Tagged: SPY

Can It Last?

It’s the number one question.  Tack “how long” on the front.

I’m asked all the time: “Tim, do you think the stock market is sustainable? Are fundamentals driving it or is this a bubble? Stock buybacks?  The Fed is behind it, right? Isn’t bitcoin proof of irrational exuberance?”

And everybody with an opinion is asked, and answers. I’ve offered mine (read The 5.5 Market from last week) and I’ll add today what we’ve further learned about the behavior of money.

Speaking of money, Karen and I joke that we miss the recession. Hotels were a bargain.  They gave you free tickets to shows if you just came to Las Vegas. Vacations were affordable (I’m not making light of great stock returns but if we give it all back, how is that helpful?).

Now suppose at the same time interest rates would rise. People and companies with too much debt would suffer, sure. But society would save money and take on less debt. That’s what higher interest rates encourage. From Hammurabi in Babylon until fairly recently we understood this to be the formula for prosperity.

“Quast, do you know nothing about contemporary behavioral economics? What kind of idiot would think it’s better to save money and avoid debt?  Economists agree that debt and spending drive the global consumption economy.”

Ask your financial advisor if you should borrow money and spend more, or save money and invest it.  So how come the Federal Reserve encourages borrowing and spending?

Recessions have purpose – and they’re packed with opportunity!  Seriously. They reset the economic calculus.

I’ll give you an example from the Wall Street Journal yesterday, which reported that here in Denver we have 16,000 vacant metro apartments, most in the luxury category. And 22,000 more are being built. Since they’re unaffordable, the city has launched a program to subsidize rents.

This is the kind of warped outcome one gets from promoting debt and spending, and it’s influencing our stock market too. I’m not the least worried because I know boundless opportunity awaits when prices reset, and that’s the right way to see it.  Warren Buffett said it’s unwise to pay more for a thing than it’s worth.  All right, I look forward to attractive prices ahead.

And prices are products of the behavior of money.  Last week we described how the market could not correctly be credited with rational valuation because stock-picking was not the principal behavior. Over the past ten years, all the NET new inflows into US equities have gone to index and exchange-traded funds. They follow a benchmark. They don’t pick stocks.

They also rarely sell them. If things are bought and not sold, prices rise.  There is a paucity of stocks for sale. In its 2016 prospectus for the S&P 500 ETF SPY, State Street said its turnover – proportion of holdings bought and sold – was 4%.  The fund that year, the latest available, had $197 billion in net asset value. Four percent is about $8 billion.

Yet SPY traded $25 billion daily in 2016 (still does!), about three times the entire annual fund turnover. Explanation? Right there on page 2 of the prospectus: The Trust’s portfolio turnover rate does not include securities received or delivered from processing creations or redemptions of Units.

On page 30 we learn this:  For the year ended September 30, 2016, the Trust had in-kind contributions, in-kind redemptions, purchases and sales of investment securities of $177,227,631,568, $167,729,988,725, $7,783,624,798, and $6,444,954,759, respectively.

Translating to English, it means brokers called Authorized Participants created $177 billion worth of new ETF shares by exchanging assemblages of stocks for them that were not counted as sales by SPY. It counted sales of only about $8 billion – as I said above.

The functional turnover rate for SPY is closer to 100%. If it really was, the market would be volatile. Prices would fall as shares hit the market. SPY drives 10% of the entire stock market’s dollar volume.

But what trades is ETF shares. The creation and redemption process occurs away from the market in some secretive block-transaction fashion that means the natural buying or selling that would otherwise be done is not happening.

Selling lowers prices. The absence of selling, the replacement of selling with trading in ETF shares predicated primarily on price-differences – arbitrage – produces a market that relentlessly rises with very little volatility.

And which notably means investors don’t actually own anything when they buy ETF shares. If they did, that $177 billion SPY exchanged for ETF shares would carry a taxable ownership interest, and transaction costs. It doesn’t.

Think about that.

When the recession comes because of this bizarre displacement of actual buying and selling by derivatives, I look greatly forward to all the bargains, the affordable vacation homes in desirable places, the cheap stocks, and the free show tickets in Las Vegas.

I just can’t tell you when. The wise are always prepared.

Hedging Bets

We’re in Steamboat Springs this week watching the moose on the snowbanks and letting the world slow down with them for a bit. 

It sets me to thinking. “Hedge funds would be better off doing nothing.”  So postulated (requires subscription) Wall Street Journal writer Laurence Fletcher last week after data from Chicago hedge-fund researcher HFR Inc. showed stock-betting funds that as a group manage about $850 billion lost money in 2016. 

You’re tempted to smirk. The smartest folks in the room can’t beat an algorithm! They can’t top the S&P 500 index fund your 401k owns.  Losers!   

Let’s rethink that perspective.  These are the professional athletes of finance. The New England Patriots of investing. If the best are failing, the ones sorting good companies from bad and chasing them either direction, then maybe we’re missing the real problem. 

Perhaps it’s not that hedge funds are losing but that the market isn’t what it seems.

And if hedge funds are confusing busy with productive, might we be too? The investor-relations profession shares common ground with them.  Great effort and time go into telling the story so it resonates. Hedge funds come at a cost because they’re ostensibly better at sorting fact from fiction. Both disciplines are about standing out.

Apple stands out for instance, touching a 52-week high yesterday following resurgent growth. Yet as my friend Alan Weissberger at fiendbear.com notes, Apple earned $8 billion less in 2016 than the year before and spent $20 billion buying back stock.

People are buying its future, is the retort. If by that one means paying more for less since it’s likely AAPL will continue to consume itself at better than 5% per annum, then yes. But that’s inflation – more money chasing fewer goods.

I’m not knocking our epochal tech behemoth. It’s neither pulp fiction nor autobiography to the market. AAPL is its pillar. Models aren’t weighing mathematical facts such as its 5.5 billion shares of currency out, 15% less than three years back. But who’s counting? Not SPY, the most actively traded stock, an exchange-traded fund and AAPL its largest component.

If the models needing AAPL buy it, the whole market levitates in a weird, creaking, unsteady way.  This is what hedge funds have missed. Fundamentals are now back seat to weighting. If you pack weight, the cool kids of the stock market, you rise. When you’re out of the clique, you fall.  Your turn will continually come and go, like a chore schedule.

Hedge funds are also failing to realize that there is no “long only” money today.  Not because conventional longs are shorting but because the whole market is half short – 48% on Feb 6. One of our clients was short-attacked this week with short volume 23% below the market’s average. We doubt the shorts know it. 

Hedge funds are chasing the market because they don’t understand it anymore. No offense to the smartest folks in the room. They’re confusing busy with productive, spending immense sums examining business nuances when the market is a subway station of trains on schedules.

There are two lessons here for investor-relations folks and by extension executives of public companies and investors buying them.  IR people, learn by observation. Don’t be like hedge funds, failing to grasp market structure and getting run over by the Passive train.  Learn how the market works and make it your mission to weave it into what you tell management. Structure trumps story right now.

Second, hedge funds show us all that there’s a mismatch between the hard work of studying markets and how they’re behaving.  Either work, smarts and knowledge no longer pay, or there’s something wrong with the market.  Which is it? 

Stay tuned! We’ll have more to say next time.   

Weighing Options

There’s no denying the connection between tulips and derivatives in 1636.

The Dutch Tulip Mania is often cited as the archetype for asset bubbles and the madness of crowds. It might better serve to inform our understanding of derivatives risk. In 1636, according to some accounts, tulip bulbs became the fourth largest Dutch export behind gin, herring and cheese. But there were not enough tulips to meet demand so rights were optioned and prices mushroomed through futures contracts. People made and lost fortunes without ever seeing a tulip.

While facts are fuzzy about this 17th century floral fervor, there’s a lesson for 2016 equities. Grasping the impact of derivatives in modern equities is essential but options are an unreliable surveillance device for your stock.

I’ll explain. ModernIR quantifies derivatives-impact by tracking counterparty trade-executions in the percentage of equity volume tracing to what we call Risk Management. We can then see why this implied derivatives-use is occurring.

For instance, when Risk Management and Active Investment are up simultaneously, hedge funds are likely behind buying or selling, coupling trades with calls or puts. If Risk Management is up with Fast Trading, that’s arbitrage between equities and derivatives like index options or futures, suggesting rapidly shifting supply and demand (and therefore impending change in your share-price). Options won’t give you this linkage.

Dollar-volumes in options top a whopping $110 billion daily. But 70% of it is in ETFs.  And almost 48% ties to options for a single ETF, the giant SPY from State Street tracking the S&P 500.

As Bloomberg reported January 8, SPY is a leviathan instrument. Its net asset value would rank it among the 25 largest US equities, ahead of Disney and Home Depot. It trades over 68 million shares daily, outpacing Apple. It’s about 14% of all market volume.  Yet trading in its options are 48% of all options volume – three times its equity market-share.

Why? Bloomberg’s Eric Balchunas thinks traders and investors are shifting from individual equity options where demand has been falling (further reason to question options for surveillance) into index options. SPY is large, liquid and tied to the primary market benchmark.

Bigger still is that size (pun intended) begets size, says Mr. Balchunas. Money has rushed – well, like a Tulip Mania – into ETFs. Everyone is doing the same thing. And just a handful of firms are managing it.  Bloomberg notes that Blackrock, Citigroup, Goldman Sachs and Citadel are the biggest holders of SPY options. Three of these are probably authorized participants for ETFs and the fourth is the world’s largest money manager and an ETF sponsor.

Mr. Balchunas concludes: “The question is how much more liquidity can ETFs drain from other markets—be they stocks, commodities, or bonds—before they become the only market?”

SPY options are an inexpensive way to achieve exposure to the broad market, which is generally starved for liquidity in the underlying assets. As we’ve written, ETFs are themselves a substitute for these assets.

The problem with looking at options to understand sentiment, volatility and risk is that it fails to account for why options are being used – which manifests in the equity data (which can only be seen in trade-executions, which is the data we’ve studied for over ten years).  If Asset-allocation is up, and Risk Management is up, ETFs and indexes are driving the use of derivatives. These two behaviors led equity-market price-setting in 2015. If you were reporting changes in options to management as indications of evolving rational sentiment, it was probably incorrect.

In the Tulip Mania, people used futures because there was insufficient tulip-bulb liquidity. The implied demand in derivatives drove extreme price-appreciation. But nobody had to sell a bulb to pop the bubble. It burst because implied future demand evaporated (costing a great lost fortune).

Options expire tomorrow and Friday, and next Wednesday are VIX expirations (two inverse VIX ETNs, XIV and TVIX, traded a combined 100 million shares Tuesday). Vast money in the market is moving uniformly, using ETFs and options to gain exposure to the same stocks. This is why broad measures don’t yet reflect the underlying deterioration in the breadth of the market (the Russell 2000 this week was briefly down 20% from June 2015 highs).

And now you know why. People tend to frolic in rather than tiptoe through the tulips. Be wary when everybody is buying rights.