals, you are the HR director for the driverless fleet. You’re the chief intelligence officer of the capital markets, whose job encompasses a regular assessment of market sensors.

One of the sensors is your story.  But you should consistently know what percentage of the driving instructions directing the vehicle are derived from it.  It’s about 12% marketwide, which means 88% of the market’s navigational data is something else.

Investors, the same applies. The market is as ever driven by its primary purpose, which is determined not by guesses, theory or tradition, but by what dominates price-setting.  In April, the dominating behavior is Exchange-Traded Funds.  Active investment was third of four big behaviors, ahead only of Fast Trading (curious, as Fast Traders avoid risk).

ETF shares are priced by spreads versus underlying stocks. Sure, investors buy them thinking they are consuming pooled investments (they’re not). But the motivation driving ETFs is whether they increase or decrease in price marginally versus stocks.

ETF market-makers supply stocks to a sponsor like Blackrock, which grants them authority to create an equal value of ETF shares to sell into the market. They aim to sell ETFs for a few basis points more than the value of exchanged shares.

The trade works in reverse when the market-maker borrows ETF shares to return to Blackrock in exchange for a group of stocks that are worth now, say, 50 basis points more than the stocks the market-maker originally offered.

If a market-maker can turn 30-50 basis points of profit per week this way, it’s a wildly winning, no-risk strategy. And it can and does carry the market on its updraft. We see it in patterns.

If it’s happening to your stock, IR professionals, it’s your job to know. Investors, you must know too, or you’ll draw false conclusions about the durability of cycles.

Big Market Lesson #1 in 2019: Learn how to measure behaviors. They’re sensors. Watch what’s driving your stock and the market higher (or lower – and yes, we have a model).

Speaking of learning, IR people, attend the 50th Anniversary NIRI Annual Conference. We have awesome content planned for you, including several not-to-be-missed market-structure sessions on hedge funds, the overall market, and ETFs.  Listen for a preview here and see the conference agenda here.  Sign up before May 15 for the best rate.

Big Market Lesson #2: Understand what stops a driverless market.

ETF-led rallies stall when the spread disappears. We have a sensor for that at ModernIR, called Market Structure Sentiment™ that meters when machines stop lifting or lowering prices.

It’s a 10-point scale that must remain over 5.0 for shares to rise. It’s averaged 6.2 since Jan 8 and has not been negative since. When it stalls, so will stocks, without respect to earnings or any other fundamental sensor.

I look forward to driverless cars. But we’ll want perfected technology before trusting them. The same should apply to a driverless stock market.

 

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.

Bad Liquidity

JP Morgan’s global head of macro quant and derivatives research (if you have that title, you should be a big deal!), Marko Kolanovic, says the market’s rising propensity toward violent moves up and down reflects bad liquidity.

Bad Liquidity would be a great name for a rock band. But what’s it mean?

Most measure volatility with the VIX.  The trouble with it predictively is it’s not predictive. It spikes after the fact, not ahead.

It was not always so. Modern Portfolio Theory (MPT), a hot investment thesis of the 1990s stock market, said rising volatility reflected growing price uncertainty. Managers like Louis Navellier flew private jets on fortunes made shifting from stocks as volatility mounted.

I’d argue it’s the opposite now. When volatility vanishes, arbitrage opportunities, the primary price-discovery mechanism today (“price discovery” means “trying to figure out the price of a thing”), have been consumed. What happens then? Money leaves.

Speaking of money leaving, Mr. Kolanovic blames falling Active investment for a lack of liquidity. He says algorithm

Image shows weekly spreads between composite stocks and State Street sector SPDR ETFs, with negative numbers indicating more volatility in ETFs, positive numbers, more volatility in composite sector stocks.

s – “stock recipes” run by computers – are present when markets rise and absent when markets fall, exacerbating liquidity shortages.

Active investors tend to sell when prices are high and buy when they’re low, helping to ease liquidity constraints. As Active investment declines (he says just 10% of trading, presumably he means at JP Morgan, comes from Active stock-picking, eerily near the figures we measure – with algorithms no less), stabilizing liquidity shrinks.

Liquidity boiled down (so to speak!) is the availability of a thing at a stable price.  The more that’s available, the better your chance of getting it at the same price.

Investors tend to want a lot of something – a truckload.  Arbitragers tend to want the price to change. These aims are diametrically opposed.

By the way, I’m speaking to the NIRI Minneapolis chapter today on Exchange Traded Funds, which are predicated on an arbitrage mechanism. That means they can only exist as investment instruments if there is volatility. Mr. Kolanovic thinks volatility is the root rot.  Connection?

Yes. ETFs distort liquidity in two crucial ways that compound risk for stocks. As we’ve explained, ETFs are not pooled investments. They are most closely akin to put and call options, in that they are created when people want more of them and removed from the market when people don’t want them.

As with puts and calls, they become ends unto themselves. Too many mistake options prices for future stock prices. Sometimes that’s true. But changes in the value of options are a discrete profit opportunity themselves.

Goldman Sachs wrote in February this year as Q4 2018 results were coming in (thank you to an alert reader!): “What’s interesting this quarter is that buying calls for earnings reports has posted its best return in over thirteen years (record). In fact, buying the closest out of the money call 5 days ahead of earnings and closing the day after has produced an average return of 88%.”

Eighty-eight percent! That’s not a bet on results but pure arbitrage in options.

ETFs offer the same opportunity. Shares are created when investors want exposure to equities and redeemed when investors want out. But the investors to a large extent now are ETF market-makers profiting on spreads between ETFs and the underlying stocks comprising a tracking instrument. It’s arbitrage. Profiting on price-differences.

The problem with this liquidity is it’s continuously fluctuating. We can have no consistent, measurable idea of the supply of ETFs or the demand for stocks. That means the market at any given time cannot be trusted to provide meaningful prices.

The data to me say it’s the arbitrage mechanism in ETFs behind bad liquidity. ETFs can only establish prices through spreads with stocks. The market is now stuffed with ETFs. The motivation is the spread. Not fundamentals – or even fund-flows.

We track spreads between ETFs and composite stocks. Our data say spreads totaled hundreds of percentage points from Dec 2018 to Mar 2019. At Apr 5, stocks are 33% more volatile in 2019 on net than ETFs. That’s way more than the market has risen.  Somebodies will want to keep it.

If we want to know where the next financial crisis will develop, we need look no further than ETFs. They are now a mania. They depend on spreads. As liquidity goes, that’s bad.

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.

Activism Science

In fourteen years, we’ve not missed an Activist.

“Chest-thumping, Quast?” you say.

No, a market structure lesson, a way for investor-relations professionals to be valuable.

Activism has become the de jour Value Investment proposition for modern markets. Our data indicate 10% of all US stocks – just 12% of daily volume is driven by Active Investment – have footprints of Activism.

Think about the enormous sums spent on Activism defense.  Surveillance firms that (no offense, friends!) almost never catch Activist presence proactively because Activists have had 35 years to know how to hide their footprints from settlement-based market intelligence.

The lawyers.  The bankers. The proxy solicitors. The communications consultants.  The running taxicab meter for expenses.

I’m not saying these advisors are pointless by any stretch. But wouldn’t it be prudent to observe what the money is actually doing?  I can offer a litany of examples (scores, but here just a few).

We saw footprints of Activism more than a quarter ahead of the advent of Activism in a small-cap.  Nine months later, the Activist pushed the company into a merger with a competitor.

Maybe a deal was best. But clunky Activist steps were crudely apparent in the data. We’d see a burst of derivatives bets – and five days later the Activist would issue some public declamation. So we could always tell the company when the Activist was about to spout off again.

At no point during the process were investors enthusiastic – but management quit early. The data clearly indicated they could win. The bankers didn’t have that data. Neither did surveillance or the proxy solicitors. I don’t know what those advisors told the team. Isn’t it wise to check and balance your advisors too?

Our data in the hands of a management team with temerity would have produced a fight – and maybe a much better deal.

Market Structure Analytics are like an EKG. We can see how the heart of investment is responding. Is there a burst of adrenaline? We’ll measure it. Apathy? We’ll see that too.

We warned another small-cap two quarters before Elliott showed up in 13Fs (and surveillance was utterly unaware throughout). We have algorithms that remove subjectivity. They are indiscriminate in identifying hedge funds, which half the time are not nefarious. But it’s better to know than not, right?

Advance warning put management in a strong position, and while that situation too also concluded in a deal, the company drove it rather than the other way around, which is always best for executive teams. And too, investor-relations is frontline defense, chief of intelligence for its boards and executive teams. That earns rewards, kudos.

In a high-profile case, we observed pervasive deal-arbitrage in a large-cap with a controlling shareholder. We told the IR team we were flummoxed, but the data were irrefutable. People were betting on a deal. They had no answer.

Then they and we both learned that indeed a deal was in the works that no one (apparently not no one!) ostensibly knew about, including the IR team.

Then an Activist manifested. Every time the Activist would publicly oppose the plan, we saw short-covering and long bets hidden behind headline selling – telling us the Activist really favored the plan but wanted a bone, an appeasement.

That data was vital for decision-making and led to a solution favorable to all parties.

Behavioral data isn’t a silver bullet freeing you from the travails of event-driven behavior (Market Structure Analytics are equally effective at predicting deals and their success, signaling where arbs expect news, predicting and tracking the arc – including success or failure – of short attacks, and spotlighting big bets on surprises around financial results).

The market is mathematical. It’s unwise in event-driven situations to spend all your resources on qualitative input from wildly expensive advisors, when affordable quantitative data offers the most accurate, predictive, unvarnished and timely view of success, failure, threats, opportunities.

If you want to know how we see Activism, deal-arbitrage, short attacks and more, ask us. We can look back historically and show patterns around your own experiences – which lays the foundation for future warning. And we have a compendium of event-driven situations we’ve addressed.

What’s better than glimpses into the future? Would that we had more of them in life – but you can have them in the stock market. It’s math. And science.

Five Questions

Is less more?

This is the question anyone looking at the stock market as a barometer for rational thought – from stock-pickers to investor-relations professionals – should be asking.

A Wall Street Journal article yesterday, “Passive Investing Gains Even in Turbulent Times,” notes that $203 billion flowed to Exchange Traded Funds (ETFs) between September and January, while $167 billion went to index funds.

Most thought stock-pickers would win assets during volatility. So let’s ask another question. From where did the money come?  Morningstar, the WSJ says, shows $370 billion – the same figure – left stock-picking funds from Sep 2018-Jan 2019.

Here’s a third question: What sets prices for stocks?

If you move money from savings to checking, total value of your bank accounts doesn’t gyrate. Should we be asking why moving money from stock-pickers to indexers would be so violent?

I’ve got one more question for IR practitioners before we get to answers: If stock-pickers are seeing net redemptions – money leaving – what should we expect from them as price-setters in stocks?

Okay, let’s review and answer:

Is less stock-picking worth more?  What sets stock-prices? Where did the money going to ETFs and indexes come from? Why did the market move violently these last months? And finally, what should we expect from stock-pickers as price-setters?

Less is not more.  I’m reminded of a line from a professional poker-player who taught poker to a group of us.  He said, “People who chase straights and flushes borrow money to go home on buses.”

The point is that hoping something will happen isn’t a strategy. Hoping stock-pickers, which have lost trillions to passive investments over the past decade, will set your price more is chasing a flush.

We teach our clients to cultivate a diverse palette of those shrinking Active Investment relationships so an Active force will be present more frequently. We show them how to use data to better match product to consumer, further improving the odds.

But look, IR people: If stock pickers saw $370 billion of outflows, they were selling stocks, not buying them. Less is not more.

Stock prices are set by the best bid to buy or offer to sell. Not your fundamentals, or news or blah, blah, blah. What MOTIVATES somebody to hit the bid or the offer is most often that the price changed.

The investment category benefiting most from changing prices is ETFs, because they depend on an “arbitrage mechanism,” or different prices for the same thing.

(Editorial Note:  I’ll be speaking to the Pittsburgh NIRI chapter the evening of Mar 26 on how ETFs affect stocks.)

ETFs are not pooled investments. Blackrock does not combine funds from investors to buy stocks and hold them in an ETF.  ETFs don’t manage other people’s money.

ETF sponsors receive stocks from a broker as collateral, and the broker creates and sells ETF shares. Only the broker has customer accounts. The ETF’s motivation is to profit on the collateral by washing out its capital gains, leveraging it, selling it, investing it.

I’m trying to help you see the motivation in the market. The longer we persist in thinking things about the market that aren’t buttressed by the data, the greater the future risk of the unexpected.

The money that motivated ETFs to profit from changing prices September to January came from stock-pickers.

The market was violent because ETFs form a layer of derivatives in markets obscuring the real supply and demand of stocks. As stocks declined, the number of shares of ETFs did not – causing a downward cascade.

Then as money shifted out of stocks to ETFs, the supply again did not increase, so more money chased the same goods – and ETFs were a currency reflating underlying assets.

If no money either came into or left the market, and it was tumultuously up and down, we can conclude that the actual withdrawal of money from equities could be epic straight-chasing, everybody borrowing money to go home on buses.

We should expect stock-pickers to drive the market to the degree that they are price-setters. That’s 10-15% of the time. In this market riven with collateralized derivatives, you must know what sets prices.

Stock-pickers, if you know, you won’t chase straights and flushes. IR professionals, you’ll help your board and executive team understand the core drivers behind equity value. It’s your story only sometimes. They should know when it is – and when it’s not.

Much of the time, it’s just because your price changes (which ETFs feed). Ask us! We’ll show you the data behind price and volume.

FX Effects

It’s all about the Benjamins, baby.

What I mean is, Forex (FX) is the world’s most active trading market, with some $5 trillion daily in currencies changing hands on a decentralized global data network.  It can teach us how to think about the effects of Exchange-Traded Funds (ETFs) on stocks.

It’s a 24-hour-a-day market, is FX. And by the way, I’m moderating a panel called “24 Hours of Trading: What You Should Know About Market Structure” Friday at the NIRI Silicon Valley Spring Seminar.

We’re the closing panel, and happy hour follows, so come learn from our outstanding guests and stay for a beverage.  Every investor-relations professional should know how the stock market works now, because the reason we have jobs is the stock market.

Back to our thesis, ETFs trade like currencies. So they’ll have the motivation found in currency-trading.

Currencies trade in pairs, like the dollar/euro, and transactions are in large defined blocks. Most FX trades are bets that a currency will move up or down, producing a profit.  It’s always a pair – if you’re selling a currency, you’re buying another.

The transactions that create ETFs are also in blocks, though they occur off the stock market between ETF creators and broker-dealers. If you want to know more, read this.

The pair in ETF trading is stocks. In fact, ETFs by rule must have what the SEC terms an “arbitrage mechanism.” That’s esoterica meaning there are two markets for ETFs, fostering different prices for the same thing.  ETFs are created wholesale off-market in big blocks and sold retail on the market in small pieces.

The big profit opportunity, though, as with currencies, is in the pair, the underlying stocks. They move apart, creating profit opportunities. Last week, the average spread between the stocks comprising a sector and the ETF for trading that sector was 57 basis points (we wrote about these spreads).

No wonder ETFs are cheap for investors. You can make as much trading them in a week as Active investment managers charge for managing portfolios for a year (SEC: why do ETFs charge a management fee at all, since they don’t manage customer money?).

Let me use an analogy. Picture a gold-backed currency. There’s a pile of gold. There’s a pile of money representing the gold. To have more money, there must be more gold.

Of course, all gold-backed currencies have dropped the gold, because the pile of gold, which is hard to get, fails to pace the easy creation of paper.

ETFs are stock-backed currencies. There are piles of stocks off the market. There are piles of ETF shares issued into the stock market that represent the value of stocks.

Managing collateral isn’t really investment. The head of equities for a big global asset manager told me they’d gotten into ETFs because of a decade-long rout of assets from stock-picking funds.

He said it’s a completely different endeavor. There are no customer accounts to maintain.  The focus is tax-efficiency, managing collateral, constructing the basket, relationships with Authorized Participants who create ETF shares.

He said, “And then what do you need IR (investor relations) for?” They’re not picking investments. They’re efficiently managing the gold backing the currency.

Nasdaq CEO Adena Friedman told CNBC’s Squawk Box Monday, marking the 20th anniversary of the QQQ, “If there’s too much index investing and not enough individual investing, then there become arbitrage opportunities.”

She meant “arbitrage opportunity” not as a good thing but as a consequence of too much passive money.  The focus of the market shifts to spreads and away from fundamentals. The QQQ is a big success. But ETFs have now exploded.

Much of the volume in ETFs is arbitrage, because the arbitrage mechanism is the only way they can be priced – exactly like currencies now.

Investors and public companies act and think and speak as though fundamentals and economic facts are driving the market. The more the market shifts toward collateral and currency, the less fundamentals play a pricing role.  This is how ETFs are giving stocks characteristics of an FX market where the motivation is profit on short-term spreads.

Like currencies, changes in supplies are inflationary or deflationary. Consider how hard it is for countries to reduce supplies of currency.  Whenever they try, prices fall. Falling prices produce recessions. So instead countries don’t shrink currency supplies and we have catastrophic economic crises.

Are ETF shares keeping pace with the assets backing them? It’s a question we should answer. And IR folks, your relevance in this market is as chief intelligence officer measuring all the forces behind equity value. You can’t remain just the storyteller.

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.

Clashing Titans

While Karen and I consumed Arctic Char in Iceland, stock exchanges sued the SEC.

Talk about a big fish story.

The NYSE, Nasdaq and CBOE, representing about 57% of trading volume over a combined twelve platforms, asked a federal court to halt the SEC’s plan to test changes to trading fees and credits via a Transaction Fee Pilot program set to begin late in 2019.

It’s the more curious because investors transacting in markets generally support the planned study. Reading through hundreds of comment letters (including our own, offered in support), we tallied around $24 trillion of assets backing the test.

What’s got the exchanges in such a tizzy about a probationary effort – not an actual rule-change, mind you – that they’ve lawyered up?

The answer lies in the four key tenets of Regulation National Market System, a sort of current Magna Carta for stock-trading in the USA.  Every investor-relations professional and investor should know baseline facts about it.

In 1975 when the USA was mired in screaming inflation, a plunging dollar loosed from its gold moorings in 1971, an oil crisis, and failure in Vietnam, the US Congress decided to throw a fence around stock markets as a vital strategic interest.

So they passed the National Market System amendments to the Exchange Act of 1934, now part of the leviathan United States Code, 15 USC, Section 78c.

Oh boy.

The wheels of regulation mire in swampy muck, so it was thirty years later when the SEC finally got around to fulfilling the vision (no longer needed, in my view) Congress saw in 1975.  Enter Reg NMS.

The regulation has four pillars.  First, exchanges must ensure that stocks trade only at a single national best price (the Order Protection Rule). Second, the SEC – and this is the essence of the Fee Pilot – capped (the SEC said “harmonized”) what exchanges could charge so nobody would be priced out of access (The Access Rule) to stock quotes. It also required a spread between the bid to buy and offer to sell. No locked (same bid, offer) or crossed (higher bid than offer) markets.

Third, the law prohibited stock-quotes (unless under $1 in value) in increments of less than one penny (in effect, guaranteeing speculative traders a profit, because while quotes are in pennies, trades are often in far smaller increments at variations of midpoints) so every stock would have a bid and offer separated by at least a penny.

Finally, the law changed how revenue from data (Market Data Rules) would be allocated.

Reg NMS was implemented in 2007.

I think a legal case could have been made that both decimalization and Reg NMS six years later were unconstitutional. Nowhere does our governing charter give Congress the power to set prices and commandeer property not for public use.

Yet it did so by forcing exchanges to share what before had been proprietary intellectual property – data – and setting what they could charge for services. So how ironic is it that now exchanges are suing to keep this structure?

Not ironic at all when you realize that big exchange groups (the newest entrant IEX is not suing, supports the fee pilot, and didn’t build business on data and technology services) have exploded in size, profits, revenues and influence under Reg NMS.

Humans are an intelligent species. We adapt. The exchanges discovered that they could pay traders to set the bid and offer, and sell the data generated in that process – and then sell all kinds of services for using that data effectively.  Genius!

The pilot plan threatens this construct.

You’ll read that the concern is brokers routing trades for payments instead of where it’s best. That’s to me a red herring.

We oppose prices set by participants wanting to own nothing. They distort fair value, supply, demand, and borrowing. If you use our analytics, you know it’s 44% of trading volume directly, and over 70% indirectly (we calculate that 94% of SPY volume is arbitrage).

If half the volume is intermediation, the market is a mess.

The stock market is supposed to match investors and public companies. Reg NMS derailed the market’s central purpose. That’s my opinion. Predicated on data. I run a technology firm that for the entirety of the Reg NMS regime has measured the collapse of rational thought and capital-formation consequent to this regulation.

The stock market today is a great place to trade stuff. Exchange Traded Funds have prospered because they’re by law dependent on arbitrage, profiting on different prices for the same things. The regulatory structure requires different prices for the same things.

Let’s summarize what’s occurring. The exchanges have invested billions of dollars to make money under Reg NMS. And they’ve succeeded.

The SEC now realizes that Reg NMS hurts the root purpose of equity capital markets and it wants to test ways to roll back rules promoting short-term trading.

The exchanges are opposed because short-term trading is the very cornerstone of profitable data and technology services.

I don’t fault them.  But come on, guys. The SEC has finally seen how the market has devolved into a laser light show of speculation and fleeting intermediary profiteering that has pushed meaningful capital-formation into private equity.

That in turn defrauds mom and pop investors of the Intel Effect (I don’t have to explain it), and my profession, investor relations, of a thriving job market.

Could we run this test, please, and see what happens, exchanges?