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ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

Let me frame that statement with backstory. I consider it our mission to help you understand market behavior. The biggest currently is arbitrage – taking advantage of price-differences. Insert that phrase wherever you see the word.  We mean that much of the money behind volume is doing that.  Yesterday eleven of the 25 most active stocks were Exchange-Traded Funds (ETFs). Four were American Depositary Receipts (ADRs).

Both these and high-frequency trading turn on taking advantage of price-differences. Both offer the capacity to capitalize on changing prices – ADRs relative to ordinary-share conversions, and ETFs relative to the net asset value of the ETF and the prices of components. In a sense both are stock-backed securities built on conversions.

For high-speed traders, arbitrage lies in the act of setting prices at different markets. Rules require trades to match between the best bid to buy and offer to sell (called the NBBO). Generally exchanges pay traders to sell and charge them to buy.

In fact, the SEC suspended an NYSE rule because it may permit traders to take advantage of price-differences (something we’ve long contended). We’ll come to that at the end.

Next, ETFs are constructed on arbitrage – price-differences. Say Blackrock sponsors an ETF to track a technology index. Blackrock sells a bunch of ETF shares to a broker like Morgan Stanley, which provides Blackrock with either commensurate stocks comprising the tech index or a substitute, principally cash, and sells ETF shares to the public.

If there’s demand, Morgan Stanley creates more ETF shares in exchange for components or cash, and then sells them. Conversely, if people are selling the ETF, Morgan Stanley buys the ETF shares and sells them back to Blackrock, which pays with stocks or cash.

The trick is keeping assets and stock-prices of components aligned. ETFs post asset positions daily. Divergences create both risk and opportunity for the sponsor and the broker alike. Blackrock cites its derivatives-hedging strategies as a standard risk associated with ETF investing. I’m convinced that a key reason why ETFs have low management fees is that the components can be lent, shorted, or leveraged with derivatives so as to contribute to returns for both the sponsor and the broker.

On the flip side, if markets are volatile as they have been post-Brexit and really since latter 2014, either party could lose money on unexpected moves. So both hedge.

For arbitragers, a perfect market is one with little direction and lots of volatility. Despite this week’s move to new market highs, there remains statistically little real market movement in the past two years. If a market is up or down 2% daily, does it over time gain, lose or stay the same?

Run it in Excel. You’ll see that a market declines over time. Thus arbitragers short securities using rapid tactics to minimize time-decay. If you want a distraction, Google “ETF arbitrage shorting” and read how traders short leveraged ETFs to make money without respect to the market at large.

In fact, this is the root problem: Taking advantage of price-differences is by nature a short-term strategy. Sixteen of the most actively traded 25 stocks yesterday (64% of the total!) were priced heavily by arbitrage, some by high-speed traders and some by investors and the market-makers for ETFs.

Offering further support for arbitrage ubiquity, the market is routinely 45-50% short on a given day. Short volume this week dipped below 45% for the first time since December, perhaps signaling an arbitrage squeeze and certainly offering evidence that arbitragers hate a runaway market.

If the market rises on arbitrage, it means parties SUPPLYING hedges are losing money. Those are big banks and hedge funds and insurance companies. Who’d take the market on a run to undermine arbitrage that’s eating away at balance sheets (big banks and hedge funds have suffered)?  Counterparties.

In our behavioral data Active investment is down and counterparties have been weak too, likely cutting back on participation. That comports with fund data showing net outflows of $70-$80 billion from US equities this year even as the market reverts to highs. The only two behaviors up the past 50 trading days are Fast Trading (arbitrage) and Asset Allocation (market-makers and brokers for ETFs and other quantitative vehicles). Yet more evidence. And both are principally quantitative.

Assemble these statistics and you see why the market seems oblivious to everything from US racial unrest, to a bankrupt Puerto Rico, to foundering global growth and teetering banks.  The market is running on arbitrage.

What’s the good news, you ask?  The SEC is aware of rising risk. It suspended an NYSE rule-filing on fees at the exchange’s Amex Options market after concluding the structure may incentivize arbitrage.  The SEC is scrutinizing leveraged ETFs and could end them.

But most important is the timeless self-regulation of knowledge. If we’re all aware of what’s driving the market then maybe the arbitragers will be their own undoing without taking the rest of us with them.

Janus ETFs

Everybody adapts, including institutional investors like Janus.

Rattle off a top-ten list of the best active stock pickers visited by teams of company execs and investor-relations pros trundling through the airports and cities of America, and Denver’s Janus likely makes the cut.

Ah, but.  In 2014 Janus bought VelocityShares, purveyor of synthetic exchange-traded products.  Just as a drug manufactured in a laboratory rather than from the plant that first formed its mechanism of action is a replica, so are these lab-made financial instruments. They replicate the act of investment without actually performing it.

It’s neither good nor bad per se, as I explained yesterday to the NIRI San Diego chapter. But synthetics are revolutionizing how public stocks trade – without owning public stocks. Describing its effort at adaptation, Janus says on its website that it’s “committed to offering distinctive strategies for today’s complex market environment. Leveraging almost a half century of investment experience, we are now pleased to make our expertise available through Exchange Traded Funds.”

Janus says it’s intending to offer a range of returns beyond simple capital-appreciation, including “volatility management” and “uncorrelated returns.” Janus’s VelocityShares directed at volatility aim to produce enhanced or inverse returns on the VIX, an index called the “fear gauge” for reflecting volatility in forward rights to the S&P 500.

But traders and investors don’t fear volatility. They invest in it.  On Monday May 16, four of the top 20 most actively traded stocks were exchange-traded products leveraging the VIX.  Those offered by Janus aren’t equity investments but a debt obligation backed by Credit Suisse. Returns derive from what is best described as bets using derivatives.

The prospectus for the most active version is 174 pages, so it’s hard to decipher the nature of wagers. It says: “We expect to hedge our obligations relating to the ETNs by purchasing or selling short the underlying futures, listed or over-the-counter options, futures contracts, swaps, or other derivative instruments relating to the applicable underlying Index…and adjust the hedge by, among other things, purchasing or selling any of the foregoing, at any time and from time to time, and to unwind the hedge by selling any of the foregoing, perhaps on or before the applicable Valuation Date.”

Got that?  Here’s my attempt at translation: “We’ll do the exact opposite of whatever return we’ve promised you, to keep from losing money.”

During the mortgage-related financial crisis there was a collective recoil of horror through media and into Congress that banks may have been betting against their clients. Well, come on.  It’s happening in equities every day!  Exactly how do we think somebody who says “sure, I’ll take your bet that you can make double the index without buying any assets” can possibly make good without farming the risk out to someone else?

In the mortgage crisis we learned about “credit default swaps” and how insurers like AIG were on the hook for hundreds of billions when real estate stopped rising. Who is on the hook for all these derivatives bets in equities if stocks stop rising? It’s the same thing.

Last Friday the 13th, five of the top 20 most actively traded instruments on the Nasdaq and NYSE were synthetic exchange-traded products attempting to produce outsized returns without correlating to the market. That’s 25% of the action, in effect.

For stock-picking investors and public companies it means a significant contingent of price-setting trades in the stock market are betting on moves uncorrelated to either fundamentals or markets. You’ll find no explanation in ownership-change.

What do you tell management and Boards about a market where, demonstrably, top price-setting vehicles like TVIX owned by conventional stock-pickers aren’t buying or selling stock but betting on tomorrow’s future values using derivatives?

In fact, everyone is betting against each other – traders, banks, investors. I take you back to the mortgage-backed securities crisis. The value of underlying assets was massively leveraged through derivatives the values of which bore no direct connection to whether mortgages were performing assets.  That by any definition is credit-overextension. A bubble.  A mania. Then homes stopped appreciating. The bubble burst two years later.

Look at stocks. They’ve not risen since Nov 2014. Is anyone out there listening or paying attention to the derivatives mess in equities?

ETFs and Divine Creation and Redemption

There’s a saying: It’s easier to keep the cat in the bag than to get it back in there once you’ve let it out. Nobody is likely to stuff the Exchange Traded Fund (ETF) cat back in the bag.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea. (more…)

Snapped

SNAP broke yesterday. I’ll explain two reasons why.

Yes, the company blew the quarter. Dramatic swings in guidance don’t instill joy.

But the losses occurred before anybody talked about them.  SNAP closed Monday at $22.47 and opened Tuesday for trading at $14.49 and closed at $12.79.

It lost 36% when most couldn’t trade it and shed just $1.30 during official market hours.

Illustration 135866583 © Jm10 | Dreamstime.com

How is that fair?

Regulations are meant to promote a free, fair and open stock market. I think premarket trading should be prohibited because it’s not a level playing field.

Who’s using it? Big institutions with direct access to brokers who operate the markets running around the clock. Hedge funds could dump shares through a prime broker, which instantly sells via so-called dark pools.

And the hedge funds could buy puts – and leverage them – on a whole basket including the stock they dumped, peers, ETFs, indices.  All outside market hours.

Something unfair also happens DURING market hours. I’ll explain with my own experience as a retail trader using our decision-support platform, Market Structure EDGE.

It’s not that my trade was unfair.  I understand market structure, including how to use volatility, trade-size, liquidity and stock orders to best effect.  I made money on the trade.

But it’s instructive for public companies, traders, investors.

I sold 50 shares of NXST. Small trade, with a reasonable return. I pay a modest commission at Interactive Brokers to observe how trades execute.

Most times I buy and sell 100 or fewer shares, often 95 or 99. The average trade-size in the market is less than 100 shares so I don’t want to be an outlier. And you’re looking for blocks? Forget it. The market is algorithmic.

And I know the rules require a market order, one accepting the best offer to sell, to execute immediately at the best price if it’s 100 or fewer shares.

Stay with me – there’s a vital point.

NXST trades about $7,300 at a time (a little under 50 shares), the reason for my trade-size. And it’s 2.1% volatile daily. Since it was up 2% during the day, I knew it was at the top of the daily statistical probability, good time to sell.

I checked the bid/ask spread – the gap between the best bid to buy and offer to sell.  Bid was $176.01, offer was $176.25. A spread of $0.25. That’s big for a liquid stock.

So I used a marketable limit order – I picked a spot between them, aiming to the lower side to improve the chance it filled: $176.05. I was wanting to leave.

The trade sat there for a bit, and then filled.  I checked. It split into two pieces, 45 shares at “Island,” which is Instinet, the oldest Electronic Communications Network, now owned by Nomura. I paid a commission of $0.19.

And the other piece, five shares, also executed at Instinet at the same price.  And I paid $1.02 in commission. For five shares!

What the hell happened? 

This is how the ecosystem works.  And this rapid action can smash swaths of shareholder value, foster wild and violent market swings – especially during options-expirations (yesterday was Counterparty Tuesday, when banks square monthly derivatives books, and it was a tug-of-war) – and, sometimes, work masterfully.

It’s market structure.

My broker sent the trade to Instinet, determining by pinging that undisplayed shares there would fill it.

And one or more Fast Traders hit and cancelled to take a piece of it, permitting my broker to charge me two commissions, one on five shares, another on 45 shares.

And now my one trade became ammo for two. The going rate at stock exchanges for a trade that sets the best offer is around $0.25 per hundred shares – the exact spread in NXST.

Yes, that’s right. Exchanges PAY traders to set prices. I traded 50 shares, but since the order split, it could become the best national offer two places simultaneously, generating that high frequency trader about $0.15.

What’s more, my order originated as a retail trade, qualifying for Retail Liquidity Programs at stock exchanges that pay an additional $0.03.

So my intermediary, Interactive Brokers, made $1.21. Some high-frequency trader probably made another $0.18 for breaking the trade up and buying and selling it at the same price two places. Zero risk for an $0.18 return.

Do that 100,000 times, it’s big, risk-free money.

It didn’t cost me much. But suppose it was 500,000 shares or five million?  Every trade navigates this maze, public companies and investors, getting picked and pecked.

Not only do costs mount for moving any order of size but the market BECOMES this maze. Its purpose disappears into the machination of pennies. Oftentimes it’s tenths of pennies in liquid stocks.

And you’re telling your story, spending on ESG reports, a total approaching $10 billion for public companies complying with rules to inform investors.

And the market is the mass pursuit of pennies.  Yes, there are investors. But everybody endures this withering barrage that inflates on the way up, deflates on the way down.

And it’s wrong that the mechanics of the market devolve its form into the intermediated death of a thousand cuts. Is anyone going to do anything about it?

Create and Destroy

The Terra Lunacy (cough cough) is about creating and destroying. 

If you’re thinking, “Lord, I want to read about cryptocurrencies like I want to use a power tool on a molar,” hang on.  It’s about stocks.

Illustration 247279717 / Cryptocurrency © Vladimir Kazakov | Dreamstime.com

But first, here is Market Structure 101, public companies and investors.  If the market is going to turn, or if money is going to shift from Value to Growth, it almost ALWAYS happens at options-expirations.

This is why you shouldn’t report earnings during expirations.

It’s not hard. Sit down with your General Counsel and say, “There are about $900 trillion of derivatives notional value tied to the monthly expirations calendar. Our market cap is a lot less than that.  So is the entire stock market, all the stock markets on the globe. All the GDP on the planet. So how about we don’t report results till AFTER those expire?”

Here’s the 2022 calendar.

In the 1990s, Active money was over 80% of market volume, and you could report whenever the hell you wanted.  In 2022, Active money is less than 10% of volume. 

Read the room.  Don’t hand your hard-earned earnings to the buffalo herd of speculators in derivatives to trample.  Remember that song by Roger Miller, you can’t roller skate in a buffalo herd?  Wise words.

And that’s why the market surged yesterday and may do it again.  It’s short-term trading into expirations, moving stocks to profit on sharper moves in options. It will take more than that to be durable.

Now back to Terra Luna.  A so-called stable coin pegged algorithmically to the US dollar, TerraUSD or UST for short, imploded last week.

It was supposed to be tethered to the dollar.  Monday it was trading at nine cents.  The token used to keep it aligned with the dollar, called Luna, was trading for a thousandth of a penny after at one point being worth over $100.

What’s this got to do with stocks? Exchange Traded Funds have the same mechanism.  It’s the create/destroy model. 

The point of stable coins is that by pegging them to something else, they’re supposed to be…stable.  Otherwise, supply and demand determine the value.

TerraUSD is supposed to be worth $1.  Always.  To sustain that value, Terra and Luna act like two sides of a teeter-totter.  One Terra can be burned, or destroyed, in exchange for one Luna, and vice versa.

So if Terra drops to $0.99, smart arbitragers will destroy Terra and receive Luna, bringing Terra back up to $1. Luna could become worth a lot more than $1 if the ratio skewed big toward Terra.

ETFs work the same way.  ETFs are pegged to a basket of stocks.  So stocks are Terra, ETF shares are Luna. 

As an example, XLC is the Communications Services ETF from State Street. It holds 26 of the roughly 140 stocks in the sector. Issued against that basket of stocks are ETF shares that when created had the same value as the aggregate basket of stocks.

If the stocks rise in value but the ETF lags behind, traders will scoop up ETF shares and return them to State Street, which gives them an equal value from the basket of stocks, which are valued in the open market at higher prices.

So traders can then sell and short the stocks.  That’s an arbitrage profit.

And if spooked investors sell the ETF, the process reverses. Market-makers gather up ETF shares and State Street redeems them – destroys them – in trade for stocks.

The idea is to continuously align the two (of course, that means a great deal of the trading between the ETFs and your stocks is arbitrage). 

The trouble is, even though the value of the stock market has come down markedly, the supply of ETF shares has actually risen. In fact, in March nearly $1 trillion of ETF shares were created or redeemed and creations sharply exceeded redemptions.

The Investment Company Institute publishes that data and we’ve tracked it since 2017.

When both ETF shares and stocks are losing value and prices are moving wildly, it’s much harder for arbitragers to calculate a low-risk trade.  That’s why markets swoon so dramatically now.

If market-makers stop buying or selling one or the other, we’ll have an equity Terra Luna.

It’s a small risk. But because ETFs are so pervasive ($6.5 trillion in the US market alone), at some point we’ll have a colossal failure.

It’s not fearmongering. It’s math.  We can see in the data that money has an easy time getting into the stock market, thanks to vast ETF elasticity, but a hard time getting out.

It will take a dramatic and sustained move down to cause it.

I suspect we came close in the last two months.  Maybe May options-expirations will save us, but the math says more trouble lies ahead.  The prudent foresee evil and hide themselves from lunacy.

Experience

“The market structure is a disaster.”

That’s what Lee Cooperman said in a CNBC conversation yesterday with “Overtime” host Scott Wapner.

What he thinks is wrong is the amount of trading occurring off the exchanges in so-called dark pools and the amount of shorting and short-term trading by machines.

I’m paraphrasing.

Mr. Cooperman, who was on my market-structure plenary panel at the 2019 NIRI Annual Conference, decries the end of the “uptick rule” in 2007. It required those shorting stocks to do so only on an uptick.

To be fair to regulators, there’s a rule. Stocks triggering trading halts (down 10% in five minutes) can for a set time be shorted only at prices above the national best bid to buy. It’s called Reg SHO Rule 201.

But market-makers are exempt and can continue creating stock to fill orders. It’s like, say, printing money.

Mr. Cooperman has educated himself on how the market works. It’s remarkable to me how few big investors and public companies (outside our client base!) know even basic market structure – its rules and behaviors.

Case in point.  A new corporate client insisted its surveillance team – from an unnamed stock exchange – was correct that a big holder had sold six million shares in a few days.

Our team patiently explained that it wasn’t mathematically possible (the exchange should have known too).  It would have been twice the percentage of daily trading than market structure permits.  That’s measurable.

Nor did the patterns of behavior – you can hide what you own but not what you trade, because all trades not cancelled (95% are cancelled) are reported to the tape – support it.

But they’re a client, and learning market structure, and using the data!

The point though is that the physics of the stock market are so warped by rules that it can’t function as a barometer for what you might think is happening.  That includes telling us the rational value of stuff.

You’d expect it would be plain crazy that the stock market can’t be trusted to tell you what investors think of your shares and the underlying business.  Right?

Well, consider the economy.  It’s the same way.

Illustration 91904938 © Tupungato | Dreamstime.com

The Federal Reserve has determined that it has a “mandate” to stabilize prices.  How then can businesses and consumers make correct decisions about supply or demand?

This is how we get radical bubbles in houses, cryptocurrencies, bonds, equities, that deflate violently.

Human nature feeds on experience. That is, we learn the difference between good and bad judgement by exercising both.  When we make mistakes, there are consequences that teach us the risk in continuing that behavior.

That’s what failure in the economy is supposed to do, too.

Instead, the Federal Reserve tries to equalize supply and demand and bail out failure.  

Did you know there’s no “dual mandate?”  Congress, which has no Constitutional authority to do so, directed the Fed toward three goals, not mandates: maximum employment, moderate long-term interest rates and stable prices.

By my count, that’s three. The Fed wholly ignores moderate rates. We haven’t had a Fed Funds rate over 6% since 2001.  Prices are not stable at all. They continually rise. Employment? We can’t fill jobs.

From 1800-1900 when the great wealth of our society formed (since then we’ve fostered vast debt), prices fell about 50%.  The opposite of what’s occurring now. 

Imagine if your money bought 50% more, so you didn’t have to keep earning more.  You could retire without fear, knowing you wouldn’t “run out of money.”

Back to market structure.

The catastrophe in Technology stocks that has the Nasdaq at 11,700 (that means it’s returned just 6% per annum since 2000, before taxes and inflation, and that matters if you want to retire this year) is due not to collapsing fundamentals but collapsing prices.

How do prices collapse?  There’s only one way.  Excess demand becomes excess supply.  Excess is always artificial, as in the economy.

People think they’re paying proper prices because arbitragers stabilize supply and demand, like the Fed tries to do. That’s how Exchange Traded Funds are priced – solely by arbitrage, not assets. And ETFs permit vastly more money to chase the same goods.

It’s what happened to housing before 2008.  Derivatives inflated the boom from excess money for loans.

ETFs permit trillions – ICI data show over $7 trillion in domestic ETFs alone that are creating and redeeming $700 BILLION of shares every month so far in 2022 – to chase stocks without changing their prices.

And the Federal Reserve does the same thing to our economy.  So at some point, prices will collapse, after all the inflation.

That’s not gloom and doom. It’s an observable, mathematical fact.  We just don’t know when.

It would behoove us all to understand that the Federal Reserve is as big a disaster as market structure.

We can navigate both. In the market, no investor, trader or public company should try doing it without GPS – Market Structure Analytics (or EDGE).

The economy?  We COULD take control of it back, too.

For the Birds

Did you know the Caribbean is full of brown boobies? 

The blue-footed brown booby, about the size of a seagull.  We’re just back from sailing St Martin and St Barts, where the critters of both sea and sky delighted.

Unlike the stock market, apparently, which has gone to, um, the birds. 

By the way, best food in the islands?  Grand Case on St Martin. It’s French. Need I say more?  On our boat, we had French food, French wine, French chef.

It’s a wonder we left. I gained five pounds. You can see it in the photo, aboard our catamaran in St Barts (more trip photos if you’re interested).

Tim and Karen Quast aboard Norsegod in St Barts Harbor (courtesy Tim Quast).

Back to stocks, we should have expected cratering markets because fundamentals have deteriorated dramatically.

Oh no, wait. They haven’t. 

Zscaler (ZS), which has been crushing expectations every quarter, is up just 6.7% the past year now after rising over 500% the past five years. It’s down 33% the last six months.

Philip Morris (PM), which is not growing, is down 7% the past five years but up 8% the past six months.

The popular explanations for why these conditions exist have reached such shrieking insanity that I might be forced to return to the sea.  And French food.

First, let’s understand how stocks go up.  Not the “more buyers than sellers” version but the mechanics. 

There is demand.  It can come from investors, traders or counterparties. Active investors buy opportunity, Passive investors buy products – growth, value, etc. Traders chase arbitrage (different prices for the same thing). Counterparties buy or sell to meet or mitigate demand for derivatives like options.

When all converge, prices explode. 

And there are compounding factors. Many investors now prefer Exchange Traded Funds (ETFs), which don’t increase the SUPPLY of stocks, just the DEMAND for them.

And traders buy or sell short-term prices with connection only to previous prices, leading to spiraling short-term gyrations.

And derivatives as both implied demand and supply magnify moves.

Are you with me still? Think this is for the birds?

The Tetris of the stock market, the arranging of these blocks, distorts perceptions of supply and demand and fosters absurd explanations.

And over time, it erodes realized returns.  All the toll-collectors – money managers, ETF sponsors, trading intermediaries, stock exchanges, counterparties – get rich.

As of yesterday, the Nasdaq is up about 6.5% annually since March 2000, before taxes and inflation and without respect to risk premia. Tech stocks move 3.5% intraday daily.

You see? Daily price-moves are more than half the average expected pre-tax returns. That’s because of what happens when all the Tetris blocks start falling.

Here’s how. Active investors stop buying equities. Passive investors slow allocations and see redemptions.  Speculators stop setting prices. ETFs have to redeem shares so compounding demand is suddenly replaced by a vacuum. Implied demand via derivatives vanishes.

And prices implode.

This is how the DJIA drops 800 points in a day.

And we haven’t even talked about short volume.  The SEC permits intermediaries to create stock when no real supply exists to satisfy it. That is, they can short stocks without borrowing.

That works great on the way up as it provides supply to rising prices that would otherwise go unsatisfied. On the way down, we become aware that the implied demand in created stock just doesn’t exist.

So, Tim. What can we do in this market?  

You can’t control it.  We could fix it if we stopped letting shilling Fast Traders set prices and create stock.

If we junked the continuous auction market and returned to periodic auctions of real demand and supply. No real buyers or sellers, no prices.

And stock markets should actually compete by offering separate “stores” that aren’t connected electronically and forced to share prices. As it is, markets are just a system.

Alas, none of this will happen anytime soon.

So.

We can continue as companies, investors and traders fooling ourselves that fundamentals drive markets.  Or we can learn how markets work. The starting point.

Otherwise, we’re like somebody reading the opening line today. “Did he just say ‘boobies’?”

I was talking about birds.

We need to understand the topic. The market (ask us, we’ll help).

Troubling Signs

Ahoy!

As you read, we are stopping in Charlotte en route to a 2pm arrival in Sint Maarten in the Caribbean.

Illustration 91269233 © Dharshani Gk Arts | Dreamstime.com

We saw the inflation print at 8.5%, plunging consumer confidence, rising credit risk, the supply-chain morass, and said, “Let’s flee to the sea.”

Okay, not really. We reset this sailing trip that vanished into the Pandemic.  Weirdly, we need no Covid test to see the sand and sea but for us citizens of the Land of the Free, we can’t get back in our OWN COUNTRY without one.

After being shot, boosted and afflicted with Covid in roughly that order.

We the People need to put the little despots in their places, power-seekers lording it over others without respect to math, science or common sense.  Untenable.  Unacceptable.

Back to market structure.  And monetary policy. 

Options expire this Good Friday short week, today and tomorrow. Trading is a tug of war between parties to expiring options and futures on Treasuries, currencies, interest rates, commodities, equities and bonds, and the counterparties with risk and exposure on the other side.

Don’t expect the market to be a barometer on investor-sentiment right now.

And new options trade Monday. Then counterparties square books Tuesday. Volatility derivatives expire Wednesday.

What will be apparent is if risk-taking is resuming.  I think Mon-Tue next week (Apr 18-19) are key.  Look, you can’t peg the day. Could be before, could be after.  But the market will either turn because investors and traders reset swaths of options and futures or we could get clocked.

No middle ground?

Broad Sentiment signals risk.  Might be a couple months away, or not.  Data going back the past decade that we track show that Broad Sentiment with a 90-day rolling read near 5.0 precedes a steep decline.

That’s about where it is.  History warns us.

What about the risk of recession?  Well, of course there’s risk.  Central banks globally exploded the supply of currency and shut down output. Nothing could be more damaging to economies.  Trying to remedy that catastrophe will take a toll.

And the Federal Reserve knows it and knows it must get interest rates back to a level that leaves room to chop them to zero to try to forestall an economic collapse. 

The Fed is motivated to stock up some ammo, not to “normalize rates.” The quickest way to do that is to lift overnight rates and start selling off bonds. If demand for bonds falls, interest rates rise.

That simple. And the Fed is wholly willing to put everything and everyone in jeopardy in order to give itself policy tools. 

I’m not opposed to raising rates. I’m opposed to low rates that devalue savings and purchasing power and encourage debt and consumption.

Impact on equities?  I think we’re seeing it already.  Passive Investment marketwide has fallen from 20.4% of trading volume over the trailing 200 days, to 18.8% now.

Doesn’t seem like much. But a sustained recession in demand from indexes, ETFs and quants will reduce stock prices.  Derivatives demand is down too, from 18% to 17.2%.

Mathematically, that’s an 8% long-term decline in Passive Investment, 4% drop in derivatives demand. Is a 12% reduction in real and implied demand meaningful?  

Absolutely.

So, it’s a matter of the degree of effect, and if or when that trend reverses.  A trend-change across the whole market is unlikely here at April options-expirations. 

How about earnings season?  Only if it’s a barnburner, which is improbable.

I think the best chance is June options-expirations, the next time big money can make meaningful changes to asset-allocations.  In between are Russell rebalances in May.

I’m neither bull nor bear. We’re data analysts. We track the trends.  There are troubling signs here.  Yes, they could dissolve again under the inexorable repetition of There Is No Alternative.

But if not, there’s a rough ride ahead.  So.  You will find us on a boat.  See you Apr 27.

Suspended

Shocking.

No other word for it.

Yesterday as VIX volatility futures settled on an odd Tuesday, Barclays suspended two of the market’s biggest Exchange Traded Notes (ETNs), VXX and OIL.

Let me explain what it means and why it’s a colossal market-structure deal.

VXX is the iPath Series B S&P 500 VIX Short-Term Futures ETN. OIL is the iPath Pure Beta Crude Oil ETN (OIL). iPath is a prominent Barclays brand. Barclays created the iShares line that Blackrock bought.  It’s an industry pioneer.

Illustration 76839447 © Ekaterina Muzyka | Dreamstime.com

These are marketplace standards, like LIBOR used to be.  This isn’t some back-alley structured product pitched from a boiler room in Bulgaria (no offense to the Bulgarians).

Let’s understand how they work. ETNs are similar to Exchange Traded Funds (ETFs) in that both trade like stocks.  But ETNs are unsecured, structured debt.

The aim of these particular notes is to pay the return via trading reflected in crude oil, and volatility in the S&P 500 stock index. 

OIL uses quantitative data to select baskets of West Texas Intermediate oil futures that the model projects will best reflect the “spot” market for oil – its immediate price.  But nobody owning OIL owns anything. The ETN is just a proxy, a derivative.

VXX is the standard-bearer for trading short-term stock-volatility. It’s not an investment vehicle per se but a way to profit from or guard against the instability of stock-prices.  It’s recalibrated daily to reflect the CBOE Volatility Index, the VIX.

In a nutshell, a security intended to give exposure to volatility was undone by volatility.

I loved this phrase about it from ETF.com: “Volatility ETPs have a history of erasing vast sums of investor capital over holdings periods as short as a few days.”

ETP is an acronym encompassing both ETFs and ETNs as Exchange Traded Products.

It’s not that Barclays shut them down. They continue trading for now. The bank said in a statement that it “does not currently have sufficient issuance capacity to support further sales from inventory and any further issuances of the ETNs.”

ETF industry icon Dave Nadig said, “The ‘Issuance Capacity’ thing is a bit of a get out of jail free card, so we can interpret that as ‘we no longer feel comfortable managing the implied risk of this product.’”

Barclays said it intends to resume supporting the funds at some future point. But we’ll see.  Credit Suisse ETNs that failed in Mar 2020 amid Pandemic volatility were stopped temporarily too but suspensions became permanent.

The lesson is clear. The market is too unpredictable to support single-day bets, which these instruments are principally designed for. 

I’ve long written about the risks in ETPs. They’re all derivatives and all subject to suddenly becoming worthless, though the risk is relatively small.

And it’s incorrect to suppose it can happen only to ETNs. All tracking instruments are at risk of failure if the underlying measure, whatever it is, moves too unpredictably.

You might say, “This is why we focus on the long-term.  You can’t predict the short-term.”

Bosh. Any market incapable of delivering reliable prices is a dysfunctional one.  It’s like saying, “I don’t know what to bid on that Childe Hassam painting but I’m sure over the long-term it’ll become clear.”

Bluntly, that’s asinine. Price is determined by buyers and sellers meeting at the nexus of supply and demand.  If you can’t sort out what any of that is, your market is a mess.

It remains bewildering to me why this is acceptable to investors and public companies. 

It’s how I feel about empty store shelves in the USA. No excuses. It reflects disastrous decisions by leaders owing a civic duty to make ones that are in our best interests.

Same principle applies. We have a market that’s supposed to be overseen in a way that best serves investors and public companies. Instead it’s cacophony, confusion, bellicosity, mayhem.

At least we at ModernIR can see it, measure it, explain it, know it.  We’ve been telling clients that it’s bizarre beyond the pale for S&P 500 stocks to have more than 3% intraday volatility for 50 straight days. Never happened before.

Well, now we know the cost.

Oh, and the clincher? VIX options expired yesterday. Save for four times since 2008, they always expire on WEDNESDAY. Did one day undo Barclays?  Yes.

That’s why market structure matters. Your board and c-suite better know something about it.

Eyes Wide Open

Here’s my grand unified theory on the world. We stopped following the rules.

Not that humans don’t color outside the lines routinely. But in the last two years we jettisoned restraint. That gave rise to chaos in the stock market, imperialism in Ukraine.

Here’s what I mean. The Pandemic prompted a reversal of the relationship between people and governments. Governments derive their purpose and support from the people.

Even in tyrannies.  French Nobel-Prize-winning writer Albert Camus who coincidentally wrote a book called The Plague said, “The welfare of humanity is always the alibi of tyrants.”

We did it for the people.

During the Pandemic, governments uniformly, whether free or autocratic, assumed supreme authority and bullied everybody into submission. Rules be damned.

That’s a bullhorn to brigands, cretins and miscreants.  If the rules don’t apply, then what’s to stop me?

Everybody started taking other people’s stuff.

Here in the USA, the country’s system of production and distribution through free-market capitalism was crushed by a tsunami of manufactured money. Businesses were unevenly and forcibly shuttered (some essential, others not, for no reason save an opinion) when the cornerstone of the rule of law is uniform justice.

And the money whooshed away from commerce into financial assets and real estate. There was a geyser drenching everything.

Waves come in, waves go out. 

I told users of our trading decision-support platform Market Structure EDGE last May that the long Pandemic Money momentum arc might have ended. The data signaled it (see image).

Market Structure EDGE data. Sentiment (Demand) changed in May 2021. Price has returned there, and Demand is ever more volatile.

The market doesn’t suddenly recede.  The tsunami comes in.  Reaches a zenith. Goes back out. You can see it in the sea but the ebb and flow is deceitful in asset markets.

Plus, human attention spans are short. We think that whatever is happening at this moment is reflected in the mirror of capital markets, forgetting the most basic economic principle besides Supply and Demand: Cause and Effect.

The tripwires might be immediate. Somebody coughs in a quiet theater. Russia invades Ukraine. Jay Powell says, “We’ll raise rates…” and everybody stampedes. And then he adds, “By and by.”

The stock market is now trading where it was in May 2021 when Pandemic Momentum died. Sure, there was a carryover. (We wrote about the changes here and here.)

But the wave that advanced for more than a year is receding. We’re experiencing the consequences of monetary actions that smashed every concept of good behavior.

We shouldn’t have thrown the rules out.

The roiling waters now may calm and settle and return to a regular tidal cadence. The data suggest a surge in Tech stocks in particular is possible and maybe in the whole market.

But we’ve done damage that may be far longer-lasting ultimately.

There are bigger reasons why Russia invaded Ukraine and no excuses for thuggery (though thuggery is a timeless imperialist trait).  But what greenlights bad behavior is evidence the rules don’t apply anymore.

And so here we are at the crossroads of geopolitics and markets in a world where anything goes. Russia ETFs are cratering. Nickel was halted. Wheat doubled in a day. Oil is at 2008 weak-dollar pre-Financial-Crisis prices as the dollar hits Pandemic highs.

Half the S&P 500 is down 20% or more. Half the Nasdaq stocks are down by half, and the Nasdaq Composite is now down 2% for the trailing year!

Consequences.

Now, throw in market mechanics. Market Structure. The reason the trouble from Ukraine is so cataclysmic for asset markets isn’t rational but structural.  I wrote about volatility last week in a post called Rise and Fall. I think it’s worth reading.

By the way, did you see John Stewart is the new Market Structure expert?

The stock market is volatile because 53% of trading volume derives from participants with better data and faster prices and shorter horizons than the investors and companies who depend on the market.

They magnify markets up and down.

Once we thought markets should be free, fair and open, and rules should level the playing field for all. We’ve thrown those rules out.  Now rules promote specific outcomes.

How do we get back to good? Stop doing all that stuff. And in case that’s awhile coming, our best defense is understanding what’s happening.

The great international relations classicist Hans Morgenthau said all politics are the pursuit of power defined by self-interest, and human nature doesn’t change.

That’s a good lens for seeing the world.

And in the stock market, understand that 10% of volume is rational. The rest is reactive, leveraged, constantly evolving, changing prices, hedging. It’s all measurable, though.

Eyes wide open is always the best strategy. 

It begins with understanding what’s going on. In the stock market, we can help you.  In life, my advice is biblical: The prudent foresee evil and hide themselves.