June 5, 2024

A Writhing Market

Somebody pulled a pin and dropped a grenade in the stock market and nobody noticed.

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Let me explain:

  • Giving a rough count, there were 300 volatility halts May 31-June 4.  Not a record but the biggest number in a long time. The charged electrons of trading were gyrating. 
  • Numerous large-cap stocks were volatility-halted and a half-dozen including BRK.A were ruled to have Clearly Erroneous Trades.  BRK.A, market cap of $880 billion and price near $630,000 per share, traded to $185.  The jubilant buyers had their trades “busted,” as the regulators say.
  • Data supplied by the Consolidated Tape Association through the SIP (securities information processor) that we in the public rely on to see stock prices failed June 3 in a swath of stocks, as did the backup system. 
  • A number of exchanges including IEX, MEMX and the NYSE had technical glitches, prompting other exchanges to “declare self-help,” regulatory lingo for “something is wrong with you, so go pound sand.” 
  • On May 31, The S&P 500 Index (SPX) opened around 5,243, meandered down to about 5,195 midday and then reversed course and shot up to 5,280 at the close – an 85-point swing.  Weirdest, all three benchmarks did the same thing 20 minutes before the close. 

Now, there were explanations. Index options on the SPX expired at month-end as they do every last trading day of the month, and MSCI indices rebalanced. 

But I’ve never seen the market gyrate so wildly on a MSCI rank day. Not a single person on CNBC all day long May 31 mentioned the wild moves (I traded notes with IEX’s Ronan Ryan about them). 

The market has since then writhed like a reptile.  You don’t notice it unless you’re watching like we do, or, say, running a long/short strategy. Futures might point higher, and then the market tanks, only to reverse course (try adapting your short position to that!).  Nothing about how a trading day will unfold can be deciphered at any point from what’s come before it. 

What the heck is going on? 

The first thing we thought was “it’s T+1.”  For those who missed it, the market moved May 28 to trade-day plus one for settlement of transactions, meaning trades clear by the next day. 

But there’s not a rash of new entrants onto the threshold lists of stocks failing to deliver (exchanges must post that data).  At the NYSE, the ProsShares Ether Strategy ETF (EETH), the SPDR S&P Insurance ETF (KIE), the ProShares UltraShort Bloomberg Natural Gas ETF (KOLD), the Global X S&P 500 Quality Dividend ETF (QDIV) and the ProShares Short Russell 2000 ETF (RWM) are on the list.  

There are 42 on the Nasdaq list but most are tiny.  You might know Trump Media (DJT), Canopy Growth (CGC), maybe ICOP, the Blackrock iShares Copper and Metals ETF. 

Still, we don’t look at the lists and go whoa! 

If not FTDs, what then? 

I’ll give you a theory.  It is in fact Fails to Deliver, but only in the sense that the cause is the way investors have changed their behavior.

There are clues.  The SEC announced its intention to move settlement to T+1 on Feb 15, 2023.  Between Jan 1, 2022 and Feb 23, 2023 – February options-expirations – the intraday spread between SPY high and low prices (Volatility) averaged 1.8% daily. 

From there on, it averages 0.9%.  Cut in half.

Now, maybe that’s coincidence or false correlation. The 2022 data were bumpy after all.   

But let’s suppose price-changes — volatility — exacerbate settlement problems because 50% of volume is market-making by machines that don’t really own the stock. They create it under regulatory exemptions from short-locate rules. Less volatility, less FTD risk. 

So, we next looked at the fluctuating patterns of Passive and Active investment. From Jan 1 2022, to Feb 23, 2023, the patterns showed a daily average change of 1.6 standard deviations.  Let’s call that “normal.” 

Since then, the degree of change is down to 0.3 standard deviations.  The rate of change – meaning movement of owned positions – has collapsed.     

Now, what would explain it?  I’ll tell you what would: ETFs. 

ETFs dominate the stock market.  They’re approaching $9 trillion in assets in the U.S. But that’s not what matters. Shares of ETFs are created and redeemed in trade for incoming and outgoing baskets of stocks at a rate of $700 billion per month, data from the Investment Company Institute show. An all-time record.

Yet volatility is down. Investment patterns are down.  Seems incongruous.

Maybe again it’s coincidence.  But what if it means ETF sponsors aren’t buying and selling assets and instead are just…swapping baskets back and forth, to avoid Fails to Deliver?

Perhaps there’s nothing wrong with that. Blackrock could take an IOU from Morgan Stanley rather than title to stocks. But maybe it explains the data issues. There’s insufficient data for normal pricing. 

I’ll tell you this:  SPY in the past few days has had the highest volatility without a decline in the 2022-2024 data we reviewed. Nearly always, volatility rises as prices fall because it’s harder to get money out of the stock market than into it. 

In the past few days, volatility spiked but markets didn’t fall. They writhed. Hm. 

The good news is money adapts. Maybe the biggest managers have found a way around trouble.  The bad news is these data suggest the market could get clocked if there was a surge in actual movement of underlying assets.

Relax, we’re not doomsaying.  But. We’ve called out the liquidity risks in ETFs before. As the complex gets ever larger, the risk of sudden downside risk soars because machines don’t know there are insufficient assets supporting ETF prices. 

We’ll see how it goes. 

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