This Week = Next Year

This is now the second worst December in the history of the S&P500. It’s the fifth fastest that it has ever dropped 17% from an all time high. The sheer speed and size of its decline has everyone asking if it’s a portent of doom for the economy, or just a kind of flash crash capitulation. Is it a policy mistake from the Fed? Is it Trump’s manhandling of his staff and Congress?

No, it’s just what happens when people look ahead, feel uncertain, and move into cash.

But that in itself isn’t enough. Those choices don’t usually have historically significant impacts on pricing.

It is what happens when the system is inherently unstable. It’s what happens when liquidity disappears. It’s what happens when hidden leverage is revealed.

It’s Flows + Liquidity + Leverage + Risk = mayhem. 

This isn’t a flash in the pan. This is the future.


1. Lipper data shows a massive shift recently: $81bn has gone into Money Market funds in one week, more than they typically take in for a year. $100bn has come out of Equity funds (ex ETFs) in three weeks.

2.  Meanwhile ETFs have taken in $26bn in the week to 20 Dec. Mixture of equity and bond funds, mixture of big and small:

3. Hurrah then! Passive ETFs beat Active, they’re the port in the storm!

Not quite.

4. ETFs are being used like futures. Those inflows can be market maker hedges against outflows in other ETFs. Or places to park money before moving it onwards. They’re the pressure valve for short-term traders.

5. But long-term investors still use them. Many of the ETFs on this list are “mom and pop” favourites. Buy the dip is alive and well. It’s just being drowned out by the big institutions.

6. And there have been significant outflows. This Bloomberg story flags up how one big investor pulled out of all of Vanguard’s Sector ETFs during 12noon-1pm NY time on Monday. It wasn’t just about taking x% or y$bn out of each one. It’s clearly a decision to cut all of their positions, as the flows show:

The highlighted sectors are those which were reclassified by MSCI as of 28th September. Conspiracy theorists might note that this is when volatility started to increase in the S&P500. They’re also the ones where this investor made some of the biggest shifts in terms of the % of AUM of the ETF.


7. The thing is, ETFs are as liquid as anything else in December markets, i.e. not very. And volumes have been huge. HYG, the favoured High Yield ETF, traded $5.5bn yesterday, more than Facebook, and well above its recent average:

8. At the same time, liquidity in single stocks it as its worst for a decade, as Goldman point out:

9. The market can’t handle these big flows. So yesterday the HYG traded at its widest deviation from its intrinsic value since February’s vol-mageddon. (Intrinsic value reflects the pricing of all of the components of the index at that point):

10. You wouldn’t know this if you weren’t watching intra-day, particularly as the IV is only available on various expensive trading platforms. If you’re merely a private investor who wants to check if your ETF is tracking its underlying, you just see this on the ETF issuer’s website:

A mere -0.20% discount. Very run of the mill. Not that you can easily check back to see how that fits in to what’s happened in the past. You can only see a quarter of history at a time, and you can only see a bar chart range. Maybe that doesn’t matter. You’re a long term investor. You’ll be exiting at the NAV of the day. That can’t deviate much from the underlying index. Can it?


11. This is where the hidden leverage comes in.
– To keep an ETF tightly tracking an index, its market makers must be able to arbitrage away any of these differences to its intrinsic value. That’s fine, until the underlying assets become less tradeable. Then the arbitrage is impaired.
– Losses start to mount for the market maker. They step away from the market.
– Prices for the ETF itself widen. Those using the ETF as a hedge start to worry.
– Flows come out of the ETF and market makers must hedge themselves in a market with less and less liquidity, both for the underlying asset and for the ETF itself.
And so on the vicious circle goes.

In reality the arbitrage is usually done by a machine. It doesn’t actually go and do anything to all 972 bonds in the HYG. They’ll choose the quickest and cheapest most closely correlated instrument. Which has historically been the S&P500. Here’s the 3 month correlation between HYG and SPY this year, it has basically been around 70%:

12. The tracking characteristic of an ETF therefore creates a shadow position. That multiplies up exposures. As prices shift, these exposures must be managed. That delta hedging process is akin to a massive derivative position on the S&P500.

13. …which means stock markets are entirely prey to something called short gamma. As our friend @SqueezeMetrics pointed out yesterday, ‘we are very deep into short gamma land. About 200 SPX points away from 0 GEX. Volatility until we can dig ourselves out.’


The tinder to light this fire can then simply be a risk that forces a shift in people’s positions. Fear of a more volatile Trump ahead now that his own advisors are all leaving? A more unpredictable Fed now that they’ve done 9 hikes? Liquidity disappearing as the Fed sticks to Quantitative Tightening? Brexit hurtling towards No Deal? France rioting? Hungary rioting? China hacking?

Let’s not go all Billy Joel We Didn’t Start The Fire.

The truth is that this week is just a harbinger of what is to come next year. Keep an eye on the flows. Everything else is in place for more volatility ahead.

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