The Most Dangerous Market in History
If you read the title and thought it was because we’re in the third longest expansionary business cycle or that growth of this last cycle has been the weakest in history or that debt levels are the highest across the globe, you might be right. Is it because valuation metrics show this market is somewhere between the highest and third highest in history? Perhaps it’s because credit conditions for businesses and consumers are collapsing at a rate only seen during a recession. While all of those are good reasons the market is overvalued, it’s not the reason why this market may be the most dangerous in all of history. The reason is short volatility.
In past updates, I’ve used the video portion of the update to discuss the risks of short volatility. As long as the stock market is going up and volatility is falling, everything is okay. But if the stock market falls and volatility spikes, it would be like pouring gasoline on a forest fire. With the VIX (Volatility Index) at the lowest closing-value in history, I thought it would be a good time to cover this more in depth.
Before I get too far, I feel compelled to fully disclose the risks of trading long- or short-volatility positions. Volatility trading should only be used by professional money managers, large institutional money managers or pension fund managers, who have a need to hedge with volatility. The Prospectus states that market conditions could cause the value of a volatility fund can go to zero (investors can lose more than 100% of their investment) and even though they are traded on a major exchange, market conditions could cause them to become illiquid. And, in case you’re wondering, I don’t use them.
Before I can explain why short volatility is creating a huge amount of risk in the market, I first need to define volatility. The non-technical definition of volatility states it’s the amount of fluctuation a security will have in the short-term. If volatility is low, as it is now, stocks should expect minor or small fluctuations in prices going forward. If volatility is high, which it is when perceived levels of risk are high, stocks should expect large fluctuations in value.
When volatility is in a declining trend, which it has been since the presidential election, stock prices usually rise. When volatility is as low as it is now, the fluctuations in that uptrend should be very low, which they have been. When stock prices rise without any major fluctuations, it gives investors a feeling of safety. With the perceived absence of risk in the stock market, investors are willing to take an increasing amount of risk with their money. In a sense, investors feel like they can’t lose. In market speak, there is a strong sentiment shift to becoming “bullish” or the belief that stock prices are going to continue to rise. And as we have seen, investors have gone “all in” with stocks.
“Shorting volatility” is an indirect or direct act by an investor. When an investor purchases an index fund, such as the S&P 500, they are indirectly shorting volatility. Indexation by itself, is being short volatility. As more investors pour their money into index funds, volatility falls. Buying a short volatility fund that purchases short positions on a volatility index is the direct act of shorting volatility. I should also point out that prior to 2010, the public didn’t have any easy way to directly short volatility.
In 2010 someone had the great idea to create several Exchange Traded Funds (ETFs) to allow the public to buy long- or short-volatility shares. I believe someday that someone, besides myself, will point out that this was a bad idea. In order to understand how toxic volatility trading can be, let’s explore why someone might use them.
Let’s imagine that I manage a pension fund worth several billion dollars. As the manager, when I buy stocks, I buy them with a twenty- to thirty-year (or longer) time horizon. I know there will be booms and busts along the way, but due to the sheer size of money I manage, I run the risk of moving the market if I want to enter or exit a position. When I buy, I buy to hold. Now, let’s imagine right now volatility is low and the market is high, which it is. I should expect that at some point that relationship will change and my pension fund will lose money when the stock market falls.
Since I can’t sell positions very easily, my only recourse would be to hedge the portfolio. One way I could hedge a rise in volatility, which is usually associated with a fall in stock prices, would be to use a small amount of money to purchase long volatility shares. If volatility spikes, those long volatility shares would rise in value. While they wouldn’t rise enough to offset the losses of the stocks, it would reduce the losses. By the same idea, when volatility is high, I might want to short volatility to help further recover my losses. Hopefully this explanation seems logical to you and explains how to properly use volatility for hedging purposes. But as you can probably guess, it’s not being properly used right now.
Earlier I mentioned that volatility ETFs were created in 2010 to allow the public to trade long- and short-volatility positions. You might think that is where the problem starts. No, it’s much worse than that. The public arrived late to the game, as they always do. As you’re about to see, they have only made the situation worse.
Shorting volatility is all the rage today. When someone buys a share of short volatility, they are selling an insurance policy that only makes a claim if the market declines. If the market goes up, the seller profits on the sale of the share of volatility. If the market goes down, the seller of volatility has a major problem on their hands, depending on how fast the market goes down. It’s much like selling a homeowner’s policy on your neighbor’s house and hoping their house never burns down. If it does burn down, then the seller of the policy holds all the liability. As long as the stock market goes up and nothing shocks the system, everything is okay.
When someone buys a share of short volatility there must be someone on the other side of the trade. In this case, it’s the securities dealers. In a normal market, buyers and sellers are matched up. Right now, however, about 97% of all volatility shares sold are on the short side. The dealers are making up the other side of the trade. When an order for a share of short volatility comes in, the dealer must buy a share of long volatility for their portfolio, so there is balance. To hedge the long volatility share that the dealer is holding, the dealer also buys a long position on the S&P 500. Now you can see the relationship that occurs between volatility and the market. As more short volatility positions are sold, the stock market goes up. And there’s been a huge amount of short volatility positions sold in the past year.
This will come as a surprise to you, but pension funds have been big buyers of short volatility. I’ve mentioned that pensions, both public and private, do not have enough money to pay their future benefits. A recent report showed that the average state pension is only 69% funded, with CalPERS at 68% funding. The reason pension funds are short volatility is because they are long US equities. Because the Fed has suppressed interest rates for so long, pension funds have been forced to overweighting their portfolios in stocks to generate a return. Given they are already underfunded today, it’s hard to think about where they will be at the end of the next recession. Pension funds are heavily motivated to keep stock prices up and motivated to make up for the shortfall in their bond portfolio, so they have turned to shorting volatility to generate excess return. It doesn’t stop there.
Insurance companies have also gotten in the mix. Variable annuity companies created volatility controlled products that move the investment mix between stocks and bonds based on volatility. When volatility is low, the allocation is 100% to stocks. When volatility rises, the allocation moves to bonds. And there’s a lot of money in these products that is currently fully allocated to stocks. Insurance companies aren’t the only ones on the bandwagon.
Investment companies created risk-parity products that adjust the allocation of the portfolio based on risk (or volatility) rather than defined asset allocation principals. These portfolios overweight stocks when volatility is low and shift money into bonds when volatility rises. They are currently overweighed in stocks.
And then there is the public. The public has been buying short volatility because the stock chart has been going up. But those ETFs haven’t been around during a financial crisis, so nobody knows how they will perform. In the meantime, buying short volatility is a leveraged (and very risky) trade on a rising stock market.
Now if all this sounds like it could go very bad, it can. Some experts believe that a sharp 3-5% down move in the stock market could trigger a spike in volatility which would lead to an unwinding of these trades. The simple reason for the unwind is that those who are short volatility and can’t exit their trades will be forced to buy volatility to keep from losing everything. As more people buy volatility, volatility will rise and stock prices will fall. As stock prices fall, volatility will rise higher. What you quickly get is a massive feedback loop where stocks are falling and volatility is rising. Of course, nobody thinks that will ever happen. Everyone thinks there will be a slow gradual fall in the stock market where everyone will be able to get out of their positions without losing money.
That’s what makes this market so dangerous. Equity prices are at all-time highs. Volatility is at all-time lows. Both require equity prices to continue rising and volatility to continue falling – in perpetuity. If anything triggers a spike in volatility this whole market could implode.
This is how I think it could go: Let’s say the stock market makes a large one day move down of 5-20%. I know that’s crazy, but let’s just pretend. As the market drops those who are short volatility will either sell their short positions or be forced to buy long volatility positions. Both moves will cause volatility to rise.
That night the annuity and risk-parity products will begin making their moves to bonds, meaning volatility will rise the next day, forcing more selling of short volatility positions, which will further drive the stock market down. Over the next week the annuity and risk-parity products will continue to adjust into bonds.
The public, who now is losing money quickly, will also start selling their equity and short volatility positions, again causing a further increase in volatility and decrease in stocks.
And I haven’t even bothered to include what happens when the algorithmic computer programs that helped push this market up start selling. The market could fall much quicker than anyone anticipates. If it does, it will drive interest rates down.
I regularly get asked why I believe interest rates are going to fall. Aside from the fact that when recessions occur, interest rates usually fall to a new all-time low, but once you begin to understand volatility controlled products and how they switch from equities to bonds when volatility goes up, it’s easy to see how that will cause interest rates to plummet. Given that we are close to a recession and the stock market usually falls before a recession starts, it’s a perfect storm that leads to a new all-time low in interest rates.
As I mentioned in the start that it’s not due to high valuations and other metrics that potentially make this market the most dangerous market in history—it’s short volatility and its potential rapid unwind.
Video Topic of the Week
This week I discuss inflation from the recent Federal Reserve data on the factory sector and what’s keeping yields from falling in the short term.
I also perform a poorly executed magic trick to show you how earnings have been manipulated by stock buyback programs. I explain how this manipulation can’t go on forever and that earnings this coming quarter won’t likely look so good, which is why I think the stock market probably isn’t going to go much higher.
Chart of the Week – S&P 500 Trading Volume
I keep hearing how this market is going to indefinitely rise and yet trading volume, or the number of shares traded per day, keeps falling. Markets only rise if there are new buyers willing to pay a higher price. As markets exhaust themselves, or run out of buyers, eventually the short sellers arrive to drive the market down. While I’m surprised the market has held up this long, with a lack of trading volume, declining money supply, declining credit, low cash levels and high leverage, one can only speculate how much longer this market can keep going.
Momentum Strategy Update
Next on the list is to get the Morningstar factsheet in a client-approved format. I just haven’t had a chance to work on the design of it this week, but the data is all there. Still working on this, but getting closer. I’m hoping to have it approved to share with you by the end of next week.
Speculation has reached a record high as central banks continue to buy stocks and investors have borrowed a record amount of money to buy stocks. Like any bubble, they are easy to spot but hard to time. Just like the 2008 real estate bubble was built on leverage and speculation, this stock market bubble will eventually burst. How high it will go before that happens is hard to say. What I can tell you is that history has shown that in a very short period of time, as fast as an hour, a year or more worth of returns can be wiped out. Markets that rise on speculation typically have an equally rapid decline.
We are in the third longest expansionary business cycle in history and we are within 10 months of becoming the second longest expansionary cycle. This is the third most expensive market in history, surpassing the valuations set back before the Great Depression, based on the Cyclically Adjusted Price-to-Earnings (CAPE) ratio. The most expensive based on ratio Price-to-Sales ratio. The second highest based on Price-to-Revenue ratio and very close to being the highest. Not to mention that debt levels are at a record high, growth over this past cycle is the worst in any prior cycle and wage growth has been weak.
Those who believe earnings are driving the market need to be aware that earnings are below the 2014 peak of this cycle. The reason they appear to be good is that earnings are reflected on a per share basis. Corporations have been engaging in aggressive stock buyback programs. That reduces the number of shares, which can make even mediocre earnings look good. This is why profits matter, but nobody seemed to mention that corporate profits declined in the first quarter of 2017 and are below their 2014 highs.
Very few people own US Treasuries, but when the stock market blows up, people will flee to safety. US Treasuries historically perform very well during recessions. Even though the Fed has been raising rates, the misconception is that bond yields go up as well. For the past thirty years, there has been no correlation between the Fed raising rates and bond yields rising. If anything, the Fed has created every recession by raising rates, which is why yields have fallen from their recent peak as the Fed continues to hike.
The inflation data tells us where bond yields are headed. As inflation decreases, which it has been, bond yields fall. As bond yields fall, bond prices rise. US inflation data fell again last month along with European inflation data. Despite popular view, mass money printing initially leads to massive deflation. Deflation and a recession are reasons why US Treasuries remain one of the best hedges against this market. Before this is all done, I predict interest rates will see a new all-time low.
The European business cycle runs about eight weeks behind us. While I want to like European stocks because their valuations are attractive compared to the United States, it’s important to understand that a rising Euro (their currency) is not good for their economy. The belief is that if the US stock market sees new all-time highs, other markets must as well. This is a false narrative. Back in the late 1920’s, the US stock market was in a speculative bubble and that didn’t lead to new highs for foreign indices. When the global recession started and the stock market bubble burst, foreign equities fell less.
While I want to like emerging markets, there isn’t a long-term focus here. Emerging markets have been correlated to European Union policy rates. As they seek to normalize their rates, emerging markets should underperform.
I like this sector as it is the most undervalued sector in the markets. It’s a buy low, sell high opportunity, which is why we have invested in it. Plus, in 2008 as the equity markets were blowing up, commodity prices nearly doubled in a 12-month period. While it hasn’t taken off yet, all positions are near are buy in point. The crop reports show that weather conditions are less than favorable. Lower yields lead to higher commodity prices.
As I predicted the US dollar was overvalued and would embark on a multi-year decline. So far the dollar index is down about 8% from its high. Normally a falling dollar is bullish for agricultural commodities and precious metals. It hasn’t been, but that doesn’t mean it won’t be.
If there’s one asset class I’m in love with, it’s this one. What I’m referring to are mining stocks which are a leveraged play against precious metals. My long-term outlook on these is still very high. My short-term outlook isn’t as optimistic.
In both the gold and silver miners, prices have been following a descending right triangle pattern. Based on classical charting techniques, this is a bearish pattern that suggests prices are likely to further fall. It won’t surprise me if mining stocks fall as the market falls, but at some point, that will change. There is likely to be a global recession, global deflation, and a global financial crisis. Precious metals like those things.