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The Latest Hammer to Smash the Market's Thumb

Andrew Stewart, CFA
Feb 27, 2018

 

The Latest Hammer to Smash the Market's Thumb.png

We spend much of our time in our writings here discussing high level topics like the importance of financial plans, why working with a fiduciary is so valuable, and the traps of behavioral finance. Rightfully so, as these are the big decisions we need to get right to achieve our goals. Nonetheless, I expect most of our readers go a level deeper in their interest and keep track of the stock market (and maybe the bond market) over long periods of time, and we write on broad market behavior now and then to help articulate what we see in our research. Sometimes, though, the market watchers among us notice market movements like we experienced at the beginning of this month and wonder "why the heck did that happen?!" Completely answering that question is almost impossible, but I believe two things:

  1. This was not a selloff driven by bad economic data (also known as "fundamental" reasons), but rather a "technical" selloff started by investors getting a little spooked.
  2. The large stock market swings we saw during the days of February 5th and 6th were driven by the volatility derivatives markets more than the stock market itself.

The small fundamental concern that triggered a large technical selloff.

Some economic data was published that indicated inflation would be somewhat higher over the next 12-18 months. Inflation cuts many ways, but the equity market seemed to focus on two potential negatives: wage inflation will cut into corporate profits a bit and perhaps the Fed would execute four rate hikes in 2018 instead of the previously expected three. These possibilities are worthy of consideration, but enough to cut the S&P 500 by 10% in a week based on economic predictions a year away? That's a bit much. The continued selling was technical in nature, with investors taking profits out of fear, not fundamentals.

The tail that wagged the dog.

On Monday, February 5th, things got worse. The technical selling in stocks continued, but the steep decline that afternoon was mostly driven by the unwinding of certain products that are short volatility, not the stock market itself. Volatility, often equated with fear, is simply a measure of the change in prices in the equity market. A short volatility trader sells insurance against rising volatility in the future, pockets the insurance premium, and makes money when the volatility in the future doesn't actually increase. If volatility does increase, though, the trader has to pay out on the insurance. If the trader doesn't have the cash to pay a potentially huge insurance claim, they will buy back the insurance policy before the loss gets too large. Everyone can see that purchase, though, and a new buyer of volatility insurance appears to the market as an expected increase in volatility, which is interpreted as fear, which drives down the equity markets and drives up volatility, and the cycle continues...

The legal hammer that smashed the tail.

If all that were only happening in the traditional institutional volatility derivatives markets, it still would have been trouble, but probably a bit more subdued as the human beings managing those portfolios can step in and take a breath. A new tool was created a few years back, though, that allowed retail investors to get into the volatility markets: specially built Exchange Traded Notes (ETN). These products allow investors to make bets for and against market volatility without the size and scale that typically restricted this market to institutional investors. Unfortunately, the way the ETNs are legally built can force them to self destruct when the volatility markets don't behave like normal. The portfolios never plan to hold cash intended to pay out an insurance claim. They always buy the insurance back when the market moves against them, and they do so daily, no matter what, per the legal prospectus.

If it sounds like tragic irony to you that a tool advertised to capitalize on others' fear also drives itself off cliff when fear shows up, you're not confused. These products can deliver as advertised when volatility moves around in a linear fashion over reasonable periods of time, but overnight surprises in the market (or even a fast moving market during the day) can turn these products into forced sellers or buyers at the worst possible time. This is when the institutional volatility investors (who are not bound by systematic rules but instead can be intelligent and patient humans) can take the other side of the ETN's trade, provide the demanded liquidity, and make a killing in the process.

It is reasonable for the market to respond to economic data. Slightly higher inflation requires some thought and response from investors, especially in a market like this one where everything is relatively expensive. Running for the exits is an overreaction, though, and trying to squeeze through the exit with a stampede that was started by an automaton is simply foolish. Be the thoughtful human in the room: don't succumb to your fears let alone the fears of others, and don't invest in tools that force you down that path by design. Instead, recognize your limitations, get some help, focus on a plan, and stick to it.

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Andrew Stewart, CFA is a Senior Portfolio Manager at Exchange Capital Management, a fee-only, fiduciary financial planning firm.  The opinions expressed in this article are his own.  

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