Tagged: Derivatives

Where’s It Going?

Where’s what going?

Time? Hm.

Money?  Well. Yes.

It abounds and yet it doesn’t go far.  Why that’s the case is another story (I can explain if you like but it usually clears a room at a cocktail party).

First, if you were spammed last week with the MSM, apologies! It was inadvertently set on full-auto.  And one other note, our sister company Market Structure EDGE  is up for several Benzinga Fintech Awards.  As in American politics, you may vote early and often (just kidding!). No, you can vote daily though till about Oct 22, 2021.  We hope you’ll help! Click here, and turn it into a daily calendar reminder.

Today we’re asking where the money gushing at US stocks and bonds like a ruptured fire hydrant is going. Morningstar says it’s $800 billion into US securities the last twelve months through July.

That’s minus a $300 billion drop in actively managed equity assets. Stock-pickers are getting pounded like a beach in a hurricane. Public companies, you realize it?

That’s not the point of this piece. But investor-relations professionals, realize the money you talk to isn’t buying. It’s selling.  There are exceptions and you should know them.  But don’t build your IR program around “targeting more investors.” Build it on the inflows (your characteristics), not the outflows.  If you want to know more, ask us.

So where did the $800 billion go? 

About $300 billion went to taxable bond funds.  Not for income. Appreciation. Bonds keep going up (yields down, prices up). They’re behaving like equities – buy appreciation, not income.

The rest, about $500 billion, went to US equities.  We’re going to look at that. 

$500 billion seems like a lot.  Ross Perot thought a billion here, billion there, pretty soon you’re talking real money. For you who are too young to know it, Google that.

But today $500 billion ain’t what it was. And frankly, five hundred billion deutschemarks wasn’t much in the Weimar Republic either.  The problem wasn’t inflation. The problem was what causes inflation: too much money.

Ah, but Weimar didn’t have derivatives. Silly fools.

For perspective, more than $500 billion of Exchange Traded Funds (ETF) are created and redeemed in US equities every month.  Stocks trade more than $500 billion daily in the US stock market.

And the money supply as measured by the Federal Reserve’s “M2” metric reflecting the total volume of money held by the public, increased by $5 trillion from Feb 2020 to July 2021.  That’s a 32% increase. About like stocks (SPY up 33% TTM).

Wait. The stock market is up the same as the money supply? 

Yup.

Did everybody sell stocks at higher prices?

No. Everybody bought stocks at higher prices.

Okay, so where did the stock come from to buy, if nobody sold?

Maybe enough holders sold stocks to people paying 33% more to account for the difference. Good luck with that math. You can root it out if you want.

But it’s not necessary.  We already know the answer. The money went into derivatives. 

The word “derivative” sounds fancy and opaque and mysterious. It’s not.  It’s a substitute for an asset.  You can buy a Renoir painting. You can buy a Renoir print for a lot less. You can buy a stock. You can buy an option on that stock for a lot less.

Suppose you want to buy the stocks in the S&P 500 but you don’t want the trouble and expense of buying 500 of them (a Renoir). You can buy a swap (a print, No. 347 of 3,900), pay a bank to give you the returns on the index (minus the fee).

Or you can buy SPY, the S&P 500 ETF.  You think you’re getting a Renoir.  All those stocks. No, you’re getting a print somebody ran on an inkjet printer.  It looks the same but it’s not, and it’s not worth the stocks beneath it.

Image courtesy ModernIR, Aug 25, 2021.

See this image?  There is demand.  There is supply. The former greatly exceeds the latter like we’ve seen the last year during a Covid Pandemic (chew on that one for a bit), so excess demand shunts off to a SUBSTITUTE. Derivatives. ETFs, options, futures.

That’s what’s going on. That’s where the money went. Look at GME and AMC yesterday. Explosive gains on no news. Why? Banks squared derivatives books yesterday after the August expirations period. Demand for prints (options), not paintings (stock), vastly exceeded supply.

So banks bought the underlying paintings called GME and AMC – and sold traders ten times as many prints. Options. Derivatives. It’s implied demand. The stocks shot up.

Bad? Well, not good. The point isn’t doom. The point is understanding where the money is going. Every trader, investor, public company, should understand it. 

It’s all measurable if you stop thinking about the market like it’s 1995. It’s just math. About 18% of the market is in derivatives.  But about 75% of prices are transient things with no substance.  Prints, not paintings.

Public companies, know what part of your market is Renoir, what part is just a print.  Traders, do the same.

We have that data.  Everybody should always know where the money is going.

Optional Chaos

So which is it?  

Monday, doom loomed over stocks. In Punditry were wringing hands, hushed tones. The virus was back. Growth was slowing. Inflation. The sky was falling!

Then came Tuesday. 

Jekyll and Hyde? Options expirations.  Only CNBC’s Brian Sullivan mentioned it. As ModernIR head of client services Brian Leite said, there wasn’t otherwise much effort to explain where the doom went. One headline said, “Stocks reverse Monday’s losses.”

WC Fields said horse sense is the thing a horse has which keeps it from betting on people. We could have used some horse sense.  I Tweeted this video.

Anyway. What must you know, investors and public companies, about why options cause chaos in stocks? (I’m explaining it to the Benzinga Boot Camp Sat July 24, 30 minutes at 1220p ET.  Come join.)

It’s not just that options-expirations may unsettle equity markets. The question is WHY?

Let me lay a foundation for you. Global Gross Domestic Product (GDP) is about $85 trillion. The notional value – exposure to underlying assets – of exchange-traded options and futures is about the same, $85 trillion give or take, says the Bank for International Settlements. The BIS pegs over-the-counter derivatives notional value at $582 trillion.

So call it $670 trillion. All output is leverage 8-9 times, in effect.

Now, only a fraction of these derivatives tie to US equities. But stocks are priced in dollars. Currency and interest-rate instruments make up 90% of derivatives.

All that stuff lies beneath stocks. Here, let’s use an analogy. Think about the stock market as a town built on a fault line.  The town would seem the stolid thing, planted on the ground. Then a tectonic plate shifts.

Suddenly what you thought was immovable is at risk.

Remember mortgage-backed securities?  These derivatives expanded access to US residential real estate, causing demand to exceed supply and driving up real estate prices.  When supply and demand reached nexus, the value of derivatives vanished.

Suddenly the market had far more supply than demand.  Down went prices, catastrophically. Financial crisis.

Every month, what happened to mortgage-backed securities occurs in stocks. It’s not seismic most times. Stocks are assets in tight supply.  Most stocks are owned fully by investors.  Just three – Blackrock, Vanguard, State Street – own a quarter of all stocks.

So just as real estate was securitized, so are stocks, into options, futures, swaps.  While these instruments have a continuous stream of expiration and renewal dates, the large portion ties to a monthly calendar from the Options Clearing Corp (our version is here).

Every month there’s a reset to notional value. Suppose just 1% of the $50 trillion options market doesn’t renew contracts and instead shorts stocks, lifting short volume 1%.

Well, that’s a potential 2% swing in the supply/demand balance (by the way, that is precisely last week’s math).  It can send the Dow Jones Industrials down a thousand points.  Hands wring.  People cry Covid.

And because the dollar and interest rates are far and away the largest categories, money could leave derivatives and shift to the assets underpinning those – BONDS.

Interest rates fall. Bonds soar. Stocks swoon.  People shriek.

Marketstructureedge.com – Broad Market Sentiment 1YR Jul 21, 2021

Options chaos.  We could see it. The image here shows Broad Market Sentiment – DEMAND – for the stocks represented by SPY, the State Street S&P 500 Exchange Traded Fund (ETF).  Demand waxes and wanes.  It was waning right into expirations.

In fact, it’s been steadily waning since Apr 2021.  In May into options-expirations, Sentiment peaked at the weakest level since Sep 2020. Stocks trembled. In June at quad-witching, stocks took a one-day swan dive.

Here in July, they cratered and then surged.  All these are signals of trouble in derivatives. Not in the assets.  It’s not rational. It’s excessive substitution.

We can measure it at all times in your stock. Into earnings. With deals. When your stock soars or plunges.

In 1971, the USA left the gold standard because the supply of dollars was rising but gold was running out. The derivative couldn’t be converted into the asset anymore. The consequence nearly destroyed the dollar and might have if 20% interest rates hadn’t sucked dollars out of circulation.

High interest rates are what we need again. During the pandemic the Federal Reserve flooded the planet with dollars. Money rushed into risk assets as Gresham’s Law predicts. And derivatives.

When the supply/demand nexus comes, the assets will reprice but won’t vanish. The representative demand in derivatives COULD vanish.  That’s not here yet.

The point: Derivatives price your stock, your sector, your industry, the stock market. Adjustments to those balances occur every month.  We can see it, measure it. It breeds chaos. Pundits don’t understand it.

It’s supply and demand you can’t see without Market Structure goggles. We’ve got ‘em.

Swapping Volatility

Google chose as motto “don’t be evil.” “Beware derivatives” isn’t a bad motto either.

If you’ve read the MSM long, you know we’ve beaten the drum like Boneshaker (when you hear the sound of the drum, here we come) over the risk in derivatives.

Oh please, Quast.  Can’t we talk about something more interesting, like the molecular structure of Molybdenum?

Do you want to know what’s coming, public companies and investors?  We’ve now been warned twice.  I’ll explain.

Before that, this: Recall that we said the market could take a beating this week because of derivatives. A raft of major banks have reported combined damage in the billions from bad derivatives bets by one hedge fund, Archegos Capital.

And VIX bets hit today.  Volatility bets blew up another fund.  Warning Signal No. 2.

Gunjan Banerji wrote about it yesterday in the WSJ (subscription required), admirably explicating the complexities of variance swaps.  The Infinity Q Diversified Alpha Fund shut down.

Diversified Alpha, a mutual fund marketed as a hedge fund for the masses, had roughly $1.75 billion of assets at last word.  The fund aimed in part at volatility strategies.  It said:

“The Volatility Strategy seeks to profit from the mispricing of volatility related instruments across equities, currencies, bonds, interest rates, and commodities markets. These instruments include options, variance swaps, correlation swaps, and total return swaps. The Strategy invests across a wide range of time horizons and takes long and short positions in the underlying volatility instruments.”

The fund went broke betting on volatility – mispricings.  That’s two in short succession.  Diversified Alpha filed its plea with the SEC Feb 21 to halt redemptions. Right after February expirations. Archegos Capital went belly-up with March expirations.

Much of the money in equities trades mispricings. That’s what ETFs do (ETF vs a basket). It’s what Fast Traders do (one price vs another). It’s what derivatives traders do (stocks vs options).  Those behaviors are roughly 80% of US equity volume.

These disasters you describe, Tim, are isolated to leveraged outfits.

Nope.

Here’s the SAI for the Blackrock Technology Opportunities Fund. I have read a great many SAIs, a reason I’ve in the past highlighted risks, especially for Exchange Traded Funds.

On page 3 is this: Only information that is clearly identified as applicable to the Fund is considered to form a part of the Fund’s SAI.

Then follows a table, with X’s by what applies.  See page 4, the derivatives section. Derivatives for hedges and speculation apply.  Credit default swaps, interest-rate swaps, total return swaps, options on swaps, on it goes.

I’m sure it’s a small part of this fund’s assets, used within rules to true up tracking or remediate some of the unremitting volatility that’s been seeded in all financial instruments by vast artificial quantities of money and low interest rates. But read the SAI on your favorite fund. What’s it say?

By the way, volatility in stocks has plunged by 50% the past couple weeks. Almost like a tide going out ahead of a tsunami. Behind it in other data we track are vast swings in standard deviation between the prices of sector stocks and the ETFs tracking them.

That is, if we compile moves of all sector stocks and the average is a 1.8% decline and the composite average for sector ETFs is 0.1%, standard deviation is 625%.

It suggests to me that ETFs are substituting stuff that moves less than stocks – like swaps or IOUs of some sort, or cash – to get away from the error-inducing volatility in stocks.

But that could blow up derivatives predicated on a statistical equity basket. What the hell is going on?  Exactly.  That’s what I want to know. Something is wrong, and we’re seeing little fissures, seeping steam, wisps of ash.

We’ve long been concerned about these risks. But they’re like the way Ernest Hemingway described how one goes broke (a line I’ve used often): very slowly then all at once.

I’m not wringing my hands. Forewarned is forearmed. Investors and traders, it’s wise to get out of the pool around these things, which we observe in the data, and report.

And for public companies, it’s high time to make sure your executive teams realize risk resides beyond “alternative investments.” It’s everywhere. All around us. 

How central are Morgan Stanley, JP Morgan, Credit Suisse, Deutsche Bank, banks losing on Archegos, to financial markets from IPOs to Treasury Open Market operations?  Derivatives to equity and ETF trading?

It may be the cost of paying ourselves to sit out a Pandemic is the stability of our financial markets. We’re inflating everything including derivatives.  We can survive it.  In fact, it would do us good to roll around in the dirt and develop some resilience.

Whatever happens, we’ve got the data.  We warned EDGE users to be out by last Friday. We can tell you, public companies, if these instruments are large in your price. 

Everybody is swapping volatility. Beware.

Suez on Wall

The stuff Archegos used expires today. Sound like Greek?

Courtesy SEC.gov

Let me explain. A hedge fund blew up. Its counterparties are taking huge hits. There are ramifications. What happens?  Maybe nothing. Maybe everything.

First, let’s understand “counterparty.”  A counterparty accepts the risk of the opposite of your desired trade. That is, if you want to bet something rises, somebody else will necessarily have to bet it falls by selling a put – a right to sell a stock.

Do you follow? It’s why winning trades are hard.  Somebody is always taking a countermanding risk (as ever, market structure matters because you can see the ODDS on which way things go).

And public companies, bets are pervasive.  One of these lately punctured the time-space continuum of the market.  Hedge fund Archegos (“guiding light” in Greek) gambled on derivatives tied to stocks and lost.

I won’t recapitulate details. Stories abound. What matters is WHY NOW, and what does this event mean to you as public companies and investors?

We wrote about CFDs – Contracts for Difference – in 2012.  Total return swaps are a type of CFD. These contracts give funds – I don’t say “hedge funds,” because, reading prospectuses for Blackrock and others, they too can use them – a way to put money on Red 34, but where Red 34 is half the spots on the Roulette wheel.

Why would a counterparty take that bet?  Because they too – Goldman Sachs, Morgan Stanley – make bets on the outcomes to offset the risk that Red 34 comes up.  Remember, Lloyd Blankfein, erstwhile Goldman Sachs CEO, said in the aftermath of the 2008 debacle, “We’re in the risk-transfer business.”

I think it’s the HOPE of the markets biggest participants that nobody understands this stuff – because everybody would be outraged.  I’m not a cynic. I’m looking at the data. Trading unrelated to how your business performs, public companies, pops eyeballs from sockets. Investors, if you don’t know, you’ll be a popped eyeball.

Remember the mortgage-backed securities pandemic?  The movie and book The Big Short? Why would banks sell credit default swaps and then bet against the outcome they just sold?

Because you can always offload your risk.

Until you can’t.

Friday was an “until you can’t” moment for the market.  I’m surmising based on the available data that hedge funds bet certain stocks in a limited period of time expiring today – Mar 31 – would outperform some benchmark by a defined percentage.

Banks took that bet.  Other banks unaware of the size of the bet lent money to the firm making the bet, making it massively larger than anyone comprehended.

To offset risk, banks require collateral. The hedge fund in question put up its portfolio, which the banks shorted – which raised cash and hedged exposure.

I suspect the fund first pledged the SAME collateral to the banks lending money, but then actually assigned it to GS and MS, firms backing swaps.

Here’s the WHY NOW answer. As expirations drew nigh – Mar 31 – it became apparent to the banks selling the swap to the hedge fund and to the hedge fund itself that it was going to fail.  Banks holding collateral sold it.

Those with just a pledge held only the bag they’d been left holding. This is why Credit Suisse and Nomura face big losses, it seems to me (it could be some variation on this theme of course).

But that’s not the heart of the problem here.

This is the Suez Canal converging with Wall Street.

If you’ve somehow missed it, a cargo ship longer than the Empire State Building got stuck in the Suez, blocking everything. God freed it. That is, engineers used a combination of the Worm Moon, a super moon and its incumbent high tides, and a lot of tugging. It’s free now. But the damage is done.

In the stock market, as in the Suez Canal, there’s not much liquidity – not much floating things. And a handful of banks serve the bulk of transactions in Treasurys, currencies, bonds, derivatives (like swaps), commodities, equities, ETFs.

Indexes need to true up tracking right now for the quarter. They depend on these banks. Investors want to lock quarterly results. Massive futures obligations are expiring that the same banks back, to true up index-tracking.

What if something just can’t get done? Which thing do they pick to let go?

Maybe they can juggle it all.  The Suez couldn’t. Maybe Wall Street can. If not, there’s a CHANCE of severe dislocation for markets between today and Apr 6, when books will be all square.

Vahlcue

You’re wondering what the heck “vahlcue” is. It was up almost 4% in the last hour yesterday as stocks tipped off the diving board.

Meanwhile, cue fall.  The photo at right reminds us that today is a consequence of yesterday. Autumn follows summer. In the Flat Tops near Steamboat, fall flames as summer smolders out.

In the stock market, cue volatility.  Pursuing “vol,” as the traders call it, is big business. It’s everything that depends on an implied price, such as the VIX index tracking implied volatility over the next 30 days in the S&P 500.  It’s priced from options on the index, which in turn is comprised of futures.

Got that?  Volatility is the implied price of an implied price, gleaned from other implied prices.  All instruments derived from implied prices are ways to trade volatility – gaps between rising and falling prices.

Cue intro music.

The Nasdaq, in concert with the Chicago Mercantile Exchange (CME), launched the VOLQ this past Monday, Oct 5, another way to play volatility.

I assume it’s pronounced “vahlcue.”

VOLQ is a futures contract reflecting the implied volatility of the Nasdaq-100, the NDX. It employs a methodology developed by Nations Indexes, innovator in volatility products that isolates the implied volatility of at-the-money options.

Ready to run a power drill through the palm of your hand to stay awake?  If you want intricate details about how it works and how it’s calculated, you can read more.

I’ve got a specific purpose.

VOLQ, like the VIX, is a futures contract derived from options on underlying stocks – three steps from the asset.  It’s a particular set of both put and call options designed to get to the volatility of instruments priced the same as the futures contract, called at-the-money options.

Have you moved on from drilling a hole in your hand to braining yourself on a brick wall?

Here’s the point. Derivatives have proliferated in the stock market. All derivatives are a right but not an obligation.  As such, the propensity to quit them is much higher than one finds in the actual asset.

Famed hedge-fund manager Lee Cooperman, whom I interviewed in the plenary session of the 2019 NIRI Annual Conference, back when humans gathered innocently, lamented in a CNN interview that stock indexes shouldn’t gap 50 points in a matter of minutes.

He blamed trading machines, the rapid-fire intermediaries setting prices. And he’s right.  But the more trading chases products that are rights but not obligations, ways to pursue changing prices, the more heightened the risk of sudden lurches.

Why? All layers of options and futures are forms of implied supply or demand.  But the moment prices move, those layers become ethereal, dissolving in an instant like those animated transitions you can put in you Powerpoint slide deck.

And the more people pursue the gaps rather than the assets, the greater the assets can be blighted by sudden lurches.  Realize VOLQ is just another clip for the automatic weapons in the Nasdaq’s volatility arsenal that already includes e-Minis and micro e-Minis on the Nasdaq 100.

The first e-Mini S&P 500 futures contract began trading in 1997 and was 20% the size of the standard contract.  Micro e-Minis are a tenth of the e-Mini, 2% of the original contract.  And you can trade options on Micro e-Mini futures too.  We wrote about them in August.

Markets keep migrating away from size, away from the core asset, toward tiny, uncommitted bets and hedges comprised of multi-layered derivatives.

It’s great for the firms selling the products.  But it makes volatility accessible to the masses.  And the masses don’t understand it. And the more the masses are exposed to things that vanish, the more given to wild swings become the underlying assets.

Sure, derivatives can work well.  VOLQ was the right play today.  Traders can hedge exposure to sudden market moves, play the probability of profits in snap swings.

But the consequence is a market that cannot be trusted.

Market Structure Analytics help one survive it. Everybody should have baseline market-structure metrics.

The market is likely to rebound, data say. But this lurch manifested a week ago – much of implied volatility is predicated on weekly options – when the sector data looked ragged to us.  Sure enough it was.  Blame volatility and its instruments. Cue the exit music.

Mini Me

Minis abound.

You can trade fractions of shares.  Heck, the average trade-size is barely 100 shares, and 50% of trades are less than that.  Minis, as it were.

There are e-mini futures contracts on the S&P 500 index, and the newer micro e-mini futures product is the CME’s most successful, says the derivatives market operator.

Starting Aug 31 there will be micro options on e-mini futures for the S&P 500 and the Nasdaq 100. As of Aug 10, there are mini CBOE VIX volatility futures too, with a 10th of the face value of the conventional contract (expiring Aug 19).

One can spend less to have exposure to stocks and market-moves. The same notion animated a push toward decimalization before 2001 when it was implemented.

Decimals didn’t kill the stock market but they gutted analyst-coverage. Spreads – that is, the difference between the cost to buy and sell – funded research. In the 1990s there were on average 60 underwriters per IPO, and there were hundreds of those.

Today, there are five underwriters on average, the data show, and IPOs don’t keep pace with companies leaving markets through deals.  The Wilshire 5000, which in 1998 had 7,200 components, today has 2,495, factoring out micro-caps comprising just basis points of total market-capitalization.

Half the companies in the Wilshire 5000 have no analysts writing, while the top few hundred where trading supports it are festooned with quills – pens – like porcupines.

I think the inverse correlation between markets and the proliferation of minis bears some connection. It’s not the only thing, or perhaps even the biggest. But there’s a pattern.

And you should understand the market so you know what to expect from it. After all, who thought the March bear turn for stocks would be the shortest in history?

No one.  Including us.  Market structure, the way the ecosystem functions, explains it far better than fundamentals. But read to the end. We’ll say more.

Are the minis playing a role?

Look I’m not knocking fractional shares or tiny derivatives.  Rather, let’s think about the ramifications of growing layers separating trading from underlying assets.  Consider:

  • You can trade the stocks of the Nasdaq 100, the largest hundred at the exchange.
  • You can trade them in fractions without paying a commission.
  • You can trade the QQQ, the popular Exchange Traded Fund (ETF) that tracks the performance of the 100. ETFs as we’ve explained repeatedly are substitutes for stocks, not pooled interest in owning them.
  • You can trade e-mini futures contracts on the Nasdaq 100.
  • And now you can trade micro options on the e-mini Nasdaq 100 futures.
  • And you can trade options on the QQQ, and every component of the Nasdaq 100.
  • And you can trade the S&P 500 with exactly the same kinds of instruments, and SPY, the ETF.

It’s ingenious product-creation, and we’re not criticizing the innovators behind them.  It’s that I don’t think many people ask what effect the pursuit of mini increments of investment will have on market-behavior and prices, things that matter particularly to public companies depending on the market as a rational barometer.

And investors join public companies in caring how markets work.  Derivatives are becoming an ever-larger part of market volume. They’re layers of separation from underlying assets that become ends unto themselves, especially as increments shrink.

Why trade the stocks? Trade the rights on how they may behave – in tiny slices.

It disguises real supply and demand, which drives markets up relentlessly. Until that stops. Then markets collapse violently. These are chronic conditions in markets with too many derivatives.

Just saying.

Speaking of the market, it did as we wrote last week, with Market Structure Sentiment™ bottoming Aug 7, presaging gains a week out. Now options are expiring (including the VIX today), and Sentiment is topping, and behavioral volatility is massive, larger than we’ve measured at any point in the pandemic.

Maybe it’s nothing. Sometimes those data pass without a ripple. The FAANGs look good (low shorting, bottomed Sentiment). But we may be at the top of the Ferris Wheel after all those minis drove us this short, sharp way back up.

Counterparty Tuesday

Anybody hear yesterday’s volatility blamed on Counterparty Tuesday?

Most pointed to earnings fears for why blue chips fell 500 points before clawing back.  Yet last week the Dow Jones Industrial Average zoomed 540 points on earnings, we were told.  We wrote about it.

Counterparty Tuesday is the day each month following expiration of the previous month’s derivatives contracts like puts, calls, swaps, forwards (usually the preceding Friday), and the start of new marketwide derivatives contracts the following Monday.

When grocery stores overstock the shelves, things go on sale.  When counterparties expect a volume of business that doesn’t materialize, they shed the inventory held to back contracts, which can be equities.

Counterparty Tuesday is a gauge indicating whether the massive derivatives market – the Bank for International Settlements tracks over $530 trillion, ten times the global economy – is overstocked or understocked. It’s much larger than the underlying volume of Active Investment behavior in the US stock market.

Let me use a sports analogy. Suppose your favorite NFL team is beating everyone (like the LA Rams are).  “They are killing everybody through the air,” crow the pundits.

You look at the data. The quarterback is averaging five passes per game and zero touchdowns.  But on the ground, the team is carrying 40 times per game and averaging four rushing touchdowns.

These statistics to my knowledge are fake and apply to no NFL team right now. The point is the data don’t support the proffered explanation. The team is winning on the ground, not through the air.

In the same vein, what if market volatility in October ties back to causes having no direct link to corporate earnings?

What difference does it make if the stock market is down on earnings fears or something else?  Because investor-relations professionals message in support of fundamental performance, including earnings.  Boards and management teams are incentivized via performance. Active stock-picking investors key off financial performance.

If the market isn’t swooning over performance, that’s important to know!

Returning to our football analogy, what data would help us understand what’s hurting markets?  Follow the money.

We wrote last week about the colossal shift from active to passive funds in equities the past decade.  That trend has pushed Exchange-Traded Funds toward 50% of market volume. When passive money rebalanced all over the market to end September, the impact tipped equities over.

Now step forward to options expirations, which occurred last week, new ones trading Monday, and Counterparty Tuesday for truing up books yesterday. Money leveraged into equities had to mark derivatives to market. Counterparties sold associated inventory.

Collateral has likely devalued, so the swaps market gets hit. Counterparties were shedding collateral. The cost of insuring portfolios has likely risen because counterparties may have taken blows to their own balance sheets. As costs rise, demand falters.

Because Counterparty Tuesday in October falls during quarterly reporting, it’s convenient to blame earnings. But it doesn’t match measurable statistics, including the size of the derivatives market, the size and movement of collateral for ETFs (a topic we will return to until it makes sense), or the way prices are set in stocks today.

The good news?  Counterparty Tuesday is a one-day event. Once it’s done, it’s done. And our Market Structure Sentiment index bottomed Oct 22. We won’t be surprised if the market surges – on earnings enthusiasm? – for a few days.

The capital markets have yet to broadly adapt to the age of machines, derivatives and substitutes for stocks, like ETFs, where earnings may pale next to Counterparty Tuesday, which can rock the globe.

Looking Back: Dec 2015

In New York City, it’s beginning to look a lot like Christmas around Rockefeller Center and it feels more like it here than in Denver where we hear yesterday it was 66 degrees (on Dec 12!).

In the weather forecast today is a probable Federal Reserve rate hike, followed by index-options expirations Thursday, quad-witching Friday along with quarterly index rebalances, and volatility expirations next Wednesday.

The market’s Teflon character the past year means we have to go back to Dec 2015 to recall risk. Remember when the Fed lifted rates for the first time since 2006?  We went to sea to avoid the fallout. Read on. -TQ

 

Dec 9, 2015: The Vacuum

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how they’re priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

Selling the Future

Karen and I are in Playa del Carmen, having left the US after the Trump election.

Just kidding! We’re celebrating…Karen’s 50th birthday first here on the lovely beaches of Quintana Roo and next in New York where we go often but never for fun. This time, no work and all play.

Speaking of work, Brian Leite, head of client services, circulated a story to the team about Carl Icahn’s election-night buys. Futures were plunging as Mrs. Clinton’s path to victory narrowed. Mr. Icahn bought.

If you’ve got a billion dollars you can most times make money.  You’d buy the cheapest sector options and futures and aim your billion at a handful of, say, small-cap banks in a giant SEC tick-size study that are likely to move up rapidly. Chase them until your financial-sector futures are in the money.  Cash out.  See, easy.

(Editorial observation: It might be argued the tick study exacerbated volatility – it’s heavily concentrated in Nasdaq stocks and that market has been more volatile. It might also be argued that low spreads rob investors of returns and pay them to traders instead.)

If you’re big you can buy and sell the future anytime. The market last week roared on strength for financials, industrials, defense and other parts of the market thought to benefit from an unshackled Trump economy.

An aside: In Denver, don’t miss my good friend Rich Barry tomorrow at NIRI on the market post-election (Rich, we’ll have a margarita for you in Old Mexico).

We track the four main reasons investors and traders buy or sell, dividing market volume among these central tendencies. Folks buy or sell stocks for their unique features (stock picking), because they’re like other stocks (asset allocation), to profit on price-differences (fast trading) and to protect or leverage trades and portfolios (risk management).

Fast trading led and inversely correlated with risk-management. It was a leveraged, speculative rally. Traders profited by trafficking short-term in people’s long-term expectations (there was a Reagan boom but it followed a tough first eighteen Reagan months that were consequences of things done long before he arrived).

Traders buy the future in the form of rights and sell it long before the future arrives, so that by the time it does the future isn’t what it used to be.

They’re grabbing in days the implied profits from a rebounding future that must unfold over months or even years. Contrast with stock-pickers and public companies. Both pursue long arcs requiring time and patience.

Aside: ModernIR and NIRI will host an incredible but true expose with Joe Saluzzi of Themis Trading and Mett Kinak of T Rowe Price Dec 1 on how big investors buy and sell stocks today. 

Why does the market favor trading the future in the present? It’s “time-priority,” meaning the fastest – the least patient – must by rule set the price of stocks, the underlying assets. We could mount a Trump-size sign over the market: Arbitrage Here.

We’re told low spreads are good for investors. No, wide spreads assign value to time. Low spreads benefit anyone wanting to leave fast. Low spreads encourage profiting on price-differences – which is high-frequency trading.

Long has the Wall Street Journal’s Jason Zweig written that patience is an investing virtue.  Last weekend’s column asked if we have the stamina to be wealthy, the clear implication being that time is our friend.

Yet market structure is the enemy of patience. Options expire today through Friday. The present value of the future lapses. With the future spent, we may give back this surge long before the Trump presidency begins, even by Thanksgiving.

I like to compare markets and monetary policy. Consider interest rates. High rates require commitment. Low borrowing costs encourage leverage for short-term opportunities.  We’ve got things backward in money and the markets alike. Time is not our friend.

Upshot?  The country is in a mood to question assumptions. We could put aside differences and agree to quit selling the future to fast traders. Stop making low spreads and high speed key tenets of a market meant to promote time and patience – the future.

Rational Signals

The market message appears to be: If you want to know the rest, buy the rights.

While rival Nintendo is banking on Pokemon Go, Sony bought the rights to Michael Jackson’s music catalog for an eye-popping $750 million. This may explain the sudden evaporation of Jackson family discord. Cash cures ills.

In the equity market, everybody buys the rights to indexes and exchange-traded funds. TABB Group says indexes and ETFs drove 57% of June options volume, with ETFs over 45% of that and indexes the balance. TABB credits money “rushing into broad-market portfolio protection” around the Brexit.

Could be.  But that view supposes options are insurance only.  They’re also ways to extend reach to assets, tools for improving how portfolios track underlying measures and substitutes for stock positions. I’ve wondered about the Russell rebalances occurring June 24 as the Brexit swooned everything, and whether indexers were outsized options buyers in place of equity rebalancing – which then aided sharp recovery as calls were used.

We can see which behaviors set price every day.  On June 24, the day of the dive, Asset Allocation – indexes and ETFs primarily – dominated.  On June 27 Fast Traders led but right behind them was Risk Management, or counterparties for options and futures.

The tail can wag the dog. The Bank for International Settlements tracks exchange-traded options and futures notional values. Globally, it’s $73 trillion (equaling all equity markets) and what’s traded publicly is about half the total options and futures market.

Sifma, the lobbying arm of the US financial industry, pegs interest-rate derivatives, another form of rights, at more than $500 trillion. You’d think with interest rates groveling globally (and about 30% of all government bonds actually digging holes) that transferring risk would be a yawn.  Apparently not.  You can add another $100 trillion in foreign-exchange, equity and credit-default swaps tracked by Sifma and the BIS.

Today VIX derivatives expire. The CBOE gauge measures volatility in the S&P 500.  Yesterday VXX and UVXY, exchanged traded products (themselves derivatives), traded a combined 90 million shares, among the most actively traded stocks. Yet the VIX is unstirred, closing below 12. Why are people buying volatility when there’s none? For perspective, it peaked last August over 40 and traded between 25-30 in January and February this year and again with the Brexit in late June.

The answer is if the VIX is the hot potato of risk, the idea here isn’t to hedge it but to trade the hot potato. And for a fear gauge the VIX is a lousy leading indicator.  It seems only to point backward at risk, jumping when it’s too late to move. Maybe that’s why everybody buys rights?  One thing is sure: If you’re watching options for rational signals, you’ll be more than half wrong.  Might as well flip a coin.

We learned long ago that rational signs come only from rational behavior. In the past week right through options-expirations starting Thursday the 14th, Active Investment was in a dead heat with Risk Management, the counterparties for rights. That means hedge funds were everywhere trying to make up ground by pairing equities and options.

But options have expired.  Do hedge funds double down or is the trade over?  Short volume has ebbed to levels last seen in November, which one might think is bullish – yet it was the opposite then.

Lesson: The staggering size of rights to things tells us focus has shifted from investment to arbitrage. With indexes and ETFs dominating, the arbitrage opportunity is between the mean, the average, and the things that diverge from it – such as rights.

Don’t expect the VIX to tell you when risk looms. Far better to see when investors stop pairing shares and rights, signaling that the trade is over.