Tagged: Arbitrage

Hot Air

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Six See Eleven

What do you do in Steamboat Springs when autumn arrives at the Botanic Park? Why, have a Food & Wine Festival of course!

Meanwhile the derivatives festival in equities continues, thanks to the SEC, which through Rule 6c-11 is now blanket-exempting the greatest financial mania of the modern era, Exchange Traded Funds (ETFs), from the law governing pooled investments.

I’ll explain what this means to companies and stock-picking investors.

Look, I like Chairman Clayton, Director Redfearn, and others there.  But the SEC isn’t Congress, legislating how the capital markets work (one could argue that the people never delegated that authority to government through the Constitutional amendment process at all. But I digress).

The point is, the SEC is supposed to promote free and fair markets – not one purposely tilted against our core audience of stock-pickers.

The problems with ETFs are they’re derivatives, and they foster arbitrage, or profiting on different prices for the same thing. If arbitrage is a small element – say 15% – it can highlight inefficiencies. But thanks to ETFs, 87% of volume (as we measure it) is now directly or indirectly something besides business fundamentals, much of it arbitrage.

Do we want a market where the smallest influencer is Benjamin Graham?

ETFs in fact can’t function without arbitrage. ETFs have no intrinsic value.  They are a traded substitute for a basket of underlying stocks that depend on prices of those stocks for a derivative price applied to the ETF shares. So, unless brokers trade both ETF shares and stocks simultaneously, ETF prices CAN collapse.

That was an outlier problem until ETFs became the fastest-growing financial instrument of all time outside maybe 16th century Dutch tulip bulbs.

But collapse is not the core threat from ETFs. Arbitrage distorts the market’s usefulness as a barometer of fundamentals, warps the market toward speed, and shrivels liquidity.

How and why are these conditions tied to ETFs and arbitrage?  I’m glad you asked!

The motivation for arbitragers is short-term price-changes.  The motivation for investors is long-term capital formation. These are at loggerheads.  The more arbitrage, the faster prices change.  Price-instability shrinks the size of trades, and liquidity is the amount of something that can trade before prices change. It’s getting smaller as the market balloons.

If money can’t get into or out of stocks, it will stop buying them and start substituting other things for them. Voila! ETFs.

But.

We’ll get to that “but” in a minute.

ETFs are a fantastic innovation for ETF sponsors because they eliminate the four characteristics that deteriorate fund-performance:

Volatility. ETF shares are created off-market in big blocks away from competition, arbitrage, changing prices, that war on conventional institutional orders.

Customer accounts. ETFs eliminate asset-gathering and the cost of supporting customers, offloading those to brokers. Brokers accept it because they arbitrage spreads between stocks and ETFs, becoming high-frequency passive investors (HFPI).

Commissions. ETF sponsors pay no commissions for creating and redeeming ETF shares because they’re off-market.  Everyone else does, on-market.

Taxes. Since ETFs are generally created through an “in-kind” exchange of collateral like cash or stocks, they qualify as tax-exempt transactions.  All other investors pay taxes.

Why would regulators give one asset class, which wouldn’t exist without exemptions from the law, primacy? It appears the SEC is trying to push the whole market into substitutes for stocks rather than stocks themselves.

The way rules are going, stocks will become collateral, investments will occur via ETFs. Period.  If both passive and active investors use ETFs, then prices of ALL stocks will become a function of the spread between the ETFs and the shares of stocks.

Demand for stocks will depend not on investors motivated by business prospects but on brokers using stocks as collateral. Investors will buy ETFs instead of stocks.

If there is no investment demand for stocks, what happens when markets decline?

What would possess regulators to promote this structure? If you’ve got the answer, let me know.

And if you’re in IR and if you play guitar (Greg Secord? You know who you are, guitar players!), start a rock band. Call it Six See Eleven. Book some gigs in Georgetown. Maybe Jay Clayton will pop in.

Meanwhile, your best defense is a good offense, public companies and investors. Know how the market works. Know what the money is doing. Prepare for Six See Eleven.

Beneath the Surface

I don’t think it should be overlooked that “Quants” and “Quasts” differ by only a letter.

Scott Patterson’s 2010 book, The Quants, is a great read.  You’ll be riveted by what was cascading beneath the market’s surface before the financial crisis.  Here’s a taste:

“That Wednesday, what had started as a series of bizarre, unexplainable glitches in quant models turned into a catastrophic meltdown the likes of which had never been seen before in the history of financial markets….

“Oddly, the Bizarro World of quant trading largely masked the losses to the outside world at first, since the stocks they’d shorted were rising rapidly, leading to the appearance of gains on the broader market that balanced out the diving stocks the quants had expected to rise.

“Monday, the Dow Industrials actually gained 287 points. It gained 36 more Tuesday, and another 154 points Wednesday. Everyday investors had no insight into the carnage taking place beneath the surface, the billions in hedge fund money evaporating.”

Key phrase:  Beneath the surface.

What the market appears to be saying may be the opposite of what gurgles in its depths.

It’s why we say price and volume are CONSEQUENCES, not metrics.  What’s causing price or volume to change?  This is the question every public company, every investor, should answer today (we have that data, so there’s no reason to go begging!).

Take the broad market Monday, with the Dow Industrials up 260 points. Cause? Risk Mgmt – counterparties to bets, covering their exposure.

And shorting rose. Yesterday, 47% of all volume marketwide was borrowed – short.  Intraday volatility, the average move from highest to lowest price, is 3%.

That’s 50% of market volume, combined. Can the market sustainably rise if half its volume depends on lower or fluctuating prices?  Well, it’s not impossible. But probability is poor.

High shorting doesn’t mean the market will tank. But short-covering is necessary for shares to rise.  Consider Jan 2018.  Shorting dropped, volatility vanished, stocks surged.

The VIX (coming volatility destroyed two synthetic ETFs), price and volume, gave everyday folks no clue to the looming maw.  But under the surface the gurgling hit a fever pitch. Market Structure Sentiment, our 10-point gauge of price peaks and troughs, topped Jan 19. Behavioral change was a black swan – more than three standard deviations from norms.

Behavioral change is the daily demographic evolution in the money behind price and volume. A surge is a stampede – with delayed effects. Sentiment usually says which way.

On Jan 22, the market’s Chernobyl core melted under a staggering six-standard-deviations move in behaviors.  The market continued to rise. Nobody on CNBC was warning people.

By mid-February, from peak to trough the S&P 500 fell over 10%.

On Sep 19, 2018, Market Structure Sentiment topped weakly, not even regaining 6.0 (the market trades between 4.0-6.0 most of the time).  Black swans crashed through behavioral-change Sep 14-19.  The market kept rising.

Sep 25-28, behavioral-change demolished every record we’d ever seen, cascading daily at an average six standard deviations over norms.  SPY, the S&P 500 ETF, hit 293.58 Oct 1, 2018.  Yesterday it closed at 286.87.

From its Oct 1 zenith to the Dec 24 nadir of 234.34, SPY declined 20.2%.

SPY reached an all-time peak Jul 15, 2019 as Market Structure Sentiment topped just over 6.0. And yup, you guessed it. Black swans flapped in Jul 31 and Aug 1. Another struck Aug 13.

Why has the market become so mathematical? Behaviors.  All trades must occur between the best bid and offer, and the bid must be lower. Somebody can make a half-penny on each side of the trade – the aim of Fast Traders.  Arbitrage.

ETFs have ten TIMES the assets they did in 2008 — $4 trillion in the US alone, the bulk in equities. There’s one ETF for every four companies. ETFs depend on arbitrage for prices.

Derivatives are an arbitrage trade. What is something worth now versus what it might be in the future?  Put these all together.  It’s 87% of volume. The market runs on arbitrage. Continuously differing prices.

It’s transformative to see, beneath the surface, why your stocks behave as they do.  Then what, public companies?  You have a duty to know what the money is doing and to understand when it’s story and when it’s not. That’s a puzzle solved only with data.

Investors, if you’re one day wrong, you can lose your gains.  Data are protection.

When you’re ready to go spelunking, let us know.

The Canary

For a taste of July 4 in a mountain town, featuring boy scouts serving pancakes, a camel amongst horses, sand crane dancers, and Clyde the glad hound, click here.  Americana.

Meanwhile back in the coal mine of the stock market, the canary showed up.

We first raised concern about the possible failure of a major prime broker in 2014. By “prime,” we mean a firm large enough to facilitate big transactions by supplying global trading capacity, capital, advice and strategy.

We homed in on mounting risk at HSBC and Deutsche Bank.

Last weekend Deutsche Bank announced an astonishing intention:  It will eliminate global equity trading and 18,000 jobs. It’s a long-range effort, the bank says, with targeted conclusion in 2022.

But will a bank erasing the foundation of investment-banking, cash equities, retain key people and core customers? Doubtful. In effect, one of the dozen largest market-makers for US stocks is going away.

It matters to public companies and investors because the market depends on but a handful of firms for market-efficiency in everything from US Treasurys, to stocks, to derivatives, and corporate bonds.

And Exchange Traded Funds.  Industry sources say over 80% of creations and redemptions in ETF shares are handled by ten firms. We don’t know precise identities of the ten because this market with over $300 billion of monthly transactions is a black box to investors, with no requirement that fund sponsors disclose which brokers support them.

We know these so-called “Authorized Participants” must be self-clearing members of the Federal Reserve system, which shrinks the pool of possibilities to about 40, including Deutsche Bank, which hired an ETF trading legend, Chris Hempstead, in 2017.

It’s possible others may fill the void. But you have to be an established firm to compete, due to rigorous regulatory requirements.

For instance, brokers executing trades for customers must meet a stout “best execution” mandate that orders be filled a large percentage of the time at the best marketwide prices. That standard is determined by averages across aggregate order flow dominated in US markets by yet again ten firms (we presume the same ones), including Deutsche Bank.

It’s exceedingly difficult to shoulder in.  The great bulk of the 4,000 or so brokers overseen by Finra, the industry regulator, send their trades to one of these ten because the rest cannot consistently achieve the high required standard.

So the elite club upon which rests the vast apparatus of financial markets just shrank by about 10%.

Already the market is susceptible to trouble because it’s like a soccer stadium with only a handful of exits.  That’s no problem when everyone is inside.  But getting in or out when all are in a rush is dangerous, as we saw in Feb 2018 and Dec 2019, with markets swooning double digits in days.

Let’s go back to a basic market-structure concept.  The “stock market” isn’t a place. It’s a data network of interconnected alcoves and eddies.  What’s more, shares don’t reside inside it.  The supply must continuously be brought to it by brokers.

Picture a farmers’ market with rows of empty stalls. When you move in front of one, suddenly products materialize, a vendor selling you goat’s milk soap. You go to the next blank space and instantly it’s a bakery stand with fresh croissants.  As you move along, contents vanish again.

That’s how the stock market works today under the mandatory market-making model imposed by Regulation National Market System. High-speed traders and gigantic brokerage firms are racing around behind the booths and stands at extreme speeds rushing croissants and goat’s milk soap around to be in front of you when you appear.

The network depends on the few.  We have long theorized that one big threat to this construct is its increasing dependency on a handful of giant firms. In 2006, a large-cap stock would have over 200 firms making markets – running croissants to the stand.

Today it’s less than a hundred, and over 95% of volume concentrates consistently at just 30 firms, half of them dealers with customers, the other half proprietary trading firms, arbitragers trading inefficiencies amid continuous delivery of croissants and goat’s milk soap – so to speak – at the public bazaar.

We said we’ll know trouble is mounting when one of the major players fails. Deutsche Bank hasn’t failed per se, but you don’t close a global equity trading business without catastrophic associated losses behind the scenes. The speedy supply chain failed.

Why? I think it’s ETFs. These derivatives – that’s what they are – depend on arbitrage, or profiting on different prices for the same thing, for prices. Arbitrage creates winners and losers, unlike investment occurring as growing firms attract more capital.

As arbitrage losers leave, or rules become harder to meet, the market becomes thinner even as the obligations looming over it mount.

We are not predicting disaster. We are identifying faults in the structure. These will be the cause of its undoing at some point ahead.  We’ve seen the canary.

 

Euripides Volatility

Question everything.

That saying is a famous Euripides attribution, the Athenian playwright of 2500 years ago. The Greeks were good thinkers and their rules of logic prevail yet today.

Let’s use them.  Blue chips dropped over 600 points Monday and gained 200 back yesterday. We’re told fear drove losses and waning fear prompted the bounce.

What do you think the Greeks would say?

That it’s illogical?  How can the same thing cause opposing outcomes?  That’s effectively the definition of cognitive dissonance, which is the opposite of clear thinking.

The money motivated to opposite actions on consecutive days is the kind that profits on price-differences. Profiting on price-differences is arbitrage.

Could we not infer then a greater probability that arbitragers caused these ups and downs than that investors were behind them?  It’s an assessment predicated on matching outcome to motivation.

Those motivated by price-changes come in three shades. The size of the money – always follow the money, corollary #1 to questioning everything – should signal its capacity to destabilize markets, for a day, or longer.

There are Risk Parity strategies.  Simon Constable, frequent Brit commentator on markets for the Wall Street Journal and others, suggested for Forbes last year following the February temblor through US stocks that $500 billion targets this technique designed to in a sense continually rebalance the two sides of an investing teeter-totter to keep the whole thing roughly over the fulcrum.

Add strategies designed to profit on volatility or avoid it and you’ve got another $2 trillion, according to estimates Mr. Constable cites.

The WSJ ran a story May 12 (subscription required) called “Volatility in Stocks Could Unravel Bets on Calm Markets,” and referenced work from Wells Fargo’s derivatives team that concluded “low-vol” funds with $400 billion of assets could suddenly exit during market upheaval.

Add in the reverse. Derivatives trades are booming. You can buy volatility, you can sell it, you can hedge it.  That’s investing in what lies between stocks expected to rise (long bets) and stocks thought likely to fall (short bets).

This is the second class:  Volatility traders. They are trying to do the opposite of those pursuing risk-parity. They want to profit when the teeter-totter moves. They’re roughly 60% of daily market volume (more on that in a moment).

The definition of volatility is different prices for the same thing.  The definition of arbitrage is profiting on different prices for the same thing.

The third volatility type stands alone as the only investment vehicle in the history of modern capital markets to exist via an “arbitrage mechanism,” thanks to regulatory exemptions.

It’s  Exchange-Traded Funds (ETFs). ETFs by definition must offer different prices for the same thing. And they’ve become the largest investment vehicle in the markets, the most prolific, having the greatest fund-flows.

EDITORIAL NOTE: I’m hosting a panel on ETFs June 5 at the NIRI Annual Conference, one of several essential market-structure segments at the 50th anniversary event. You owe it to your executive team to attend and learn.

Size matters. Active Investment, getting credit for waxing and waning daily on tidal trade fear, is about 12% of market volume. We can’t precisely break out the three shades of volatility trading. But we can get close.

Fast Trading, short-term profiteering on fleeting price-changes (what’s the definition of arbitrage?), is about 44% of volume. Trades tied to derivatives – risk-parity, bets on price-changes in underlying assets – are 19%.  Passive investment, the bulk of it ETFs (the effects of which spill across the other two), is 25%.

One more nugget for context:  Options expire May 16-17 (index, stock options expirations), and May 22 (VIX and other volatility bets). Traders will try to run prices of stocks to profit not on stocks but how puts, calls and other derivatives increase or decrease far more dramatically than underlying stocks.

The Greeks would look at the math and say there’s an 88% probability arbitrage is driving our market.

Euripides might call this market structure a tragedy. But he’d nevertheless see it with cold logic and recognize the absence of rational thought.  Shouldn’t we too?

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?

Flowing

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

So how can stocks be up?

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

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

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

That combination is ETFs.

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

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

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

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

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

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

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

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

It happened in December.

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

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

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

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

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

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

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

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

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

Your boards and executive teams deserve to know.

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

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

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

Form Follows Function

We’re told that on Friday Jan 18, the Dow Jones Industrial Average soared on optimism about US-China trade, then abruptly yesterday “global growth fears” sparked a selloff.

Directional changes in a day don’t reflect buy-and-hold behavior, so why do headline writers insist on trying to jam that square peg every day into the market’s round hole?

So to speak.

It’s not how the market works. I saw not a single story (if you did, send it!) saying options expired Jan 16-18 when the market surged or that yesterday marked rare confluence of new options trading and what we call Counterparty Tuesday when banks true up gains or losses on bets.

Both events coincided thanks to the market holiday, so effects may last Wed-Fri.

The point for public companies and investors is to understand how the market works. It’s priced, as it always has been, by its purposes. When a long-term focus on fundamentals prevailed, long-term fundamentals priced stocks.

That market disappeared in 2001, with decimalization, which changed property rights on market data and forced intermediaries to become part of volume. Under Regulation National Market System, the entire market was reshaped around price and speed.

Now add in demographics.  There are four competing forces behind prices. Active money is focused on the long-term. Passive money is focused on short-term central tendencies, or characteristics. Fast Traders focus on fleeting price-changes. Risk Management focuses on calculated uncertainties.

Three of these depend for success on arbitrage, or different prices for the same thing. Are we saying Passive money is arbitrage?  Read on. We’ll address it.

Friday, leverage expired. That is, winning bets could cashier for stock, as one would with the simplest bet, an in-the-money call option. The parties on the other side were obliged to cover – so the market soared as they bought to fulfill obligations.

Active money bought too, but it did so ignorantly, unaware of what other factors were affecting the market at that moment.  The Bank for International Settlements tracks nearly $600 trillion of derivatives ranging from currency and interest-rate swaps to equity-linked instruments. Those pegged to the monthly calendar lapsed or reset Friday.

Behavioral volatility exploded Friday to 19%. Behavioral volatility is a sudden demographic change behind price and volume, much like being overrun at your fast-food joint by youngsters buying dollar tacos, or whatever. You run out of dollar tacos.

That happened Friday like it did in late September. The Dow yesterday was down over 400 points before pulling back to a milder decline.

And there may be more. But it’s not rational thought. It’s short-term behaviors.

So is Passive money arbitrage?  Just part of it. Exchange-Traded Funds (ETFs) were given regulatory imprimatur to exist only because of a built-in “arbitrage mechanism” meant to keep the prices of ETFs, which are valueless, claimless substitutes for stocks and index funds, aligned with actual assets.

Regulators required ETFs to rely on arbitrage – which is speculative exploitation of price-differences. It’s the craziest thing, objectively considered. The great bulk of market participants do not comprehend that ETFs have exploded in popularity because of their appeal to short-term speculators.

Blackrock and other sponsors bake a tiny management fee into most shares – and yet ETFs manage nobody’s money but the ETF sponsor’s. They are charging ETF buyers a fee for nothing so their motivation is to create ETF shares, a short-term event.

Those trading them are motivated by how ETFs, index futures and options and stocks (and options on futures, and options on ETFs) may all have fleetingly different prices.

The data validate it.  We see it. How often do data say the same about your stock?  Investors, how often is your portfolio riven with Overbought, heavily shorted stocks driven by arbitrage bets?

What’s ahead? I think we may have another rough day, then maybe a slow slide into month-end window-dressing where Passive money will reweight away from equities again.  Sentiment and behavioral volatility will tell us, one way or the other.

Ask me tomorrow if behavioral volatility was up today. It’s not minds changing every day that moves the market. It’s 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.