Tuesday, February 6, was a disaster for an untold number of speculators. For anyone holding an electronically traded product ( ETP ) tracking the inverse of the VIX index, the end of the low volatility regime that was 2017 obliterated their allocated positions. As various commentators have warned, an 80% increase in the index could trigger liquidation of the respective funds. Given the more than 100% rise in the VIX, such provisions were indeed triggered and internet message boards are abuzz with speculators licking serious financial wounds from their overexposure.
The ETF revolution has spawned products far less user-friendly than the funds tracking the S&P 500. I will not replicate here the proliferating explanations of VIX-related products. They are long and involved. That alone highlights the absurdity of offering such complicated products, with no restriction, to anyone in reach of a smartphone.
This is the story of retail investing gone wrong. As the bull market has leapt to new heights, at unprecedented rates since the new year, retail investors, supposedly long on the sidelines if financial media are to be believed, rushed to jump on the train. Consequentially, equity inflows hit an all-time record in January, as did the proportion allocated to ETFs. The rush was towards a cliff, however. Since January 26, the broad markets have lost about 10% of their value. Those who bought the wrong ETP lost everything.
But there’s never just one cockroach… I believe that recent movements will prove that adage to be understated. We have already seen the biggest daily VIX spike in history as ETPs moved to reduce their exposure, likely constricting liquidity in VIX futures. The liquidation of a few billion dollars, however, is really just peanuts. In the scheme of the volatility trade, ETPs are likely a minor news story. If blogs and news broadcasts are all reporting the same theme, we are likely focused on first-order consequences.
Whether another shoe will drop in the ETP sphere is beside the point. Markets are still overvalued and the most visible trade in volatility is surely not the most dangerous one. Much greater threats to systemic stability exist.
While we hardly read or listen to all pundits, the consensus seems to be that the economy is fine. The recent market moves reflect economic strength (rising inflation and interest rates) rather than weakness. This perspective, however, sees the data through the prism of a rising market. First of all, not all is fine in the economy.
The heartbeat of the American economy is not found on Wall Street. Burgeoning debt and anemic productivity should be the headlines of the economic story. Further, the recent low in consumer savings and the surge in borrowing during December 2018 empirically demonstrates that any growth the economy enjoys on the back of consumer spending is being fully financed by credit expansion.
Why are consumers so fully extending themselves? It could be consumer confidence. The moderate increase in income from the new tax law and slow gains in wage growth have left folks marginally better off. More importantly, though, a rising market creates a socially felt wealth effect—a sensation resulting from an increase in wealth on paper. This actually has little impact on real spending given the immense disparity in wealth. For example, just 10% of the population owns 84% of equities. The growth in stock prices may result in a changed psychology, but with very little really changed such feelings are easily reversed.
Consumer saving could also be low because consumers are more stressed than is generally acknowledged and are using credit to cover essentials. This was the case in the years preceding the last recession. Mortgage payments were stressing consumers before that was widely understood. Incidentally or not, the savings rate was the same then as today, even as consumer credit liabilities were less.
We believe a case can be made that the recent market peak signals the end of this historic cyclical bull run. The market and the economy are both unstable complex systems. The only path to sustainable stability is through bouts of gut-wrenching instability. I’m reasonably confident that the volatility we are experiencing is more likely the beginning than the end of that process.