ETF

Who the hell is Leeroy Jenkins?

One of the more uniques ways of describing the behaviour of the US Fed. Zerohedge noted that the Fed has gone full Leeroy Jenkins. Who the hell is Leeroy Jenkins?

As you will see in the video clip, the team gamers are discussing a coordinated strategy to defeat the monsters waiting in the next stage of the game. Unfortunately one of the gamers, Leeroy Johnson takes matters into his own hands.

Since 2001, we have continuously said that easy credit would become so addictive. The resulting complacency would turn destructive.

We said that the then-Fed Chairman Alan Greenspan would go down as the most hated central banker in history. Despite being heckled, laughed at and mocked, we never waivered from the key tenet that his actions and those of the subsequent Fed chairs would ultimately end up in tears.

We should have had that cathartic moment to reset back in 2008/09 (and 2000 for that matter). Instead, we merely doubled down on the very same mistakes that got us into trouble in the first place.

If the Fed moves to support the junk bond market, undeserving companies run by irresponsible boards will be kept on life support instead of the free market being able to set clearing prices and potentially terminate them. Why not let market forces determine whether anything of value remains inside their entrails?

The Fed doesn’t have the power to buy equities yet but surely that is a coming attraction. We have seen how dismally it has worked in Japan.

The Head of Japan’s stock exchange admitted that  Japan’s central bank now owns around 60% of all Japanese Exchange Traded Funds (ETF) which is almost a quarter of the broader market. By stealth, the Bank of Japan has become a top 10 shareholder in almost 50% of listed stocks. In a sense, we have a trend which threatens to turn Japan’s largest businesses into quasi-state-owned enterprises (SoE) by the back door. At what point does it stop? When is enough?

We must accept a new reality where bankruptcy is openly accepted as a cure to weeding out excesses in the economy. Should there be demand, more efficient players can pick up the spoils.

We need this to make people realise that moral hazard isn’t going to be tolerated and personal responsibility is the order of the day. Anyone who is more than happy to have a winner-take-all mentality on the upside must be prepared to accept that the loser has to take all as well. Why should Main St bailout people who poorly assessed personal risk because our authorities provided a platform that encouraged the behaviour?

Let us not kid ourselves. There are no excuses in the game of greed. Lessons need to be taught to avoid such calamities in the future.

Sadly, our authorities will reject that advice and continue to fool around using the same reckless tools tried making us pay an ultimately higher price.

Buy Gold.

Unlimited QE and a reminder of discontinued series

Just when you thought it couldn’t get crazier, the Fed has announced that it will buy unlimited sizes of treasuries, mortgage-backed securities and corporate bonds. Recall our comments in 2018 when the Fed discontinued its reporting of assets. We noted that the Fed discontinued M3 money stock in 2006, two years before the GFC. Coincidence?

We were always struck by former Fed Chair Janet Yellen’s comments in 2016:

Monetary and fiscal policy is far better prepared for large positive shocks than negative ones

and 2017:

Don’t expect another financial crisis in our lifetime

The only thing left is to buy equities outright which would require an act of Congress. Such moves once again only highlight just how bad the situation has become. The Bank of Japan can hardly be credited with success over its ETF based equity purchases. It has now lost $30bn in this recent market rout. We should mention that the BoJ is a top 10 shareholder in almost 50% of listed stocks, creating an overhang of epic proportions should it ever announce it wants to reduce holdings. It now owns $300bn and due to be $400bn by year-end.

“Simplicity of ETFs” doesn’t always equate to more safety vs “Complexity of CDOs”

Remember how we were told how CDOs and synthetic CDOs were so mathematically complex that only a mythical hermit in the Himalayas could decode them?

Thank god we saw an explosion “as it says on the tin” exchange-traded-funds (ETFs) thrust upon us. So simple. Pick a basket of stocks, indices or commodities and one could get access to a whole range of products under that banner. One might feel that the S&P500 will go up so will look to buy a leveraged product of 2x or 3x to maximise returns. Even better the ETFs were far cheaper fees wise too.

Unfortunately, to hedge the risk of doubling exposure requires liquidity in the derivatives market. When markets panic and start sinking, the ability to keep the product true to its promises becomes quantum leaps harder. The explosion in the spreads on derivatives pricing (delta bleed) of the hedged products puts more downward pressure on the market.

Looking to ETF activity in the market, for the first week of March they comprised 34% of total activity up from 24% in February.

This is why ETF volatility on the downside is so much worse. By its design, an ETF ‘replicates’ the cash index it tracks. If the S&P500 falls by 2%, the S&P500 ETF product is designed to copy it. So it is always lagging, not leading.

Therefore if the market is having a coronavirus based sell-off, what might have been a 4% decline (big but not diabolical) turns into a 7% correction, especially when the leveraged products chime in. They might be small at 2% of the traded ETF market but the additional pressure starts to compound in the non-leveraged product too.

Because the media is so conditioned to compare apples with oranges with these recent declines to those we saw in 1987, 2000 or 2008, periods where relatively tiny levels of ETFs drove volatility, the cash market equity investors can get spooked by the optics of the sell-off which is merely the ETFs/levered ETFs playing catch up. So it can trigger more selling which exacerbates panic under, some might say, false pretences. It starts a chain reaction.

If you wish to learn more about the dynamics of ETF sell-offs please refer to the link here. The CEO of Blackrock, the world’s largest ETF provider infamously said,

leveraged ETFs have the potential to “blow up the whole industry one day.

We are starting to see the evidence emerge. The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPXSM) call and put options. On a global basis, it is one of the most recognized measures of volatility.

It is back toward 2008 highs. The spikes are effectively marking the “delta bleed”. This is why we need to keep an eye on the levels of activity in the ETF market potentially accelerating the extent of the market gyrations. Don’t be fooled into thinking ETFs are safe as houses products.

VIX

Explaining stock market volatility

They say a picture explains 1,000 points…

…the lighter side of market volatility which in reality is probably not far off the mark.

FNF Media wrote back in October 2015,

ETFs are hitting the market faster than the dim-sum trolley can circle the banquet hall. Charles Schwab, in the 12 months to July 2015, saw a 130-fold preference of ETF over mutual funds given their relative simplicity, cost and transparency….

…ETFs, despite increasing levels of sophistication, have brought about higher levels of market volatility. Studies have shown that a one standard deviation move of S&P500 ETF ownership as a percentage of total outstanding shares carries 21% excess intraday volatility. Regulators are also realising that limit up/down rules are exacerbating risk pricing and are seeking to revise as early as October 2015. In less liquid markets excess volatility has proved to be 54% higher with ETFs than the actual underlying indices. As more bearish market activity has arrived since August 2015 we investigate how ETFs may impact given a large part of recent existence has been under more favourable conditions…

CEO Larry Fink of Blackrock, the world’s largest ETF creator, has made it clear that
leveraged ETFs (at present 1.2% of total ETF AUM) have the potential to “blow up the whole industry one day.” The argument is that the underlying assets that provide the leverage (which tend to have less liquidity) could cause losses very quickly in volatile markets. To put this in perspective we looked at the Direxion Daily Fin Bull 3x (FAS) 3x leverage of the Russell 1000 Financial Services Index. As illustrated in the following chart FAS in volatile markets tends to overshoot aggressively

…The point Mr Fink is driving at is more obvious in volatile markets, the average daily return is closer to 10x (in both directions) than the 3x it is seeking to offer. This is post any market meltdown. On a daily basis, the minimum and maximum has ended up being -1756x to 1483x of the index return, albeit those extremes driven by the law of small numbers of the return of the underlying index. Which suggests that in a nasty downturn the ETF performance of the leveraged plays could be well outside the expectations of the holders.”

FNF Media has said for many years, where CDOs and CDSs required the intelligence of a mythical hermit atop a mountain in the Himalayas to understand the complexities, ETFs are the complete opposite. Super easy to understand which inadvertently causes complacency. Unfortunately, as much as they might try to do as written on the tin, the reality could well turn out to be the exact opposite.

Central banks use coronavirus as a convenient cover-up

Image result for death by 1000 cuts

Where would we be without central banks? The Reserve Bank of Australia (RBA) has trimmed another 25bps of the cash rate to 0.5%, an all-time low and the fourth cut in 9 months.  It is amazing how central banks can shape-shift from climate scientists to doctors.

Given the recent three rate cuts were unrelated to coronavirus and have failed to stimulate the economy as hoped, the pandemic has allowed the RBA to continue its limited ammunition under the context of rescuing us.

We aren’t supporters of ever more rate cuts, truth be told. Yet if central banks want to keep the disco ball spinning, why bother with a sissy 0.25%? If the RBA wants to jolt the economy back to life it would have been better to go straight to zero. Show the markets they are serious rather than drip-feed to the inevitable.

No doubt we will get the usual song and dance from politicians goading banks into passing on the full rate cut to customers. This time banks will probably fold on the back of the Hayne Royal Commission even though the truth is their funding costs won’t fall by the full amount meaning profit will be forgone for the sake of keeping up appearances.

Think through the logic. Last month, China PMI plunged to 35.7 from 50 in January, the lowest reading since January 2005  38.8 during the 2008 Global Financial Crisis.

Australia’s next economic print will be awful. Pushing through a miserly 0.25% won’t put a spring in people’s step unless they see a cycle. Personal credit growth is negative and at levels not seen since the GFC. Housing and business credit growth are at 6-yr lows. Money velocity is slowing. Business investment is at 1994 lows. Nothing to see here.

The economy needs proper industrial, structural and tax reform. After 28 years of untrammelled growth, Australia needs to realise that the complacency bred over that period will come back to haunt if we don’t wake up from the sleep walk.

As Jonathan Rochford of Narrowroad Capital said,

“When it comes to central banks, I would prefer to believe it is a combination of groupthink, an unwillingness to take career risk by speaking the truth and a willingness to either ignore or disregard counter-evidence that has resulted in the detrimental decisions since the financial crisis. However, the increasing amount of evidence, often produced by central banks themselves, points to central banks being more culpable than gullible.”

Don’t believe the hype. Coronavirus has given another excuse to cover up failed central bank policy alongside climate change green swans.

Forget the return “ON” your money. Just look to the return “OF” it

CM knew a lot of passive indices existed but not to this crazy extent. Probably explains why there is so much stupid money tied up in me too commoditised investment products. 4 years ago CM wrote a piece on the dangers of ETFs (especially leveraged)  and passive products in a downturn. These products predominantly follow the market, not lead it. So if these products end up stampeding toward the exits in a market meltdown, the extent will be amplified, especially those levered funds potentially making market panic look worse than it really might otherwise be. Don’t be surprised to see the mainstream media sensationalise the size of any falls in the market.

According to Bloomberg, 770,000 benchmark indexes were scrapped globally in 2019…however  2.96 million indexes remain around the world, according to a new report from the Index Industry Association…There are an estimated 630,000 stocks that trade globally, including c.2,800 stocks on the NYSE and c. 3,330 on NASDAQ or 5x as many indices as there are securities globally.

CM wrote back in October 2015,

ETFs are hitting the market faster than the dim-sum trolley can circle the banquet hall. Charles Schwab, in the 12 months to July 2015, saw a 130-fold preference of ETF over mutual funds given their relative simplicity, cost and transparency….

…ETFs, despite increasing levels of sophistication, have brought about higher levels of market volatility. Studies have shown that a one standard deviation move of S&P500 ETF ownership as a percentage of total outstanding shares carries 21% excess intraday volatility. Regulators are also realising that limit up/down rules are exacerbating risk pricing and are seeking to revise as early as October 2015. In less liquid markets excess volatility has proved to be 54% higher with ETFs than the actual underlying indices. As more bearish market activity has arrived since August 2015 we investigate how ETFs may impact given a large part of recent existence has been under more favourable conditions…

CEO Larry Fink of Blackrock, the world’s largest ETF creator, has made it clear that
leveraged ETFs (at present 1.2% of total ETF AUM) have the potential to “blow up the whole industry one day.” The argument is that the underlying assets that provide the leverage (which tend to have less liquidity) could cause losses very quickly in volatile markets. To put this in perspective we looked at the Direxion Daily Fin Bull 3x (FAS) 3x leverage of the Russell 1000 Financial Services Index. As illustrated in the following chart FAS in volatile markets tends to overshoot aggressively

…The point Mr Fink is driving at is more obvious with the following chart which shows in volatile markets, the average daily return is closer to 10x (in both directions) than the 3x it is seeking to offer. This is post any market meltdown. On a daily basis, the minimum and maximum has ended up being -1756x to 1483x of the index return, albeit those extremes driven by the law of small numbers of the return of the underlying index. Which suggests that in a nasty downturn the ETF performance of the leveraged plays could be well outside the expectations of the holders.”

CM has said for many years, where CDOs and CDSs required the intelligence of a mystical hermit atop a mountain in the Himalayas to understand the complexities, ETFs are the complete opposite. Super easy to understand which inadvertently causes complacency. Unfortunately, as much as they might try to do as written on the tin, the reality could well turn out to be the exact opposite.

Hence CM continues to believe that stocks with low levels of corporate social responsibility (CSR) scores like tobacco companies such s Philip Morris, JT and Imperial Tobacco, as well as gold/silver bullion,  look the places to be invested. Cash won’t necessarily be king because the banks are already in a world of pain that hasn’t even truly started yet. Aussie banks look like screaming shorts at these levels. The easiest way for the plebs – without access to a prime broker – to do this is to buy put options on individual bank names. Out of the money options are dirt cheap.

Banks

Forget the return ONyour money. Just look to the returnOFit.

NB, none of this constitutes investment advice. It is a reflection of where CM is invested only. 

 

Return of the State-Owned Enterprise

Image result for state owned enterprises

A new investor to Japan once asked CM how to categorise corporate behaviour in the land of the rising sun. CM replied, “Japan is not capitalism with warts, but socialism with beauty spots.

Latest reports confirm the Bank of Japan (BoJ) has now become a top 10 shareholder in almost 50% of listed stocks. In a sense, we have a trend which threatens to turn Japan’s largest businesses into quasi-state-owned enterprises (SoE) by the back door. The BoJ now owns $250bn of listed Japanese equities. It is the top shareholder in household Japanese brands such as Omron, Nidec and Fanuc. At current investment rates, the BoJ is set to own $400bn worth of the market by 2020-end.

The original reason for this move was to boost the ETF market and hope that Mrs Watanabe would pocket her winnings and splurge them at Mitsukoshi Department Store to increase consumption. Sadly all she has done is stuff it under the futon.

Although the government has been very public about the drive for good corporate governance, a stewardship code that drives to unwind cross-shareholdings, improve liquidity and lift returns, sadly the BoJ essentially reverses free-float and confounds the ability of companies to be attractive investments. What will happen if one day the BoJ announces it needs to pare its balance sheet back or that its holdings become too noticeable? These stocks will crater and Mrs Watanabe will become even more gun shy.

We shouldn’t forget that behind the walls of the BoJ, there is discussion to buy all $10 trillion of outstanding Japanese Government Bonds (JGBs) and convert them into zero-coupon perpetual bonds with a mild administration fee to legitimise the asset. Global markets won’t take nicely to wiping out 2 years worth of GDP with a printing press. Such a reckless experiment has yet to hit the Japanese Diet for discussion because such a move will require legislation to approve it. If it happens, the inflation the BoJ has now given up on will turn into a tsunami.