ETFs Endure Knight Glitch Better than 2010 Flash Crash

August 6th at 1:13pm by Paul Weisbruch, Street One Financial

Last week began with equity markets leading off on solid footing with the S&P 500 trading as high as 1391.74 last Monday. But momentum quickly faded by midweek as major liquidity provider/market maker, Knight Capital Group (NYSE: KCG) in both Equities and ETFs failed investors last Wednesday, causing the stock to go into a complete free-fall ($10 price range last Wednesday and traded as low as $2.27) before rebounding somewhat to end the week.

Wednesday of last week was vaguely reminiscent of the May of 2010 “Flash Crash” where ETFs were to blame according to most uninformed media types, when in reality there was a system wide “outage” in data feeds and price calculations, causing many clearly erroneous trades to occur. Last Wednesday’s fiasco was much different, as the system issues seem relegated to one firm, and not at all a “contagion” that affected other financial trading firms. In fact, the market seems to agree with this logic as well, for despite a hiccup in performance on Wednesday, with the SPX dipping as low as 1354 intraday, stocks rallied to finish the week on strong economic data at 1390.99 and seem poised to break out further as we move into August.

A “bull” August is certainly what investors would love to see given last year’s carnage, and now with the market digesting poor AAPL earnings several weeks ago, and now a major trading glitch from a huge market participant (KCG), and still trotting higher, it’s no wonder the VIX is trading at a depressed $15.64 level. Even mighty Treasury Bonds, which continue to catch a bid in all seasons and circumstances these days as soon as “fear” rears its ugly head, fell sharply on Friday as stocks rallied. [5 Lessons for ETF Investors After the Knight Meltdown]

TLT (iShares Barclays 20+ Year Treasury Bond) for instance, which most use as a proxy for the Long Bond, traded as low as $126.77 on Friday before finding support on its 50 day moving average. Amid this move, we saw renewed interest in “Bear Treasury” products including TBT (ProShares UltraShort 20+ Year Treasury Bond) and TMV (Direxion Daily 20 Year Plus Treasury Bear 3x) via outright buying of the ETFs and/or via options in the ETFs, as well as via measured put buying in TLT.

Technically, the SPX has solid support at the 1375 level if it were to dip there, and of course upside resistance at this juncture lies at 1400 and if not for any other reason, it is psychological in nature.

Fund flows for the week reflected a mixed picture once again, but are decidedly leaning more toward “Risk On” than in previous weeks. SPY and VWO (Vanguard Emerging Markets) led all ETFs in net creation activity last week, reeling in $5 billion and more than $1 billion in new assets respectively. QQQ also took in more than $700 million and we note that AAPL (the number one holding in the Nasdaq 100 with roughly an 18% weighting), despite taking a small beating after its recent earnings report, has rebounded to challenge recent highs which is certainly a bullish sign not only for the Tech sector but for the equity markets on the whole. DIA (SPDR Dow Jones Industrial Average) also took in about $500 million last week, and a number of fixed income ETFs were also among fund flow leaders.

IEI (iShares Barclays 3-7 Year Treasury Bond), JNK (SPDR Barclays Capital High Yield Bond), HYG (iShares High Yield Corporate Bond) and TLT all were among the top 10 leaders in terms of ETF inflows last week, collectively attracting about $1.5 billion in new assets. Additionally, several sector ETFs, XRT (SPDR S&P Retail) and XLI (SPDR Industrials) were also among the most active, taking in about $250 million apiece last week.

In examining redemption activity last week, IWM (iShares Russell 2000) and IYR (iShares DJ U.S. REIT) led all ETFs in terms of outflows, with approximately $1 billion leaving the two funds collectively. UWM (ProShares Ultra Russell 2000) was also surprisingly active last week, trading more than 13 million shares last Wednesday on what was apparently a gigantic institutional fund liquidation of a long holding in the fund. Did this trade contribute to the dislocation and trading issues experienced by KCG (Knight) last week or was it coincidence that the fund, which is structured to deliver two times the daily leveraged return of the Russell 2000 Index, traded large blocks that day and saw large dollar redemption activity and ultimately more than 13 million shares versus average daily volume of 1.5 million share?

Other suspicious activity that emerged from last Wednesday were the 80,000 August 7.50 strike put contracts that were bought, and subsequently closed out, as KCG stock fell rapidly from a $10 handle, ultimately under $7 during Wednesday’s session, only to open with a $3 handle last Thursday. In options world, such a quick, and enormous profit, can be a career-making trade for whomever was fortunate enough to scoop up the KCG puts “prior” to the full effect of the news and the subsequent tanking of the stock. This oddly “fast” options orderflow will likely be examined by regulators, as the FXI (iShares FTSE China 25) call buyers ahead of a China central bank surprise rate cut were earlier this summer.

Other ETFs that lost net assets on the week include IVV (iShares S&P 500), IWN (iShares Russell 2000 Value), and XLF (SPDR Financials), but compared to the net dollar inflows given SPY alone took in more than $5 billion last week, the assets “out” are inconsequential for the most part.

Looking into the week ahead, despite last week’s midweek hiccups, it would be fair to say that we began August on the right foot instead of like last year’s August, which was a European driven debacle where “selling any rallies” was the norm, and the only way to play the equity market. Interestingly, throughout June and July, “buying the dips” has been a profitable strategy, with most market indices (with the exception of Small Caps via the Russell 2000) challenging multi-month breakout highs.

For more information on Street One ETF research and ETF trade execution/liquidity services, contact pweisbruch@streetonefinancial.com.

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