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Derivatives and Computers Gone Wild!


Massive short squeeze on speculators gyrates the markets…

Financial speculators that were short leveraged derivative products based on the VIX Index, caused massive late afternoon swings in the stock markets last week.

One product, the XIV, dropped from $129.35 on February 1 to $7.35 on February 6 (3 trading days). The XIV is toxic mix of 3 speculative activities: 1) you are shorting (selling something you don’t own and hoping to buy it back at lower prices), 2) you are using leverage (borrowing money) to juice up the price movement, and 3) the VIX is a highly volatile index that can jump over 100% in a day.

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Super smart math PhDs understand how the VIX is calculated but even they and their computers couldn’t keep up with the mercurial intraday price changes we saw last week. With the VIX spiking last week, these speculators and their computers were squeezed on their “short” VIX positions. Hit with large losses, they rushed to buy massive amounts of VIX futures late in the afternoon, spiking the VIX from below 20 to 50 and driving equity markets lower.

The tail wagging the dog…

This sequence of the VIX driving stocks is unusual. It has always been that as stock investors become fearful of holding stocks for the next 30 days, they buy derivatives like the VIX to hedge (insure) their investments; these hedging activities move stock prices lower. Last week, speculators and their computers with no natural positions in stocks moved the market dramatically lower by massively covering their short VIX positions.

Below is an interesting comment in last week’s Financial Times by Sandy Rattray, the co-founder of the VIX:

Sandy Rattray, who jointly devised the formula to trade futures contracts tied to the Vix back in 2003 when working at Goldman Sachs, said products that allow investors to trade volatility could be creating a “circular system” of measuring risk in financial markets.

“If the tail was wagging the dog before, you didn’t notice it very much. What happened on Monday was the tail grabbed the dog and gave it a swing around the room,” said Mr Rattray, who is now chief investment officer of London-based Man Group, which runs some of the world’s largest systematic trading funds. “The Vix has moved from being a measure of something to being something that influences this thing it is trying to observe.”

Real world fundamentals and cash flushed corporations…

While spikes in volatility, for short periods, can create a negative feedback loop to the real world, the real world eventually will take control. Investment fundamentals are sound:

1) Banks which caused the crisis in 2008 are financially stable
2) There is a global synchronized economic recovery
3) Corporate profits are accelerating after anemic growth since 2014

As has been the case throughout the last 10 years, corporations will step in to buy back their stocks after these “flash sales”. They have huge cash piles and the piles are growing thanks to strong profits and the tax cut. The corporations came in to buy their stocks in every pullback over the last 10 years and I expect them to do so again (January 2016 and August 2015 were the two recent 10% corrections that the corporations took advantage of to buy back their stocks).

This time around I expect corporations to not only buy their own stock, but to buy out entire corporations as mergers & acquisitions should dramatically increase.

Rising Inflation “expectations” may lead to higher interest rates and higher volatility...

We do need to monitor inflation “expectations” as we are entering the “good news is bad news” phase of the economic recovery…that is, strong economic growth may lead to higher inflation expectations and cause interest rates to spike, which will hurt long-term bond and stock valuations. Ed Yardeni, a prominent economist coined the phrase, Bond Market Vigilantes (BMV), in the early 1980’s. The BMV seeing the US Federal Government ramping up spending and borrowing, might sell their US Government Bonds to protest, driving up interest rates. While secular forces such as the aging baby boomers, Walmart, Costco, Amazon, and the Internet are disinflationary…inflation expectations need to be watched carefully.

Adjusting your asset allocation to factor in higher volatility…

Volatility needs to be considered in determining your asset allocation on how much should be invested in cash, bonds (short and long term), stocks (US and International). If you didn’t sleep well last week, it is best to have a discussion with your portfolio manager and/or relationship manager. Please call us to set something up.

Chatham Wealth Management
10 Town Square Suite 100
Chatham New Jersey 07928

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