Sep

2

In the past six years, we have basically seen two phenomena in stocks: 1. etf growing use, and 2. share buybacks. My theory is that these two forces combine to totally drain liquidity from the stock market. The general downward trend in volume is the proof, also probably explains persistent small upward march of stocks, and the tendency for "corrections" to be much more like "flash crashes."

With one, we have something like robotic superfunds who accumulate mass quantities of stock and hold, rebalancing based on volume in the etf. With two we have drastic reductions in float.

A bear market in that environment will bring a certain violence and toxicity never seen before. Down days are almost forced to be large. So when we talk about a bear and months of down days, it will probably be something truly awful. Etfs will dump stocks on a reduced float market that is largely composed of funds anyways.

The size of the exit is determined by volume and float. Door is getting small…

Ken Drees writes: 

This article explains ETF mechanics well.

Almost as important for the ETF are the authorised participants, or APs, which act as marketmakers. The APs, most of which are banks, help to keep the share price of the ETF close to the value of the underlying assets. Imagine that one big investor in an ETF with, say, a 10% stake, wanted to sell its holding in a single day. There might not be ready buyers for such a large holding, causing the ETF to fall to a price below the value of the assets it owns.

To avoid this, the APs act to balance supply and demand. If the ETF is expanding (more people want to buy shares than to sell), then the AP puts in an order to the fund manager for a block of new shares, dubbed creation units, in the ETF. In return, it transfers a bundle of securities, based on the index the fund is tracking, to the manager (this bundle is known as the creation basket). If the ETF is shrinking (more people want to sell than to buy), then the AP sells creation units to the fund manager and receives in return a bundle of securities known as the "redemption basket".

The AP can also keep the price of the fund in line with its assets through arbitrage. The asset value of the ETF is published on a regular basis during the day; if the price of the ETF is higher than its underlying assets, then the AP (or any big investor) can sell ETF shares and buy the underlying assets. If the price is lower, they can buy ETF shares and sell the assets.

The AP can also keep the price of the fund in line with its assets through arbitrage. The asset value of the ETF is published on a regular basis during the day; if the price of the ETF is higher than its underlying assets, then the AP (or any big investor) can sell ETF shares and buy the underlying assets. If the price is lower, they can buy ETF shares and sell the assets.

So how might this process go wrong? One obvious danger might be the role of the APs. If they fail to make a market in the security, then the price could get out of kilter with the asset value of the fund. Alternatively, they might go bust in the middle of the creation or redemption process, which takes three days to complete. That might leave the ETF short of the shares needed to top up the fund (and match its benchmark) or the cash to pay its investors.

anonymous writes: 

Larry, your analysis seems reasonable. I'm curious if you or other folks here think the lack of liquidity applies more generally than just the stock market (e.g., in the banking and currency markets). See for instance:

"Into The ‘Dollar’ Run Now More Than Illiquidity?"

"Volatility As ‘Money’; Or Really Rising Vol As Anti-Money"

Ralph Vince writes: 

And the fact that leveraged and short ETFs must move stock exponentially with a drop in prices. That is to say, the more the underlying securities in the ETF drop in price, the more shares must be sold and this is not — a a drop of 2d takes more than twice as many shares to be sold as a drop in 1d. This would seem not such a big problem except that it is likely to occur during times of vacuous liquidity. 


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