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.
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.