April 3, 2024

Sherlock Holmes Market

Is impending volatility predictable? 

Sherlock Holmes would not tell Watson it’s elementary, that’s for sure.  But there is a tale behind the tape. Permit me to tell it. 

I wrote this last week:

Some volatility you can’t control. The market is fragile and fast-moving and it does bizarre things behind the scenes. Like the recent collapse in shorting in SPY, proxy for the S&P 500, and corresponding surge in Fast Trading, plunge in Passive flows. Impending volatility? Maybe.

Son of a gun. 

dreamstime l 27136185
Photo 27136185 | Sherlock Holmes © Pixattitude | Dreamstime.com

Look, most of the data offered no threat signals. We understand “market structure,” the mechanics of the market.  We watch these things:

Broad Sentiment. Our algorithm measuring short-term Demand in the stock market is 5.9 and still leaking higher. A top is 6.0 so it’s near that but not tipping over. It’s been over 5.0 – the nexus of buying and selling – since Jan 30 and it’s not dipped below 4.0, a bottom, since Oct 30.

Supply. We use Short Volume, the data set for Reg SHO Rule 201, to meter the stock market’s supply chain.  It’s been trending down since October and sits at 49% of trading in the S&P 500.  Sounds like a lot. It’s below the 50% 200-day average.  No troubles.

Big Tech. Demand is 6.2 and steady, Supply in the group is about 40%, way below market levels. 

Tech sector.  Demand at 6.5, Supply at 49%. Check.

SPY. This ETF proxy for the S&P 500 is the market, so it should be 5.0.  Sure enough.  It’s been at or over 5.0 since Nov 6, 2023.  Supply is 43%.  All systems green.

Aside from manifesting a very long top – time spent at or near 6.0 – these data don’t scream, “We’re going down!” 

But seven of the last ten trading days in SPY had net selling.  Haven’t seen that since October.  And in the Tech sector, half the past 20 trading days had net selling. We might have to go back to 2022 to find that condition.

In a stock market dominated by ETFs one expects that roughly every other day will show net selling. ETFs are priced by arbitrage. If stocks are up and the ETF lags, market-makers short stocks and buy the ETF. And vice versa. So long as inflows are greater than outflows, the market rises on this continuous trading teeter-totter.

If one removed the so-called “basket” that an ETF tracks, there would be no way to price it.  ETFs have no intrinsic value. In fact, yesterday a new ETF trading as “ULTY” published a faulty basket and trading was suspended until it could be corrected. If you paired XLF with a basket of Utilities stocks, it would track Utilities stocks, not Tech stocks. 

Because machines don’t know the difference.

And over the past year, $1.7 TRILLION of new ETF shares have been created, says ici.org. Over that same time, about $500 billion has flowed out of Active investment funds (equities and bonds both), fund manager First Trust observes. 

In the first two months of 2024, ETFs shares have been created and redeemed at a pace of $700 billion per month. Massive market.

It hinges on spreads.  And they’re falling. Volatility in the average S&P 500 stock has fallen from a 200-day average of about 2.1% to a five-day average of 1.8%, down 14%. But volatility in SPY fell from 0.9% to 0.5% in the same comparatives.  A 44% drop.

Meaning? I’ll tell you. 

In effect, the SEC cedes the spread between stocks and ETFs to market-makers as a cost of maintaining the “continuous auction.” The SEC wants constant prices, constant trades. No break in the action. 

Since that’s a physical impossibility, the SEC manufactures activity in the market by approving products that depend on arbitrage.  ETFs. Options expiring in a day or week. 

Which brings us full circle.  The strange late-March collapse in Supply in SPY coincided with an equally strange collapse in Passive demand for SPY – and volatility in SPY. 

Passive money has averaged 27% of SPY daily volume the past 200 days (almost three times Active money). That’s massive. Larger than in the underlying stocks. Indexes and stock-pickers alike substitute SPY for stocks because it trades over 500,000 times daily, over $35 billion of volume.

But suddenly that number plunged to 18% (20D ave). In fact, it dropped to 13.5% during March options-expirations and quarterly index-rebalances. And during that same period, traders shorted Tech. 

Conclusion? Money quietly quit stocks, shorted Tech, and volatility fell and the arbitrage mechanism faltered. It didn’t happen yesterday but back in March.  Sure, it may be that global macro money changed its view on rates and the dollar. But it happened then. Not now.

What’s next?

Almost never does the market crack and crumble unless the Demand/Supply balance changes.  So. Either this will be a brief blip and the real reckoning lies somewhere ahead, or a chain reaction is unfolding that started when Passive money stopped showing up in SPY at March options-expirations.

And that’s your Sherlock Holmes market-structure tale.  Stay tuned for the exciting conclusion. 

PS – Two EDITORIAL ITEMS: I’ll be joining my colleagues at the NIRI Rocky Mountain Summit today and sharing our thoughts on Rethinking the Earnings Cycle. And tomorrow, I’m hosting an Interactive Brokers webinar. Come join!

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