Dear Strategic Trader Subscriber,
Wall Street recently marked the nine-year anniversary (March 9th) of the long-term bullish uptrend we are currently in and, let’s face it, there has been a lot to celebrate. While there have been a few volatile periods during this nine-year run, most of this bullish uptrend has been characterized by steady spans of uninterrupted bullish moves higher.
This general sense of bullishness has been great for investors, as it seemed virtually every stock out there had been moving higher, but it has also created a cohort of lazy investors who have been able to sit back and take advantage of the phenomenon that “a rising tide floats all boats” without doing a lot of analytical work on their positions. That all changed last month when the S&P 500 Volatility Index (VIX) shot higher and sent stocks down 12% from their highs.
What Drove the Crash?
To be clear, this isn’t a situation where we know for sure what triggered the initial decline, but what turned it into a crash looks very likely to be an implosion in certain exchange-traded funds (ETFs). Specifically, some exotic exchange-traded notes (ETNs) — which are a little different than ETFs — based on the VIX futures seem to be the primary culprits.
The VIX is a measure of investor expectations for volatility and represents a pretty close approximation to the average level of implied volatility in the options of the S&P 500. When it rises, stocks fall, and vice versa. This inverse relationship with stocks is very tight, but not perfect. There are times when investors get nervous about the potential for future volatility and push the value of the VIX futures higher even while stock values are rising.
As you can imagine, if a large trader sees VIX futures rising near the end of the day, they can do two things to hedge: 1.) short stocks, or 2.) go long VIX futures. On most days, if traders need to neutralize their portfolios at the end of the day, it won’t make a big impact on the market because not everyone agrees on the same short-term forecast, so buying and selling can remain stable.
This time was different. An organic balance didn’t appear, a selling feedback-loop took hold and the market sustained a nasty shock.
The 900-lb Gorilla
In a normal market, investors are widely distributed and can do a lot to offset each other’s expectations. There is usually a bias in one direction or the other, which creates trends and normal price fluctuations, but a large group of unrelated buyers and sellers tends to smooth things out.
However, imagine that a massive VIX futures-buyer appears and creates a huge imbalance. To attract enough sellers, this VIX-buyer will have to continue paying higher and higher prices to get their positions filled. That is very similar to what happens in a short-squeeze.
Eventually, other traders who would otherwise not have purchased VIX futures (or shorted stocks) may be forced to do so in order to neutralize their portfolios, which further throws the big VIX-buyer out of balance, and the feedback loop continues.
The big buyers this time were VIX ETNs, and it was enough to trigger the feedback loop of VIX-buying and stock-selling. A significant part of the problem wasn’t even that the VIX ETNs were all that large. Rather, it was the fact that everyone knows how those funds must be managed. At a certain point, those ETNs will have to make portfolio adjustments, and traders rushed in to get ahead of them. While the 2015 flash crash was different, an ETF arbitrage selling-frenzy was a large part of the reason it got so bad as well.
The VIX ETNs that appear to have specifically contributed to this week’s crash are the VelocityShares Inverse VIX ETN (XIV) and the ProShares Short VIX ETN (SVXY). The former has been shut down already, and it is uncertain how long the ProShares version will last. You can see a chart of how much value the VelocityShares version lost during the debacle. These funds have been favorites among traders who have profited from a long-term decline in volatility, but that decline also created one-sided risk that hit the market in February.
Were There Any Warning Signs?
Long periods of low volatility, selling by pension funds and a divergence between the VIX indicator and stocks in January were all key warnings signs that a crash could happen. However, it’s important to remember that two-thirds of the time, these signals are false alarms. If a crash happens, those signals almost always immediately precede it, but the failure rate can lead to complacency.
Are Investors Out of the Woods?
The pullbacks in February and March seem to have broken that complacency and the bullish spell that had enveloped Wall Street for so many years, and now investors have to start doing their homework again because not all boats are floating right now. Some are, but others are not.
You can see the discrepancy in performance by looking at a comparison chart of the SPDR Sector ETFs since the beginning of 2018. As you can see in Fig. 1, the 10 S&P 500 sectors tracked by SPDR have produced the following results:
- Technology Select Sector SPDR Fund (XLK): -0.06%
- Consumer Discretionary Select Sector SPDR Fund (XLY): 0.53%
- Financial Select Sector SPDR Fund (XLF): -2.29%
- Health Care Select Sector SPDR Fund (XLV): -2.97%
- Industrial Select Sector SPDR Fund (XLI): -3.56%
- Materials Select Sector SPDR Fund (XLB): -7.48%
- Utilities Select Sector SPDR Fund (XLU): -3.83%
- Consumer Staples Select Sector SPDR Fund (XLP): -7.48%
- Real Estate Select Sector SPDR Fund (XLRE): -5.86%
- Energy Select Sector SPDR Fund (XLE): -8.94%
Seeing technology stocks flat for the year while energy stocks are losing 9% indicates a rather large discrepancy in sector performance. But if you are willing to spend the time to research and see which sectors are doing relatively well compared to which sectors are doing poorly, you can take advantage of these discrepancies.
The Bottom Line
So are investors out of the woods? Lazy investors are most definitely not out of the woods. Gone are the days when you can buy just any old stock and have confidence that it will rise. There will be stocks that will continue to go up as we head into the second quarter of 2018, but investors are going to have to do their homework and look for them.
John Jagerson and Wade Hansen
Editors, Strategic Trader