Markets Plunge Again; What To Do Now - Bezek's Daily Briefing

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Includes: DIA, FB, KMI, NFLX, QQQ, SPY, UVXY, VXX, WMB, XBI
by: Ian Bezek

Summary

Markets continue to sink.

A comment on volatility and the general market outlook.

If you're feeling panicked, please use this selloff to do an honest gut check of your risk tolerance and investing objectives.

Down After a slight opening bump, markets tumbled Wednesday. Unlike previous volatile days, there was no real up/down volatility to the session, stocks pretty much just sold off steadily all day, starting at the high and ending at the lows. Bulls were waiting for relief that never came.

The S&P 500 (NYSEARCA:SPY) ended down 48 points for the day (2.5%). The Dow (NYSEARCA:DIA) shed 365 points on the day. And the Nasdaq (NASDAQ:QQQ) was hit much harder than the other two, dropping 3.4% on the session.

There was a spirited discussion in the comments section of yesterday's Briefing regarding my usage of volatility (NYSEARCA:VXX) (NYSEARCA:UVXY) as a market indicator.

I suggest that muted volatility readings show the market is not particularly fearful of an immediate cascade lower. Typically, in fearful markets, VXX will race ahead, moving up way more quickly than the market, front-running to buy insurance.

In cases such as this week, where volatility remains fairly muted as shares dump, it is indicative that there isn't any major interest in hedging against further downside. Other people suggested that the inability of VXX to make new highs as the market dives indicates complacency, suggesting markets have a lot more downside.

VXX Price Chart

VXX Price data by YCharts

SPY Price Chart

SPY Price data by YCharts

Note that VXX came nowhere near Monday's high reading, whereas the S&P 500 has already taken out the Monday low by more than 10 points.

There are two possible explanations. One, smart money isn't buying insurance, as they expect this correction will end soon. The media is running around calling crashes and analyst houses are saying to "sell everything." If you remember 2007-08, relatively few people were calling for crashes, usually they come when least expected. (Everyone claimed to have seen it coming in hindsight, but few actually predicted it in real time)

If we are to crash here, it will be one of the first crashes in recent memory that was widely expected among analysts and pundits.

The second possibility is that markets continue barreling much lower. The low volatility reading, in this scenario, would be indicative of the market's complacency despite further selling. A market that's not buying puts (what VIX represents after all) is without insurance and thus exposed to large losses.

It can go either way from here. The historical record indicates that markets usually bounce in these situations. However, the risk/reward is with the bears. If markets bounce, the market would likely recover 5-10% over the next month. If we take the big dive approach, we could easily be down another 10-20% in the short term. Probability favors bounce, but you lose big if you're wrong.

I remain aligned with the optimists. I see the market recovering in short order, within the next couple weeks, I expect us to be trading significantly higher.

A Gut Check: Are You Prepared For A Worst Case Scenario?

However, I acknowledge the possibility that the market may suddenly collapse here. I don't think it's an entirely fair analogy, but you can compare the current situation to the run-up to the 1987 crash. For those that don't recall, in late 1987, after a harrowing few weeks, stocks suddenly came unglued without any particularly compelling reason for doing so, plunging 20% in a single day.

You have to ask yourself, if another 1987 happened tomorrow, would I be prepared, or would I be crushed?

I chuckled when someone in the comments section speculated that I might be insolvent because UVXY was up 20% yesterday. UVXY is a miniscule portion of my portfolio, I structure my volatility trades so that UVXY can rally 1,000% against me before it starts to become a major problem.

You had traders in 1987 who had careers spanning decades built on selling volatility, particularly via naked puts. Many of them were wiped out overnight. If Nicholas Taleb has taught us anything, it's that unexpected events occur far more frequently in the financial world than computer models suggest.

You must prepare your portfolios to be ready to endure worst case outcomes ... and then model an even worse case scenario on top of that and re-check your assumptions.

If you're in a world of pain because the S&P 500 is 10% off the highs, you need to reevaluate your risk tolerance and return objectives. Have you used too much leverage? Have you concentrated too much in one sector? Have you taken overly big bets, driven by confidence based on recent successes?

As the saying goes, everyone is a genius in a bull market. If - and it's still a big if - but if we're really going into a bear market here, everything that's been working to make money recently will be flipped on its head.

I fear for many younger investors who haven't been through a down cycle yet. I see many folks commenting about biotech (NYSEARCA:XBI) stocks suggesting the bottom must be near. One look at the chart should dispel that notion fairly quickly.

XBI Chart

XBI data by YCharts

When people call for much greater collapses in those biotech stocks, these new investors start pointing to pipeline, balance sheets, management expertise and other such factors. That misses the point.

You're witnessing a liquidity event in biotechs. The XBI ETF is getting hit by 10 million+ share trading days over and over - far above average - with most of that being sell orders. That's hundreds of millions of dollars a day of volume, mostly people wanting out.

I don't care how good the pipeline is at your individual bio you champion, it's getting buried by sell orders that are totally indiscriminate. If your stock has a bid, they'll sell into it.

Look at this table (data from finviz.com) Here are the 18 US-listed mid-cap biotech stocks' performance yesterday:

Click to enlarge

Note that 12 of the 18 were down between 4% and 8%. Three got hit for double digit % losses, and three sold off somewhat less than 4%. In general, the whole batch was down basically the same amount, driven by sectorwide sell orders that far exceed the normal level of interest in these particular shares.

Biotech could easily lose another 50% from here. Look again at that chart above and ask yourself if 25 would really be that crazy. It'd still be well above the 2011 lows.

If you're holding biotechs, hoping and praying for a bounce, please reconsider that approach. The market is looking to raise money, and selling stocks that are up huge over the past 5 years is a good way of getting much-needed hard crash. Particularly with the politicians cracking down on the sector, any hedge fund facing margin calls will be selling their biotechs first.

Similarly, a ton of money has flooded into the FANG and other such high profile tech stocks. Much of this deluge has been from millennial investors who are trying out these sexy stocks as their first experience in the market.

Seeing the pained reactions on social media this week, many of these new investors never realized these stocks could go down in value. And there's potentially a lot more pain to come. Stocks like Facebook (NASDAQ:FB) and Netflix (NASDAQ:NFLX) haven't gotten hit that hard yet in 2016, compared to the broader market.

If you're a new investor reading this column, and you're shaken up by the recent fall in your portfolio, please do some reading on past bear markets and reconsider your portfolio allocation. What we've seen so far in 2016 is roughly a tropical storm on the 5-point hurricane-rating system.

Finally, I must address the yield-seeking investors, many of whom are seeing their investments in tatters. It's hard to write this, as unlike younger investments, many of these yield hunting investors are retirees or near retirees that need the money and rely on the dividends to pay the bills.

Without much more earned income prospects, existing investments become more important. Your author is relatively young, and as such, can make concentrated investments in emerging markets and other such high risk things. If the world goes into a depression and my stakes are wiped out, I can earn more money in the future.

But for retirees, there's little way to recover permanently impaired capital. That's why it was so troubling to see so many people making risky positions such as Kinder Morgan (NYSE:KMI) to be their top holding. We kept hearing the 'it's not affected by oil prices' claim, but it was tinted with increasing tones of desperation as the pipeline sector continued to crumble throughout the fall of 2015.

Instead of responding to declining fundamentals by considering selling, many people retrenched, they literally couldn't afford to be wrong due to poor portfolio construction. Backed into a corner, they felt compelled to hold to the bitter end.

In the comments section of many KMI and other such articles on SA, we saw people saying it was too far down to sell, and that it had to come back, they were pot committed. And that was when KMI was still up in the 20s.

Well, it's a painful thing to have to say, but the market doesn't care what you or I need from it. The market doesn't care that you are expecting $1,500 of dividends this month to coverage the mortgage and health insurance premium. The market and you don't have a personal relationship.

If people are dangling something alluring, you have to research it with your own head. People have been calling MLPs, REITs, BDCs and other such products great yield opportunities the whole way down, and they just keep dropping. If I had a dollar for every time people asked me if I was buying pipelines yet, I could start a well-capitalized bank (The answer is still no, by the way).

There's nothing wrong with using some portion of your funds on more speculative positions, but you can't bet your retirement on aggressively run, barely investment grade companies like KMI and be assured that everything will turn out alright. Even the "safer" pipelines such as Williams (NYSE:WMB) are flat-out collapsing now. This is a 5-day chart(!)

WMB Price Chart

WMB Price data by YCharts

If you're looking at your portfolio and wondering if you can survive one more down day or week, then I implore you to consider reallocating your positions. It hurts to take losses, but doing nothing and hoping things improve is an even worse approach.

With any luck, markets will bounce in the near term, allowing people that are trapped in bad positions to get out at better prices. Regardless, if you are having trouble sleeping, let this correction be a guide to you to cut back your risk exposure, before the market involuntarily forces you to do so.

And if a market bounce does allow you out of a bad situation, don't take it as a free pass to keep using too much leverage in the future. If this correction doesn't wipe out badly constructed portfolios, the next one probably will.

Disclosure: I am/we are short VXX; UVXY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.