THE ETF EXPLOSION: Algorithm Illusions That Can Freeze Your Wealth… by Lynette Zang
When one door closes, another one opens. In 2008 an experimental derivative called a CDO (Collateralized Debt Obligation) dried up and sent the world into the “Great Recession.†Since then, there has been an explosion in a new derivative called an ETF (Exchange Traded Fund), which is typically unmanaged by humans and uses algorithms (computer formulas) to determine buying and selling.
Central Bank easy money policies produced a low volatility market that lulled investors into market complacency. ETFs generally hold no cash for redemptions, and mask true supply and demand for the underlying stocks, which sets up herding and could be the transmission mechanism for the next crisis.
Herding happens because many ETFs hold the same stock, so if a buying or selling algorithm is triggered, the move could be outsized, which is great on the way up, but likely to be problematic on the way down, particularly in a prolonged decline.
A prolonged decline would test the strength of the ETF derivative market. The test began in October of 2018 and by December 24th the market could have been at a critical danger point. In my opinion, this is what caused the central bank pivot heard around the world.
In my work I look at patterns to understand what’s happening and where we are in the market cycles. The price action of Walgreens Boots Alliance (WBA) on April 2nd provided an example of herding’s impact on ETFs. On the open, massive selling forced the stock to gap down (open well below the previous nights close). CNBC showed three of the ETFs (RHS, XLP, DIA) that have large positions in WBA and the dramatic impact it had on them.
Now imagine what would happen if there were a rush of redemptions. Since the ETFs hold virtually no cash, the “authorized participants†(banks) would be forced to hold the shares. OK on a short-term basis, but a prolonged sell off could force the banks to sell those shares putting further downward pressure on them and forcing a self-reinforcing doom loop as banks were forced to raise cash for redemptions.
What will wall street do when a flood of redemptions enters the markets? Halt trading. In other words, you are not getting out.
What are the smartest guys on money and markets doing for their “safe†money? Buying gold
Slides and Links:
https://www.stockcharts.com/h-sc/ui
https://www.stockcharts.com/h-sc/ui
https://www.cnbc.com/2018/12/06/the-stock-selloff-started-with-a-mysterious-fall-in-the-futures.html
