Where Do XIV And SVXY Go From Here?

| About: VelocityShares Daily (XIV)

Summary

Short volatility ETFs have historically return 50%+ each year.

Over the past 8 months they have dropped by 60%+.

There is 100% upside from here for short volatility ETFs by end of year.

I last posted an article on the volatility ETFs on August 26, 2013, just about 2.5 years back. I ask the question (without understanding the significance of it) Where Do VIX And Volatility ETPs Go From Here? The answer, in hindsight, was nowhere good. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV), for example, closed at $26.28 on August 26, 2013. On Feb 22, 2016, it closed at $19.69. That's a hefty 25% drop over 2.5 years, or about 11% per year.

XIV Chart

XIV data by YCharts

A little bit about what these inverse ETFs do. Below is a description for XIV and SVXY from the Seeking Alpha. It is a bet on the Volatility Index (VIX) dropping. While it doesn't really track the VIX, it does track the VIX futures (first and second months), which in theory should also track the actual VIX.

1. The VelocityShares Daily Inverse VIX Short-Term ETNs (the "ETNs") are senior, unsecured obligations of Credit Suisse AG ("Credit Suisse") acting through its Nassau branch. The return on the ETNs is linked to the inverse of the daily performance of the S&P 500 VIX Short-Term Futures™ Index ER less the investor fee. The ETNs provide traders with an exchange traded instrument enabling them to efficiently express their market views on the short-term futures contracts on the CBOE SPX Volatility Index® (the "VIX®"). The ETNs do not guarantee any return of principal at maturity and do not pay any interest during their term.

2. The ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY) seeks a return that is -1x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their holdings consistent with their strategies, as frequently as daily.

Since the recent trend for these ETFs is to go up by 50%+ each year (as it did from Jan 2012 to Dec 2014), this is definitely something out of ordinary. So, I wanted to ask the same question again - Where Do Short Volatility ETPs Go From Here?

XIV Chart

XIV data by YCharts

First, the good news. From 8/26/13 to 6/23/15, or about 20 months, XIV went up from $26.28 to $49.68, or ~90%. Annualized, this amounts to about 47%, in line with prior years. However, with the Greek default to the IMF, market volatility spiked, S&P 500 dropped, and neither the market nor XIV has recovered from that. So, what's on tap for XIV and SVXY in the coming months? It really all depends on the S&P 500 (NYSEARCA:SPY).

XIV Chart

XIV data by YCharts

As the above chart shows, XIV really acts like a ~4x leveraged version of the S&P 500. When the latter drops, so does XIV (and vice versa). So, to project where XIV will land, say, in a month, we will need to first think about where we would expect S&P 500 to land. And where the S&P 500 will land, in my opinion, depends on the Fed. Not on oil prices, not on other commodity prices, and especially not on China. It's the Fed.

The current market weakness is driven, again in my opinion, by the Fed first removing QE, then talking about raising interest rates, and then actually raising the interest rates. The bull market from 2009-2015 was almost purely driven by QE and low interest rates. The Fed will need to get back on that track if the markets are to recover. There is serious deflation going on everywhere due to commodity price drops, and companies that manufacture in or buy from China are seeing lots of rooms for lower Cost of Goods Sold. That in turn means that they are forced to not raise prices, as, if they do, their competitors who are similarly enjoying better COGS will steal share from them.

While one print of very moderate inflation uptick in January is being interpreted by many (especially those who have been crying currency debasement for the past 7 years) in the media as proof positive that the Fed must keep on raising rates, I am not quite convinced. We have been around this 2% mark since 2012 (sometimes higher and sometimes lower). Unadjusted CPI came in at 1.4%, and that's all driven oil. That will start to trickle into the adjusted one going forward. There's no reason for the Fed to keep raising rates. If anything, if the situation worsens, the Fed may just lower rates and go back to QE.

Back to XIV, the current situation seems very similar to 2011 to me. We have a Greek crisis to start the market tumble in 2011 as well. XIV fell from the peak of $19.17 in 7/7/2011 to the low of $4.91 in 11/25/2011. By 11/26/2012, it was back at $19.2.

Has XIV reached bottom? I don't know, but I remain bullish that by end of this year, we will very likely see $40+ (or more than 100% increase) on XIV again. This assumes, of course, that the Fed does the right thing, and helps the market rather than raises rates in the middle of a deflationary cycle with a probable recession looming.

Going forward, I will start to post my model prediction for weekly XIV targets. I think the time to get back into the short volatility ETFs is back.

Disclosure: I am/we are long SVXY, XIV.

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.