four stock market questions: the first one

I got an email recently from a reader (and relative) that I thought I’d answer through posts. Here is the first one:

Q: Does an ETF have to go up or down in general proportion to the underlying stocks that make it up?  Like if ARKK was made up of just 10 stocks, and one day all 10 went down 5% each, would ARKK itself drop 5% in aggregate?  Or could people decide they liked ARKK as a long term investment and buy it and ARKK goes up 5% despite each and every stock that makes it up dropping 5% the same day?

A: An ETF is like a mutual fund in that both are special purpose corporations (details). One key difference is that mutual funds handle recordkeeping and sales/redemptions themselves and deduct prospectus-specified administrative charges from overall fund assets for doing so. Mutual funds sell/redeem once daily, after the US market close, and at net asset value. So the question of transactions away from NAV never comes up.

In contrast, brokers that an ETF designates as authorized agents keep the fund’s records of trades. They also make a market in the shares, buying and selling them during normal market hours, just like they do for individual stocks, and taking a bid-asked spread as compensation.

An aside: the major stock exchanges update prices of US-traded stocks every 15 seconds; brokers use these feeds to calculate the NAV of any ETF precisely (a practical impossibility for you and me). So we can’t know exactly how our buy/sell price differs from NAV at the time we transact. This is a big edge for the broker. But in a normal market, the broker markup will likely be less than 0.5% of NAV.

In the real world, brokerage house traders routinely keep open positions, both long and short, that they plan to close at a more profitable point later on. Let’s assume, though, that the trader’s goal is not to have any risk on his books and to close positions as fast as possible.

Let’s look at the case of common stock XYZ trading at $10 right now.

In the simplest case, one client wants to sell 100 shares of XYZ and at the same time a second customer wants to buy the same number. The trader simultaneously agrees to pay the seller $9.95/sh and charge the buyer $10.05/sh, and pocket the $.10/sh spread. The trade will settle in two days.

If the sells are 300 shares and the buys 100, the broker will execute the buy/sell of the first 100 shares in line and lower the price he is willing to pay for the rest to, say $9.80 or $9.75. This process both draws in new buyers and encourages price-sensitive sellers to withdraw their orders.

If, in contrast, the buys are 300 and the sells 100, the broker will act in analogous fashion by raising the price he is willing to pay for the rest.

In either case, the right-now hopes and fears of the market can move XYZ up and down, without apparent regard for any intrinsic value of the underlying company.

An ETF is different, however. The underlying assets are themselves publicly traded stocks, whose asset value the broker calculates every 15 seconds. Also, the agreement between ETF and authorized agent allows the agent to both exchange ETF share for the underlying assets and to exchange packages of the underlying assets for ETF shares.

So if the ETF begins to trade above NAV, the broker will sell the ETF short in the market, buy the underlying assets, convert them into new ETF shares and use them to close out the original short. If the ETF is trading below NAV, the broker buys the ETF, shorts the underlying stocks and converts the ETF into stocks to close the short.

In simpler terms, if the ETF is trading at $100 and NAV is $105, the broker buys the ETF (spending $100) while shorting the underlying stocks (taking in $105), and then exchanges the ETF share for the underlying stocks and closes the trade. This arbitrage is simple, can be done automatically, is virtually costless–and nets $5.

If the ETF is trading at $105 and the NAV is $100, the opposite happens. Short the ETF, buy the stocks, present them to the ETF for a new ETF share, close out the short. Net $5.

So, although in theory the situation you describe could happen–the ETF trading at a substantial premium to NAV–it’s highly unlikely, both because the ETF can create new shares to meet stepped-up demand and because the arbitrage opportunity, were a premium to develop, is so lucrative.

One possible exception: at the bottom of the market during the 2008–09 financial crisis, shares of ETFs containing only foreign stocks closed one day at discounts of as much as 12% to NAV. The main reason, I think, is that foreign markets weren’t open at that time of day for arbitrage to happen.

conventional wisdom: competing paradigms

One of the oldest rules on Wall Street is that a bear market isn’t over until the last bull capitulates. In the past, the obvious questions have been: how we can know who the last bull is and how we can tell that he/she has finally given in to despair and sold. Arguably, the identity doesn’t matter that much and we see the capitulation through a selling climax–meaning a dramatic market decline on huge volume.

During the past few market cycles, the investing world has changed so that it is no longer the resolve of professional portfolio managers that is crucial. Rather, panic selling has become a group affair, with individuals holding shares in mutual funds, mostly no-load, doing the damage. (During one big downturn when I was managing a load fund, for example, I lost about 5% of my assets to redemptions. A comparable, though somewhat weaker, no-load competitor from Fidelity lost something like a third of its.)

Today it seems to me that if there is a last bull it’s Cathie Wood. If I understand her behavior correctly, she’s responded to the loss of two thirds of her asset value over the past year by increasing her portfolio concentration. This is the opposite of what conventional portfolio management wisdom would prescribe, though one might argue that hers is mainly a move out of the group’s least liquid names. In any event, my guess is that Ms. Wood herself won’t capitulate.

Does the bear market go on forever, then? No. Capitulation will likely come through ETF holder redemptions, especially in the ARK arena. As far as I can tell, this hasn’t happened yet.

A second, equally venerable, rule is that the stock market acts in a way that makes the greatest fools out of the largest number of people. For a portfolio manager, this implies: read/hear the financial news, try to figure out what the consensus opinion is …and then set up a portfolio based on the premise that the opposite of these consensus beliefs will play out.

The underlying assumption is that information flows from companies to a cadre of professional securities analysts, who know the companies well and also gather data from government and industry sources. After they have informed clients of their conclusions and given time for them to to act, the analysts typically begin to release their findings to the financial media. By the time media personalities, who tend to have no stock market knowledge or experience, begin to weigh in, the developments they are talking about would have already been pretty well already factored into stock prices.

So this indicator seems to be giving the opposite signal.

The issue I see is that in the cost-cutting the big financial firms undertook following the financial crisis of 2007-09, most/all brokerage firms decimated their stock research staffs (many mutual fund companies had done something similar with their in-house analysts a decade earlier, becoming radically dependent on sell-side research). This has eliminated the most important information source–a cynic would say the only one–for the financial media.

The result is what we see in the offerings of today’s financial media–highly emotionally-pitched gibberish. Lots of emotive performance, lots of jargon, lots of reaction to company or government data announcements, but no anticipation or analysis.

As for myself, I think the ideas of inflation and recession have been more than beaten to death in the stock market media. But because the essential link of the analyst community between press and portfolio manager has been lost, it’s hard to judge whether the current media near-hysterical pessimism extends beyond the broadcast studio. If it does, that’s a good sign, not a bad one.

NY Times: Paul Krugman

I’m not sure I’m a 100% fan of Paul Krugman. On the other hand, he is an expert on international economics, he has won a Nobel Prize, and he has been a round for a relatively long time. So he’s worth paying attention to. He’s also written several recent opinion pieces for the NYT that I think are important.

–in one from June 14th titled “How America Lost Its Edge,” recent international travel has caused him to observe that the US seems to be at best in the middle of the pack among the wealthy countries of the world, and in important ways falling behind. My sense is that this is right, even though the US is being compared with places like Europe and Japan, where the population is significantly older–a significant advantage for the US. In a sense, the Ghost of Christmas Future is turning into the GoC Present.

Washington has long had an obsession with industries of the past. Add in the Trump tariffs and his decision to shrink the domestic workforce and you have a recipe for continuing stagnation. And that’s without the coup attempt.

As an investor, this all seems to put a premium on companies that, while incorporated and traded in the US, have strong intellectual property, global sales and limited plant and equipment in the US. It also argues for rooting through the current tech rubble.

–two others are more important for the near-term stock market, I think. From the past few days, they are “Is the Era of Cheap Money Over?” and “Wonking Out: Hot Economies and High Prices.”

In the first he addresses the issue of a decade of low nominal interest rates, which some are arguing has produced an epic stock market bubble over the past couple of years that can only be cured by much higher rates in the future. Krugman points out that the mother of recent stock market excess, the Internet bubble of 1998-2000 happened when real rates were 4%, or 8x what they’ve been during the pandemic. He also suggests that today’s low rates are more a function of an aging population and lack of population growth–Japan is an extreme case of this, and, I think, a harbinger of the fate of an anti-innovation US–than anything else.

In the second, he observes that most commentators on inflation, even in the academic world, don’t have much of an idea about what inflation actually is. For one thing, on the most basic level, they mix up one-time price increases with inflation, which is a steady, years-long rise in prices. In particular, over the past year crude oil has gone from, say, $70 a barrel to $110. Is this a one-time event, or do consumers (and the stock market) expect inflation in the oil price–that crude will be going for $140 a barrel in 2023, $170 in 2024 and $200 in 2025 (and that no one is going to buy an electric vehicle)?

Also, doomsayers on inflation often refer to the Phillips curve, a generalization from the original empirical observation that at low employment rates prices tend to rise. In the 1970s, economists noted that at low employment rates, not only do workers expect prices to rise today but also for prices to continue to rise for years afterward. In other words, the idea of inflation quickly becomes imbedded in consumer expectations.

From this comes the idea that the money authority must raise interest rates to a level where unemployment rises significantly, so that inflation expectations dissipate.

The truly unfortunate part of this analysis, for Krugman, is that the the 1970s version of the Phillips curve hasn’t held true for any other period in the nearly half-century since it was formulated–and which was also not characteristic of the time before the 1970s, either.

So, if we have headline number for prices as being 8% higher today than a year ago, my guess is we should probably break this out into 4% one-time, pandemic- and Ukraine invasion-related, price rises + 4% “ordinary” inflation. If so, the Fed’s task isn’t anywhere near as Herculean as inflammatory headlines might make it seem. Also, given recent reports that merchants like Target and Walmart have massive excess inventories, we should probably question what scope retailers have to push prices higher.

interest rates and the housing market

To my mind, the oddest thing about residential real estate in all the markets around the world I’ve dealt in is that purchase price is not the primary consideration for buyers. Rather, what is top of mind is the monthly payment–mortgage interest + return of principal + taxes and utilities. Typically, people buy the most expensive property they can finance.

In the US, the traditional rule of thumb is that total monthly payment should not exceed 28% of the buyers’ gross income. I’ve shortened this rule to: the interest payment, which is by far the dominant element in the early years of almost any mortgage, can’t be more than 25% of gross income. (Overall, I’ve found over the years that taking a first step of making gigantic simplifying assumptions and seeing what they imply is, for me, the best way to get started. Refining can come later.)

Let’s assume the buyer(s) have yearly income of $100,000. This means maximum interest expense of $25,000. At 3%, the most that can be borrowed is $25,000/.03 = $833,000. This implies a total price of $1,040,000 ($833,000/.8) and, therefore, a cash down payment of $207,000. When my wife and I bought our house long ago (interest rates at 17%), our biggest problem was getting the $8,000 down payment we needed.

Assume rates rise to 6%. Interest expense of $25,000 implies maximum loan principal of $417,000. and total price of $520,000.

In other words, our imaginary buyer(s), who could afford a million-dollar house a few months ago, can only get financing for a $500,000 house today.

The biggest implication–a cooling housing market.

More tomorrow.