The Price Isn’t Right

Come on down, ladies and gentleman, for another round of The Price Is Right! Except, it’s not. Leslie Crowther was lying to you (or if you’re in the US, Bob Barker).

Leslie: Now, Ken, do you think the VIX at 17 means the stock market is going higher or lower?
Ken: Um, higher, I think, Leslie?
L: Ken, you know we didn’t trade at 17 for the whole of 2017, right? When stock markets hit record highs?
K: Well, yes, but, wasn’t 20 kind of an average level and now we’re below that so….
L: so what Ken? Come on Ken, I’m going to have to press you… [audience goes wild with excitement]

Poor old Ken. The trouble is, the market is whipped up into a frenzy and now it’s no longer clear what prices mean at all. Central bank easy money passed the baton to passive fund managers, who have been merrily investing along the lines of the indexes they track. Inflows into risky assets then compressed measures of risk such as the VIX, credit spreads, TED spreads, even bid/offer spreads. Central banks then looked like they were easing, even if they weren’t.

Just look at some of the measures that constitute the Chicago Fed’s Financial Conditions index, and ask how many of these are independent from the Passive Wall Of Money:

Not many. Almost all of these indicators have been driven by fund flows. Their price is not telling us anything about the expected future path of risky assets. So why are they being used for risk management?

We are now stuck in a frenzied feedback loop of cheap money driving cheap risk. As the table above shows, however, the feedback loop could easily flip the other way. We have already seen a much higher VIX impair the liquidity of the S&P Futures market – both suggesting the risk picture has changed. This could easily then filter into all the other indicators in the table.

Prices are dictating our judgement, rather than the other way around.

The central bank of the world’s central banks has taken note. The BIS has helpfully devoted a chapter in their recent Quarterly Review to the phenomenon of passive money. They argue:

1. Indexing reduces the stock-specific factors that drive the price of a stock
Surprise, surprise, when a stock goes into the S&P500 index, it becomes more correlated with it, given how passive money flows then scoop it up.

2. Companies change behaviour to get into an index
The larger the weight in the index, the more a rising tide will lift all boats. Small wonder then that companies are issuing more debt in order to become a larger part of bond indexes. The BIS note: ‘Regression results confirm that there is a statistically significant positive relationship between a company’s weight in the index and its leverage’

3. ETF flows are more volatile around risk events
Active funds may leap onto risk events and drive prices lower as they experience outflows, but ETFs are more volatile (see the red lines and crosses in the chart). Hence the flash crash environment we have become all too familiar with.

4. ETF trading doesn’t always hit the market
When an investor redeems from a mutual fund, they sell their holdings and it has a direct market impact. ETFs, on the other hand, don’t have to do this. Their market-makers just have to make a market. They can choose to hold onto the holdings they’ve been given. The BIS note: ‘after redeeming the ETF shares, APs can potentially warehouse the securities instead of immediately selling them in the secondary market’

In summary: 
1= fundamental factors driving asset prices are becoming less relevant
2= companies are compounding this by gaming the system
3= passive money can be volatile…
4= …but we haven’t seen its ultimate market impact as the holdings aren’t actually sold

Adding all of this up:
1+2+3+4 = prices are not telling us the truth, but when they do, the re-pricing will be violent

Come on down, ladies and gentleman, soon the Re-Price will be Right…!

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