What the Heck Just Happened?

We’re only about five weeks into the year and one of my 2018 predictions is already coming true.

The thing is, it was an easy one – though it’s always nice to be proven right. I predicted that volatility would rise in 2018 after years of middling action. And rise it did. According to Ned Davis Research, the volatility index just spiked four standard deviations above average.

It’s subsided a bit, but volatility is here to stay.

Investors were reminded that, yes, sometimes stocks actually do go down, and they responded by yanking nearly $46 billion from investment funds last week.

But I don’t think this is the start of a bear market.

Don’t get me wrong, I’m still bearish. Market sentiment is still too bullish, and valuations are way too stretched. Something will have to give.

I think the recent market action is related more to folks going short on volatility rather than a market event that could take down stocks to major bear market levels.

Why do I think that?

Well, some hedge funds have made consistent returns day after day for several years betting against market volatility. It’s worked beautifully.

Those types of trades tend to work beautifully until they don’t.

Then, after years and years of gains, it’s all wiped out in a single day before breakfast gets cold. Most of the trades are done with huge amounts of leverage to amplify the otherwise small returns.

Once the trade goes the other way, margin calls come in, the trade gets unwound, and there’s a huge reversal in whatever instrument the hedge funds are trading. Then the hedge funds experience extreme pain, and I know that some banks have experienced the greatest number of margin calls in years.

This happened in 2008 when funds had been making a lot of money by shorting the Japanese yen with higher-yielding currencies. It worked great… until it didn’t.

But that also coincided with other crises as major financial institutions cratered for reasons unrelated to that trade. The short yen trade simply added fuel to the fire.

The other clue is when I look at the price action of stocks like Johnson & Johnson (NYSE: JNJ), which are defensive in nature. When they go from near 52-week highs to near 52-week lows in a matter of days, there’s something going on besides just fundamental issues. These stocks are in the major indexes, and it’s the futures contracts on those indexes that are linked to the volatility trades.

Unlike 2008, there’s no default or major bankruptcy. Interest rates are low, although they are trending higher.

I think we’ll see the real, nasty, and painful bear market once there’s a major corporate event such as the failure of someone too big to fail, a geopolitical event, or, most likely, that the interest rates used to price loans that people use to borrow against their stock portfolios simply get too expensive. Then everyone will rush for the exits at once.

While this may not be the start of a bear market, let this be a reminder that stocks actually do go down – sometimes and higher volatility can be expected in the months ahead.

Good investing,

John Del Vecchio

This post was originally published on Economy & Markets and can be seen here.

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