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A small dose of nerves

The Days Ahead: Jobs number on Friday. Short trading week.

One-Minute Summary.  Bonds were up, large and small cap stocks up a small amount and international stocks off around 1.5%...much of that was because of autos (see below), which are around 20% of the German and Japanese stock markets. Emerging Markets had a troubled week mainly because of the bad news coming out of Argentina and Turkey (we talk about it in our podcast here).

There are really two tracks going on in Emerging Markets. One, those countries with high U.S. dollar borrowing, budget deficits and importing oil. Two, those that don't. In the first category are Turkey, Argentina and the Philippines and in the second, China, Taiwan and South Korea. We're oversimplifying, we know.

Right now, there’s a great deal of concern about the former and they're overshadowing the better story from the others. It’s also a problem that a lot of Emerging Market investing is done en bloc, meaning investors buy a single ticker and they're either all in or all out. We think some of this will settle down but in the meantime are looking to protect our Emerging Markets exposure.

1.     Markets are jumpy. Combine coming up to a long weekend, month-end positioning, little company news and some unpredictable headlines, and markets can move very quickly. Here are two examples from last week. First, the 2-Year Treasury when the Fed minutes were released at 2.00pm on Wednesday:

It’s highly unusual for the 2-Year Treasury note to move that much. The reason was that the Fed said:

 “It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective. “

Which is Fed-speak for inflation may run a little hot for a while rather than hiking rates as soon as we see a CPI print of over 2%. So it was “dovish” and the 10-Year Treasury promptly dived back under the 3% level, which people got so worked up about a few weeks ago.

The second was this:

The catalyst was the Commerce Department announcing an investigation into automobile imports under the same Section 232 of the Trade Expansion Act of 1962 used in the case of steel a few months ago. Immediately, foreign car manufacturers fell and wiped off around $20bn in market cap from the five companies shown.

Now, the world auto market is a little tricky to get your arms around. Global production is around 97m units a year. But companies have multi-country supply chains. Germany, for example, exported around 450,000 cars into the U.S. but made 804,000 in the US, some for the U.S. market and some for export. European tariffs on U.S. autos and U.S. tariffs on European autos are about the same if you adjust for America’s high tariff on trucks (SUVs are “trucks” in the U.S. and cars everywhere else).

Similarly, Ford makes a lot of cars in Mexico and Canada and imports them to the U.S. In fact, the only car producer that makes 100% of its cars in the U.S. is Tesla and they account for 1.2% of U.S. total production.

It will be fiendishly difficult to target companies and levy the right amount of tariffs. Expect a lot of carve-outs or indeed nothing at all. This all may blow over. Meanwhile, it shows us the hyper-reactive phase the market’s going through.

2.     Volume Smile. We're big fans of ETFs. Sure, there are some dopey ones  and the clue is normally in the ticker. But they're generally great vehicles and do their job efficiently.

We talk a lot around here about whether they distort markets. I mean, look, they’re multi-billion dollar behemoths and to some extent transform liquidity, which means making something inherently illiquid, liquid. Here’s a good write-up of how the folk at Blackrock manage  their $55bn Aggregate Bond Fund (AGG), which tracks 10,000 bonds but “only” buys 7,000 of them.

What we look for is, a) are they distorting markets in b) a way that can harm investors? The answer to a) is emphatically “Yes.”  So, far the answer to b) “Not sure, don't think so.” In recent years we’ve seen the emergence of the “trading smile.” Here it is:

This shows the volume for SPY, which is the mother of all ETFs and tracks the S&P 500. It's $264bn, has 2,000% turnover and accounts for around 6% of NYSE volume (even more on a dollar basis). It's a good proxy for the market. The chart shows the volume for Thursday of last week and, there it is: a large volume at the beginning (9:30am but shown here 6:30am PST) and end of the day (4:00pm or 1:00pm PST)) and a very large drop off from around 7.00 am to 12.30am. And that’s a badly drawn smile on top (hey, no one hired us for Microsoft Paint skills).

What’s going on? Well, you would expect a drop-off around lunch but this looks like traders do their thing in the opening and closing half hour of the trading day. The answer is that passive products and complex algorithmic investors realign their portfolio at these times so active managers stay away from the market. Bob Mincus of Fidelity (here but behind FT pay wall and also here) sees an opportunity here and he should know, he manages billions in equities:

“We view the close as an opportunity. As more volumes migrate towards the close, we will follow it.”

This clearly creates some problems because a big buyer coming in mid-day will almost inevitably run into a liquidity shortage, which means more volatility. So, we have a weird situation where an efficient market vehicle (an ETF) creates an inefficient market. Some people are calling for a shorter trading day. In Japan, the stock market opens from 9:30 to 3:00 and closes for an hour at lunch. All very civilized. Their market is a lot less volatile.

Anyway, we don't much like this trade funneling and try to stay away from ETFs that we think might not do well under “smile” conditions (and SPY is one of them).

Bottom Line: The market lacks a theme. Emerging Markets will move on any bad news even though the likes of Turkey and Argentina are hardly mainstream investment destinations. But otherwise, we think markets will drift for a while. They may also become inured to some of the sillier headlines and tweets. 

Please check out our 119 Years of the Dow chart  

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All charts from Factset unless otherwise noted.