I continue to believe we are entering a more normalised period of risk asset market volatility after many years of extraordinarily low volatility. The “flash crash” this week, more than likely, signals the end of the ultra-low volatility period, as it was primarily driven by the forced unwinding of ultra-low volatility leveraged ETFs. There’s some irony in that!
What happened?
It’s important to attempt to explain what happened on Wall St this week that caused kneejerk ‘risk off’ reactions in all global equity markets. Once we understand what happened, we can then look for investment opportunities amongst this.
I’m going to quote directly from a Bloomberg article, which succinctly summarised the events of Monday and Tuesday morning in Asia.
“Risk parity funds. Volatility-targeting programs. Statistical arbitrage. Smart beta. Sometimes the US stock market seems like a giant science project, one that can quickly turn hazardous for its human inhabitants.”
“You didn’t need an engineering degree to tell something was amiss Monday. While it’s impossible to say for sure what was at work when the Dow Jones Industrial average fell as much as 1,579 points, the worst part of the downdraft felt to many like the machines run amok. For 15 harrowing minutes just after 3pm in New York a deluge of sell orders came so fast that it seemed like nothing breathing could’ve been responsible.”
“Midday Monday, short-term momentum turned negative, resulting in selling from trend-following strategies. Further outflows resulted from index option gamma hedging, short-covering of short volatility trades, and volatility targeting strategies. These technical flows, in the absence of fundamental buyers, resulted in a flash crash at 3.10pm Monday”.
I am also going to quote directly from a UBS note that is more technical on what happened so you all have the background to this event.
Brief recap of what has happened since Friday…
Here’s my best effort to piece together the course of events….On Feb 1st, after a steady climb to 2.7%, the US 10 year yield accelerates towards 2.8%, breaking multi-decade resistance levels. The following day equity volatility jumps into the high teens. This triggers Risk Parity and Risk Control funds into forced substantial equity selling. This in turn saw equity volatility surge [Monday] and leveraged short volatility ETFs (ETNs) get squeezed dramatically as they offer the daily inverse performance. [Monday] the VIX rose 100%, implying they’d need to fall 100% (or close to that level), and they have if you get the current NAVs. The market risk from these ETNs seems mostly done, but the second day of vol surging means the Risk Parity funds need to further reduce equity exposure. So our derives team believe another 2-3% downside in the S&P from here to complete this very technical correction in markets.
Volatility ETNs storm was savage but brief
These inverse and levered exchange traded funds have a unique “short gamma” profile that means they need to buy high/sell low on a daily basis at the close to rebalance. Two of ETNs products are XIV and SVXY which seek “daily investment results that correspond to the inverse (-100%) of the performance of the S&P 500 VIX short term futures index.” These products have seen massive growth the past few years as short volatility was a winning strategy and attracted significant retail interest (XIV returned 187% in 2017). The net assets invested in XIV as of Friday close was $1.6B. This was equivalent to short $108mm vega ($1.6B / VIX futures ~15). SVXY net assets were $1.9B, short $124mm vega. The danger of an inverse product is that if the underlier is up 100% these products, by design, lose 100%. In the case of the inverse volatility products the short VIX futures still need to be covered.
Those products dropping close to zero created a massive squeeze in short vol that fed on itself. We estimated close to $250mm vega needed to be bought at the close to rebalance the full suite of VIX related ETPs. Buying $250mm vega in VIX Feb and Mar futures has a delta of -$12B in SPX futures. The size of these VIX trades have gotten so big that the tail wags the dog and VIX flows dominate SPX futures. Particularly when that happens at the close in a low liquidity environment.
This phenomenon is now largely over. The inverse products have been wiped out (roughly $3.4B of mkt cap was destroyed [Tuesday]) and cease to have significant market presence. The levered long VIX ETPs remain and have the same short gamma dynamic but the effective size of total short gamma from these products has been reduced by 60% (from $350mm vega to $150mm vega now). VIX Feb futures have already dropped 20% after hours.
In conclusion…
This is a technical sell off, not a growth or inflation scare. Fundamental investors should soon revert to the question of what will happen to yields and how does that impact my view on equities; particularly if we’re in a long term rising yield environment. Yield rises can be negative for equities if too fast, we calculated roughly 3% by this Friday would be disruptively fast. Short of that, remember why they might be rising – global macro growth is STRONG! This dip could be a great chance to buy your favourite growth stocks, and increase allocations to financials and cyclicals as our equity strategists advise.
While a spectacular forced selling event by a small group of ultra-low volatility leveraged ETF’s and their friends, THIS IS NOT A FUNDAMENTAL EVENT and IS CLEARLY a BUYING OPPORTUNITY IN THE RIGHT GLOBAL AND DOMESTIC STOCKS.
What next?
We have now had the long-awaited “10%” correction on Wall Street, in fact, Dow and S&P Futures were down 12% from peak to trough at the worst of Asian trading on Tuesday. As in the Brexit and Trump victory “flash crashes”, the very worst of panic was AGAIN in the Asian time zone. This is something for Australian investors to remember: US futures trading in the Asian time zone are absolutely NO GUIDE to what actually happens on Wall Street that evening.
Let me just show you S&P Futures as an example. The chart below is 3 days in S&P Futures. You can see that S&P500 Futures rallied 6.25% from their Asian lows on Tuesday. Yes, 6.25%. That means when the S&P/ASX 200 was down nearly 200 points on Tuesday these futures, which were 6.25% wrong in less than 24 hours, were pricing Australian equities.
During the Asian time zone the S&P500 futures also amazingly touched the 200-day moving average and hit an RSI under 30. Again, both of those haven’t been seen in years. Volumes were four times the average, which almost ensures a capitulation bottom has been put in place at the 200-day MVA (market value added). This is bullish for US and all global equities.
Similarly, the S&P/ASX 200 hit the 200-day moving average and bounced hard. Again, I think a capitulation bottom has been put in place in the S&P/ASX 200.
These tests and subsequent strong bounces off 200-day MVA suggest to me that the bull equity market is alive, albeit we all need to get used to increased volatility including bouts of forced selling from different strategies.
This was absolutely NOT a fundamental event. This was a technical and positioning event. These events now occur in a matter of days, not months, therefore don’t be surprised to see a V-shaped recovery, exactly as occurred after Brexit and Trump’s election victory.
What to buy?
That doesn’t mean we run out and buy everything however. Interest rates are going up, inflation is rising and bond yields are breaking higher out of a 30-year downtrend. Central bank balance sheets are shrinking and central banks have played the major role in the previous ultra-low volatility regime in markets.
For those of you with large cash holdings it is an opportunity to put some of that to work. You can give it to a global fund manager (AIM) if the volatility is hard to navigate, but a domestic exchange-traded product (ETP) such as the Switzer Dividend Growth Fund (SWTZ) for high income and potential capital growth (that should handsomely beat bank term deposit rates from here), or pick some individual stocks yourself that have been oversold.
I encourage you to think about what actually changed in the world earlier this week other than share prices. The global economy is advancing, equity earnings growth is strong, employment is strong and wages are now picking up. That means interest rates are going up, but will rise to levels that are still historically very low.
Rising interest rates and a rising VIX triggered a blow up of “low volatility” strategies. I say again, it’s ironic writing that “low volatility strategies caused a flash crash”.
However, the equity earnings and dividend outlook is unchanged. All that has happened is the “flash crash” has given all of us a chance to buy unchanged earnings and dividend streams at lower multiples. That is a good opportunity.
Of course, an event like this brings out the usual playbook. The newspapers report that market fell in “billions”, a couple of fund managers who never made any money in the bull market get wheeled out saying how “cautious” they are and how “big” their cash holdings are. Brokers will have conference calls on what happened, which are broadly useless after the event, and the usual end-of-the-world forecasters will come out from hibernation. And Peter Switzer will look a bit down in the mouth for a day and then regain his composure and bang the bull drum again as he should.
What I have been doing is aggressively covering short positions we had and adding to our high conviction longs. When I saw Aristocrat (ALL) down 6% on Tuesday my fund bought more, for example, we also bought more HUB24 (HUB) -7%. We also added to names in Hong Kong and Europe that were hit too hard.
I think for Australian based investors there is a great amount of opportunity at current prices. I’d be also considering names like CYBG (CYB), Macquarie Group (MQG), Treasury Wine Estates (TWE) and Magellan Financial Group (MFG) at current prices. Globally-exposed high-quality businesses at now cheaper multiples.
What you must NOT do is RUN AWAY FROM THE CLEARANCE SALE. These events genuinely can be like a “2-day clearance sale”. My advice is you need to buy something or do something. It may well prove the BEST buying opportunity of 2018.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
