Print Friendly and PDF

ETF Liquidity

Normal Service for a while.

The Days Ahead: CPI, Europe economic indicators, which will show how much trade tariffs hurt.

 One-Minute Summary: Nearly all sectors were up except the new Communication Services, but see our explanation below. We had felt that the October sell-off was overdone. It was pricing a recession, which is not going to happen for some time. Buyers came back to the market and the election removes a very big overhang. No surprises from the Fed but short-term rates came within a whisper of 3%. There’s now only a gap of 46bps between two-year and 30-year bonds. We don’t see that changing.

Oil is now officially in a bear market having fallen from $76 to $59 in a month. China remains a big concern on the trade issues and on how much the economy is slowing (see here for a very interesting read of how the middle class is economizing).

 1.     Did markets care about the mid-terms? Not really. Markets read polls and the outcome was pretty much as expected. Generally, markets are fine with split government. Nothing much gets done. Nice and predictable. But there were some early polls suggesting the Republicans would keep the House and the bond market, even in after-hours trading, took a sharp turn for the worse. The concern? That fiscal policy would ramp up and the already deteriorating debt position would head into even wider deficits.

We’ve talked about the deficit. It's a story that’s going to be with us for a while. Start with the deficit in the fiscal year just ended. It was $780bn, up $113bn, and would have been $823bn if spending in 2017 had not been brought forward (i.e. it ended up in last year’s deficit when it really should have been in 2018). Personal and payroll taxes rose $105bn in 2018 but corporation taxes and revenues from fines matched that almost dollar for dollar, falling $99bn. Meanwhile government spending rose $173bn.

So we saw the 2-Year Treasury climb to 2.98% on Tuesday night. It settled to 2.92% but it may not be too long until we see a 3% handle on the two year. Meanwhile, the Fed all but confirmed they will raise rates in December and the expected slowdown in the economy is already happening. It was 4.2% in Q2, 3.5% in Q3 and will probably come in at 2.7% for Q4. The concern on Tuesday was simply that with the economy slowing, a full-on Republican administration would add further fiscal stimulus.

2.     The Fed met and… didn’t really say much other than confirm the economy is growing nicely. They did point out that “Business Fixed Investment” or capital expenditure, slowed. They didn’t indicate whether this was i) noise ii) concerns about trade iii) the money was better spent on buybacks or iv) lower demand. We’d go for i) and ii). To be fair, the Fed would never really talk about buybacks so that was unfair.

 The interesting story at the Fed is away from rates. It's this:

It’s the Fed’s balance sheet and it started the year at around $4.2 trillion (the blue bars). It’s now $3.9tr. You can see how much it's down and the annualized rate of decline is in the green line. It's around 18%. This is the Fed selling the securities it bought in five years of QE. Except they don’t sell them. They let the bonds mature and do not repurchase. But unlike a regular Treasury, they don’t get their money back from the U.S. Treasury. The money just disappears in the same way it was created when they bought the Treasuries.

But the U.S. Treasury still needs the money (because we’re running the deficits up there in section 1) so now they have to borrow more than they would if the Fed just held onto their bonds. Think of it as when the Fed buys bonds, they disappear. When they sell them, or don’t reinvest, they come back to the market.

Here’s a very good description.

 Bottom line? Fed monetary policy is much tighter than it appears from watching interest rates. Hence, we like the U.S. Treasury Floating Rate Note (FRNs) for the short end of the curve. 

 3.     How ETFs distort markets. We’re big fans of ETFs but there are a few rules to follow if you want to get the best out of them. One key thing to remember about ETFs is that they are not passive. Every ETF tracks an index and that index is comprised of stocks selected by the index provider. It used to be that investment management worked like this:

  1. A fund manager made a list of stocks that they thought would go up

  2. They bought them

 Now it’s

  1. Fund manager makes up a list of stocks they think will go up

  2. They pile them into an index

  3. Set up an ETF to track the index

  4. The ETF buys the stocks

 Even the grand old S&P 500 index is not just the 500 largest companies listed on the stock market as S&P excludes companies they feel don’t meet their standards of probity, governance or profitability.  But index providers are big and powerful these days so when they make a change to an index it can leave ETFs scrambling to keep up.

And that just happened. Back in the summer the folk at S&P decided to update the various industry sectors (Called GICS or Global Industry Classification Standards). Fair enough. There used to be a steel sector, mining and railroads sector…you gotta keep up with the times. They decided to:

  1. Eliminate the Telecom sector, which had only three companies left in it and AT&T and Verizon were 90% of that sub-index

  2. Reduce the number of companies in the tech sector and move them to Consumer Discretionary

  3. Add a new sector called Communication Services

  4. Move more companies from tech to the new sector

Now, a rough guess tells us that index funds make up around 20% of the S&P 500 and another 25% of active managers use it to benchmark their performance. So, cue lots of money moving around. This is what the market sectors looked like on the day the changes went live:

The tech sector fell from about $6.8 trillion and 28% of the index down to 20%, while the newly named Telecom sector rose from $500bn to $2.3 trillion or 2% of the index to nearly 10%. There are, of course, sector ETFs that track all these and it seems that investors did not sell down their tech ETF and rebalance. That meant there were a lot of forced sellers of tech shares like Google (was tech, now Communicating Services) and Netflix (was Consumer Discretionary and also now Communication Services) but there weren’t enough buyers on the other end…indeed there were no Communication Services ETFs to take up the slack (h/t John Authers).

 Anyway, we think this along with the share buyback blackout, accounts for some of the recent weakness in tech. It will rebalance in time but meanwhile we must live with the distortions created by passive funds.

 Bottom Line: As we’ve noted before the stock market has become considerably cheaper this year. Companies have reported around a 25% increase in earnings, with another 8% at least next year, but stocks are mostly flat and the market trades at around 15x times next year’s earning. That means valuations have fallen around 20%. We would not quite count on a rerating back up to 18x but we think the rest of the year will trend up. The two big risks: China trade (who tweets first) and the pace of the economic slowdown.

 Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

 Other:

Changing the way we remember

 --Christian Thwaites, Brouwer & Janachowski, LLC 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Once upon a time…

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  

Subscribe here for our investment updates

Other:

Shrieking lynx

Ship caught in trade talks  does two gigantic U-turns

No, Uber is hopelessly unprofitable

 --Christian Thwaites, Brouwer & Janachowski, LLC

 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.