Rising interest rates, the specter of inflation and stocks’ overvaluation are all valid, fundamental concerns facing investors today.
But is that the full story?
Before the start of the swoon Friday, nine of the 10 categories of inputs to The Arora Report Global Multi Asset Allocation Model were deteriorating. This is the reason we reiterated to subscribers to hold 19%-29% in cash or Treasury bills, short- to medium-term hedges of 15%-25% and very short-term hedges of 15%. That way, those who wanted to take less risk and were hedging were protecting 69% of their portfolio.
Those who did not hedge did not have as much protection but should have been holding cash more than 29%. Please read on to see what The Arora Report Model is saying now.
The real reason behind the ferocity of selling is not the fundamentals but the so-called penny pickers. These are no ordinary penny pickers; they have been getting rich jumping in front of moving bulldozers to pick pennies. Yesterday they died, but in the process hurt good investors who were following the rules. Let us explore with a chart.
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The chart
Please click here for the chart. The chart is of Velocity Shares Daily Inverse VIX Short-Term ETN XIV, -92.58% sponsored by Credit Suisse. Similar chart patterns show up in ProShares Short VIX Short-Term Futures SVXY, -82.96%
The Chicago Board Options Exchange, owned by Cboe Global Markets CBOE, -10.41% popularized the VIX VIX, +1.60% VIX measures volatility expectations from S&P 500 SPX, +1.74% index options. There have been a number of exchange traded note (ETN) products related to VIX that are useful in hedging, such as VXX, -2.41% and VXZ, -2.81% A favorite of day traders has been a leveraged product, UVXY, -33.45%
Since the Trump election, volatility has been extraordinarily low. Just take a look at the chart of the popular ETFs S&P 500 ETF SPY, +1.97% Nasdaq 100 ETF QQQ, +2.65% DJIA ETF DIA, +2.34% and small-cap ETF IWM, +1.20% Without understanding that such low volatility is not normal, making money by shorting volatility had become a popular trade.
I have always advocated hedging carefully with long volatility products (carefully because they decay and have tracking errors). But I have been cautioning against extensively using inverse volatility products. I have said for a long time that shorting volatility is like picking pennies in front of moving bull dozers. The reason is that volatility can spike at any time and blind side investors and traders. Yesterday this is exactly what occurred. Volatility spiked and those invested in short volatility products got wiped out.
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Contagion
By now you may be asking how come trillions of dollars of value can be erased in ferocious selling by these obscure volatility products. By some estimates over a trillion dollars have been tied to volatility-related strategies. There is a contagion effect from these instruments that cause some selling as hedges and related strategies take place simultaneously without the market having the ability to smoothly absorb it all. There are also strategies that take risk off (“selling,” in plain English) when volatility spikes over a certain level.
Is the contagion done?
It is not done as of this writing. At this time nothing can be ruled out. There are some shades of the 1987 crash when the market fell 22% in one day. I remember it vividly because I lived through it and lost millions of dollars on that day. The cause at that time was portfolio insurance. Please see “Six similarities between now and 1987, when the Dow plummeted 23% in one day.”
The differences
There are several differences this time that should stem the tide. First, there is a much better regulatory regime. Second, earnings are rising. Third, the economy is in great shape. Please see “Six differences in the stock market between today and 1987.”
Gold, oil and margin calls
Initially there was a rush out of stocks into gold and oil. For those using ETFs, money was flowing into gold ETF GLD, -1.05% silver ETF SLV, -0.57% gold miner ETF GDX, -2.64% and oil ETF USO, -0.55% We said yesterday before the market open that if the market continued to deteriorate, the momo (momentum) crowd would get margin calls, and they would sell gold and oil. That call has proven spot on.
Short-selling
It is tempting to short-sell (betting on a decline, in other words), but it has not been appropriate so far because there is not a good way to control risk. In short-selling, it is important to control risk. A vicious bounce can happen any time. Stops may not protect as the market can run through them without fills.
What does The Arora Report timing model say?
The Arora Report timing model is adaptive. The model automatically changes with market conditions. Please click here to see how it is done. The model called the 2008 crash and then turned aggressively bullish in March 2009, which turned out to be the start of the current bull market. The model continued to not only stay bullish throughout this long bull market but called most of the major dips and subsequent buying opportunities during this bull market. The model also called for buying after the Trump election.
Before the market swoon, the model was calling for a garden-variety correction. Right now the model gives very heavy weight to smart money flows. We have been sharing with investors for over a week that the smart money (professional investors) was selling into strength and trimming positions. Please see “Concerned about the stock market? Here are the ‘smart money’ signals on 10 popular companies.”
Over a week ago, the headline of the Morning Capsule that is made available before the market open to The Arora Report subscribers read: “Dollar strengthens and bonds slide to a dangerous level.” We also said that the smart money was selling stocks due to rising interest rates. The message that the smart money was selling was repeated based on the new data in subsequent Morning Capsules and other posts.
The model is still seeing an 80% probability of this being a garden-variety correction and a bounce after the correction is over. Please note that this means a 20% probability of it becoming worse.
As an important caution, new data goes into the model every day and, thus, conclusions from the model can change quickly. Under these market conditions it is important to stay tuned.
As appropriate, the plan is to start realizing enormous profits that now exist on the hedges, deploy some cash in long positions and selectively short-sell. Many desirable stocks and ETFs are likely to come into buy zones.
Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article or may take positions at any time. All recommended positions are reviewed daily at The Arora Report.
Nigam Arora is an investor, engineer and nuclear physicist by background, has founded two Inc. 500 fastest-growing companies, is the developer of the adaptive ZYX Global Multi Asset Allocation Model and the ZYX Change Method to profit from change in trading and investing. He is the founder of The Arora Report, which publishes four newsletters.