The Investment Company Institute (ICI) says US equities saw net outflows of $5.1 billion Jan 2-23, the latest data. Add the week ended Dec 26 and a net $26.2 billion left.
So how can stocks be up?
Maybe flows reversed after the 23rd? Okay, but the S&P 500 rose 12.2% from Dec 24-Jan 23. It’s now up about 16%, meaning 75% of gains occurred during net outflows.
Is the ICI wrong? In a way, yes. It treats redeemed Exchange Traded Fund (ETF) shares as outflows – and that’s not correct.
Let me explain. The stock market is up because of whatever is setting prices. We measure that stuff. The two big behaviors driving stocks Dec 26-Feb 4 were Passive Investment, and Risk Mgmt, the latter counterparties for directional bets like index options.
That combination is ETFs.
ETF shares are redeemed when brokers buy or borrow them to return to ETF sponsors like Blackrock, which exchanges them for stocks or cash of equal value.
If ETF shares are removed from the market, prices of ETFs tighten – and market makers bet long on index and stock options. That’s how derivatives rally underlying assets.
See, ETFs depend on arbitrage – different prices for the same things. And boy do prices differ. We track that data too. When ETFs rise more than underlying stocks, the spreads are small. Stocks are far less liquid than ETFs because share-supplies don’t continually expand and contract like ETFs.
As an example, Consumer Discretionary stocks were up 1.6% last week (we meter 197 components for composite data on behaviors, shorting, Sentiment, etc.). But the State Street Sector SPDR (pronounced “spider,” an acronym for S&P Depository Receipts, an ETF) XLY was up just 0.2%.
XLY is comprised of 65 Consumer Discretionary stocks. As we’ve explained before, ETFs are not pooled investments. They’re derivatives, substitutes predicated on underlying assets.
So it really means State Street will take these stocks or similar ones in exchange for letting brokers create ETF shares, and vice versa.
You can’t short a mutual fund because it’s a pooled investment. You can short ETFs, because they’re not. In fact, they’re a way to short entire sectors.
Want to pull down a swath of the market? Borrow key components correlated to the ETF and supply them to a big broker authorized to create ETF shares, and receive off-market blocks of a sector ETF like XLY. Then sell all of it on the open market.
It happened in December.
Here’s how. A staggering $470 BILLION of ETF shares were created and redeemed in December as the market plunged, putting the Nasdaq into bear territory (down 20%) and correcting major indices (down 10% or more).
And guess what? There were $49 billion more creations than redemptions, which means the supply of ETF shares expanded even as the market declined.
I doubt regulators intended to fuel mass shorting and supply/demand distortion when they exempted ETFs from key provisions of the Investment Company Act of 1940 (and how can they do that, one wonders?).
But it’s happening. More proof: shorting in stocks topped 48% of all volume in December.
Returning to spreads, we’ve since seen the reverse of that trade. Stocks are being arbitraged up in value to reflect the supply of ETF shares outstanding, in effect.
And shorting has come down, with 5-day levels now below 20- and 50-day averages.
We’ve showed you ETF patterns before. Here’s the Industrials sector, up 5% the past week. Those purple and green bars? ETFs. Stocks, plus leverage. The purple bars are bigger than the green ones, meaning there is more leverage than assets.
That was true Jan 8-15 too, ahead of expirations the 16th-18th, the only period during which the sector and the market showed proportionally flat or down prices (see linked image). Traders used their leverage (options volumes in 2018 crushed past records – but the culprit is short-term ETF leverage, arbitrage. Not rational behavior).
Why should you care about this stuff, investor-relations professionals and investors? We should know how the market works and what the money is doing. With ETF-driven arbitrage pervasive, the market cannot be trusted as a barometer for fundamentals.
Your boards and executive teams deserve to know.
What can we do? Until we have a disaster and the SEC realizes it can’t permit a derivatives invasion in an asset market, we must adapt. Think ahead.
For companies reporting results next week or the week after, risk has compounded because this trade is going to reverse. We don’t know when, but options expire Feb 14-16. Will bets renew – or fold?
Whenever it happens, we’ll see it coming in the data, by sector, by stock, across the market, just as we did in late September last year before the tumult.