For the past few years, investors have been lulled into a false sense of security, in at least one respect – near-zero volatility. With markets moving in mostly one direction (up), volatility in global markets, and U.S. markets in particular has been at unprecedented low levels.
Explaining this eerie calm in markets defies rationality. However, for investors, the important take-away in this equation is that it was never possible for this near-zero volatility to persist over the long term.
Over the past week, we have seen explosive volatility. Ironically, the greatest degree of volatility has been in U.S. markets, disrupting its eight-year flight into Bubble Country. Even after the sharp pullback from last week, U.S. markets are at extreme bubble valuations. The likelihood that U.S. markets will continue to exhibit high volatility (going forward) is high.
The investor group that experienced the greatest
“life lesson” with this sudden spike in volatility were the holders of an anti-VIX fund: VelocityShares Daily Inverse VIX Short-term ETN (XIV). For newer investors, “VIX” is a market index that measures volatility.
XIV suffered a near-100% loss over the past week, at which point the fund manager (Credit Suisse) simply folded the fund.
Betting on the VIX has been an investment option for several years: a bet that volatility would
increase. Obviously such bets would have been a losing venture over the past few years.
The short VIX fund is a much more recent market contrivance: betting against volatility. It was a good bet for a couple of years. The question is: why were people still sitting in this fund?
There was no possibility that this extreme lack of volatility could get even more skewed. A certain amount of volatility is mathematically inevitable. This was a fund that could not possibly go higher, with an extremely high probability of a sharp move down – as soon as volatility returned.
Clearly those investors holding this fund suffered from terminal complacency, sitting on an investment that couldn’t possibly go higher, just because they liked it. Even more bizarre, reports indicate that the largest holders of this fund were
other fund managers.
These people are supposedly “experts” in investing. How could they have gotten caught with their pants down like this, resulting in a 100% meltdown in one of their holdings? Complacency.
Yesterday, the Dow jumped several hundred points off the open. It gave back all of those gains and moved into the red, then it spiked higher closing the day up more than 500 points. Insane.
In just a few days, we have gone from record low volatility to extremely high volatility. This could be a signal that markets have peaked. It could just be temporary turbulence. Either way, investors have received a wake-up call – especially the holders of XIV.
Volatility is a normal part of markets. They go up; they go down. Betting against volatility was a bet against human nature.
Volatility has returned to our markets. It would be unwise to bet that it is going to go away.