What Is Going On? … The VIX of It All
By Carolyn Walder
We know that the recent market activity might have you wondering, “What is going on?” We want to reach out to you with a bit of an explanation and our take on this incredible uptick in volatility. First of all, warning: this article is long and the end is quite technical. We will do our best to explain this in layman’s terms, but we think that it does help explain the craziness that is going on in the market!
As you probably are aware, we have been calling for a correction for some time now. The markets do not go up in a straight line, and historically we have had a correction of 10% on average every few years. However, up until Friday, February 2, the S&P 500 had the longest period EVER without a 3% pullback in stock prices. Something was bound to happen.
A Long-Overdue Correction
There are a couple of factors that are being cited as the reason for the sell-off. The first is, simply, we have been long overdue for a correction. The last correction was in January-February of 2016, or about 2 years ago. Couple that fact with the other statistics such as that noted above or the fact that 2017 set a record for the number of stock market records set in one year(!), and you have a perfect setup for a market correction. We agree that we were long overdue for a correction, and the current market situation proves the old adage that the faster the market goes up, the faster it will fall. However, the historically extreme volatility has us wondering if there is something else going on as well. (Read on to the end of the article for the theories for the incredibly extreme volatility.)
Bond vs. Treasury Yields
The second reason given is the steep rise in bond yields over the past week as the 10-year treasury gets closer to the 3% yield that many are saying will trigger income-oriented investors, particularly older Americans, to sell their dividend-paying stocks and buy treasury bonds. One of the most widely bought sectors for dividend yields is now and has historically been utility stocks. Hence, with this theory, one would expect that the sell-off would be most predominant in utilities stocks and other high-yielding stocks. That just has not been the case, as the Dow Jones Utilities index is down just shy of 6%, while the Dow Jones industrial average is now down almost 9% since last Thursday. We do not buy this explanation for the sharp downturn in the stock market.
The third reason given is that investors are now spooked over inflation concerns and that accelerating inflation will give the Fed reason to raise the benchmark federal funds rate at a faster pace than the market expects. Although inflation has been relatively tame, a significant uptick in wage inflation was noted in the release of the inflation data last Friday. Inflation, and the corresponding acceleration in interest rates raises borrowing costs for companies and traditionally slows economic growth, leading to fears of a recession. While this is a valid concern, the violent[A1] nature of the correction gives us pause for attributing this correction solely to these concerns.
And Then There Are VIX and XIV
The fourth, and perhaps the most interesting, theory is based on the buying and selling of financial products related to volatility, or the VIX index... The “market” has become increasingly more sophisticated (and complicated) with the advent of more financial products following more indicators and their associated indices such as the VIX. A full explanation of the VIX requires quite a bit of market knowledge, so we will try to explain this as best we can in layman’s terms.
The VIX is considered an “alternative investment” that rewards investors with a positive return when the markets are volatile. The VIX is highly uncorrelated with stocks: as the market was setting new record highs throughout 2017 and into early 2018, the record lowest close on the VIX was recorded on November 13, 2017! If you were invested in the VIX over the past 2 years (up to the end of January) you would have lost money, but investors in the VIX were rewarded with a 148% return over the past week! However, it has not been the VIX itself that has caused the violent move to the downside in the market, but speculation is that the inverse of the VIX is the culprit. While investors can purchase a bet on volatility with the VIX, they can also buy a bet on no/low volatility with a number of exchange traded funds (ETFs) and exchange traded notes (ETNs) that purchase what is essentially the inverse (or exact opposite) of the VIX. This is where the problem lies. These ETFs and ETNs purchase “bets” on futures exchanges (technically known as “shorting” the futures contracts) that there will be low or no volatility in the stock market. When volatility DOES appear, the ETF and ETN managers are forced to buy back their short position (technically known as “covering” their short position) by the very nature of these products in the nearest term contract and roll their short position out to a later dated contract. Buying back their position adds to [A2] the volatility in this vicious cycle because they have to buy back the VIX or the very representation of stock market volatility! In fact, the highest volatility, as measured by the VIX, ever recorded was on Monday, February 5, 2018, at 116%, the highest daily percentage increase recorded since the index began in 1990. Monday’s volatility was even higher than that when Lehman Brothers or Bear Stearns failed during the Great Recession! How this vicious cycle will end is anyone’s guess, as the very nature of these ETFs and ETNs require them to buy back (purchase) the VIX (volatility) thus begetting more volatility. With that said, there may be some clues in recent actions by some of these funds/notes.
Credit Suisse created a popular ETN called the VelocityShares Daily Inverse VIX Short Term ETN. This ETN has the ticker symbol XIV because it is the inverse or the exact opposite of the VIX. This fund makes money when the market is stable and rising, and it loses money when the market makes sharp corrections as we have seen over the past week. (An ETN is structured more like a bond than a stock, and ETNs are issued by banks.) This particular ETN had a clause in the prospectus (everyone reads the prospectus, right?) that gave Credit Suisse the “option” to liquidate the entire “fund” if the XIV ETN declined by at least 80% in one trading day. They recently announced that they are exercising this option and declared that the note will be liquidated on February 21, 2018, after the ETN lost more than 80% of its value in after-hours trading on February 5, 2018.
VIX History Lesson
How does this affect the market? First, a short history lesson and some more education on how we got to where we are. Historically one could not “buy” the VIX index. It could only be speculated on by buying and selling futures contracts and generally were used by experienced investors, such as hedge funds and pension funds, to make calculated bets on the volatility of the market. Over the past 8 years, “shorting” volatility has been extremely profitable as these sophisticated investors have been able to cash in on the lower volatility of the stock market since the Great Recession. However, this large profitability led to the creation of ETFs and ETNs which have allowed retail and less sophisticated investors to “get in” on the action. The same ETN that is now being liquidated because of the extreme losses experienced this week was introduced in December 2010 and began trading at around $11.04 per share. Between December 3, 2010, and January 12, 2018, the price of XIV had risen to $144.75, or more than a 1,211% gain in 8 years (data from Google Finance). As any long-term investor knows, any investment that goes up that much in that short a period of time has a LOT of risk embedded in it. Does anyone remember the dot.com era and the outcome for many of the high-flying internet stocks? (Hint … many went bankrupt). This was bound to come to an end at some point.
Fast Forward to Today
This brings us to the point of how this ETN and others like it are relevant to the state of the stock market today. We do not want to scare you, but the fallout could cause a more severe market crash. The process may have already started, but the theory goes something like this … first for retail investors:
1. XIV shareholders have their positions liquidated by February 21 at the net asset value of the fund which represents an 80%-100% loss.
2. If any shareholders of the XIV ETN bought their positions on margin (i.e., borrowed money against their stocks), they will be forced to sell their stocks to meet the “margin calls,” essentially the brokerage firm saying you need to pay us back the money we loaned you and we are going to force you to sell your stocks to pay us back.
3. Many investors will be spooked by the intense selling pressure and will hesitate to buy into the market, thus creating an imbalance between sellers and buyers, causing prices on stocks to drop further.
4. This decline in stock market can force further selling of stocks for the investors that put so-called “stop losses” on their positions which tells their brokerage firm to sell their stocks if the price gets down to a predetermined level.
5. Finally, the ongoing decline causes an even larger rise in volatility, and the institutional investors with exposure to “short volatility” are impacted, forcing even more selling.
The impact caused by the institutional investors becomes even more complicated (and too technical for a lay article like this one). Suffice it to say, however, that the VIX itself is a calculated number based on the implied volatility of the options market. This directly affects the stock futures markets, which impacts the prices that stocks are expected to be selling at in the futures markets, which impacts the prices that stocks are actually selling at upon the opening of the stock markets.
What Does This All Mean?
What does this all mean for you? While we cannot tell you when this selling will end or how far the indices will fall before it is over, we do believe that the selling will come to an end. When it does, we suspect that many investors on the sidelines will be back buying fiercely in the market such that we may see a steep rise in the market after the selling subsides. There is no fundamental reason for a crash of this apparent magnitude to be happening. Companies have strong earnings and the recent permanent tax cuts for corporations have made them significantly more profitable going forward. The budget deficit and our long-term debt is a concern. The level of that concern is subject to debate, but not a reason to cause a lingering stock market crash that turns into something much worse. Even if the market is expecting much higher inflation and interest rates, the impacts would be more gradual than the “falling knife” we are presented with right now with the current stock market declines.
Lifetime Wealth’s Response
How will Lifetime Wealth react to these events? As you know, we are long-term investors who realize that buying low and selling high will always win in the stock market. We also recognize that it takes time to realize these benefits—time which may be measured in months or even years. Our plan is to continue to watch the markets closely and review your rebalancing reports daily. If the market sells off to the point that we can sell fixed income to buy stocks, we know that we will be “buying low,” even if we are not buying at the lowest point of the market. We may even have multiple opportunities to do this opportunistic rebalancing. For our clients who were with Carolyn at Bernhardt Wealth Management on September 11, 2001, you may remember that we were busying buying/rebalancing when the stock market finally opened, four days after that terrible day in our history. While the positive effects could not be felt right away, the “buying low” helped to propel our clients' portfolios to greater returns than would otherwise if we would have just waited out the ensuing stock market crash.
In closing, we urge you to go on with your daily lives, enjoy your vacations, stick with your routines, and try not to worry about what is happening in the market on a day-to-day basis as it could get a lot worse before it gets better. We hope not, but we are prepared in case it does. Just remember our mantra: “Stay calm, stay cool, and stay the course.”
As always, we are here for you if you have any questions or concerns about your financial situation. Please contact our office, and one of us will get back to you as soon as possible!