Daily State Of The Markets: Hedge Fund Follies

 |  Includes: TVIX, VXX, VXZ
by: David Moenning

Good Morning. It is fairly safe to say that nearly early every trader, chartist, and market analyst on the planet will agree that the stock market is extended and that the bulls are likely to take a break at some point in the near future. Call it a pullback, a consolidation, a correction, a "sloppy period" (this one's my personal favorite), or whatever you'd like, but the bottom line is that most everyone is looking for the current joyride to the upside to pause soon.

So, given this nearly universal expectation for a pullback to occur, what would we expect the really smart guys and gals on Wall Street, you know, those who possess the right degrees from the right colleges as well as the biggest, baddest, and fastest computers around to be doing these days? Personally, I'd be expecting these really smart folks to be finding a way to profit from the pullback that will almost assuredly occur - and soon!

One of the ways the fast-money investors would accomplish this is to hedge their long positions. This can be accomplished in any number of ways including buying or selling options, purchasing non-correlated assets, raising cash, selling short, or something called "being long volatility." This last approach is getting a lot of attention these days because even the not-so fast money investor can now purchase any number of ETF's and ETN's that allow them to bet on the idea of volatility increasing.

This really isn't a bad idea at all, especially if you think that the market is bound to correct at some point in the near future. If memory serves, stocks go down something like three times as fast as they go up. Thus, volatility tends to go up dramatically when the market enters a corrective phase. And unlike buying an inverse ETF or selling and index fund short, being long volatility means your timing doesn't have to be perfect in terms of when the decline begins. As long as you are long something that mirrors the volatility index (aka the VIX), your hedge will pay off when (or in this case, if) the market goes down. Except, of course, when it doesn't.

Frankly, the idea of buying an ETF or ETN that is designed to mirror the VIX has become all the rage these days. You simply buy some VXX (the iPath S&P 500 VIX Short-Term Futures ETN), some TVIX (VelocityShares Daily 2X VIX Short-Term ETN), or some VXZ (iPath S&P 500 VIX Mid-Term Futures ETN) and wait for the market to go down. Since these things are designed to profit when volatility increases, your holding in the VIX ETF/N should go up when stocks go down.

I'll say it again, except, of course, when fancy securities don't work the way they are supposed to. Since last Friday, the S&P is about flat (1402.89 vs. 1404.14). However, there has been some downward pressure seen in the market during this time and as one might expect, the VIX has perked up a bit (4.56% to be exact since Friday's close). Thus, one would expect the ETF's designed to mirror the VIX to be enjoying gains as well. But, I am sorry to report that the VXX - the ETN most investors favor to play the VIX with - hasn't kept pace. In fact, instead of being up over the last three sessions, the darn thing has plunged -14.8%. And while the VXZ has done much better (-5.3%), I'm guessing this is not what anyone who wanted to be "long volatility" was expecting.

It turns out that this may be yet another example of hedge fund follies as the algorithms used by the fast-money appears to be making the market for volatility go haywire. You see, I learned Wednesday that the fast-money types are indeed expecting volatility to increase in the future, just not in the near future. So, apparently "the trade" these days is to buy longer-dated volatility contracts (options and futures) and then sell the near-term contracts. And since the VXX owns futures on the VIX over the next two months, the thing has been going down due to the selling going on in the futures the VXX owns.

While understanding the game being played by these folks is often helpful in staying in tune with the market, and I do now understand why my little VXZ hedge isn't doing what I thought it would, my bigger point is that there a whole bunch of people selling near-term volatility right now. Sure, they are doing it as part of a "trade." But the bottom line is that the uber-fast money crowd apparently thinks that (a) stocks won't correct much in the next two months and (b) stocks will see a serious correction at some point between July and September. Interesting, eh?

Turning to this morning ... The "flash" (meaning preliminary and unofficial) PMI reports out of China and Europe overnight have put the global growth thesis in question this morning as the reports were weak across the board. And although the market appears to have, for the most part, moved on from Europe, there is some negative news relating to Portugal, Ireland, Spain, and Italy this morning. As such, it looks like a "risk off" day for the markets so far.

On the Economic front ... Initial Claims for Unemployment Insurance for the week ending 3/17 fell 5,000 to 348K, which was below the consensus estimate for 354K and below last week's revised total of 353k. Continuing Claims for the week ending 3/10 came in at 3.352M vs. consensus of 3.378M.

We will also get Bloomberg's Consumer Comfort Index at 9:45 am eastern and then the U.S. Leading Indicators and the FHFA House Price Index reports at 10:00 am.

Thought for the day ... Consider raising your expectations. As Michelangelo said, the danger is not that your hopes are too high, but rather ...
Pre-Game Indicators
Here are the Pre-Market indicators we review each morning before the opening bell ...
  • Major Foreign Markets:
    • Australia: +0.41%
    • Shanghai: -0.10%
    • Hong Kong: +0.22%
    • Japan: +0.40%
    • France: -1.58%
    • Germany: -1.40%
    • Italy: -1.69%
    • Spain: -1.58%
    • London: -0.89%
  • Crude Oil Futures: -$1.22 to $106.05
  • Gold: -$15.30 to $1635.00
  • Dollar: lower against the yen, pound and euro
  • 10-Year Bond Yield: Currently trading at 2.266%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: -7.29
    • Dow Jones Industrial Average: -48
    • NASDAQ Composite: -9.25
Positions in stocks mentioned: VXZ