April 6, 2016

Chasing Gaps

Have you ever set an important goal?

Whatever your objective, you must plan how to arrive at your final destination as though it were a journey and you were constructing a map or set of directions. And then you persevere, letting nothing deter your purpose.

We don’t all achieve our goals and any extended effort carries risk. You can fail. Your directions could be wrong. You may have underestimated the obstacles between aspiration and destination.  Or you stop caring. Right?

What if success instead constituted correctly tabulating the difference between planned and actual progress? Boy that would be a lot less stressful. And you would have an arbitrage formula!

Every week governments the world round disgorge data on employment, the real estate market, manufacturing, exports, imports, budgets, capital spending, commodities, corporate profits, relative values of currencies, economic growth and more.

Yesterday, markets in the US considered the balance of international trade, The Institute for Supply Management’s non-manufacturing index (fairly strong) and the Purchasing Managers Index of services (modest but new orders were abysmal). Today’s data smorgasbord features mortgage applications, oil inventories and the Federal Reserve’s Open Market Committee ledger called the FOMC Minutes about what central bankers said at the March meeting.

Economists and investors troll the data for indications of future economic growth or contraction. They’re looking for progress toward purpose. Arbitragers react to it differently, trading the spread between expectations and outcomes.

Fundamental investment dominates? If only. We measure market behaviors. Active investment is barely more than a third of the daily volume of arbitrage.

We could define arbitrage as the difference between planned and actual progress – how something is faring relative to goal, or expectation.  In practical terms, arbitrage funds seek spreads between the current price of stocks and their forward value reflected in a futures contract.  If a stock is considered undervalued now but likely to rise later (call that a goal), a trader will buy the stock and sell a futures contract for commensurate shares.

The less predictable the future is, the shorter the arbitrage timeframe. Weekly options and futures tied to equities, exchange-traded funds and indexes used to be a rounding error. Today they’re 35% of the options market. Trading in options has a notional value five times that of stock-market dollar-volume daily. Nearly 50% of options trace to one security: SPY, the giant S&P 500 ETF.

If the S&P 500 is the goal, the path, the standard, then options reflect the difference between the goal and the expectations, the progress. You see?

Alas, a marketplace with relentless data minutia and nearly infinite ways to bet money on the difference between goal and progress shifts the purpose of the market from goal-achievement to chasing gaps. Why focus on the long term with its pervasive risk and uncertainty when it’s cheaper and less risky to speculate on whether the PMI Services number will be up or down and how new short-term expectations will affect markets?

Now add this in:  Yesterday the Bank of Japan talked the yen down by suggesting it might take interest rates further negative. The Reserve Bank of Australia warned about currency strength, tantamount, too, to talking money down. The Reserve Bank of India cut rates to a five-year low. Money denominates stocks, bonds, derivatives, commodities. Moving money-values constantly shifts focus from the future to a pairs-trade.

Markets are packed with speculators because we’re obsessed with information that deviates the purpose of capital markets from goals to whether something has departed from a benchmark. It institutionalizes averages and promotes arbitrage – chasing gaps.

We could change it by stilling the tides of data and currencies. Prospects for that goal? Currently a number approaching zero. I believe I’ll take out a short futures position.

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