Tagged: ETFs

Age of Discovery

Bom Dia!

We returned Monday from Portugal after two fantastic weeks roaming and pedaling this land famed for its explorers. We stood at Cape St. Vincent, once the end of the known world where Vasco da Gama, Ferdinand Magellan and Christopher Columbus sailed off to what many thought was a ride over the edge.

In a sense, the investor-relations and stock-picking professions are at Cape St. Vincent. The market we’ve known, the one driven by business fundamentals, is a spit of rock projecting into a vast sea of unknown currents.  We are explorers on a forbidding shore.

Henry the Navigator, father of the Age of Discovery, challenged fear, superstition and entrenched beliefs to create the Harvard of sailing schools on the barren shoals of Sagres, a stone’s throw south of Cape St. Vincent. From it went intrepid adventurers who by sailing what proved to be a globe laid the cornerstones of today’s flattened earth that’s interconnected economically and culturally.

Speaking of conquering the unknown, I’m paneling for the NIRI Virtual chapter at noon ET today on the impact of Exchange Traded Funds, then tomorrow addressing the Capital Area NIRI group on how ETFs drive the market.

It’s what the money is doing. If as IR professionals we’re to fulfill our responsibilities to inform our boards about important facets of equity valuation, we have to know these things as explorers knew the sextant.

By the same token, investors, if you know only how stocks should be valued bottom-up but not how the market transforms stocks into products and data priced by arbitrage, then you’ll fail to beat the benchmark.  Market Structure is as essential to navigation as was knowing currents and stars and weather patterns for yesteryear’s seafarers.

How do we at ModernIR know we’ve got the right navigational tools for today’s market?  Vasco da Gama combined knowledge and forecasts learned at the School of Navigation to find a passage by sea to India.

We combine knowledge of market rules and the behavior of money with software and mathematical models that project outcomes – passages.  If our knowledge is correct, our sextant will mark a course.

Our models are roughly 93% accurate in forecasting short-term prices across the entire market – a startling achievement. For comparative purposes, moving averages have no measurable statistical capacity to forecast prices, and variances between them and actual prices are factors larger than that in our models. Why use tools that don’t tell you where you’re going?

Ownership-change is a tiny fraction of trading volume. What does it tell you about how your price is set?  Nothing. By contrast, patterns of behavioral change are as stark as waves in Cascais – or the world’s biggest surfers’ waves off Nazare.  We see waves of sector rotation, short-term turns in the market – just like weather patterns.

We’re in an age of discovery. Some will cling to a barren spit of land, doing what they’ve always done. The rest will set a new course to a future of clarity about how stocks are priced and valued and how money behaves.  Which group will you be in?

Hope to see you at a NIRI chapter meeting soon!  And ask us how we can help you navigate the coming earnings season with better tools.

Borrowed Time

“If a stock trades 500,000 shares daily,” said panelist Mark Flannery from hedge fund Point72 last Thursday on my market-structure panel, “and you’ve got 200,000 to buy or sell, you’d think ‘well that should work.’ It won’t. Those 500,000 shares aren’t all real.”

If you weren’t in Austin last week, you missed a great NIRI Southwest conference.  Mr. Flannery and IEX’s John Longobardi were talking about how the market works today.  Because a stock trades 500,000 shares doesn’t mean 500,000 shares of real buying and selling occur.  Some of it – probably 43% – is borrowed.

Borrowing leads to inflation in stocks as it does in economies.  When consumers borrow money to buy everything, economies reflect unrealistic economic wherewithal. Supply and demand are supposed to set prices but when demand is powered by borrowing, prices inevitably rise to unsustainable levels.  It’s an economic fact.

All borrowing is not bad. Borrowing money against assets permits one to spend and invest simultaneously.  But borrowing is the root of crises so watching it is wise.

Short interest – stock borrowed and sold and not yet covered and returned to owners as a percentage of total shares outstanding – isn’t unseemly. But it’s not a predictive indicator, nor does it describe risk. The great majority of shares don’t trade, yet what sets price is whoever buys or sells.

It’s far better to track shares borrowed as a percentage of total traded shares, as we described last week. It’s currently 43%, down one percentage point, or about 2.3%, as stocks have zoomed in latter August.

But almost 30% of stocks (excluding ETFs, routinely higher and by math on a handful of big ones averaging close to 60%) have short volume of 50% or more, meaning half of what appears to be buying and selling is coming from something that’s been borrowed and sold.

In an up market, that’s not a problem. A high degree of short-term borrowing, much of it from high-speed firms fostering that illusory 500,000 shares we discussed on the panel, means lots of intraday price-movement but a way in which short-term borrowing, and covering, and borrowing, and covering (wash, rinse, repeat), may propel a bull market.

In the Wall Street Journal Aug 25, Alex Osipovich wrote about how Goldman Sachs and other banks are trying to get a piece of the trading day’s biggest event: The closing auction (the article quotes one of the great market-structure experts, Mehmet Kinak from T Rowe Price). Let’s dovetail it with pervasive short-term borrowing.

We’ve mapped sector shorting versus sector ETF shorting, and the figures inversely correlate, suggesting stocks are borrowed as collateral to create ETFs, and ETFs are borrowed and returned to ETF sponsors for stocks.

A handful of big banks like Goldman Sachs are primary market-makers, called Authorized Participants (as opposed to secondary market-makers trading ETFs), which create and redeem ETF shares by moving stock collateral back and forth.

The banks give those using their versions of closing auctions the guaranteed closing price from the exchanges.  But it’s probably a great time to cover short-term ETF-related borrowings because trades will occur at an average price in effect.

The confluence of offsetting economic incentives (selling, covering borrowings) contribute to a stable, rising market. In the past week average intraday volatility dropped to 1.9% from a 200-day average of 2.5% at the same time shorting declined – anecdotal proof of the point.

What’s the flip side?  As with all borrowing, the bill hurts when growth stalls. When the market tips over at some future inevitable point, shorting will meet shorting. It happened in January 2016 when shorting reached 52% of total volume. In February this year during the correction it was 46%. Before the November election, short volume was 49%.

The point for both investors and public companies is that you can’t look at trading volume for a given stock and conclude that it’s equal and offsetting buying and selling. I guarantee you it’s not.

You don’t have to worry about it, but imbalances, however they may occur, become a much bigger deal in markets dependent on largescale short-term borrowing. It’s another market-structure lesson.

Block Monopoly

This year’s rare midweek July 4 prompted a pause for the Market Structure Map to honor our Republic built on limited government and unbounded individual liberty. Long may it live.

Returning to our market narrative: Did you know that 100% of Exchange Traded Fund creations and redemptions occur in block trades?

If you’ve got 48 minutes and a desire to understand ETFs, catch my podcast (you can get our ETF White Paper too) with IR Magazine’s Jeff Cossette.

In stocks, according to publicly reported data, three-tenths of one percent (0.03%) of NYSE trades are blocks (meaning 97.7% are non-block).  The Nasdaq compiles data differently but my back-of-the-envelope math off known data says blocks are about the same there – a rounding error of all trades.

Blocks have shrunk due to market regulation. Rules say stock trades must meet at a single national price between the best bid to buy and offer to sell.  That price relentlessly changes, especially for the biggest thousand stocks comprising 95% of volume and market cap (north of $2.5 billion to make the cut) so the amount of shares available at the best price is most times tiny.

We track the data.  At July 9, the average Russell 1000 stock traded 13,300 times per day in 160-share increments.  If you buy and sell shares 200 at a time like high-speed traders or algorithmic routers that dissolve and spray orders like crop-dusters, it’s great.

But if you buy cheese by the wheel, so to speak, getting a slice at a time means you’re not in the cheese-wheel buying business but instead in the order-hiding business. Get it? You must trick everybody into thinking you want a slice, not a wheel.

The cause? Market structure. Regulation National Market System, the regime governing stock trades, says one exchange must send to another any trade for which a better price exists there (so big exchanges pay traders to set price. IEX, the newest, doesn’t).

Put simply, exchanges are forced by rules to share prices. Exchanges cannot give preference to any customer over another.

ETFs get different rules. Shares are only created in blocks, and only traded between ETF creators and their only customers, called Authorized Participants.

I’m not making this up. When Blackrock wants more ETF shares, they create them in blocks only.  From Blackrock’s IVV S&P 500 ETF prospectus: Only an Authorized Participant may engage in creation or redemption transactions directly with the Fund. The Fund has a limited number of institutions that may act as Authorized Participants on an agency basis (i.e., on behalf of other market participants).

Why can ETFs offer preference when it’s against the law for exchanges? Fair question. There is no stated answer. The unstated one is that nobody would make markets in ETFs if a handful of firms didn’t have an unassailable competitive advantage, a sure chance to make money (why ETF fees are so low).

Again from the IVV prospectus:

Prior to trading in the secondary market, shares of the Fund are “created” at NAV by market makers, large investors and institutions only in block-size Creation Units of 50,000 shares or multiples thereof.

Each “creator” or authorized participant (an “Authorized Participant”) has entered into an agreement with the Fund’s distributor, BlackRock Investments, LLC (the “Distributor”), an affiliate of BFA. A creation transaction, which is subject to acceptance by the Distributor and the Fund, generally takes place when an Authorized Participant deposits into the Fund a designated portfolio of securities (including any portion of such securities for which cash may be substituted) and a specified amount of cash approximating the holdings of the Fund in exchange for a specified number of Creation Units.

And down a bit further (emphasis in all cases mine):

Only an Authorized Participant may create or redeem Creation Units with the Fund. Authorized Participants may create or redeem Creation Units for their own accounts or for customers, including, without limitation, affiliates of the Fund.

Did you catch that last bit? The creator of ETF shares – only in blocks, off the secondary market (which means not in the stock market) – may create units for itself, for its customers, or even for the Fund wanting ETF shares (here, Blackrock).

And the shares are not created at the best national bid to buy or offer to sell but at NAV – Net Asset Value.

Translating to English: ETF shares are created between two cloistered parties with no competition, off the market, in blocks, at a set price – and then sold to somebody else who will have to compete with others and can only trade at the best national price, which continually changes in the stock market, where no one gets preference and prices are incredibly unstable.

It’s a monopoly.

Two questions:  Why do regulators think this is okay? The SEC issued exemptive orders to the 1940 Investment Company Act (can the SEC override Congress?) permitting it.

We wrote about the enormous size of ETF creations and redemptions. Which leads to Question #2: Why wouldn’t this process become an end unto itself, displacing fundamental investment?

The Actionable Hoax

What’s actionable?

It’s a buzzword of business and the investor-relations profession. And, yes, my title violates a rule of grammar because you can’t tell if the topic is a hoax about actionability or if a hoax out there has proved actionable.

We’ll answer using the market. Like this: Trade-war threats are wrecking markets!  Right?

Wrong.  Pundits tying moves in the market to headlines don’t understand market structure. Suppose you’re getting “actionable” information from pundits who don’t know how the market works. Are the recommended actions reliable?

While you ponder that, consider this: If trade concerns for tech stocks caused the correction in February, why did the Nasdaq hit an all-time high June 20? Did the same money that rejected the market back then on trade fears three months later without resolution to those concerns pay more?

You can say, “No, they were sellers.” Okay, so who bought?

Market experts are often offering actionable intelligence based on outdated ideas. But they have a duty to understand how the market works and what the money is doing.

In fact, these two pillars – how the market works, what the money is doing – should be the bedrock for understanding markets.

What’s the money doing?  It’s not choosing to be directed by rational thought. We know  because a vast sea of data on fund flows tells us so. If we as investors or investor-relations practitioners continue doing what we did before fund flows surged to passive money, who is the bigger fool?

Exchange Traded Funds (ETFs) are driving 50% of market volume now. They are passive vehicles. But they uniquely among investment products permit ETF creators like Blackrock and Vanguard a step-up in tax basis through creation and redemption.

How? Say NFLX is up 100% in three months, imputing tax costs to ETF shares. Creators of ETFs collateralized by NFLX shares will put it in redemption baskets exchanged to brokers for returned ETF shares.  (NOTE: If you don’t know how ETFs work, ask us for our ETF whitepaper.)  NFLX then plunges as brokers sell and short it.

Five days later, the ETF creator can bring NFLX back now in a creation basket of new ETF shares that it will issue only in exchange for NFLX – laundered of tax consequences.

Apply this to the Technology sector (or the whole market for that matter).  We just had Russell index rebalances, and Technology is a big part of market cap.  S&P indices rebalanced June 22 and Technology is over 25% of the S&P 500 now.

This week is quarter-end window-dressing. ETFs are trying to bleed taxes off runups in Tech stocks.  We could see it coming in Sentiment by June 14, when it topped, signaling downside, and when behavioral volatility indicated big price-swings. Data say we have another rough day coming this week.

Headlines may help prioritize what gets tax-washed, so to speak, but the motivation is not investment. It’s aiming at picking gains and packing off tax consequences.

The market is driven far more by these factors than rational thought, which we know by studying the data. ETF creations and redemptions are hundreds of billions of dollars monthly. Inflows and outflows from buy-and-hold funds are nonexistent by comparison.

Ergo, it can’t be rational thought driving the market no matter the talking heads declaiming trade threats.

It’s what lawyers call a “fact pattern.” ETFs dominate passive investment, drive 50% of market volume, depend on tax efficiency, which process is an arbitrage trade that involves a continual shift of hundreds of billions monthly in underlying assets, and a corresponding continual shift in collateralizing assets called stocks – with market-makers profiting, and ETF creators profiting – without regard to market direction.

It’s poor fodder for a 24-hour news cycle. But it explains market behavior. Moves have become more pronounced because money stopped pouring into US equities via ETFs this year. Volatility exploded because getting tax efficiency got harder.

Which brings us to the “actionable” hoax. The word “actionable” says consumers of products or services are fixated on a prompt, a push, an imprimatur.

Fine. But flinging the word around causes investors and IR professionals to miss what matters more, and first.  Investors and public companies should be asking: “How does this service or that tool help me understand what the money behind stocks is doing?”

Ask your service provider to explain how your stock trades. Then ask us to explain it.

If they don’t match, ask why. The beginning point of correct action is an understanding of what you can and cannot control, and how the environment in which you operate works.

Take the weather. We can’t control it. But it determines the viability of our actions. The same applies to understanding market structure. It determines the viability of actions.

If you want to learn market structure, ask us how, IR professionals and investors.  It’s the starting point. What you think is actionable may be a hoax. Compare how the market works to what you’re doing. Do they match? If not, change your actions. We’ll help you.

Liar’s Poker

We’re back! We recommend Barbados but we didn’t see Rihanna.

We also endorse floating around the Grenadines on a big catamaran turning brown and losing track of time. We had rum off the shore of Petit Tabac where Elizabeth set Captain Jack Sparrow’s rum store afire.

Meanwhile, back in reality the dollar rose and interest rates fell, and Italy slouched into confusion, and Argentina dodged a currency crisis for now, and Venezuela…well, Venezuela is like that rum fire Elizabeth set in Pirates of the Caribbean.

I at last read Liar’s Poker, Michael Lewis’s first book (and also Varina, by Charles Frazier, a lyrical novel that sighs like wind through live oaks, imagining life in the eyes of Mrs. Jefferson Davis).

With the boat and the sea taking us far from cell towers, we hit the power buttons and blinked out and I with cold Carib at hand, the beer of the Caribbean, sailed through Mr. Lewis’s time at Salomon Brothers in the bond frenzy of the 1980s.

Mr. Lewis explains how a Federal Reserve decision in Oct 1979 by then chairman Paul Volcker to fix the supply of money and float interest rates stuffed the turkey for Salomon. Overnight, bonds moved from conservative investments held to produce income, to speculative instruments driven by bets on big swings in prices.

For Salomon, the money was in toll-taking. They bought bonds from those selling at incorrect prices and sold them to others willing to buy at incorrect prices. They kept a middleman’s sliver. Do it enough and you’re rich. If you’ve not read the book, do so. There’s verisimilitude for today’s stock market.

The Fed abandoned floating interest rates in 1982, reverting to influencing the Fed Funds rate as it still does today (setting interest rates and flexing the money supply). But speculation on price-changes is now rampant, having spread into everything from currencies to equities.

It matters because anytime supply and demand are not the principal price-setters, a market cannot be depended on to offer reliable fundamental signals. The US stock market thanks to Exchange Traded Funds now may be the most arbitraged in human history.

You might be thinking, Tim, did time on the boat not dump your ETF cache? Also, why do I care?

I return to the ETF theme because investors and public companies continue to assign the market disproportionately fundamental interpretations. You should care because Salomon is gone, swept away on the tides of history because it didn’t keep up. Are we keeping up?

The motivation behind the two parties to every ETF creation and redemption – and neither one of them is you – is capturing a price-spread.  It’s not investment.  Yes, you as an investor may buy ETFs as an investment. But the parties creating and redeeming them are doing so to make money on how prices change.

That’s arbitrage. And what determines the value of investments isn’t who holds them but who buys or sells them (this is the flaw in thinking your stock reflects value assigned by buy-and-hold investors).

In a way, it’s what Mr. Lewis describes in Liar’s Poker, where Salomon merchandised the market’s ignorance about what priced bonds.

How many people understand that ETFs are not managing the money they spent buying ETF shares? ETFs have everyone believing they’re buying a pooled investment when it’s not. Whose fault is it?  Don’t we all bear a responsibility to understand what we’re buying, or what’s affecting the value of our traded shares, companies?

ETFs are the dominant stock financial vehicle of this very long bull market. What matters to those behind trillions of dollars of ETF share-creations and redemptions isn’t the objective of the ETF – but how the prices of ETFs change versus the underlying assets used to collateralize their creation.

Thus a fundamental tremor like trouble in Italy becomes volcanic, spewing molten lava all over stocks. The true driver is arbitrage. Bets. Liar’s Poker. Let’s not be fooled again.

BEST OF: Green and Purple

EDITORIAL NOTE:  We are on a big catamaran with Painkillers in hand watching the sun dissolve into an aqua Grenadine sea. So while we all float on, here’s Part Two of our return to the past to learn today’s lessons. The piece below originally ran Mar 7, 2018. If we’re going to understand today’s market, we must wrap our minds around the vastness of the ETF Effect:  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Best Of: The Housing ETF

Editorial note:  We looked at market Sentiment topping into this week’s options expirations cycle and said to ourselves, “Selves, we should be cheeseburgers in paradise instead of hanging around here waiting for the market to fall!”  So we are somewhere on Barbados, not searching for Rihanna but chasing tranquility. You all are in charge. We’ll catch you up May 30!  But this below to me is the most important thing to know at the moment in the stock market:  How ETFs work. 

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Substitutes

Substitutes were responsible for yesterday’s market selloff.

Remember back in school when you had substitute teachers? They were standing in for the real deal, no offense to substitutes.  But did you maybe take them a little less seriously than the home room teacher?

The market is saturated with substitutes. The difference between stocks and the home room back in grammar school is nobody knows the difference.

If shares are borrowed they look the same to the market as shares that are not borrowed.  If you use a credit card, the money is the same to the merchant from whom you just bought dinner or a summer outfit. But it’s a substitute for cash you may or may not have (a key statistic on consumption trends).

Apply to borrowed stock. The average Russell 1000 stock trades $235 million of stock daily, and in the past 50 trading days 46%, or $108 million, came from borrowed shares. The Russell 1000 represents over 90% of market capitalization and volume. Almost half of it is a substitute.

Why does it matter?  Suppose half the fans in the stands at an athletic event were proxies, cardboard cutouts that bought an option to attend a game but were there only in the form of a Fathead, a simulacrum.

The stadium would appear to be full but think of the distortions in player salaries, costs of advertisement, ticket prices.  If all the stand-ins vanished and we saw the bleachers were half-empty, what effect would it have on market behavior?

Shorting is the biggest substitute in the stock market but hardly the only one.  Options – rights to buy shares – are substitutes. When you buy call options you pay a fee for the right to become future demand for shares of stock.  Your demand becomes part of the audience, part of the way the market is priced.

But your demand is a Fathead, a representation that may not take on greater dimension. Picture this:  Suppose you were able to buy a chit – a coupon – that would increase in value if kitchen remodels were on the rise.

Your Kitchen Chit would appreciate if people were buying stoves, fridges, countertops, custom cabinets.  Now imagine that so many people wanted to invest in the growth of kitchen remodels that Kitchen Chits were created in exchange for other things, such as cash or stocks.

What’s the problem here?  People believe Kitchen Chits reflect growth in kitchen remodels. If they’re backed instead by something else, there’s distortion.  And buying and selling Kitchen Chits becomes an end unto itself as investors lose sight of what’s real and focus on the substitute.

It happens with stocks. Every month options expire that reflect substitutes. This kitchen-chit business is so big that by our measures it was over 19% of market volume in the Russell 1000 the past five days during April options-expirations.

It distorts the market.  Take CAT.  Caterpillar had big earnings. The stock was way up pre-market, the whole market too, trading up on futures – SUBSTITUTES – 150 points as measured by the Dow Jones Industrial Average.

But yesterday was Counterparty Tuesday, the day each month when those underwriting substitutes like options, futures, swaps, balance their books.  Suppose they had CAT shares to back new options on CAT, and they bid up rights in the premarket in anticipation of strong demand.

The market opened and nobody showed up at the cash register. All the parties expecting to square books in CAT by selling future rights to shares at a profit instead cut prices on substitutes and then dumped what real product they had.  CAT plunged.

Extrapolate across stocks. It’s the problem with a market stuffed full of substitutes. Yesterday the substitutes didn’t show up to teach the class. The market discovered on a single day that when substitutes are backed out, there’s not nearly so much real demand as substitutes imply.

Substitution distorts realistic expectations about risk and reward. It’s too late to change the calculus. The next best thing is measuring substitutes so as not to confuse the fans of stocks with the Fatheads.

Big Movers

You can’t expect the stock market to reflect earnings. I’ll explain.

By week’s end, 20% of the S&P 500 will have reported, and earnings are up 17% over the same period last year so far (normalized to about 7% sans federal corporate tax reform legislation).

Yardeni Research, Inc. reports that price-to-earnings ratios in various categories of the market are not misaligned with history.  The S&P 500 trades just over 16 times forward expected earnings, about where it did in 2015, and in 2007 before the financial crisis, and well below levels before Sep 11, 2001.

Sure, by some measures valuations are extreme. Viewed via normative metrics, however, the market is as it’s been. From 1982-2000, PE ratios were generally rising.  From there to 2012, they were generally falling. Yet between we had multiple major market corrections.

Which returns us to my incendiary opening assertion that earnings today don’t drive stocks. What does? The money setting prices. Let me explain.

Buy-and-hold money tends to buy, and hold. Most conventional “long” equity funds must be fully invested, which means to buy something they must sell something else.  Buying and selling introduces tax, trading-commission, and volatility costs, which can cause stock-picking investors to underperform broad indexes.

The Investment Company Institute reported that 2016 turnover rates among equity funds averaged 34%, or about a third of positions annually. Passive index and exchange-traded funds tout low turnover. State Street, sponsor for the world’s largest ETF, SPY, claimed 2017 turnover was 3%.

We’ll come to the fallacy of low turnover in ETFs.

First, Big Reason #1 for the movement of stocks is arbitrage. Follow the money. Using our proprietary statistical measures of behavior in stock trades, nearly 46% of market volume (20-day ave.) in the Russell 1000 (which is over 90% of market cap) came from high-speed traders.

They are not investors. These machines trade tick data in baskets, aiming most times to own nothing at day’s end. The objective is to profit on intraday price-moves.  For instance, 52% of Facebook’s daily trading volume is high-speed machines. Less then 9% is Active investment by stock-pickers.

Viewed another way, there’s a 46% chance that the price of stocks reflects machines trading the tick. Since less than 12% of Russell 1000 volume was fundamental, there is but a one-in-eight chance that earnings set prices. High-speed trading is arbitrage – profiting on price-differences.

Don’t fundamentals price the market long-term? Again, that would be true if the majority of the money setting prices in the market was motivated by fundamentals. That hasn’t been true this century.

How about fund flows?  Assembling data from EPFR, Lipper and others and accounting for big outflows in February, about $40 billion has come into US stocks this year.

Using Investment Company Institute data and estimates for Mar and Apr this year, ETFs have by comparison created and redeemed some $1.5 TRILLION of shares. Fund flows are less than 3% of that figure.

These “in-kind” exchanges between ETF creators and big brokers that form the machinery of the ETF market are excluded from portfolio turnover. If they were counted, turnover rates in ETFs would dwarf those for conventional funds. And the objective behind creations and redemptions is not investment.

ETF creators make money by charging brokers fees for these transactions (which are tax-free to them) and investing the collateral. Brokers then trade ETFs and components and indexes to profit on the creations (new ETF shares sold to investors) and redemptions (returning ETF shares to ETF creators in exchange for collateral to sell and short).

Neither of these parties is trying to produce an investment return per se. They are profiting on how prices change – which is arbitrage (and if ETF creations are greater than redemptions, they permit more money to chase the same goods, lifting markets).

Summarizing: The biggest sources of movement of money and prices are machines trading the tick, and ETF creators and brokers shuttling tax-free collateral and shares back and forth by the hundreds of billions. If pundits describe the market in fundamental terms, they are not doing the math or following the money.

And when the market surges or plunges, it’s statistically probable that imbalances in these two behaviors are responsible.

The Housing ETF

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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