Tagged: Arbitrage

Deal Data

From another rumor that game-maker Zynga might have a buyer, to a Trian bid for Papa John’s, to Bill Ackman’s stake in Starbucks, deals and rumors of them abound. Suppose it’s your company, investor-relations professionals. How do you add value for your executives?

These situations are often chess games.  Here’s an example, since much of the drama is now old news.  When Disney battled Comcast for 21st Century Fox and before bids were hiked, patterns of deal arbitrage signaled starkly that a war would ensue.

One could say it’s logical that the price would rise, and so it was.  But there is no certitude like the power of data – patterns of long bets, covered bets. They are stark in the market if one knows how to measure the data (which we do).

After Disney won the bidding war, data then showed high expectation Comcast would win Sky Broadcasting, the European unit partly owned by Disney.  Data then signaled a sudden turn toward accelerated bidding – before the UK Takeover Panel announced that a speeded process would indeed follow.

Think about the data-powered value investor-relations, so armed, delivers to those making important decisions.

I’ll give you more examples.  Two years ago, longtime client Energy Transfer tried a combination with The Williams Companies that would have created an energy giant. The deal-arbitrage data were woeful. Active money stopped buying. Massive short bets formed and never wavered. Ultimately, the firms called off the effort.

A later plan to consolidate Sunoco, an Energy Transfer unit, presented challenges. It would cut cash distributions by roughly a quarter.  Would holders support it?

Data patterns were opposite what we’d seen in the Williams deal – strong, long bets, solid Active investment. We were confident shareholders would approve. And they did.

The company is now consolidating its Master Limited Partnership into the general partner.  We highlighted big positive bets at September options expirations. A week later, both Glass Lewis and ISS came out in favor of the transaction.

Data are every bit as powerful an IR tool as telling the story.  Maybe more so, because we have a mathematical market today riven with behaviors that arbitrage events and track benchmarks passively, motivations fueled by mathematical probabilities and balances more than story.

Oh, did I mention? We have never yet missed an Activist in the data. We’ve always warned early. And we’ve seen a bunch of them.  We know legacy market intelligence struggles to find them because, as we wrote last week, routinely 98% of trading volume fails to manifest in settlement data.

In one instance years ago, Carl Icahn took a major stake in a pharmaceutical company that had two high-paid surveillance providers watching. Neither saw it. Suddenly, Icahn filed with over 8 million shares – accumulated without buying a single share (he used European-style puts.).

We showed the company Market Structure Analytics and the stark patterns of derivatives.  They hired us. Subsequently, our data showed investors were betting against Icahn. His proxy bid to put a slate of directors on the board failed.  We then tracked his gradual withdrawal in the data. Not through shares owned but in patterns of behavior (nearly realtime, at T+1).

Lips can lie. Data those behind it believe are hidden from view – but which shine like light through night-vision goggles for us – is truth.  We have an unfolding situation now where what hedge funds are doing and saying are diametrically opposite. That’s a negotiating tactic. Since management knows, they have the stronger hand.

That’s IR in the age of Big Data.  And it’s fun to boot!  Seeing patterns of behavior and reporting it to executives and board directors puts IR in the right-hand advisory seat.  Right where it belongs in this era of fast machines and market reavers.

If you want a confidential analytics assessment of what’s behind your price and volume (which are not metrics but consequences of behaviors), let us know.

Electric Market Toothbrush

We were in Portugal and our electric toothbrush went haywire.

It would randomly turn on in the night, and no amount of pressing the button would silence it. We abandoned it in Evora in the shadow of 2,000-year-old Roman aqueducts that still work.

The point isn’t the ephemeral nature of manufactured products (Amazon assured we’d have a replacement waiting, so the modern era works!). But two recent events show how the stock market is built for the short-term – and may run of its own accord.

First, the Wall Street Journal reported Sep 21 that a judge is permitting a class action suit from customers to proceed against TD Ameritrade alleging the big discount broker with 11 million customers breached its “best execution” obligation.

For you investor-relations professionals who’ve heard about the Fee Pilot Program proposed by the SEC, this gets to the heart of it. For you investors, it illustrates how market structure is trumping investment motivation.

Let me explain.  The suit claims TD Ameritrade put its own interest above that of its customers because it routed customer trade-executions to high-speed traders for payment, earning $320 million. TD Ameritrade had net income of about $870 million in 2017 – so selling orders was over 35% of the bottom line.

There’s no law against it, and rules encourage it by forcing trading to occur between the national best bid to buy or offer to sell. Prices constantly change as machines move bids and offers, breaking trades into small pieces to profit on intermediating them.

Retail brokerages sell orders to high-speed firms to avoid these marketplace challenges (of note, the WSJ said Fidelity stopped selling its orders in 2015, an exception in the group). That fast traders paid $320 million for orders suggests they can sell them for more – money that should have gone to the customers rather than the intermediaries.

One could argue spreads are so low that what difference does it make?  What’s a few pennies on a hundred-share order?

The problem is that fees for orders change behavior. High-speed firms aren’t investors. They profit by changing prices. That’s arbitrage, and it becomes both means and end.

What’s the definition of volatility?  Unstable – changing – prices. Rules create economic incentives to change prices. Intraday volatility marketwide is 2.3%, far higher than what the VIX based on implied volatility suggests. Arbitrage is the opposite of long-term investment. Why would we want rules that encourage it?

This is why we support the proposed SEC study that would include eliminating fees in one group (an astute IR guy observed to me in Washington DC last week that every stock should spend time in each of the buckets so there is no discrimination). We don’t want arbitrage pricing the market we all depend on as a gauge of fair value.

Which leads to the second item. The ETFMG Alternative Harvest ETF, a pot fund amusingly tickered “MJ” (last dance with Mary Jane, one more time to kill the pain, sang Tom Petty), made headlines for sharp divergence from its intraday indicative value.

ETFs are required to report net asset value every 15 seconds. Traders can arbitrage – here it comes again – ETF shares as they cross above or below NAV.

(Programming note: I’ll be at the Connecticut/Westchester Chapter Oct 3 talking about the impact of ETFs on markets and your stock, and we’re sponsoring the NIRI Chicago Chapter this Friday the 28th so stop by and say hi!)

The SEC is now proposing to eliminate that requirement so ETFs would price once a day like actual pooled investments such as index mutual funds.  Here’s the kicker: The SEC in first permitting ETFs to trade exempted them from the “redeemable security” mandate in the Investment Company Act of 1940.

That is, all pooled investments must exchange investors’ shares for a proportionate part of the pool of assets when asked. ETFs are exempted from that provision. They are not redeemable. The SEC approved them because creators said the “arbitrage mechanism” would make them in effect redeemable because they would have the same value as an index.

What if the arbitrage incentive diminishes?

To me, the problem today for investors and public companies is the market’s staggering dependency on arbitrage. High-speed traders and Passive money, the latter mostly ETF market-making, are 80% of market volume. The two behaviors at issue in these situations. The math on SPY, the world’s largest ETF, suggests arbitrage is an astonishing 94% of its trading volume when compared to gross share-issuance.

It’s like an electric toothbrush you can’t shut off. What you thought was an instrument designed to serve a purpose can no longer be controlled.  It’s creditable that the SEC is investigating how its rules may be running the toothbrush – and courts could put a spotlight on a market priced by the fastest orders.

We don’t need to go back to Roman aqueducts (though they still work). We can and should recognize that the market has gotten awfully far removed from its intended purpose.

Shell Game

The earnings-versus-expectations construct that fixates Wall Street and business journalism as companies report results fuels bets on which shell hides the pea.

In fact, the stock market is built now on hiding the pea and moving the shells, apparent in the Fee Pilot debate we’ve written about recently.

You know the shell game, right?  This cat is pretty good at it.

As to picking the shell that hides the pea, I’m surprised the investor-relations profession isn’t up in arms over claims like Google parent Alphabet’s good numbers reputedly “boosting earnings optimism,” as one headline read.

What stock picker following GOOG trends and drivers and listening to its IR team and executives providing color and guidance didn’t know the quarter would be good? Keen observers didn’t wake up shouting, “Shazzam! I’m shocked at the numbers!”

But yesterday was Counterparty Tuesday, the one day every month when banks backing directional bets – most very short term – square derivatives books. Every third month it falls amidst earnings. If your bets are right, you get paid. Wrong, you pay up.

Banks shuffle assets accordingly. Yesterday, blue chips were up (GOOG is one now), risky stocks were down.

Take the new Communications Services ETF, XLC (see here in sector ETFs), which presages a reshuffling of Consumer Discretionary and Technology stocks into a re-imagined and amalgamated General Industry Classification System (GICS) for everything from Twitter, to Disney, to Facebook, to Electronic Arts that officially hits markets Sep 21, 2018.

Just four companies accounted for XLC gains yesterday if you view Alphabet’s two stock classes as a single company. Alphabet is 24% of the ETF’s weighting. With Facebook, two stocks are 45% of purported assets (read our ETF White Paper for more on “assets”).

The others with gains were VZ and T, two of the spare coterie comprising the old Telecom GICS that’s going away.  Combined the five green elements of XLC yesterday are 54% of its weighting. The other 21 were all in the red.

If you bet on GOOG and you pile in regardless of numbers, your bet pays because GOOG is so massive that as counterparties cover, it drives the entire market up. No wonder betting abounds.

But it’s not fundamentals. It’s betting on the law of large numbers.

Coming back to the Fee Pilot proposed by the SEC to study whether trading incentives distort how orders are handled, we support it because Fast Traders turn the market into a shell game.

Take HRT Financial, a top high-speed trader. We’ve got nothing against the smart folks behind it. But look up its 13F reports. It trades many billions of shares of stocks every month yet owns almost nothing – a measly few hundred million dollars.

Public companies are led to believe that having a bunch of prices set by high-speed firms that don’t want to own anything is good. Well, where do they get shares to sell to investors?  They borrow most of them – from owners! If they didn’t, it would show up as ownership. Or they buy them elsewhere in the market, in tiny pieces, in fractions of seconds, and immediately sell them. They are moving the shells, not fostering a market with deep supply.

It all fits together.  The earnings-versus-expectations model shifts focus from long-term prospects to how something fluctuates.  What is betting on fluctuations? Arbitrage.

Next piece of the puzzle:  How are prices set in the stock market?  By the fastest order bidding to buy or offering to sell. Fast machines like those run by HRT Financial set prices in tiny increments.  Exchanges offer incentives to high-speed traders to set prices in tiny increments – to keep moving the shells, keep that pea in motion, keep fooling people about where the best price is.

And exchanges sell the data from this shell game because rules require everybody in pursuit of the pea to buy it to prove they’re not gaming their customers. It would be laughable if it weren’t true, and describing the stock market.

Three big lessons, investors and public companies. Number one, you’ve got to have better data than the operators of the shell game if you want to keep track of the pea.  And we’ve got it.  Number two, don’t trust a shell game to give you an accurate portrayal of either business fundamentals or future outcomes.

And number three, the best defense against any form of shell game is knowledge. Education. Knowing how the game works. I refer you to the cat above. If the cat can figure it out, so can we!  Market Structure knowledge is now essential for both investors and public companies.

The Housing ETF

Recent market volatility is, we’re told, investors one day saying “let’s sell everything because of tariffs and a trade war” and two days later “let’s buy in epic fashion because the USA is negotiating with China.”

That conforms market behavior to a fundamental explanation but omits the elephant: Exchange Traded Funds. They are 50% of market volume. They’re no side show.

Today you’ll see the way wild swings trace to how ETFs work, by creating an ETF that lets people trade houses. Sound fun?

Let’s name our ETF company after a color and something from nature. How about WhiteTree? WhiteTree is in Denver. We make Big Broker Inc., our Authorized Participant (AP) responsible for creating ETF shares, and we advertise: “Want to own residential real estate but trade it like stocks? Buy PADS!”

There’s demand (Editorial note: ETFs like STWD offer this exposure) and we tell our AP, Big Broker Inc., to provide a “Creation Basket” of titles to Denver homes as collateral, and in exchange BBI can create ETF shares to sell to the public.

We get deeds to real estate tax free. Cool! Why? It’s an “in-kind” exchange under IRS rules and SEC exemptive orders. One thing of equal value is exchanged for another. No fund turnover, no commissions (and we can charge BBI to boot!).

We don’t manage any money, just the collateral, the houses.  Demand is great for PADS and analysts say, “It’s a boom in residential real estate.”  We need more PADS to sell.

So we ask BBI for more collateral and BBI says, “We’re out of Denver homes. Will you take some in Minot, ND?” Sure. It’s collateral. More PADS shares, investor demand is strong, and The Housing Index, the benchmark PADS is tracking, rises.

We can’t keep up with PADS demand. We tell BBI the Creation Basket will take any housing deeds they’ve got. “We’re out,” BBI says. “How about a check for the amount of a house in Minot?”

Done! More ETF shares created. The media says WhiteTree is managing billions of investments in housing. No, we manage collateral. And we’re now writing futures on The Housing Index to boost reported ETF returns.

Home prices in Minot, ND soar. Pundits are saying, “Minot is an economic model for the nation. Everybody wants to live in Minot!”

But at WhiteTree, we’ve got a problem. Home values nationwide are rising and those capital gains taxes will be imputed to PADS shares, hurting our performance versus the benchmark. We need to get rid of capital gains, something ETF Redemption permits.

So we survey the collateral and Minot deeds have risen most.  We offer a Redemption Basket to BBI: PADS shares for equal value in Minot deeds (or a cash substitute).

BBI shorts The Housing Index, borrows PADS shares from another broker, gives them to WhiteTree, which delivers Minot deeds, and BBI dumps them.

Real Estate in Minot implodes.  Pundits are saying, “The economy turned. Nobody wants to live in Minot!”

This is precisely how ETFs work. Replace housing with stocks. It’s how they expand beyond the asset base and become an engine for the asset class.

Take the last two weeks. Bad times for Facebook (FB). The Tech Sector is over 25% of the S&P 500, and FB is the third largest Tech holding. It WAS the Redemption Basket, with brokers trading S&P 500 ETFs like SPY and IVV for FB and shorting FB and buying puts on Tech and FB. The market imploded.

But now ETF funds have removed capital gains via the Redemption process and instead with the Mar 31 quarter-end looming they need to true up tracking versus benchmarks.

On Monday Mar 26, the Creation Basket was full of stocks that had declined, capital gains wrung out. Brokers bought calls, bought futures on indexes, and the market before the open was set to rise over 300 points on the Dow.  It gained about 700 points.

But the REASON is arbitrage opportunity between COLLATERAL for ETFs, and trading the components, and ETF shares, and options and futures on indexes. Do you see?

Yesterday, nobody showed up to buy the new ETF shares. Investors are skittish. Thus as Tuesday wore on, brokers were worried that the ETF shares they had collateralized could lose value along with the collateral they had supplied to create them. Big trouble!  The market rolled over as they began selling and shorting Tech again to raise cash.

While we have theorized with PADS, what I’ve described about stocks is what we saw in the analytics we invented to track Passive Investment. Everything in the theoretical PADS scenario describes what I’ve read in ETF regulatory documents.

ETFs are like a currency backed by gold. After awhile there’s no more gold and you start backing the currency with something else – or nothing, as is the case today.  The creation of money drives up prices, the rise of which is misconstrued to be economic growth.

ETFs are not rights to stocks via pooled investments. They are substitutes you buy from brokers. As WhiteTree manages no ETF money, so it is with the big ETF sponsors.

The good thing about ETFs is they allow more money access to a finite asset class. But that’s the bad news too. Overextension of assets inevitably leads to bubbles which leads to popping bubbles.

Volatility since February has roiled the value of ETF collateral. Managing collateral exposure is wholly different than investing, and why inexplicable behavior is becoming more common in stocks.  You can see with PADS how complicated resolving this tangle might prove to be.  It’s the age-old lesson about derivatives.

Green and Purple

I can’t find a team (men’s or women’s) headed to March Madness, the annual collegiate sports fete in the USA, wearing green and purple. But the market’s awash in them.

Don’t you mean red and green, Tim?  Buy and selling?

No, green and purple.  See this image?  Green and purple are Passive Investment and Risk Management, a combination revealing how arbitrage in Exchange Traded Funds (ETFs) is taking over the stock market.

In the first circle, green and purple coincide with short covering (lower bar graph) and a surge in price.  In the second, green and purple again, shorting up, price falls.  It’s an anonymous stock exemplar but we see these patterns everywhere.

Monday, a friend sent me a note: “First thing I heard today when I got in the car to go to work and turned on the news is ‘Dow is down on fears of Trump tariff.’  Now I see the market is up 400 points. Should it say: ‘Markets up on Trump tariff?’”

Some pundits, coughing in advance, said it was reduced fears of tariffs on Canada and Mexico. It may be the green and purple gang and not rational thought at all.

I’ve written before about the “arbitrage mechanism” for ETFs.  Google “ETF arbitrage mechanism.” It’s presented as a good thing – the way ETFs can closely track an index.

Yet apart from ETFs, regulators, congresspersons, pundits, investors, all rail at “the arbitragers” for distorting prices and manipulating markets.  Isn’t it cognitively dissonant to say it’s good for ETFs but bad elsewhere?

If we don’t know what’s pricing the market because a pervasive “arbitrage mechanism” – green and purple going long and short – trumps Trump tariffs or any other fundamental consideration, the market cannot serve as a reliable barometer for corporate effort or economic activity.  I’m surprised it’s not troubling to more.

For every trade executed in the stock market in December, 19 were cancelled before matching according to Midas data from the SEC.  Of those that completed, 30% were odd lots – less than 100 shares (no wonder average trade size is about 180 shares).

Trade-cancellations in ETFs run about four times higher than in stocks, near 80-to-1, Midas shows. If trading motivation is changing the price, cancellations will run high.  Investors don’t do it. Profiting on price-differences is arbitrage. Only 5% of US stock orders execute, suggesting a lot of arbitrage. It’s rampant in ETFs. Green and purple.

Here’s what I think. Brokers trade collateral like stocks and cash at a fixed, net-asset-value to ETF sponsors tax-free for ETF shares. They cover borrowed stock-shares, bet long in futures and options on the indexes and components and sell ETF shares to investors.

When the group or index or sector or market-measure has appreciated to the point the ETF sponsor will incur taxes on low-basis stocks in the collateral the brokers provided, the brokers short those stocks and the options and futures and buy the ETF shares and return them to receive the collateral back in exchange.

Headlines may create entries and exits. This process repeats relentlessly, prompting investors and pundits and companies to draw widespread false correlations between market behavior and fundamental or economic factors.

It’s a genius way for brokers, traders and fund sponsors to make money. One could say we all benefit by extension. To a point, yes. So long as more money comes into the market than leaves it, stocks rise.

Volatility mounts on over-correction, where the arbitragers cover at the wrong time, short at the wrong time or exchange collateral for ETF shares in ill-timed ways, leaving puzzled people watching the tape.

Upon reflection, I guess it’s a good thing no team is wearing green and purple. The rest of us would do well to get as good at pattern-recognition as we are at PE ratios, because the patterns are setting prices. Watch the green and purple.

Livermore Lesson

A guy from Cumbria in the UK has built a Twitter Tape Machine.

Programmer Adam Vaughan was long intrigued by ticker tape, the stock market technology standard from 1869, when Thomas Edison patented a version better than inventor Edward Calahan’s, until the 1960s when TV and computers made paper tape spitting out price and volume for stocks obsolete.

Mr. Vaughan built his device from spare parts and networked it to check his Twitter feed every thirty seconds and burn anything new onto a strip of thermal cash-register paper. No ink. No checking the device. Tear off the strip and read.

It’s a goofy idea. Isn’t it better to scroll a phone screen with your index finger?  But you can order the Twitter Tape Machine if you’re moved.

Sometimes we need absurdity to shine brightly before we see things.  Nobody reads ticker tape anymore. And yet. Price and volume scrolling on screens is still the standard.

Jesse Livermore started trading stocks in 1891 after working as a board boy transferring figures from ticker tape to the quotation board at Paine Webber. In his tumultuous life speculating in stocks, he famously made $100 million shorting the 1929 crash – the equivalent today, using an income measure of worth, of about $7 billion.

He’d be the John Paulson, the George Soros, of then. Before the riches, on May 9, 1901 Livermore lost $50,000. He later said, “The ticker beat me by lagging so far behind the market. The divergence between the printed and the actual prices undid me.”

A hundred years ago the top high-frequency trader of his time saw opportunity in the gap between posted and actual prices. Today we call that “latency arbitrage,” one form of profiting on price-differences by spotting lagging price patterns. You need machines in the National Market System to win the gap trade, and firms like Tower Research and Hudson River Trading have made it an automated science.

Livermore made and lost fortunes, going bankrupt three times, living large and then committing suicide in 1940, saying in a note his life was a failure. Ticker tape won in the end.

But Livermore was an outlier. Most of the prices and volume on the tape then came from committed investment.  It’s to me fantastically ironic that the SEC was formed in the 1930s to mitigate nefarious “bucket shop” short-term manipulation – and now under a heavy regulatory regime half the market’s volume is a form of exploitation via short-term price-moves. Every one of those costs you minutely, investors and companies.

Leveraged ETFs, investment funds sanctioned by the SEC that use derivatives to deliver one-day directional bets, are arbitrage. Speed traders exploiting slow and fast prices, intraday volatility, divergences from the mean tracked by passive investments, are arbitraging, profiting on price-differences.

Where Livermore was on the cutting edge in 1929 shorting stocks, today 45% of ALL daily market volume is short – from borrowed shares.  Routinely now we see shorting running up as prices rise and down as prices fall. Traders make money via a sort of above-the-surface, below-the-surface trade that works best in a placid VIX environment.

If speculators exploit the tape – price and volume – why do price and volume remain the convention for measuring what investors think? In a market riven with arbitrage?

On every investor-relations website are displayed price and volume. Ticker tape. As if that connotes fair value when we know so much volume, the relentlessly changing prices (our clients average 14,000 trades daily – 14,000 theoretical different prices!), reflect arbitrage.

It’s absurd if you think about it. In 1901 Jesse Livermore could exploit patterns in the tape, and the tape showed price and volume. In 2017, price and volume remain the key data points public companies use to measure the market. But exploitation has exploded.

Investors and public companies alike should be going BEHIND price and volume to the patterns, trends, drivers. Price and volume are consequences. Patterns are the future for well-informed constituents. I suspect even Jesse Livermore would agree.

Our new Key Metrics Report released yesterday for clients puts the focus not on price and volume but six metrics stacked by period, so one can see when the Livermores are leading, or Active investors committed to story.  Instead of searching the tape, scroll to see patterns in Rational Price, Engagement, Short Volume, Key Behavior, Sentiment.

Best, patterns signal what’s coming. There are patterns in weather, patterns in stocks, because mathematical principles govern both. And all things in this universe.

I imagine a day when on websites everywhere are Rational Prices instead of just market price and volume.  And more. But one step at a time!  First, learn your patterns. It’s the future. Price and volume are prologue, like the past.

Half the Market

I’ve seen at least four Wall Street Journal stories in May alone about a quiescent VIX.

The CBOE’s volatility index derived from options pricing on the S&P 500 hit a low Monday last seen in Dec 1993, the WSJ said (subscription required). It moved lower still yesterday, 9.58 intraday.

Implicit in the storyline is a bull market, since one roared from 1993 to the bursting of the dot-com bubble. But the conclusion violates the Law of Small Numbers, the human propensity to assign undue value to insignificant data sets.  As proof, the VIX was a hair’s breadth from record low in Jan 2007.

Remember that? Lehman, little did we know, was failing. The financial crisis thereafter manifested in markets like a Hollywood blockbuster action movie where the hero outruns the explosion as the structure dissolves in showering computer-generated fantasia.

Since we can make equal bull or bear cases with the same data, it supports neither.

Aside: The investor-relations profession has a notorious proclivity toward the Law of Small Numbers. Stock’s down 3%, so we call somebody to learn why. You’re chasing the exception. Track instead the central tendency in the whole data set so you can see what changed before the stock fell 3%.

And assigning rational motivation to the VIX defies the data.  Less than 20% of daily market volume comes from rational thought. The rest is tracking the mean, arbitraging spreads back to the mean, or hedging departures from the mean.

Where everything is average, volatility vanishes. Thus a dead VIX fits. It offers little predictive value (save higher volatility always follows very low) and simply points to low spreads.

The reason is market structure. Passive investment tracks benchmarks and so seeks the mean – average price. Arbitragers look for departures from the mean to trade for profit. The market is riven with arbitrage so few mean-divergences survive to the close. But boy is there opportunity. You’ll see soon.

Meanwhile, those managing risk offload exposure to someone else, which produces equal and offsetting trading – which reinforces the mean.

And here’s a shocker. We track daily share-borrowing – shorting – as a percentage of total trading volume. Short shares are 48.1% of volume, which means long trades are 51.9%. In other words, nearly half the market is short.

Locked markets, or trades where the bid to buy equals the asking price to sell, are prohibited, so there will always be a spread, a dab of volatility. Arbitragers are almost guaranteed gains by being long and short everywhere.

We also measure intraday volatility, the spread between average intraday high and low prices. It’s 2.5% – astonishing arbitrage fodder.

For perspective, the S&P 500 rose 0.5% the last ten sessions. That means stocks are 400% more volatile every day than the ten-day change in closing prices.

Arbitragers are making tremendous gains by consuming intraday volatility.

It may be that Exchange-Traded Fund (ETF) market-makers are responsible. It explains why ETF costs are so low: Arbitrage gains are additive.

And ETF sponsors can rent out liquidity, shares accounting for the 48% of trading that’s borrowed – boosting returns. There’s support in the data. We track passive-investment patterns and correlate them to short volume, and there’s agreement.

ETF market-makers have four arbitrage opportunities: a) ETF net asset value versus ETF price; b) ETF versus underlying index; c) ETF price versus prices of components of the index; d) ETF price versus options and futures on components and the index.

By the close, ETFs and indexes want to peg the measure so divergences converge at average.

It’s a circumstantial case. But evidence piles up that ETFs are consuming spreads while simultaneously driving stock-prices and deflating the VIX.

What’s the risk?  Mortgage-backed securities did the same thing to real estate.  There was a finite asset, homes. With cheap mortgages, lots of money wanted exposure. So home loans were securitized – replicated – to expand demand, delivering great returns to those selling them. It worked till home prices stopped rising. Then replicated value evaporated. Half the market.

There are less than 3,600 US public companies when ETFs, multiple share classes and closed-end funds are removed. Low rates have created high demand. To expand access, ETFs replicate exposure, and are booming. It works so long as stocks rise.

When that stops at some sure point, extrapolated value will be marked to zero. Half the market.  Won’t arbitragers save the day? Not if volatility jumps as average prices plunge.

Expectations vs Outcomes

“Earnings beat expectations but revenues missed.”

Variations on this theme pervade the business airwaves here during earnings, currently at fever pitch.  Stocks bounce around in response. Soaring heights, crushing depths, and instances where stocks moved opposite of what the company expected.

Why?

Well, everyone is doing it – betting on expectations versus outcomes.  The Federal Reserve Open Market Committee meeting wraps today and much musing and a lot of financial betting swirls around what Chair Yellen is expected to offer as outcome.

Then Friday the world stops at 8:30am ET, holding its breath to see if the expectation for April US jobs matches the outcome.

And by the way, I will join Rick Santelli in Chicago Thursday morning, in between, on Squawk on the Street to pontificate fleetingly and I hope meaningfully.

Obsession with expectations versus outcomes in equity markets and across the planar vastness of economic and monetary data blots out long-term vision and fixes attention on directional bets.

It’s not investment. And it’s no way to plan the future, this mass financial pirouette around a data point.  But it’s the market we’ve got. We must understand it, like it or not.

Back to your stock. The reason that after you beat and raise your stock falls is what occurred ahead of your call.

It may have nothing to do with how you performed versus consensus. For proof, droves from the sellside are looking for IR jobs because trillions of dollars migrating from active portfolios into indexes and ETFs aren’t using sellside research. Or listening to calls.

It reminds me of the Roadrunner cartoons, Wile E. Coyote running off the cliff. Remember? Parts of Wile E. drop in order, the last thing remaining, his blinking eyes.

That’s to me like results versus consensus.  The eyes of Wile E. Coyote, last vestige of something fallen off the cliff of colossal change to investment and trading behavior. The sellside still has everybody thinking outcomes versus expectations matter to investors.

No, they matter to the hordes with directional bets – over 40% of the market.

They bet long or short, or on the spread between high and low prices. They may have fixed for floating swaps that pay if you beat, leading counterparties to sell your shares – and the bettors are short your stock too, so they make a fee on the bet and more covering as your stock falls.

And the CEO says to you, “What the heck?”

If your stock is 50% short (we measure it) and slamming the ceiling of Sentiment due to a marketwide derivatives surge after expirations – which happened Apr 24-25 – it doesn’t matter if you crush consensus. Structure trumps Story. Price will fall because bets have already paid thanks to the broad market.

The market makes sense when you understand what sets price.

Active investment leads less than 20% of the time. The juggernaut of indexes and ETFs rumbles through at about 34%, and it’s now distorting share-borrowing and Risk Management. The latter is 13-16% of your market cap – hopes for the future that can sour or surge on any little data point.

Let’s bring it back to the Fed and jobs and the economy. I said your stock will move based on what happened beforehand.  That can be a day or two, or a week or two.

The economy is massive. It will move on what happened beforehand too but the arc is years. No matter what may be occurring now, which in turn will manifest in the future.

The threat to the US economy and stocks is a lack of appreciation that tomorrow is a consequence of yesterday, not of tomorrow.  For the better part of a decade, furious fiscal and monetary effort promoted borrowing and spending so people would consume more.

But the consequence of borrowing and spending is debt and a lack of money. Which causes the economy to contract in the future. Stocks are pumped on past steroids. If the economy beats and raises, everything can still fall because of what happened yesterday.

We must first navigate consequences of yesterday before reaching the fruits from today.

Same for you. The stock market is awash in bets on divergences, even more when financial results mean opportunity blooms. Your active money clangs around in there, often as confused as you.

Your challenge and opportunity, IR professionals? Helping management develop an expectation of market form that matches the outcome of its function now.

ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

Let me frame that statement with backstory. I consider it our mission to help you understand market behavior. The biggest currently is arbitrage – taking advantage of price-differences. Insert that phrase wherever you see the word.  We mean that much of the money behind volume is doing that.  Yesterday eleven of the 25 most active stocks were Exchange-Traded Funds (ETFs). Four were American Depositary Receipts (ADRs).

Both these and high-frequency trading turn on taking advantage of price-differences. Both offer the capacity to capitalize on changing prices – ADRs relative to ordinary-share conversions, and ETFs relative to the net asset value of the ETF and the prices of components. In a sense both are stock-backed securities built on conversions.

For high-speed traders, arbitrage lies in the act of setting prices at different markets. Rules require trades to match between the best bid to buy and offer to sell (called the NBBO). Generally exchanges pay traders to sell and charge them to buy.

In fact, the SEC suspended an NYSE rule because it may permit traders to take advantage of price-differences (something we’ve long contended). We’ll come to that at the end.

Next, ETFs are constructed on arbitrage – price-differences. Say Blackrock sponsors an ETF to track a technology index. Blackrock sells a bunch of ETF shares to a broker like Morgan Stanley, which provides Blackrock with either commensurate stocks comprising the tech index or a substitute, principally cash, and sells ETF shares to the public.

If there’s demand, Morgan Stanley creates more ETF shares in exchange for components or cash, and then sells them. Conversely, if people are selling the ETF, Morgan Stanley buys the ETF shares and sells them back to Blackrock, which pays with stocks or cash.

The trick is keeping assets and stock-prices of components aligned. ETFs post asset positions daily. Divergences create both risk and opportunity for the sponsor and the broker alike. Blackrock cites its derivatives-hedging strategies as a standard risk associated with ETF investing. I’m convinced that a key reason why ETFs have low management fees is that the components can be lent, shorted, or leveraged with derivatives so as to contribute to returns for both the sponsor and the broker.

On the flip side, if markets are volatile as they have been post-Brexit and really since latter 2014, either party could lose money on unexpected moves. So both hedge.

For arbitragers, a perfect market is one with little direction and lots of volatility. Despite this week’s move to new market highs, there remains statistically little real market movement in the past two years. If a market is up or down 2% daily, does it over time gain, lose or stay the same?

Run it in Excel. You’ll see that a market declines over time. Thus arbitragers short securities using rapid tactics to minimize time-decay. If you want a distraction, Google “ETF arbitrage shorting” and read how traders short leveraged ETFs to make money without respect to the market at large.

In fact, this is the root problem: Taking advantage of price-differences is by nature a short-term strategy. Sixteen of the most actively traded 25 stocks yesterday (64% of the total!) were priced heavily by arbitrage, some by high-speed traders and some by investors and the market-makers for ETFs.

Offering further support for arbitrage ubiquity, the market is routinely 45-50% short on a given day. Short volume this week dipped below 45% for the first time since December, perhaps signaling an arbitrage squeeze and certainly offering evidence that arbitragers hate a runaway market.

If the market rises on arbitrage, it means parties SUPPLYING hedges are losing money. Those are big banks and hedge funds and insurance companies. Who’d take the market on a run to undermine arbitrage that’s eating away at balance sheets (big banks and hedge funds have suffered)?  Counterparties.

In our behavioral data Active investment is down and counterparties have been weak too, likely cutting back on participation. That comports with fund data showing net outflows of $70-$80 billion from US equities this year even as the market reverts to highs. The only two behaviors up the past 50 trading days are Fast Trading (arbitrage) and Asset Allocation (market-makers and brokers for ETFs and other quantitative vehicles). Yet more evidence. And both are principally quantitative.

Assemble these statistics and you see why the market seems oblivious to everything from US racial unrest, to a bankrupt Puerto Rico, to foundering global growth and teetering banks.  The market is running on arbitrage.

What’s the good news, you ask?  The SEC is aware of rising risk. It suspended an NYSE rule-filing on fees at the exchange’s Amex Options market after concluding the structure may incentivize arbitrage.  The SEC is scrutinizing leveraged ETFs and could end them.

But most important is the timeless self-regulation of knowledge. If we’re all aware of what’s driving the market then maybe the arbitragers will be their own undoing without taking the rest of us with them.

Making Water

If someone says he’s going to make water, it means one thing.  If he says he’s providing liquidity, it means another.  We should clear (and perhaps clean) that up.

In the stock market, some firms call themselves “liquidity providers.” The term suggests they’re creating something somebody else needs (here we depart sharply from making water). Liquidity by definition is the availability of assets to a market. Providing assets is important, helpful and benign, it would seem.

Hudson River Trading, one of the biggest liquidity providers (the terms high-frequency trader and liquidity-provider can be interchangeable), said in its last 13f it had 64 positions, the largest at $32 million in the exchange-traded S&P 500 fund SPY, leading a baker’s dozen ETFs topping its holdings. The biggest stock position was XOM at $1.5 million or 19,000 shares. A retail investor could own as much. Hudson River trades thousands of securities and millions of shares daily. If one could see its short positions, I bet the two would about cancel out. Effectively, zero assets.

If liquidity is availability of assets, how do you deliver assets when you don’t own any?

The NYSE enlists the help of a group it calls Supplemental Liquidity Providers (scroll to see them). SLPs, the exchange says, “trade only for their proprietary accounts, not for public customers or on an agency basis.” In its fee schedule the NYSE says it pays SLPs $0.06-$0.30 per hundred shares.

Did you catch that? The NYSE pays firms to supply liquidity but only proprietary trades – their own orders – qualify. The traders it’s paying are just like Hudson River. If the NYSE isn’t paying them to bring assets, the only other thing they can offer of value to the exchange is prices.  And setting prices is really arbitrage.

The Nasdaq does the same thing.  It pays traders around $0.31 per hundred shares to “add liquidity.” We’ve written for years about the system of incentives in the stock market. It’s called the “maker-taker model” because buying and selling are treated differently, not as the same activity.  Search our blog for “maker taker” for more and read this one.

Are there auto parts liquidity providers?  Grocery liquidity providers? There are automobile distributors, yes, who buy inventory wholesale from manufacturers. But they sell to the public and fold service, financing and support into the customer experience.

Broker-dealers like Citigroup or Raymond James that sell shares to investors write research, commit capital, provide trading services and account management, underwrite offerings, syndicate financings.  You won’t know the names of many equity liquidity providers. Most offer no services and have no customers.

What’s the value?  Little for you, issuers and investors. They are price-setters for exchanges, which in turn are data-sellers. Best prices are valuable data. The REST of the market participants with customers (humans and software systems alike register as brokers) must by law buy data about the best prices to make sure customers get them.

It’s perverse. Exchanges pay traders with no purpose save arbitrage – which call themselves liquidity providers – to set prices for anyone who actually IS a real buyer or seller. Sound to you like making water into the wind? Yup. But to quote humorist Dave Barry, we’re not making any of this up.