Tagged: Volatility

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?


I like Thanksgiving.  We may not all always feel grateful for our circumstances, but an attitude of gratefulness is healthy, I’m convinced. So, happy Thanksgiving!

Karen and I will be feeling festively appreciative this year high in the Rockies, in Beaver Creek.

As November fades, markets seem ungrateful.  One Wall Street Journal article Friday noted that the majority of companies beating estimates this quarter underperformed. The author concluded that where investors before rewarded companies for exceeding expectations, now they have to offer rosier future views.

What data supports that contention?  There were no investors interviewed for the piece who said they dumped stocks like AMD, which was down 27% on results. Why would an investor lop 27% off returns in a day – gains earned by risking holding shares for months or longer?  It defies logic, and things defying logic should be scrutinized.

Only arbitragers profit when stocks fall – those betting on different prices for the same thing. High-speed traders, hedge funds that bet short, and market-makers for Exchange Traded Funds (ETFs).

Only one of these is ordered by regulators to engage in arbitrage. ETF market-makers.

Isn’t it extreme to say “ordered?” No. ETFs don’t work without an arbitrage mechanism because they don’t have intrinsic value.

ETFs are exempted by the SEC from the requirement in the Investment Act of 1940 to offer investors a single price for fund shares, and to make those shares redeemable in a proportionate chunk of the underlying pool of assets.

The SEC granted relief to creators of ETFs because there are two markets, two different prices for ETFs – fostering economic incentive to support them by buying low and selling high, so to speak.

Because ETFs are not redeemable – can’t be traded for money in a pool – market-makers have an unusually strong economic motivation to chase and foster big divergences.  They can trade ETF shares for stocks, and vice versa.

If money flows into the market and investors want to buy ETFs, market-makers gather up a collection of stocks to trade to firms like Blackrock for the right to create ETF shares.  They want stocks that are easy to buy or borrow or swap for, and ones that have outperformed or underperformed.

Why? Because stocks that have outperformed will be shed soon by Blackrock and other ETF creators, which can wash out associated capital gains by offering them as collateral to trade for ETF shares. So brokers might borrow them and then buy puts, knowing the likelihood that these stocks will be on the ETF chopping block soon is high.

Conversely, when stocks plunge in value, ETF market-makers will buy them to use as collateral for ETF shares that can be quickly marked up and sold at a profit.

Passive money dominated AMD around results. Same with ALGN, which also plummeted on results that beat expectations.  Both stocks were 50% or more short ahead of results.

Think of it this way:  Your stock is gold, and ETF shares are gold-backed dollar bills. Suppose gold could be acquired for half-price. If the currency stays the same, you make 50%.  So you really, really want to find cheap gold.

Whoever trades stocks sets the price. It’s not determined by who OWNS the stocks. Suppose investors stopped buying AMD and ALGN to study results. Smart market-makers for ETFs would detect the lack of normal buying and would sell and short them aggressively so the prices would fall.

Then they would scoop both up at depressed prices to supply to Blackrock in exchange for the right to create ETF shares – even ETF shares for safe-harbor value ETFs.

Stocks are collateral. Motivation for market-makers shuffling collateral around is not investing. It’s profiting on price-differences for the same thing.

This behavior is as we’ve said repeatedly far bigger than any form of fund-flows.  ETF creations and redemptions totaled $3.3 trillion through September this year, or more than $360 billion monthly.

I believe the data will show – it won’t be out until the last trading day this month – that there were ETF outflows in October for the third time this year (also in February and June, and in both months stock-market gains vanished, and in Feb stocks corrected), and the third time since the Financial Crisis.

The risk in a prolonged down market is that ETF shares and the value of collateral – stocks – are both declining simultaneously.  Market-makers can pick one and short it, or pick both and short both, in the hopes that if and when the market recovers, they get it right.

But if they’re wrong, the sheer size of ETF creations and redemptions says there’s not enough collateral to cover obligations. Today, VIX volatility bets are lapsing ahead of Thanksgiving to conclude a horrific Nov expirations cycle.

I think it’ll sort out. If not, the bull market could end. And a major contributor when that happens will be the all-out pursuit of collateral over investment by ETFs.

Blocking Volatility


As the market raged high and low, so did Karen and I this week, from high in the Rockies where we saw John Denver’s fire in the sky over the Gore Range, down to Scottsdale and the Arizona desert’s 80-degree Oct 30 sunset over the Phoenician (a respite as my birthday is…wait for it…Oct 31).

Markets rise and fall.  We’re overdue for setbacks.  It doesn’t mean we’ll have them, but it’s vital that we understand market mechanics behind gyrations. Sure, there’s human nature. Fear and greed. But whose fear or greed?

Regulators and exchanges are tussling over fees on data and trades.  There’s a proposed SEC study that’ll examine transaction fees, costs imposed by exchanges for trading. Regulation National Market System caps them at $0.30/100 shares, or a third of a penny per share, which traders call “30 mils.”

The NYSE has proposed lowering the cap to $0.10/100, or a tenth of a penny per share, or 10 mils. Did you know there’s a booming market where brokers routinely pay eight cents per share or $8.00/100 shares?

What market? Exchange-Traded Funds (ETFs).

We’re told that one day the market is plunging on trade fears, poor earnings, geopolitics, whatever. And the next, it surges 430 points on…the reversal of fears. If you find these explanations irrational, you’re not alone, and you have reason for skepticism.

There’s a better explanation.

Let’s tie fees and market volatility together. At right is an image from the iShares Core MSCI EAFE ETF (CBOE:IEFA) prospectus showing the size of a standard creation Unit and the cost to brokers for creating one.  Divide the standard Unit of 200,000 shares by the usual cost to create one Unit, $15,000, and it’s $0.08/share (rounded up). Mathematically, that’s 2,600% higher than the Reg NMS fee cap.

Understand: brokers provide collateral – in this case $12.5 million of stocks, cash, or a combination – for the right to create 200,000 ETF shares to sell to the public.

Why are brokers willing to pay $8.00/100 to create ETF shares when they rail at paying $0.30/100 – or a lot less – in the stock market?

Because ETF shares are created in massive blocks off-market without competition. Picture buying a giant roll of paper privately, turning it into confetti via a shredder, and selling each scrap for a proportionate penny more than you paid for the whole roll.

The average trade-size for brokers creating IEFA shares is 200,000 shares.  The average trade-size in the stock market where you and I buy IEFA or any other stock is 167 shares (50-day average, ModernIR data).  Do the math on that ratio.

ETF market-makers are pursuing a realtime, high-speed version of the corporate-raider model. Buy something big and split it into pieces worth more than the sum of the parts.

In a rising market, it’s awesome.  These creations in 200,000-share blocks I’ve just described are running at nearly $400 billion every MONTH. Create in blocks, shred, mark up. ETF demand drives up all stocks. Everybody wins.

What happens in a DOWN market?

Big brokers are exchanging your stocks, public companies, as collateral for the right to create and sell ETF shares.  Suppose nobody shows up to buy ETF shares.  What brokers swapped to create ETF shares is suddenly worth less, not more, than the shredded value of the sum of the parts. So to speak.

Without ETF flows to drive up it up, the collateral – shares of stocks – plunges in value.

The market devolves into desperate tactical trading warfare to offset losses. Brokers dump other securities, short stocks, buy hedges. Stocks gyrate, and the blame goes to trade, Trump, earnings, pick your poison.

How do I know what I’ve described is correct?  Follow the money. The leviathan in the US equity market today is creating and redeeming ETF shares. It’s hundreds of billions of dollars monthly, versus smatterings of actual fund-flows. You don’t see it because it’s not counted as fund turnover.

But it fits once you grasp the weird way the market’s last big block market is fostering volatility.

What’s ahead? If losses have been sorted, we’ll settle down in this transition from Halloween to November. Our data are still scary.  We may have more ghouls to flush out.

Reactively Passive

As stocks fell last week, pundits declared that interest rates and trade fears had shaken confidence. Yesterday as the Dow Jones Industrial Average zoomed 540 points, earnings, they declaimed, had brought investors rushing back. Oh, and easing trade tensions.

Didn’t we know corporate profits would be up 20% on tax cuts?

Rational factors affect stocks. But often these convenient explanations are offered afterward, and few observers seem to look at the data surrounding investment behavior.

The first image here with data from the Investment Company Institute’s 2018 Factbook shows the staggering shift from active to passive funds over the past decade. It debunks most market reporting claiming rational thought is reactively propelling markets.

A fallacy that lacks comprehension of how passive money behaves is that it rides the coattails of rational money (In fact Active investors are closet indexing with ETFs). If your stock is 1% of a weighted index fund, and shares rise faster than other components and become 1.2%, sooner or later the fund must rebalance or slip out of compliance.

If equities are meant to be 40% of a targICI Data from 2018 Factbook - Active to Passive shiftet-date fund and become 50%, the fund will rebalance.  We see the patterns, most times at month-ends and quarter-ends, and around monthly expirations when options, futures, forwards, repurchases and other derivatives used widely by investors, market-makers and fund managers must be recalibrated.

The biggest culprit is Exchange Traded Funds.

We’re told by Blackrock, Vanguard and State Street that ETFs have little turnover.  Should we believe money pours into markets but does nothing? It cannot simultaneously be true that trillions of dollars shift to ETFs and true that ETFs don’t invest it.

Unless ETFs don’t buy and sell things. In which case, what are ETFs?

I looked at the turnover rate in the last prospectus for SPY from State Street, the largest and oldest ETF. The fund says it bought or sold just 3% of its $242 billion of assets.

But turnover is footnoted: “Portfolio turnover rate excludes securities received or delivered from in-kind processing of creations or redemptions of units.”

Huh. Creations and redemptions?  We researched it (as you already know!).

Creations and redemptions, it turns out, are tax-free, commission-free, off-market block transactions between large brokers and ETF creators like Blackrock.  The broker supplies collateral such as stocks or cash and receives in-kind rights to create and sell ETF shares.

Then trillions of investment dollars buy these collateralized stock substitutes, setting stocks afire. If investors sell ETFs, brokers buy and return them to Blackrock to get collateral back. Wash, rinse, repeat.

Blackrock makes money as the rush of investors into ETFs drives up the value of the underlying collateral (gotten by brokers where?), and by minimizing taxes.

For instance, under rules for ETFs, if your stock has gone way up, Blackrock will put your shares in the redemption basket to trade for an equal value of ETF shares from, say, Morgan Stanley, which then can sell and short your stock, which plunges.

Blackrock sheds associated capital gains.  Morgan Stanley at some future point will cover or buy your shares and return them to Blackrock for the right to create more ETF shares offering exposure to – whatever, the S&P 500, a sector ETF, a market-cap ETF.

These transactions are occurring in the hundreds of billions of dollars monthly, none of it recorded as fund turnover.

If creations and redemptions were counted for SPY, its turnover rate would be 165%, not 3%. SPY created and redeemed well more than $400 billion, nearly double its total assets, in the most recent full year.

As of Aug 2018, nearly $2.9 TRILLION of these transactions has occurred – all effectively commission-free and tax-free for Blackrock, Vanguard and State Street (but not for the end consumers of ETFs, who pay taxes and commissions).

Continually, brokers try to profit on differing prices for collateral and ETF shares, and ETF managers try to wash out capital gains, removing overvalued collateral and bringing in undervalued collateral (the reason you and peers diverge).

The relentless creation/redemption tides swing stocks, and human beings then cast about for explanations like interest rates or trade fears – or wait, trade fears have eased! The market rallies!

Tech Sector behaviors Sep-Oct 2018This is what it looks like in the Tech sector. We saw the same pattern at the same time in every GICS sector to varying degrees, the most in Materials (down 10%), the least in Utilities (down less than 2% the past five days).

The last time the market rebalanced was in early July, the first part of the third quarter of 2018.  Our Sentiment Index dipped below 4.0, a market bottom.  We observed no meaningful rebalancing again in July, or August, or September. Each time the market mean-reverted to 5.0 without turning negative, we warned of compounding imbalances.

Market Sentiment was about 4.0, a bottom, Oct 15, after topping Sep 26. Into expirations today through Friday, we expected a strong surge because all the stuff that was overweight is now underweight (the surge arrived a day early, before VIX expirations).

These cycles tend to shorten as markets break down. We had six bottoms in 2015, the last time the market was negative for the year. This is the third for 2018 after just one in 2017. Aging bull market?

Three Ways

Jakob Dylan (he of Pulitzer lineage) claimed on the Red Letter Days album by the Wallflowers that there are three ways out of every box.  Warning: Listen to the song at your own risk. It will get in your head and stay there.

Something else that should get in the heads of every investor, every executive and investor-relations professional for public companies, is that there are three ways to make money in the stock market (which implies three ways to lose it too).

Most of us default to the idea that the way you make money is buying stuff that’s worth more later. Thus, when companies report results that miss by a penny and the stock plunges, everybody concludes investors are selling because expectations for profits were misplaced so the stock is worth less.

Really? Does long-term money care if you’re off a penny? Most of the time when that happens, it’s one of the other two ways to make money at work.

Take Facebook (FB) the past two days.

“It’s this Cambridge Analytica thing. People are reconsidering what it means to share information via social media.”

Maybe it is.  But that conclusion supposes investors want a Tyrion Lannister from Game of Thrones, a mutilated nose that spites the face. Why would investors who’ve risked capital since New Year’s for a 4% return mangle it in two days with a 9% loss?

You can buy stocks that rise in value.  You can short stocks that decline in value. And you can trade the spreads between things. Three ways to make money.

The biggest? We suppose buying things that rise dominates and the other two are sideshows.  But currently, 45% of all market trading volume of about $300 billion daily is borrowed. Short.  In January 2016, shorting hit 52% of trading volume, so selling things that decline in value became bigger than buying things that rise.  That’s mostly Fast Trading betting on price-change over fractions of seconds but the principle applies.

Facebook Monday as the stock plunged was 52% short. Nearly $3 billion of trading volume was making money, not losing it.  FB was 49% short on Friday the 16th before the news, and Overbought and overweight in Passive funds ahead of the Tech selloff.

The headline was a tripwire but the cause wasn’t investors that had bought appreciation.

But wait, there’s a third item. Patterns in FB showed dominating ETF market-making the past four days around quad-witching and quarterly index-rebalances. I say “market-making” loosely because it’s a euphemism for arbitrage – the third way to make money.

Buying the gaps between things is investing in volatility. Trading gaps is arbitrage, or profiting on price-differences (which is volatility).  ETFs foster arbitrage because they are a substitute for something that’s the same: a set of underlying securities.

Profiting on price-differences in the same thing is the most reliable arbitrage scheme. ETF trading is now 50% of market volume, some from big brokers, some from Fast Traders, nearly all of it arbitrage.

FB was hit by ETF redemptions.  Unlike any other investment vehicle, ETFs use an “in-kind exchange” model. Blackrock doesn’t manage your money in ETFs. It manages collateral from the broker who sold you ETF shares.

To create shares for an S&P 500 ETF like IVV, brokers gather a statistical sampling of S&P stocks worth the cost of a creation basket of 50,000 shares, which is about $12 million. That basket need be only a smattering of the S&P 500 or things substantially similar. It could be all FB shares if Blackrock permits it.

FB is widely held so its 4% rise means the collateral brokers provided is worth more than IVV shares exchanged in-kind. Blackrock could in theory make the “redemption basket” of assets that it will trade back for returned IVV shares all FB in order to eliminate the capital gains associated with FB.

So brokers short FB, buy puts on FB, buy a redemption basket of $12 million of IVV, and return it to Blackrock, receive FB shares, and sell them. And FB goes down 9%.  The key is the motivation. It’s not investment but arbitrage profit opportunity. Who benefited? Blackrock by reducing taxes, and brokers profiting on the trade. Who was harmed? Core FB holders.

This is 50% of market volume. And it’s the pattern in FB (which is not a client but we track the Russell 1000 and are building sector reports).

The next time your stock moves, think of Jakob Dylan and ask yourself which of the three ways out of the equity box might be hitting you today. It’s probably not investors (and if you want to talk about it, we’ll be at NIRI Boston Thursday).

Green and Purple

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.

Collateral Recovery

Who remembers EF Hutton?

When EF Hutton talks, people listen.  That slogan crafted by Hutton’s William Clayton, who died in 2013, and now-defunct advertising agency Benton & Bowles, wasn’t about a man but a firm. Ads ran in the 70s and 80s where characters would shout “EF Hutton!” over a din, and all clamor would stop as people leaned in to hear.

Edward Francis Hutton died in 1962. But his firm touched history via its brand, its merger with Shearson Lehman, and its subsequent mutations through Smith Barney, Citigroup and Morgan Stanley. The name lives today, in fact, through HUTN Inc., which owns the EF Hutton moniker.

In a sense the Hutton Effect today in capital markets is Amazon. Every time Amazon speaks, the market holds its breath.  From athletic apparel, to groceries, to pharmaceuticals and healthcare, the market has stopped midsentence, transfixed. Investors realize Amazon is so leviathan (searching for a synonym for “Amazon”) that it can sway the fortunes of industries.

Another mammoth in our midst seems to go unnoticed, a sort of antonym to EF Hutton and Amazon. Exchange Traded Funds.

NOTE: I’m on a panel tomorrow for the NIRI Virtual Chapter on Passive vs Active Investing and will serve as warmup or foil Thursday Feb 22 for NIRI CEO Gary LeBranche here in Denver at the Rocky Mountain chapter, on ETFs.  We’ll talk about ETFs.

ETFs have been loud about attracting $4.8 trillion of global assets and 50% of US trading volume, but dead quiet about what they really do. Were sellers of groceries thrown in a pit with a hulking sword-swinging Amazon, the cries would be shrill. A market tossed together with this beast called ETFs offers not a whimper, let alone a silence-deafening EF Hutton listen.


I’ve come to an answer.  We know how Amazon works.  Whatever you think of the Bezosian Beast, we understand its manners.  It’s among us without guile.

But I don’t think investors and public companies get what ETFs do. They are a permeating market presence of epochal significance and yet an idea persists that their influence is invisible. It’s not true with Amazon, or ETFs.

Suppose ETFs through the use of collateral drove these recent gyrations?  There’s a swamp around the way they work. Read the prospectus – not the summary but the full document – for SPY. Tell me what you learn.  Half of it is about taxes.

But I know this: ETFs don’t invest your money. They manage collateral. Big investors gather up shares in large blocks from who knows where, because there’s no transparency, and exchange them for ETF shares.

They then sell those ETF shares at a profit. Don’t believe me? Read an ETF prospectus.  What’s this got to do with market volatility?  Suppose big investors had pledged stocks belonging to others as collateral to gain access to ETF shares expected to rise in value – and then the collateral dropped sharply in value.

They’d have to sell assets to raise money to buy ETF shares to trade back for collateral that might well belong to somebody else (never pledge the mob’s donkey on your personal horse race).

Boy would that process produce volatility if it were Amazonian in scope. And volatility was leviathan. Collateral damage.

Theorizing this way, we warned clients last week (as those of you reading know): If this is sorting out who owns what, we’ll take a hit Tue-Wed Feb 20-21.

Okay, well, that happened yesterday.  A glancing blow but it was there. If collateral is sorted out, markets zoom anew now. If not, you’ll see trouble again today.

Lesson? We can see what Amazon is doing. ETFs are another story.  We don’t know what they use for collateral. That alone should make us more watchful. ETFs don’t behave like EF Hutton stilling the noisy room.

So stay tuned. If this is a collateral recovery, confidence may be shaken. And we all need to understand the Amazon of the capital markets, ETFs.

Vapor Risk

One definition of “volatile” is “passing off readily in the form of vapor.”

Through yesterday, XIV, the exchange-traded security representing a one-day swap from Credit Suisse and offered by VelocityShares, had seen 94% of its value vaporized. It triggered a technical provision in the fund’s prospectus that says Credit Suisse may redeem the backing notes if the fund loses more than 80% of its value. It’s shutting down.

By mixing exposure to futures and other derivatives of varying lengths tied to the S&P 500, XIV aims to let investors capture not the appreciation of stocks or their decline if one shorted them, but instead the difference between current and future prices. Volatility.

The fund says in sternly worded and repeating fashion things like: The ETNs are riskier than securities that have intermediate or long-term investment objectives, and may not be suitable for investors who plan to hold them for longer than one day.

The idea for investors is hitting the trifecta – long rising stocks, short falling stocks, and with things like XIV, capturing the difference between prices to boot.

The problem for “synthetic” exchange-traded notes (ETNs) like XIV backed by a Credit Suisse promissory note is they hold no assets save commitment to replicate an outcome. They are for all intents and purposes vapor.

They have proved wildly popular, with several volatility ETNs routinely in the top 25 most actively traded stocks. In a low-volatility environment, differences in prices between short-term and long-term options and futures can mean returns of 5-10% on a given day, without particular risk to either party.

But if volatility renders futures and options worthless because prices have changed too much, all the investor’s capital vanishes.

Is this what rocked stocks globally? No. There is, however, a lesson about how global financial markets work that can be drawn from the demise of XIV.  Everyone transfers risk. Investing in volatility is in a sense a hedge against being wrong in long and short positions. If you are, you still make money on the spread.

The biggest risk-transfer effort relates to currencies and interest rates. As with stocks, the transference of unexpected fluctuations through swaps – which the Bank for International Settlements says have $540 trillion of notional value (but precious little actual value, rather like XIV) – only works if the disturbances are small.

In the past month, the US Treasury was laying in dry powder before the debt ceiling. The size of auctions exploded by about 50%. Getting people to buy 50% more of the same thing caused interest rates to shoot up. The rise in debt devalued the dollar, a double whammy. Hedges fell apart.

Counterparties for these hedging swaps also transfer the risk, often with short-term Exchange-Traded-Fund (ETF) or ETN hedges that lapse on Fridays. They are the same banks like Credit Suisse making markets in stocks. This is what caused stocks to swoon, not a strong jobs number or higher wages. On Friday, Feb 2, stocks imploded. I suspect counterparties were selling assets to cover losses.

Now we come to a warning about ETFs. Their original creators, who were in the derivatives business, likened ETF shares to commodity warehouse receipts, a representation of something physically residing elsewhere.

In this long bull market, money has poured into ETFs. The supply of things in the warehouse has not kept pace with the exposure to it via ETFs.  We have written over and over about this problem. The way ETFs trade and the way underlying assets increase or decrease are two different processes.  Investors buy and sell the warehouse receipts. The fund and its Authorized Participants in large block transactions occasionally adjust underlying warehouse assets.

We can see by tracking the amount of money flowing to big ETFs from Blackrock, Vanguard and State Street and counter-checking those flows against reported fund turnover that insufficient warehouse commodities (stocks) back ETF shares.

Why? Because buying and selling things incurs transaction costs and tax consequences, which diminishes fund performance. Shaving those is a gutsy strategy – sort of like dumping fuel in a car race to give yourself an advantage in the last flaps by running light and on fumes.

But you can run out of fuel. If the value of the stuff in the warehouse plunges as everybody tries to sell, we’ll find out what part of those warehouse receipts are backed by vapor.

So far that has not happened. But we don’t know what damage has been done to market makers short ETF shares and long stocks or vice versa. The next week will be telling. If a major counterparty was irreparably harmed, we could be in a world of vapor.

If not, the hurt will fade and we’ll revert to normal. Right now, forecasts for stocks in our models say vapor risk is small. But let’s see what happens come Friday, another short-term expiration for derivatives.

Currency Volatility

 We interrupt the white-hot arc of the stock market for this public-service announcement: Watch the dollar.

While any number of factors might be selected as reason for the DJIA’s 360-point drop yesterday, one macro factor correlates well: The relative buying power of the US dollar, the world’s reserve currency.

Give me two minutes, and I’ll show you.

Sure, one can say the market is due for a pullback. But randomly? Donald Trump’s first inaugural address is an easy target. Do we call investors schizophrenic if the market regains yesterday’s losses today or tomorrow?

How the US dollar fares versus other global currencies remains a barometer for US stocks. It’s been especially true since 2008 because the Financial Crisis marked a stark turn for central banks toward coordinated global policy.

But all the way back to 1971 when the United States left the gold standard for the 20th century’s version of a cryptocurrency experiment, a floating-rate dollar, shocks to equities trace to gyrations in the currency (the economy’s risk assets like stocks and bonds have replaced gold as the backing commodity but that’s another story).

Black Monday, the October 19, 1987 global stock crash that hacked 508 points or 23% of blue-chip value off the Dow Jones Industrial Average (DJIA) followed a stretch of currency volatility (and interest-rate volatility as the two are intertwined).

For perspective, the DJIA lost a greater number of points just now, Jan 29-30 (533), than it did Oct 19, 1987 (508). Heights today are so lofty that past ravines are wrinkles.

The collapse of the Internet Bubble in 2000 came after a sharp acceleration for the dollar on rate hikes by Fed chair Alan Greenspan to slow what he famously called “irrational exuberance.” He recognized the stock market reflected inflation, which as Milton Friedman said, is always and everywhere a monetary phenomenon.

Inflation is more money than an economy can readily deploy, not rising prices, which is a consequence. Stuffing money into economies is like squeezing a balloon. You don’t know where the air pockets will form.  Prices rise, but not always how or where central bankers suppose.

On May 6, 2010, market seams split fleetingly in the Flash Crash, the DJIA first plunging down and then bucking back up about a thousand points.  Before it, volatility was rattling the euro/dollar trade, a product of 2009’s massive “quantitative easing” by the Federal Reserve as the US central bank gave the global money balloon a giant squeeze and the dollar went into a steep dive.

In latter August 2015 the DJIA lost more than 6% over a series of days following a sudden currency-devaluation in China that tripped the delicate global balance.  And remember the Fed’s first post-crisis rate hike – a buck-booster – in Dec 2015? Near catastrophe for stocks (most for energies as oil plunged when the dollar rose) in January 2016.

We come to yesterday. What came before it? Last week the dollar plummeted about 3% as traders interpreted comments by US Treasury Secretary Steven Mnuchin to mean he wanted a weaker dollar.

Sure, there’s a sort of Clockmaker God quality to the idea that if we can pan back in the mind’s eye, the financial markets are all perched atop a giant dollar bill that occasionally flutters and spills something into the abyss.

On the other hand, it could be fixed. The dollar, that is. If the dollar wasn’t always fluctuating, we could better concentrate on, say, saving more, or investing capital without worrying about the corrosive effects on returns of a depreciating currency.

So, Jay Powell.  You’ll be steering the Fed after Janet Yellen bids us adieu this week. Imagine how much easier everything would be if the dollar wasn’t one of the things gyrating like stock-prices.