Tagged: ETFs

Unstoppable

Any of you Denzel Washington fans?

He starred in a 2010 movie loosely based on real events called Unstoppable, about a runaway freight train (I have Tom Petty’s “Runaway Train” going through my head).

In a way, the market has the appearance of an unstoppable force, a runaway train.  On it goes, unexpectedly, and so pundits, chuckling uncomfortably, try to explain why.

Tellingly, however, in the past month, JP Morgan said 80% of market volume is on autopilot, driven by passive and systematic flows.  Goldman Sachs held a conference call for issuers on what’s driving stock-prices – focusing on market structure. Jefferies issued a white paper called When the Market Moves the Market (thank you, alert readers, for those!).

We’ve been talking about market structure for almost 15 years (writing here on it since 2006). We’re glad some big names are joining us. You skeptics, if you don’t believe us, will you believe these banks?

Market structure has seized control. Stock pickers say the market always reflects expectations.  Well, stocks are at records even as expectations for corporate earnings predict a recession – back-to-back quarterly profit-declines.

There’s more. Last week the S&P 500 rose 0.8%, pushing index gains to 9.3% total since the end of May. But something that may be lost on most: The S&P 500 is up less than 2.5% since last September. The bane of stock-investing is volatility – changing prices.

Hedge funds call that uncompensated risk. The market has given us three straight quarters of stomach-lurching roller coasters of risk. For a 2.5% gain?

We all want stocks to rise!  Save shorts and volatility traders.  The point is that we should understand WHY the market does what it does. When it’s behaving unexpectedly, we shouldn’t shrug and say, “Huh. Wonder what that’s about?”

It’s akin to what humorist Dave Barry said you can do when your car starts making a funny noise:  Turn the radio up.

Let me give you another weird market outtake.  We track composite quantitative data on stocks clustered by sector (and soon by industry, and even down to selected peers).  That is, we run central tendencies, averages, for stocks comprising industries.

Last week, Consumer Discretionary stocks were best, up 1.5%. The sector SPDR (XLY, the State Street ETF) was up 2% (a spread of 33% by the way). Yet sector stocks had more selling than buying every day but Friday last week.

You know the old investor-relations joke:  “Why is our stock down today?”

“Because we had more sellers than buyers.”

Now stocks are UP on more selling than buying.

An aside before I get to the punchline:  ETF flows are measured in share creations and redemptions. More money into ETFs? More ETF shares are created.  Except there were $50 billion more ETF shares created than redeemed in December last year when the market fell 20%.

The market increasingly cannot be trusted to tell us what’s occurring, because the mechanics of it – market structure – are poorly understood by observers. ETFs act more like currencies than stocks because they replace stocks. They don’t invest in stocks (and they can be created and shorted en masse).

With the rise of ETFs, Fast Trading machines, shorting, derivatives, the way the market runs cannot be seen through the eyes of Benjamin Graham.

Last week as the S&P 500 rose, across the eleven industry groups into which it’s divided there were 28 net selling days, and 27 net buying days (11 sectors, five days each).

How can Consumer Discretionary stocks rise on net selling? How can the market rise on net selling? Statistical samples. ETFs and indexes don’t trade everything. They buy or sell a representative group – say 10 out of a hundred.

(Editorial note: listen to five minutes of commentary on Sector Insights, and if you’re interested in receiving them, let us know.)

So, 90 stocks could be experiencing outflows while the ten on which this benchmark or that index rests for prices today have inflows, and major measures, sector ETFs, say the market is up when it’s the opposite.

Market Structure Sentiment™, our behavioral index, topped on July 12, right into option-expirations today through Friday.  On Monday in a flat market belying dyspepsia below the surface, we saw massive behavioral change suggesting ETFs are leaving.

Stay with me. We’re headed unstoppably toward a conclusion.

From Jan 1-May 31 this year, ETFs were less volatile than stocks every week save one. ETFs are elastic, and so should be less volatile. Suddenly in the last six weeks, ETFs are more volatile than stocks, a head-scratcher.

Mechanics would see these as symptoms of failing vehicle-performance. Dave Barry would turn the radio up.  None of us wants an Unstoppable train derailing into the depot.  We can avoid trouble by measuring data and recognizing when it’s telling us things aren’t working right.

Investors and public companies, do you want to know when you’re on a runaway train?

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.

 

Russelling Stocks

We’re back!

At the NIRI Annual Conference last week in Phoenix (where foliage defied fiery environs) we launched an ad campaign for investor-relations professionals that graced the escalator wall into the hall, and the ModernIR booth hummed.

I had the honor of co-vice-chairing, and my market structure panel with hedge-fund legend Lee Cooperman, market commentator Joe Saluzzi, and SEC head of Trading and Markets Brett Redfearn kicked off the conference Monday June 3rd.

Due to an inadvertent clerical error, I was also named a NIRI volunteer of the year (here with NIRI CEO Gary LaBranche and board chair Ron Parham) along with TopBuild’s Tabitha Zane.  And I met NIRI co-founder Dick Morrill who at 97 can still deliver a ringing speech.

Post-conference, Karen and I bolted briefly to our mountain home, Steamboat Springs, where frost dusted the grass twice the last week and Sand Mountain jutted white-capped above a voluptuous carpet of grasses and blooms.

Meanwhile back in the stock market, with trade fears gripping the world – US stocks zoomed at the best rate in 13 months, posting six straight days of gains, a 2019 record, beating even the heady January start.

Against this backdrop loom big index rebalances. The Russell indices have been morphing toward July 1 reconstitution in phases that persist through the next three Fridays. On June 21, S&P quarterly rebalances will join the jammed queue, as will stock and index options and futures expirations June 19-21.

And expiring June 28 when the Russell finalizes are monthly CBOE futures contracts created to help indexers true up benchmark-tracking on the month’s last trading day.

Russell says $9 trillion of assets are pegged to its US equity indexes.  For perspective, the Russell 1000 is 95% of US market cap, the Russell 2000 most of the remaining 5%, as there are only 3,450 public companies.

What’s at stake with rebalances is thus more than pegged assets. It’s all the assets.

Passive assets are now over 50% of managed money, Exchange Traded Funds alone drive more than 50% of volume. The effects of these events are massive not due to susurrations in construction but in the capacity for price-changes to ripple through intertwined asset classes and the entirety of equity capitalization.

It’s like being in Group One on a United Airlines flight.  The fewer the airlines, the bigger the audience, the longer the line.

When the money wanting to queue up beside a benchmark was an eclectic conclave outside Palm Springs, rebalances were no big deal. Now passives are Los Angeles and rebalances are a Friday afternoon rush hour.

Put together the trillions tied to Russell and S&P indexes, the trillions in equity-linked swaps benchmarked to broad measures, the hundreds of trillions tied to expiring currency and interest rate swaps, the ETF market-makers trying to price ETFs and stocks driving $125 billion of daily trading volume, the Active “closet indexers” mimicking models, the Fast Traders with vast machine-computing power trying to game all the spreads. It’s keying the tumblers on the locks to the chains constraining the Kraken.

It’s not a myth. It’s already happening. Stocks imploded when the Communication Services sector was yanked like a rib from the torso of Tech and Consumer Discretionary stocks last September. It happened repeatedly through October, November and December 2018 as sector and market-cap ETFs washed like tides over stocks.

It happened in January, March, May, this year.

And it just happened again. What was it? Strafing waves of short-term passive shifts.

Lead market behavior in June so far? Risk Mgmt – continuous recalibration of derivatives bets.  Followed by Fast Trading – machines changing prices. Followed by Passive Investment (which tied to Risk Mgmt is ETFs, far and away the biggest combined influencer).

All these behaviors are 30%-43% higher than Active Investment as influencers. Defined as percentages of trading volume the past five days, Active is 11.6%, Passive, 26.9%, Fats Trading 41.4%, Risk Mgmt 20.1%.

What’s rustling the thickets of equity volatility, introducing unpredictability into stocks across the board, are vast benchmarked behaviors and their trading remoras.

The longer everyone persists in trying to assign rational motivation to moves, the more dangerous the market becomes. This isn’t complicated: The elephant in the room is the money watching prices – passive, speculative, hedged.  If observers are looking elsewhere, we’ll sooner or later get caught off-guard.

Let’s not.  Instead, be aware. Know the calendar.  Listen for Russelling stocks.

Phones and Wristwatches

Numbers matter. But not the ones you think, public companies and investors.

For instance, the best sector the past month is Utilities, up 3.5%, inversing the S&P 500’s 3.5% decline over that time (a 7% spread trade, we could say).

Utilities were worst for revenue surprises among the eleven sectors last quarter, says FactSet, and ninth of eleven for earnings surprises. Financial returns were mid-pack among sectors. It wasn’t results.

Sure, Utilities are defensive, along with Staples, Real Estate, Health Care. Those are up too the last month but less than Utilities.

One number sets Utilities apart: volatility.

Or lack thereof. Measured intraday, it’s 1.5% daily between high and low prices for stocks comprising the sector. Broad-market intraday volatility is 2.7%, 50% higher than Utilities.

Staples and Real Estate trail market volatility too, while Health Care, only of late returning to the safe-harbor fold, is more than twice as volatile as Utilities.

The worst sector in the market the last month is Energy, down 8.4% as measured by State Street’s sector ETF, XLE. And Energy stocks, with daily swings of 3.9%, were 44% more volatile than the broad market – and 100% more volatile than Utilities.

Among the most popular recent investments, the WSJ reports (posted here by Morningstar), are low-volatility ETFs like $SPLV and $USMV. Assets have exploded. These funds are disproportionately exposed to Utilities. And our models show massive ETF patterns in Utilities stocks.

Remember, ETFs are not pooled investments. They’re derivatives. If money flows to these ETFs, it’s not aggregating into a big lake of custodial money overseen by Blackrock or Invesco.

Suppose I traded my cell phone for your wristwatch. You’re free to do what you want with my phone because it’s yours now. But in a sense we’re saying the phone and the wristwatch are of similar value.

Say we’re day-trading phones and wristwatches.  Neither of us has a claim per se to the phone or the wristwatch. But we’ll be inclined to buy the wristwatch when it’s worth less than the phone and sell it when it’s worth more.

Same with ETFs. Low-vol ETF sponsors want assets such as Utilities and big stocks like WMT or PFE that don’t move much intraday (about 1.3% for those two).

ETFs are priced on spreads. Low-volatility instruments demand comparatives with low volatility (creating a run on low-vol assets?). They have no intrinsic value. You can’t find an ETF lying on the sidewalk and trade it to, say, Blackrock for its face value in cash.

It has no face value. Unless there’s another item with similar value to which it compares. ETFs are priced via in-kind exchange. Phone and wristwatch.

The ETF, phones, will be attractive to a trader to buy if it’s discounted to the stuff it’s supposed to track, wristwatches, and less attractive (and a short) if it’s currently priced above that stuff (phones). Prices constantly change as a result. Volatility.

The same thing will by extension invade your stock’s pricing, because your stock is the stuff ETFs track.

This is vital to understand, public companies and investors.

If the majority of money in the market fixates on spreads, the spread becomes more important than your financial results. Spreads become better predictors of future stock values than fundamentals.

EDITORIAL NOTE: Come to the NIRI Annual Conference June 2-5 in Phoenix! I’m hosting a session on ETFs with Rich Evans from the Univ of VA Wed morning Jun 5.

Also, the Think Tank chaired by Ford Executive Director of Investor Relations Lynn Tyson has released its white paper on the future of Investor Relations. Adapting to evolving market structure and investment behavior is key.

This image (linked) looks like robot-generated modern art. It’s our data on spreads between ETFs and stocks from Dec 2018 to present.  Wide spreads matched strong markets. Diminishing spreads correlated to weakening stocks. Maybe it’s false correlation.

But what if as spreads narrow the incentive to swap phones for watches fades? Markets could be imperiled by numbers we’re not watching. Shouldn’t we know?

Are you listening, financial reporters?

Jekyll and Hyde

Your stock may collateralize long and short Exchange-Traded Funds (ETFs) simultaneously.

Isn’t that cognitive dissonance – holding opposing views? Jekyll and Hyde? It’s akin to supposing that here in Denver you can drive I-25 north toward Fort Collins and arrive south in Castle Rock. Try as long as you like and it’ll never work.

I found an instance of this condition by accident. OXY, an energy company, is just through a contested battle with CVX to buy APC, a firm with big energy operations in the Permian Basin of TX (where the odor of oil and gas is the smell of money).

OXY is in 219 ETFs, a big number.  AAPL is in 271 but it’s got 20 times the market-capitalization.  OXY and its short volume have moved inversely – price down, shorting up. The patterns say ETFs are behind it.

So I checked.

Lo and behold, OXY is in a swath of funds like GUSH and DRIP that try to be two or three times better or worse than an index. These are leveraged funds.

How can a fund that wants to return, say, three times more than an S&P energy index use the same stock as one wanting to be three times worse than the index?

“Tim, maybe one fund sees OXY as a bullish stock, the other as bearish.”

Except these funds are passive vehicles, which means they don’t pick stocks. They track a model, and in this case, the same model.  If the stock doesn’t behave like the ETF, why does the fund hold it?

I should note before answering that GUSH and DRIP and similar ETFs are one-day investments. They’re in a way designed to promote ownership of volatility. They want you to buy and sell both every day.

You can see why. This image above shows OXY the last three months with GUSH and DRIP.

Consider what that means for you investor-relations professionals counting on shares to serve as a rational barometer, or you long investors doing your homework to find undervalued stocks.

Speaking of understanding, I’ll interject that if you’re not yet registered for the NIRI Annual Conference, do it now!  It’s a big show and a good one, and we’ve got awesome market structure discussions for you.

Back to the story, these leveraged instruments are no sideshow. In a market with 3,500 public companies and close to 9,000 securities, tallying all stock classes, closed-end funds and ETFs, some routinely are among the top 50 most actively traded.  SQQQ and TVIX, leveraged instruments, were in the top dozen at the Nasdaq yesterday.

For those juiced energy funds, OXY is just collateral. That is, it’s liquid ($600 million of stock trading daily) and currently 50% less volatile than the broad market. A volatility fund wants the opposite of what it’s selling (volatility) because it’s not investing in OXY. It’s leveraging OXY to buy or sell or short other things that feed volatility.

And it can short OXY as a hedge to boot.

All ETFs are derivatives, not just ones using derivatives to achieve their objectives. They are all predicated on an underlying asset yet aren’t the underlying asset.

It’s vital to understand what the money is doing because otherwise conclusions might be falsely premised. Maybe the Board at OXY concludes management is doing a poor job creating shareholder value when in reality it’s being merchandised by volatility traders.

Speaking of volatility, Market Structure Sentiment is about bottomed at the lowest level of 2019. It’s predictive so that still means stocks could swoon, but it also says risk will soon wane (briefly anyway). First though, volatility bets like the VIX and hundreds of billions of dollars of others expire today. Thursday will be reality for the first time since the 15th, before May expirations began.

Even with Sentiment bottoming, we keep the market at arm’s length because of its vast dependence on a delicate arbitrage balance. A Jekyll-Hyde line it rides.

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?

Dragon Market

As the market fell yesterday like a dragon from the sky (Game of Throners, the data are not good on dragon longevity now), 343 companies reported results, 10% of all firms.

Market fireworks were blamed yet again on tariff fears. Every tantrum is the Fed or tariffs it seems, even with hundreds publishing earnings. What happened to the idea that results drive markets?

Speaking of data, on May 6, the market first plunged like a bungee jumper off a bridge – and then caromed back up to a nonevent.

Behind the move, 21% of companies had new Rational Prices – Active money leading other behaviors and buying. That’s more than twice the year-long average of about 9% and the third-highest mark over the entire past year.

Talk about buying the dip. Smart money doesn’t see tariffs as threats to US interests (and likes the economic outlook, and likes corporate financial results). We’ve been using them to fund government since the Hamilton Tariffs of 1789.

So if not tariffs, why did stocks fall?

Before I tell you what the data show: Come to the NIRI Annual Conference, friends and colleagues. I’m moderating a panel the first day featuring hedge-fund legend Lee Cooperman, market-structure expert and commentator Joe Saluzzi, and SEC head of Trading and Markets Brett Redfearn.

We’ll talk about the good and bad in market-evolution the past 50 years and what’s vital to know now.  Sign up here.

IR folks, you’re the chief intelligence officer for capital markets. Your job is more than telling the story. It’s time to lead your executive team and board to better understand the realities driving your equity value, from Exchange Traded Funds to shorting and event-driven trends. It’s how we remain relevant.

Before you report results, you should know what the money that’s about you, your story, your results, your strategy, is doing – and what the rest of it is doing too. 

Take LYFT, which reported yesterday for the first time. Just 8% of LYFT volume is from Active Investment. By contrast about 22% is quantitative event-driven money, and over 58% is fast machines trading the tick. The balance ties to derivatives.

From that data, one can accurately extrapolate probable outcomes (ask us for your Market Expectation, or LYFT’s, and we’ll show you).

Every IR team should be arming its board and executives with a view of all the money, not just musing on how core holders may react – which is generally not at all.

And investors, if you’re focused only on fundamentals without respect to market structure, you’ll get burned.  I can rattle off a long list of companies beating and raising whose shares fell. The reasons aren’t rational but arbitrage-driven.

Having kept you in the dark like a Game of Thrones episode, let’s throw light on the data behind the late equity swoon: Always follow the money (most in financial media are not).

ETFs are 50% of market volume.  There have been $1.4 trillion (estimating for Apr and May) of ETF shares created and redeemed in 2019 already.

ETF shares are collateralized with stocks, but ETFs do not pool investor assets to buy stocks. In exchange for tax-free collateral, they trade to brokers the right to create ETF shares to sell to investors. The collateral is baskets of stocks – that they own outright.

The motivation, the profit opportunity, for that collateral has got nothing to do with tariffs or earnings or the economy. It’s more like flipping houses.

An Invesco PowerShares rep quipped to one of our team, “You see that coffee cup? I’d take that as collateral if I could flip it for a penny.”

ETF sponsors and brokers in very short cycles flip ETF shares and collateral. As with real estate where it works

Tech Sector Composite Stocks — Behavioral Data

great until houses start to fall in value, the market craters when all the parties chasing collateral try to get out at once (and it happens suddenly).

ETF patterns for the top year-to-date sector, Tech, are elongated way beyond normal parameters (same for two of three other best YTD sectors). It suggests ETFs shares have been increasing without corresponding rises in collateral.

With the market faltering, there’s a dash to the door to profit on collateral before the value vanishes. One thing can trigger it. A tweet? Only if a move down in stocks threatens to incinerate – like a dragon – the value of collateral.

How important is that for IR teams, boards, executives and investors to understand?

Melting Up

Blackrock CEO Larry Fink sees risk of a melt-up, not a meltdown for stocks.

Speaking of market structure, I’m a vice chair for NIRI’s Annual Conference – the 50th anniversary edition.  From the opening general session, to meeting the hedge funds, to a debate on how ETFs work, we’ve included market structure.  Catch a preview webcast on So-So Thursday, Apr 18, (before Good Friday) at 2pm ET (allow time to download Adobe Connect): https://niri.adobeconnect.com/webinar041819

Back to Larry Fink, is he right?  Who knows. But Blackrock wants to nudge record sidelined retail and institutional cash into stocks because revenues declined 7%.

Data tell us the market doesn’t need more buyers to melt up. Lipper said $20 billion left US equities from Jan through Apr 3, more than the $6 billion Bloomberg had earlier estimated. Stocks rallied 16%.

We wrote April 3 that no net cash fled equities in Q4 last year when the market corrected. If stocks can plunge when no money leaves and soar when it does, investors and public companies should be wary of rational expectations.

We teach public companies to watch for behavioral data outside norms.  Investors, you should be doing the same. Behavioral-change precedes price-change.  It can be fleeting, like a hand shoved in a bucket of water. Look away and you’ll miss the splash.

Often there’s no headline or economic factor because behaviors are in large part motivated by characteristics, not fundamentals.

Contrast with what legendary value investor Benjamin Graham taught us in Security Analysis (1934) and The Intelligent Investor (1949): Buy stocks discounted to assets and limit your risk.

The market is now packed with behaviors treating stocks as collateral and chasing price-differences. It’s the opposite of the Mr. Market of the Intelligent Investor. If we’re still thinking the same way, we’ll be wrong.

When the Communication Services sector arose from Technology and Consumer Discretionary stocks last September, the pattern of disruption was shocking. Unless you saw it (Figure 1), you’d never have known markets could roll over.

Larry Fink may think money should rush in (refrains of “fools rush in…”) because interest rates are low.  Alan Greenspan told CNBC last week there’s a “stock market aura” in which a 10% rise in stocks corresponds to a 1% increase in GDP. Stocks were down 18% in Q4, and have rebounded about 16%. Is the GDP impact then neutral?

To me, the great lesson for public companies and investors is the market’s breakdown as a barometer for fundamentals.  We’ve written why. Much of the volume driving equities now reacts to spreads – price-differences.

In a recent year, SPY, the world’s largest and oldest Exchange Traded Fund, traded at a premium to net asset value 62% of the time and a discount 38% of the time. Was it 2017 when stocks soared?  No, it was 2018 when SPY declined 4.5%.

Note how big changes in behavioral patterns correspond with market moves. The one in September is eye-popping. Patterns now are down as much as up and could signal a top.

SPY trades 93% of the time within 25 basis points of NAV, but it effectively never trades AT net-asset-value. Comparing trading volume to creations and redemptions of ETF shares, the data suggest 96% of SPY trading is arbitrage, profiting on price-differences.

This is the stuff that’s invaded the equity market like a Genghis Kahn horde trampling principles of value investment and distorting prices.

So, what do we DO, investors and public companies?

Recognize that the market isn’t a reliable barometer for rational thought. If your stock fell 40% in Q4 2018 and rebounded 38% in Q1, the gain should be as suspect as the fall.

Ask why. Ask your exchange. Ask the regulators. Ask the business reporters. These people should be getting to the bottom of vanishing rationality in stocks.

It may be the market now is telling us nothing more than ETFs are closing above net asset value and ETF market-makers are melting stocks up to close that gap.  That could be true 62% of the time, and the market could still lose 20% in two weeks.

When you hear market-behavior described in rational terms – even during earnings – toss some salt over a shoulder.  I think the market today comes down to three items: Sentiment reflecting how machines set prices, shorting, and behavioral change.

Behavioral patterns in stocks now show the biggest declines since September. Sentiment reflecting how machines set prices is topped ahead of options expirations that’ll be truncated by Good Friday. Shorting bottomed last week and is rising.

(Side note: patterns don’t vary during earnings. They fluctuate at month-ends, quarter-ends and options-expirations, so these are more powerful than results.)

Nobody knows the future and we don’t either. Behaviors change. But the present is dominated by characteristics, powerful factors behind behavioral patterns.

Bad Liquidity

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Beating Hearts

As the Dow Jones Industrials surged over 300 points on April Fools Day, the behavior driving it was Exchange Traded Funds, not rational thought reacting to economic data.

But aren’t ETFs manifestations of rational thought? Investors see, say, good Chinese manufacturing data, and pump money into them?

I’m not talking about fund flows.  I’ll explain.

CNBC reported that investors withdrew about $6 billion from stock funds during the first quarter’s epic equity rally. How can stocks soar when money is leaving?

We wrote Mar 20 that tallying fund-flow data in Q4 2018 when the market fell about 20% showed net static conditions. That is, $370 billion left stock-picking portfolios and the same amount shifted to passive funds. If no money left, why did stocks crater?

We should ask why fund flows don’t match market-performance. It seems like everyone is running around with fingers in ears going, “La la la la!” amid these uncomfortable realities.

Bloomberg wrote a wildly compelling piece on “heartbeat trades” Mar 29, taking a cue from FactSet’s Elisabeth Kashner, who first wrote about this ETF phenomenon in late 2017.

The gist is that ETFs somehow get short-term cash or stocks to finance creating ETF shares, which go to the provider of the loan as collateral, and then days later the ETF sponsor provides the bank with high capital-gains stocks equal to the value of the ETF shares, which it receives back.

Follow that?  Money is traded for ETF shares, which in turn are traded for stocks.

(Note: We should also wonder where those stocks came from if the market doesn’t suddenly take a selling hit afterward. Were they borrowed to start?)

The result of this trade is that taxes associated with the stocks are washed out of the ETF portfolio, ostensibly benefiting ETF investors.

Except ETF investors don’t own a share of pooled assets carrying tax liabilities. ETFs are not backed by any assets. The assets moving back and forth between, say, Blackrock and Goldman Sachs in these heartbeat trades belong to Blackrock, not to investors.

So Blackrock gets a tax benefit.

If you as an investor sell appreciated ETF shares, you owe taxes. That is, if you bought ETFs for $20 per share and they go to $30, and you sell them, you have $10 of gains and you’ll owe either ordinary-income or capital-gains taxes.

Not Blackrock et al.  They don’t own ETF shares.  They own collateral. Washed of taxes through processes such as what Bloomberg describes.

Bloomberg acknowledges that the same event – washing capital gains – occurs through the process of creating and redeeming ETF shares in ordinary course. Vanguard says in its ETF FAQs: “Vanguard ETFs can also use in-kind redemptions to remove stocks that have greatly increased in value (which trigger large capital gains) from their holdings.”

That by the way can hit a stock, undermining great fundamentals.

Creations and redemptions are huge. We had an estimated $1 trillion of ETF “gross issuance,” it’s called, in the time ordinary investors yanked $6 billion from stocks.

Might that $1 trillion have SOMETHING to do with how the stock market has behaved?  Read anything about it?

I’ll give you an example of the impact: the April Fools Day’s stock tirade. Brokers knew ETFs were undercollateralized. That is, if ETFs are supposed to, say, hold 500 S&P components in proportion as collateral, the rate of increase of markets in Q1 has meant they’re sampling only – using a handful of the same liquid stocks repeatedly to create and redeem ETF shares.

But they have to square books sometime. Usually month-ends, quarter-ends.

Fast Traders tipped us to it last week by buying and covering shorts.  So the market surged not on investors buying economic news but on ETF bookkeeping, in effect.

What has not happened yet is washing out capital gains. We saw smatterings only at March options-expirations. That shoe awaits, and ETF horizons in the wholesale market where shares are created and redeemed – again, $1 trillion in Q1 2019 – are fleeting.

These facts – not suppositions – matter because financial punditry is describing the market in fundamental terms when it’s being driven by leviathan tax-avoidance and arbitrage around a multi-trillion-dollar ETF creation-redemption process.

For public companies and investors, that means it’s nearly impossible to arrive at reliably fundamental expectations for stocks.