Submitted by Nicholas Colas of DataTrek Research
Get ready to hear a lot about exchange traded funds tied to the CBOE VIX Index and their role in today’s market decline. Here is why:
- After the close last night two US listed inverse VIX ETFs (XIV and SVXY) gapped down 80% from their 4pm closing price on heavy volume. These are products that rise when the VIX falls intraday, and decline when it increases. The returns are supposed to be 1:1 for those moves. If the VIX rises 5% from open to close, these products should decline 5%.
- The CBOE VIX Index opened today at 19 and closed at 37, a 95% move. You can see the problem here: a 1:1 relationship between the asset values for XIV and SVXY versus the underlying VIX index doesn’t leave much value for tomorrow.
- As of Friday morning, these two funds had combined assets under management of $3.2 billion. They were also among the most heavily traded symbols at Fidelity’s retail website today, with Buys outnumbering Sells by over 2 to 1. In addition, over the last year they were popular with hedge funds as an easy way to short volatility. Their returns in 2017 were +180%. No, that’s not a typo.
The upshot: this development could well be why the VIX doubled today and equities took it on the chin. In a market already up to its eyeballs with fundamental questions of valuation and interest rate uncertainty, seeing $3 billion of value evaporate is no one’s idea of a good thing. Who owns these assets today? How will volatility trade tomorrow on any unwind? What other volatility products are at risk?
This is a market that shoots first and asks questions later.
Now, as satisfying as it might be to find a possible market structure-related explanation to today’s horrible price action, this doesn’t mean we are out of the woods. Assuming volatility-related ETFs really are a market structure “Achilles heel”, this will take days if not weeks to play out, and there could be other problems waiting in the wings.
To put it bluntly, there’s never just one cockroach in the kitchen.
To help you put the next few days into some perspective, here are some issues to consider:
#1. US equity markets remain unsure of valuation, but not fundamentals. No one we talk to thinks the US economy is on the brink of a recession. The question is how hot the economy gets on the back of tax reform and what that does to yields. We’ve gone from a market used to playing checkers (rising earnings, low rates equals higher prices) to being forced to compete in grand master 3-dimension chess (worries over growth versus rates, equity valuations, and the strength of the dollar, plus now market structure concerns).
#2. We closed very near the intraday lows, which means we’re not likely done with this decline, even if the inverse VIX ETF storyline plays out as a primary cause of today’s action. The low point on the day was 2646 on the S&P 500; the close was 2649. This leaves little room for error tomorrow, and traders will want to see markets hold that intraday low.
#3. The CBOE VIX Index says we’re near a bottom, however. Provided we don’t get some further wonky action in the VIX as a result of whatever happens in ETF land, a VIX at 37 feels like a near term bottom. Yes, we realize that is a caveat as big as a barn door… But the VIX doubling in a day without a clear and present danger to the US economy seems overdone.
#4. There was a flash melt up in Treasuries today that exacerbated the afternoon gap down, perhaps caused by the dislocation in XIV and SVXY. That air pocket you saw just after 3pm in US stocks occurred at the same time as a 2% move higher in long dated US Treasuries. Whether this was a flash melt-up (essentially a market structure glitch) or the result of real buying, it shows how closely tied equities are to volatility in other markets. Also worth noting: VIX ETFs typically tell their brokers how much exposure they need for the close around 3pm. While the meltdown in XIV and SVXY came after the close, it is possible that news started to filter out around this time.
#5. There is also a tremendous amount of buzz/concern regarding how different sorts of investors are positioned and what their exposure means to near term stock price movements. A sample of these:
- Volatility/Options Traders. Options prices got very skewed in January as the market melted up. Call options became expensive and puts were close to free. Anyone who bought into those prices to get long “on the cheap” is now forced to unwind in a hurry.
- Risk Parity Investors. Picture the classic 60/40 stock-bond portfolio, but juiced up with leverage and a computer algorithm to allocate capital. When the historically negative correlation between stocks and bond goes positive (as it has in the last week), the computer models sell both to reduce risk exposure.
- Trend followers. US equity markets have traded in largely predictable patterns for years. Traders who simply follow those trends (again, with leverage to boost returns) must now sell as the trends reverse.
#6. Markets are forcing new Federal Reserve Chair Jay Powell’s hand regarding the “Fed Put”. Ever since Alan Greenspan rode to the rescue of US stocks in October 1987, investors have believed the Fed would take stock prices into account when setting interest rate policy. Today was Chair Powell’s first day on the job. Will he say something about the equity markets’ swoon, or will he wait?
#7. Here are some key valuation levels versus today’s close of 2649, which equates to 17.0x consensus 2018 estimates of $156/share in earnings:
- If we sell off another 5%, to 2516: 16.1x this year’s estimate (that $156/share)
- Sell off 10% from here, to 2384: 15.3x (NB: this is the historical 5 year average)
- Sell off 15% from here, to 2252: 14.4x this year’s estimate
- Sell off 20% from here, to 2119: 13.6x this year’s estimate
#8. Even if you find the near term trading low, we will have to retest it before equities can move sustainably higher. In all the chatter about comparing 1987 to the current market, that is the one lesson worth remembering. The October 19th lows that year were NOT the lows for the year. Those came in December.
Our bottom line: even if the inverse VIX ETF story proves true and markets see a relief rally, don’t assume the worst is past. We remain positive on US stocks but recognize that viewpoint will likely leave some scar tissue once the current volatility has passed