"Those who cannot remember the past are condemned to repeat it."
Here we go again. Perhaps the one thing that has been more surprising than the resilience and persistence of the stock market throughout the post financial crisis has been the complete and total abdication of sound decision making by global regulators and policy makers in taking actions in the wake of the last two crises to prevent yet another market implosion in the immediate future. But here we go again. Same misguided policy actions, same policy oversights and missteps, same expected results at some point in the future.
I Read The News Today, Oh Boy
"I read the news today, oh boy"
--A Day In The Life, The Beatles, 1967
I've read the news throughout the post financial crisis period, and my thoughts have often drifted toward the "oh boy" category. And two more such articles crossed the screen this weekend that fell squarely in the "have we learned nothing?" camp.
Oh Boy #1
The first such article came in the Wall Street Journal this week. Entitled VIX index: snowballing power of the Wall Street 'fear index', the article details the experience of a retail day trader that has made $53,000 this year shorting the CBOE Volatility Index. According to Miller, "One person's fear is another person's opportunity". Indeed.
While I applaud Mr. Miller for his outsized gains shorting volatility thus far in 2017, I cannot help but be left to contemplate the following. The VIX is currently trading at historic lows. On only fifteen trading days in history has the VIX closed the trading day with a reading below 10. Six of those fifteen trading days have taken place over the past month since May 8. This includes the lowest close on the VIX in the modern era since 2003 with a reading of 9.75 on June 2. All of this implies the following - Mr. Miller is certainly not alone in seeking opportunity in the fear (or lack thereof) of others. In fact, the mere fact that a retail trader from Boca Raton, Florida is actively shorting volatility highlights the magnitude of the "short VIX" trade that has increasingly captivated investors both institutional and retail alike.
History has repeatedly shown the eventual fate of investors that get caught up in crowded trades. Highflying tech stocks, houses, and Dutch tulip bulbs are a few that come to mind. More often than not, these trades that for a while seemed without limit end up delivering punishing consequences to so many that go along for the ride.
This leads to my first doomed to repeat history point. Just as we have seen past mania in flipping houses, dot.com stocks, and Dutch tulip bulbs, we are currently seeing a mania in volatility. But unlike a house where you know how it works and you can physically walk inside of the asset and look around, and unlike a technology stock where you can see the assets and examine the financials (or lack thereof), and unlike a tulip bulb where you can see the flower growing out of the ground, volatility is a vastly more esoteric concept for most. After having seen and reviewed the prospectuses of a number of the exchange traded products that enable investors to establish long or short positions in volatility with varying degrees of leverage, I challenge a vast majority of retail and institutional investors that are using these products to even begin to explain how they actually work.
Put simply, we currently have an investment mania in a segment of the market where a vast majority of the participants likely have little to no idea what they are actually dealing with in what they are buying. What are they doing today? They are not only trading volatility, they are shorting volatility. And many are doing so with leverage. When this bubble finally bursts and volatility (NYSEARCA:VXX) finally starts to rise from its historical lows, not only will many investors get completely steamrolled in the process but it will also likely have meaningful spillover effects across capital markets including stocks (NYSEARCA:SPY).
Each and every trading day, the cylinder spins and the trigger is pulled on this volatility trade. And at some point, the deadly shot will be fired. In the meantime, the market is left to wait, with most participants left completely unaware.
Let's come back to this topic in a minute.
Oh Boy #2
The second such article this week came from a variety of news sources including Reuters. On Monday, Spanish (NYSEARCA:EWP) regulators backed by the European Securities and Market Authority implemented a short-sale ban on Liberbank stock. The reason for the decision was to prevent a 'domino effect' for the Spanish banking system in the wake of coordinated rescue of Banco Popular last week. Short sellers turned their focus to Liberbank in the aftermath and cut the market value of the bank by roughly half in recent trading days.
Allow me to reiterate for emphasis. Investors that were seeking to establish a short position in an individual stock that is described by Reuters as "a small Spanish lender" have been banned from doing so for the time being. The following is the stated explanation from the ESMA according to Reuters.
"Due to the interconnections and perceived similarities with other entities, the situation could have a domino effect of a size that could become systemic," ESMA said, warning of a 'contagion' that can hurt the entire financial system.
Where do I begin.
First, have we learned nothing from the financial crisis? Short sale ban? Really? It has been widely concluded both during and after the financial crisis that banning short sales is largely ineffective due to the reduction of market liquidity and the distortion of price discovery among other factors not to mention that any short-term stabilization of securities prices is often corrected once the ban is removed.
But even short-sale bans unequivocally worked, are we still playing this game after so many years? In the last eight years since the financial crisis, we have had policy makers literally buy up every asset in sight and backstop assets left and right to virtually ensure that investors and lenders do not have to sustain losses of any kind. So how can it possibly be after so many years of unending support and policy maker generosity can we have a financial institution in Spain that is so weak from a capitalization standpoint that they are even perceived to be a legitimate target from a short-selling perspective.
And here's the thing. No rule exists that Liberbank had to access capital markets by selling an equity stake in their banking business to the public. If a bank engages in the privilege of selling ownership and borrowing money from investors, both sides should be fully aware of the risks both to the upside and downside from doing so. And if investors, borrowers or depositors for some reason perceive that a banking institution is a risk of not being able to deliver on their claims of being able to continue as an ongoing viable concern, it is incumbent on the bank to clearly demonstrate this strength to the satisfaction of those that granted them the capital in return for an ownership stake or to lend to customers. If they cannot successfully do this, then such are the consequences and risks of participating in financial markets. In short, the risk of potential terminal losses help ensure that those that need to manage the risk of their operations are doing so prudently enough that they don't scare off their owners and lenders. And the fact that policy makers are compelled to institute a short-selling ban suggests that we are apparently still not at the point despite all of the global euphoria over rising stock prices that the system is not strong enough to sustain a loss.
What about the nature of this loss anyway? This is not Banco Santander (NYSE:SAN) or BBVA (NYSE:BBVA) that is under fire. This is Liberbank, which is a "small Spanish lender". Are we really still at the point eight years after the crisis when global central banks have already hoovered up all of the garbage in sight where we cannot allow a small lender to fail? C'mon.
But let's go much bigger. Regulators scrambled to impose a short-sale ban on a handful of speculators that were playing a part in driving the stock price of a small Spanish lender to the downside in order to prevent a 'domino effect of a size that could become systematic'. Included in this ban were steps to prevent a stock price from going down.
At the exact same time and getting back to "Oh Boy #1", we have legions of investors in the United States and around the world that are using all kinds of multi-derivative exchange traded products and exponentially leveraged strategies to relentlessly short volatility, an asset class that most investors do not even understand but is instrumental to the underlying functioning of financial markets. Of course, this shorting activity involves muting volatility and thus induces stock prices (NYSEARCA:DIA) to go up.
All of this leads to the key underlying problem that has us doomed to repeat history. Regulators and policy makers are so hyper focused on preventing known activities that might cause stock prices of any kind to go down that they are falling victim of completely overlooking activities that may cause many more stock prices to go down by orders of magnitude at some point down the road. For if the continued short selling of a small Spanish lender has the potential to result in a 'domino effect of a size that could become systematic', exactly what the heck is going to happen when the continued short selling of volatility by scores of investors with various degrees of leverage are suddenly forced to cover their positions once the trade finally ends and as volatility potentially starts screaming exponentially higher. Put simply, this has the potential to result in a domino effect of a size that would make the failure of a small Spanish bank look completely insignificant by comparison.
With all of this in mind, where are the regulators in taking action on the real risks that are threatening the future stability of global financial markets today? If we're banning short selling on a small Spanish bank, where are the short sale bans or at least the increased regulatory oversight on those that are shorting volatility? They are nowhere to be found. Why? Because it is not adversely impacting asset prices at the moment just as rising tech stocks and house prices did not adversely impact asset prices in the past. As a result, we are all left to wait and see, with many market participants completely unaware, what ends up happening in the end when the hydrogen bomb that is the short volatility trade finally detonates.
Perhaps someday we will have the opportunity to laud policy makers once again for saving us from the abyss of the next financial crisis. Too bad nobody could see the causes coming in advance to do something about it, right? Such is how we are doomed to repeat history once again.
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