Looking back at last week’s long-expected correction (remember trees don’t grow to the sky, much like, markets don’t go up in a straight line forever!), I suspect there are a number of inexperienced market participants who have not only had their egos dented, but also likely to have suffered long-lasting damage to both their capital base and investment psychology. I am sure that, within a couple of years, we will look back at this most recent correction as a painful short-term shakeout from what has been a tremendous last few years for equity markets in general.
During the course of last week, the majority of investors will have been focused on equity market movements, for us though, we were keeping a close eye on the bond markets. Interestingly, bond prices (in particularly sovereign) rose only briefly (yields fell), indicating that this wasn’t going to be a potential start of a more serious correction or more importantly the start of a bear market.
This minor market correction is slightly different to more recent ones (2013’s taper-tantrum for example), as billions have been permanently lost for those investors who have been caught out in the so-called “easy money” strategy of shorting volatility. Unfortunately, but perhaps predictably, it would appear from what we are reading that a fair proportion of those participating in this trade were novice (or certainly uninformed) retail investors. By the middle of last week, these investors had been dealt a devastating blow when the CBOE VIX Index (commonly referred to as “the fear index”) spiked almost 400%, from 13.5 to 50, in just two days, ending the tranquillity investors had come to know and rely upon. A lot of these inverse (some leveraged) exchange-traded products tied to the VIX triggered limit up/down rules and in some cases had lost as much as 90% of their NAV and ceased trading completely.
Fig 1: VIX 1-Yr
Fig 2: US Equity 1-Yr
A lot of these exchange-traded funds had received substantial inflows over the last few months and quarters, as investors have sought to take advantage of the extraordinarily ultra-low volatility environment that has prevailed for much of the past two years. For example, the Credit Suisse Velocity Shares Daily Inverse VIX Short-Term ETN had amassed over US$2 billion in assets by late January ’18, of which a high percentage was retail money.
Following last week’s events, market participants will be trying to determine the extent of any lasting impact from this popular trade that turned bad enough to shock stock markets globally.
In short, the lesson from last week, as always, know what you own and why you own it!
