Genie and the speculators

With the market correction sparked on Friday (February the 2nd), the S&P 500, and other major indices fell by ~10%.

Rising interest rates and higher than expected wage growth (which will lead to inflation) scared off investors.

What made this selloff worse was the hedge funds, behind the scenes they were leveraged. They were borrowing money and betting big on low volatility in the markets. Since 2017, the markets were placid and there was no major swings in prices and volatility was really low. Call it Nirvana. The S&P 500 surged almost 20%, it seems like Genie granted us the investors and speculators a package for 2017, long term investors didn’t care about Genie showing up and they shrugged him off, the speculators though went behind our backs and accepted Genie’s deal and, as you know when Genie shows up with his wishes, there will be always a catch; and the catch was that he will choose the last and third wish, And they only get to choose two, We can guess they chose 1. Prices go up and 2. Please no wild swings; and he chose: I will do whatever I want after 2017.

Financial instruments such as derivatives which Warren Buffett describes as the weapon of mass destruction, or exchange traded notes (ETN) became an instrument famous among speculators. ETNs are based on the performance of market index, and sometimes based on something stupid: Volatility.

History repeats itself, in the book “The clash of the cultures” by John Bogle, in page 208 he says:

“Early in 2012, yet another glitch came to light. Credit Suisse suspended the offering of its “Velocity shares Daily 2XVIX Short-Term” ETN. Promising double the return of a set of CBOE market Volatility Index futures … Betting on market volatility seems the essence of absolute absurdity; leveraging such a bet seems even crazier.” (Wait here comes the good part!) “Surging demand for USD2XVIX exceeded issuer Credit Suisse’s internal limits, at which point the bank stopped creating new units; the price soared, and then, in two-day sideways market, Dropped 50 percent.

What happened now was that the XIV, which goes up if there is no volatility in the market, was heavily betted on from hedge funds, as wild swings began this thing started its free falling. And Credit Suisse decided to halt trading in this ETN, last day will be February 20.

sell off

Hedge funds had to start selling stocks to cover for their losses because they borrowed a lot of money to bet against volatility. Roger waters describes it the best We were just another brick in the wall, as they started selling, the wall fell and our bricks (stocks) got crushed, falling down with them too.

On Wednesday data will be released, the CPI: Consumer price index, and the PPI: Producer price index. They are the both the most important indicators of inflation, which was the true reason of this selloff will be released. And we should pay close attention to them. If there will be a surprise and those indicators rise higher than expected, we might need to get ready for another nasty ride.