Tagged: spreads

Manufactured Spreads

Did Exchange Traded Funds drive the recent market rollercoaster?

The supply of ETF shares moved opposite the market. The S&P 500 fell about 16% in December and rose around 19% from Dec 24 to March 5.  In December, says the Investment Company Institute, US ETFs created, or introduced, $260 billion of ETF shares, and redeemed, or retired, $211 billion.

So as the market tumbled, the number of ETF shares increased by $49 billion.

We saw the reverse in January as the market soared, with $208 billion of ETF shares created, $212 billion redeemed, the supply shrinking a little.

If ETFs track indexes, shouldn’t available shares shrink when the market declines and increase when the market rises?  Why did it instead do the opposite?

One might point to the $46 billion investors poured into equity ETFs in December at the same time they were yanking $32 billion from Active funds, says Morningstar.

Again a contradiction. If more money flowed to equities than left, why did the S&P 500 fall?  Don’t stocks rise when there are more buyers than sellers, and vice versa?

The fact that data and market behavior are at loggerheads should cause consternation for both investors and public companies. It means we don’t understand supply and demand.

One explanation, the folks from the ETF business say, is that inflows to ETFs may have been short. That is, when ETF shares increase while stocks are falling, ETF creators are borrowing stocks and trading them to Blackrock and Vanguard to create ETF shares for investors, who borrow and sell them.

These people explain it in a tone of voice that sounds like “aren’t we geniuses?”

But if true, the unique characteristics of ETFs that permit them limitless supply and demand elasticity contributed to the market correction.

We cannot manufacture shares of GE to short.  But ETF market-makers can manufacture ETF shares to short. How is that helpful to long-only investors and public companies?  The behavior of stocks separates from fundamentals purely on arbitrage then.

Here’s another statistical oddity: The net shrinkage in January this year marks only the third time since the 2008 Financial Crisis that the monthly spread between ETF creations and redemptions was negative. The other two times were in February and June last year, periods of market tumult.

And still the ETF supply is $45 billion larger than it was when the market corrected (near $55 billion if one adds back market-appreciation).

We conducted an experiment, tracking week-over-week gains and losses for stocks comprising the eleven General Industry Classification System (GICS) sectors and comparing changes to gains and losses for corresponding sector ETFs from State Street, called SPDRs (pronounced “spiders”) from Dec 14 to present.

Startlingly, when we added up the nominal spread – the real difference between composite stocks and ETFs rolled up across all eleven sectors – it was 18%, almost exactly the amount the market has risen.

What’s more, on a percentage basis the spreads were not a penny like you see between typical best bids to buy and offers to sell for stocks. They averaged 5% — 500 basis points – every week.  The widest spread, 2,000 basis points, came in late December as stocks roared.

Now the spread has shrunk to 150 basis points and markets have stopped rallying.  Might it be that big spreads cause traders to chase markets up and down, and small spreads prompt them to quit?

Now, maybe a half-dozen correlated data points are purely coincidental. False correlations as the statistics crowd likes to say.

What if they’re not?  Tell me what fundamental data explains the market’s plunge and recovery, both breath-taking and gravity-defying in their garishness? The economic data are fine. It was the market that wasn’t. What if it was ETF market-making?

The mere possibility that chasing spreads might have destroyed vast sums of wealth and magically remanufactured it by toying with the supply of ETF shares and spreads versus stocks should give everyone pause.

Investors, you should start thinking about these market-structure factors as you wax and wane your exposure to equities.  If fundamentals are not setting prices, find the data most correlated to why prices change, and use it.  We think it’s market structure. Data abound.

And public companies, boards and executives need a baseline grasp on the wholesale and retail markets for ETFs, the vast scope of the money behind it — $4.5 TRILLION in 2018, or more than ten times flows to passive investors last year – and what “arbitrage mechanism” means. So we’re not fooled again (as The Who would say).

What do data say comes next?  Sentiment data are the weakest since January 7 – and still positive, or above 5.0 on our ten-point Sentiment scale. That’s a record since we’ve been tracking it.

So. The market likely stops rising.  No doom. But doom may be forming in the far distance.

Low Spreads

What keeps stocks going is low volatility.

By seeking only to earn the spread on each transaction and not bet on the direction of markets, you can make money close to 50 percent of the time.

This one sentence from a profile of high-speed firm Virtu by Bloomberg’s Matt Leising to me summarizes the US stock market and its durability.

Computers focus on the difference in cost to buy or sell a very small thing – a handful of shares. They don’t weigh the viability of the entity reflected in the shares or any measure humans use to determine fair value. Thus, what difference does it make whether so-called fundamentals support the price? We’re asking the wrong question.

In the world apart from stocks, European growth is abysmal. Emerging economies are sputtering. The US economy is growing about 1% and juxtaposed with a long slide in productivity, falling revenues in the S&P 500 and five quarters of earnings contraction.

Since 1954, according to Financial Advisor magazine, twelve earnings recessions have met ten actual ones, and stocks have always fallen, the least, 7%, in 1967, and the most, 57%, in 2008-9.  In this one, the stocks of businesses making what drives consumption and employing the consumers and earning the profits that fund the investments core to economic growth are thus far up.

Why is it different this time? One could say “central banks.” Yes, today’s foremost Enron-like off-balance-sheet entities, central banks, have conspired to force people to overpay for most things in the name of helping us all. But they’re a supporting cast.

The main actors are nearer. This era in stocks, thanks to regulations implemented in 2007, is the first to depend almost entirely in the very short-term for prices from computerized systems tracking spreads in prices.

What motivates machines are small spreads. Virtu, with but one losing day from 2009-2014 often pockets peanuts. In one instance from the story, Virtu traded gold ETFs and futures 26 times and earned $36.

But Virtu trades securities from Africa to London sometimes five million times in a day. Its software sits in more financial markets (Bloomberg says 230 globally) than its employee headcount (148 as of Dec 2015).

I hear good things about Virtu from people I respect.  The point here isn’t to judge Virtu or fast trading but to explain why the market cannot, for now, be measured fundamentally. Last week, silver ETFs were top performers and gold and steel ETFs lagged most. It was excruciating hearing analysts trying to explain it rationally.

How stocks behave fits the low-spread phenomenon. The market is a daily life cycle from highs to lows and recoveries and vice versa. It’s a product of tiny spreads and small changes. Narrow gaps mean limited risk as automated trading systems search for ways to set prices between buyers and sellers.

Of course there must be buyers and sellers. The epic symbiosis of our era is high-speed trading and Asset Allocation. This is investing via apportionment such as indexes, exchange-traded funds and quantitative models. This money doesn’t assess prices but follows the map, bread crumbs dropped in enticing meager increments by machines.

Watching the steady march, stock-pickers then reach a nexus of fear and greed, taking the baton and carrying on even as the most ebullient bulls put pensive scratching fingers to noggins. Yesterday we tallied new Rational Prices indicating buying by Active money in nearly 20% of our client base. Fund managers are paid to invest and do, despite wariness.

Low volatility means not the absence of risk but that machines are in charge. Shares falter only when spreads become unmanageable as on May 6, 2010, August 24, 2015, and other manic gap episodes. Big gaps form on distortion among traded asset classes such as stocks, bonds, currencies, commodities and derivatives.

What causes unexpected distortions? If we knew, I’d be writing to you from Monaco. Here outside Austin as we visit family this week, I can only theorize from a decade modeling market behavior.  Distortions today form when the value assigned to any asset class in the future is wrong.  Derivatives are the weak link.

Options expirations for August start tomorrow. Sentiment is positive and stocks are rising, which means they’ll probably fall afterward. But there’s little risk. The machines are in charge. Volatility is low.

Now if you’ll excuse me, I want to get off the bridge over these placid waters.