Volatility Is Back
I think we understand what happened to the market on Feb 5. Though the VIX may return to normal, I'm guessing that volatility is back for good. With this awakening (or reminder) of volatility, I think we're entering a long term phase of higher risk.
In this article, I will write XIV-fund to avoid confusion with the VIX index.
In the aftermath of Monday, February 5, we now have a pretty good idea what happened. Two inverse volatility funds, XIV-fund and SVXY, suffered sharp losses when the stock market volatility measure (VIX) increased dramatically. These funds had approximately $4 billion short VIX futures contracts, and were forced to rapidly buy VIX contracts to cover their short positions. The amount of contracts purchased in one day was immense; according to my calculations, these two funds alone bought 1/3 to 1/2 of the entire open interest in February and March VIX contracts! In other words, the ETFs moved the VIX market.
This enormous panic-buying of the contracts sent the VIX futures soaring, sparking fear in the broader market, and a short squeeze in the futures. By the end of the day, SVXY had suffered heavy losses and liquidation, and the XIV-fund had collapsed, reaching a termination event. (Interestingly, SVXY survived the event.)
Yesterday I posted an article explaining what might be happening, and fund data confirms my theory. SVXY was short 125,000 futures contracts at Friday's close. By Monday's close, it was only short 3,000 contracts, meaning that it had been forced to buy 122,000 futures contracts or 25% of all open interest in the two front months. The numbered sequence of events I described in yesterday's article happened on Monday.
This kind of squeeze forces other institutions to also cover their VIX shorts, and the effect can persist for a while. The VIX did not fall today, which is probably an indication that the derivatives blow-up continues behind the scenes. There will be large losses and margin calls at many institutions due to this.
Why did this happen now?
The VIX measure had recently reached all time lows around the start of 2018. The design of the XIV-fund and SVXY instruments makes them sensitive to the percent change in VIX, meaning that they are most vulnerable when the VIX is low. They were ticking timebombs.
The initial trigger of this volatility surge doesn't really matter. If it wasn't due to higher treasury yields, it would have been due to something else eventually. The market had been in a very complacent, careless mood. Eventually, some kind of market shock was going to come along and prompt a sharp uptick in the VIX.
I don't think we're out of the woods, either. Volatility trading and derivative strategies are still extremely popular, and if we return to low VIX readings (perhaps under 15), any sudden volatility shocks can still cause derivative blow-ups.
What happens next?
Derivatives blow-ups create system instability. Sometimes they subside, and other times they can have cascading effects that spread throughout the system. The LTCM and subprime disasters are two examples of derivative blow-ups that sparked contagion and much broader effects. At the moment, there is no way to tell if something like this may happen.
My guess is that the VIX will settle down in the next few days, but generally stay elevated compared to the last few years. It might first decline towards 10 as the acute shock wears off, but trend higher in the coming year or two.
I think this marks an inflection point between the unusually low volatility of the last few years, and a new period of higher risk going forward.
Just the fact that the VIX printed at such a high reading will immediately start having effects on fund managers and algorithms that try to manage risk versus reward. Since investors perceive higher risk (or are awakened to the existence of risk), they will likely turn more conservative. "Buy the dip" behaviour, which depends on calm markets, may start disappearing.
Higher volatility does not necessarily mean that stocks will fall or enter a bear market, but I generally interpret this as a bearish development. We're 9 years into one of the strongest stock market rallies of all time, and US valuations have become very high. The professionals know that we're on borrowed time and everyone is waiting for indications that the bull market is over. The spike in VIX and 5% single day index drop goes into the "bearish indicator" category.
My guess is that stocks will start getting a bit crazier: more violent moves up and down.
We knew these ETFs were dangerous
I mentioned XIV-fund and SVXY as my vehicles of choice for the "Extreme Greed Edition" of my BullSignals strategy. As far back as July 2017, I wrote:
Warning: XIV is an ETN without assets and relies on the solvency of Credit Suisse. In case of a very large single day move, Credit Suisse has the right to dissolve the fund and force you to incur an enormous loss. If a crash similar to 1987 happens again, XIV would be dissolved and investors would lose all their money. This is a very dangerous instrument and you could lose 100% of your investment.
And a similar warning about SVXY:
Warning: SVXY is an exotic derivative ETF with very high risk. If a crash similar to 1987 happens again, SVXY could become worthless and could be terminated. This is a very dangerous instrument and you could lose 100% of your investment. SVXY should only be held in a tax sheltered account due to complex tax treatment in a normal taxable account. Although you may experience very large short term returns, you could forfeit all of your profits in just a single day.
It seems that my "Extreme Greed Edition" will show some poor returns this year. Oh well.