April 10, 2019

Bad Liquidity

JP Morgan’s global head of macro quant and derivatives research (if you have that title, you should be a big deal!), Marko Kolanovic, says the market’s rising propensity toward violent moves up and down reflects bad liquidity.

Bad Liquidity would be a great name for a rock band. But what’s it mean?

Most measure volatility with the VIX.  The trouble with it predictively is it’s not predictive. It spikes after the fact, not ahead.

It was not always so. Modern Portfolio Theory (MPT), a hot investment thesis of the 1990s stock market, said rising volatility reflected growing price uncertainty. Managers like Louis Navellier flew private jets on fortunes made shifting from stocks as volatility mounted.

I’d argue it’s the opposite now. When volatility vanishes, arbitrage opportunities, the primary price-discovery mechanism today (“price discovery” means “trying to figure out the price of a thing”), have been consumed. What happens then? Money leaves.

Speaking of money leaving, Mr. Kolanovic blames falling Active investment for a lack of liquidity. He says algorithm

Image shows weekly spreads between composite stocks and State Street sector SPDR ETFs, with negative numbers indicating more volatility in ETFs, positive numbers, more volatility in composite sector stocks.

s – “stock recipes” run by computers – are present when markets rise and absent when markets fall, exacerbating liquidity shortages.

Active investors tend to sell when prices are high and buy when they’re low, helping to ease liquidity constraints. As Active investment declines (he says just 10% of trading, presumably he means at JP Morgan, comes from Active stock-picking, eerily near the figures we measure – with algorithms no less), stabilizing liquidity shrinks.

Liquidity boiled down (so to speak!) is the availability of a thing at a stable price.  The more that’s available, the better your chance of getting it at the same price.

Investors tend to want a lot of something – a truckload.  Arbitragers tend to want the price to change. These aims are diametrically opposed.

By the way, I’m speaking to the NIRI Minneapolis chapter today on Exchange Traded Funds, which are predicated on an arbitrage mechanism. That means they can only exist as investment instruments if there is volatility. Mr. Kolanovic thinks volatility is the root rot.  Connection?

Yes. ETFs distort liquidity in two crucial ways that compound risk for stocks. As we’ve explained, ETFs are not pooled investments. They are most closely akin to put and call options, in that they are created when people want more of them and removed from the market when people don’t want them.

As with puts and calls, they become ends unto themselves. Too many mistake options prices for future stock prices. Sometimes that’s true. But changes in the value of options are a discrete profit opportunity themselves.

Goldman Sachs wrote in February this year as Q4 2018 results were coming in (thank you to an alert reader!): “What’s interesting this quarter is that buying calls for earnings reports has posted its best return in over thirteen years (record). In fact, buying the closest out of the money call 5 days ahead of earnings and closing the day after has produced an average return of 88%.”

Eighty-eight percent! That’s not a bet on results but pure arbitrage in options.

ETFs offer the same opportunity. Shares are created when investors want exposure to equities and redeemed when investors want out. But the investors to a large extent now are ETF market-makers profiting on spreads between ETFs and the underlying stocks comprising a tracking instrument. It’s arbitrage. Profiting on price-differences.

The problem with this liquidity is it’s continuously fluctuating. We can have no consistent, measurable idea of the supply of ETFs or the demand for stocks. That means the market at any given time cannot be trusted to provide meaningful prices.

The data to me say it’s the arbitrage mechanism in ETFs behind bad liquidity. ETFs can only establish prices through spreads with stocks. The market is now stuffed with ETFs. The motivation is the spread. Not fundamentals – or even fund-flows.

We track spreads between ETFs and composite stocks. Our data say spreads totaled hundreds of percentage points from Dec 2018 to Mar 2019. At Apr 5, stocks are 33% more volatile in 2019 on net than ETFs. That’s way more than the market has risen.  Somebodies will want to keep it.

If we want to know where the next financial crisis will develop, we need look no further than ETFs. They are now a mania. They depend on spreads. As liquidity goes, that’s bad.

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