Monday, October 06, 2014

Gaining Fresh Market Perspectives From New Market Data

If you're looking for fresh sources of edge in financial markets, you either have to look at fresh data or look at old data in fresh ways.  Often it's the data that get overlooked that hold particular promise.

Each week I make it a habit to examine new data series.  Some are not promising at all.  Some look quite promising, only to find out that they are highly correlated with other, familiar data and so don't offer any unique edge.  Once in a while, however, new data can lead to new insights.  That's an important way to grow a trading business.

When we trade ETFs, we focus of course on their price and perhaps on the volume traded.  What we don't focus on so much is the number of shares outstanding in the particular fund.  Every day fund shares are created and redeemed by authorized participants.  This helps keep the ETF price in line with the underlying shares.  If the fund is pricey relative to the underlying shares, you can sell the ETF and buy the shares and vice versa.

If we look at the most popular ETF, SPY, we find out that daily increases in shares outstanding correlate with daily price change in the fund by a miniscule .034 going back to 2012.  That, in itself, I found interesting.  After all, if changes in shares outstanding perfectly mirrored price change, then there would be no reason to track the outstanding shares of the fund.  (Data available through State Street).

Going back to 2012, if we track 20-day changes in shares outstanding for SPY, we find something interesting.  When the number of shares outstanding is in its highest quartile over the past 20 days, the next 20 days in SPY average a gain of only .29%.  When the number of shares outstanding is in its lowest quartile over the past 20 days, the next 20 days in SPY average a meaningful gain of 2.02%.

One possible explanation for this is that the creation and redemption of fund shares is capturing something about sentiment with respect to the ETF and its shares.  In the arbitrage process, it is when stocks are priciest in a relative sense that ETFs will be created and stocks sold and vice versa.  Bursts of ETF redemption appear to be correlated with superior returns, at least for SPY.

Since the early August lows in stocks, we've seen a burst of share creation in SPY.  Despite the recent downdraft, 20-day change in shares outstanding is currently +4.77%.  (Although it's worth noting that the past six trading sessions have brought a pullback in shares outstanding; I'll be tracking this).  Interestingly, we've been seeing great share creation at a time when we've also seen waning market breadth.  That hasn't been a bullish combination for stocks.

Further Reading:  Innovation and Trading Success