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While investors are ringing the alarm bells after the more-than 12% drop in the S&P 500 over the past few days, there are many important market factors underpinning this drastic move lower. Many of these are technical reasons that may be confusing to some market investors which we seek to clarify and elucidate upon here:
1. Negative gamma selling effect of short volatility trades
One of the most popular strategies over the past 2 years, the short Volatility strategy has been implemented by professional hedge funds and novice investors alike. Much of the flows into Short Volatility strategies have gone into the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV), managed by Credit Suisse which just announced a redemption today at a large discount after the net asset value plunged more than 90% in value in late trading on February 5th. This strategy, which attracted more than $2.2 billion in assets, was touted as a way to make millions, as a former manager at Target famously rose to fame by shorting volatility. But how does this exactly work? The VIX curve is naturally upward sloping, meaning implied volatility of future contracts is higher than shorter-term contracts. This VIX Curve, combined with a persistently low spot VIX Index, is what short volatility traders are capturing as they bet high-priced longer-term contracts "roll down" to lower-priced near-term contracts, profiting from the spread that has been captured. This works until it doesn't. Much of the time, in order to augment returns, investors use leverage, magnifying the gains on the upside and downside. When the VIX Curve inverts, as it has done over the past few days, the scramble to run for the exits is intense as short-term volatility is bid up, plunging the Net Asset Value of short-volatility securities like XIV. This negative gamma creates an effect of 'selling stocks begets selling more stocks' as lower prices induce more selling as volatility explodes higher.
2. Extremely extended put-call option skew
Running parallel to the short volatility trade, the investor belief that stock markets only rise was confirmed by 2017's lack of a more than 3% sell-off. Call it Irrational Exuberance. This bore fruit to the popular strategy of selling put options - contracts giving the buyer an 'option' to sell at a pre-determined strike price on or before a pre-specified date. At the same time, investors have been buying call options, betting on the market to keep rising persistently into the future. While this strategy can effectively be distilled into a simplistic Long Stock strategy as the 'Delta' at inception is close to 1, it employs additional leverage to boost returns even further. This is because the implied volatility is usually higher for Puts versus Calls. The difference in this implied volatility is called "Volatility Skew". Thus, an evenly-spaced Option (maturity date, notional size & strike price) is usually accompanied with "positive carry", meaning that even if the stock price does not move at all, the investor will collect a Premium. So, effectively it's a Win-Win situation right? Profit when the market does not move and you get juiced returns if the market goes higher. Not so fast. This Volatility Skew, which has been averaging around 10.0 (Vol of Puts > Vol of Calls) has been consistently moving lower over the past 2 years as traders continue to pile onto these strategies. Some even sell more put options versus call options, maybe 2-to-1 or even 3-to-1, to put this strategy on steroids in overdrive. But what happens when the market sells off, or even worse, crashes? On top of the fact that those put options that investors sold become pricier as implied volatility explodes higher, the negative delta (approximate amount of shares needed to be sold to cover a potential put option exercise) increases as investors are effectively 'short gamma'. Investors that carry short gamma positions have the undesirable position of having to sell as the market goes lower and then, if the market reverts, will have to buy stock as the market goes higher - essentially, Sell Low & Buy High. Another term for this is 'negative convexity' which is akin to storing a barrel full of explosive Nitroglycerin in your living room in return for a measly $20 of rent per month. While that barrel of nitroglycerin probably won't catch fire and most likely won't explode and you'll be able to collect a "free" return every month, the sheer riskiness of doing so should dissuade the street-smart investor, or at the very least, give him pause. Just late last year, the upstart Robinhood stock trading platform recently launched a Options-Trading platform completely commission-free, luring yet more investors into this tempting Siren Song strategy. The fact that the Volatility Skew (3-month 90-110% SPDR S&P 500 Trust ETF (NYSEARCA:SPY) Skew below) had been declining consistently indicated many investors were employing this strategy. And now, many of those investors are scrambling to cover their butts with the unenviable position of carrying negative gamma.
3. Overextended, crowded long stock market positioning
Along with these concerning market developments that have taken place over the past couple years, the market has become heavily crowded and overextended on the long side as low volatility and a persistently rising market has attracted more entrants into the market. These entrants haven't been limited to retail traders but has also included professional Hedge Fund Managers, who are exhibiting their highest Beta (correlation to stock market returns) in history. We recently wrote about this concerning market development at the start of last week as the market was showing signs of dangerously crowded market positioning that tends to be followed by a market pull-back. Our measurements have showcased an extremely long market that represents the highest concentration of relative stock market longs over the past 10 years. During the final stages of a stock market cycle, investors begin concentrating their investment purchases into a narrowly held group of stocks, which characterizes the FAANG group in this investment cycle. The stock positioning reading of Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) all have CrowdThnk© consensus positioning readings in extreme overweight territory around 10 on a Scale of 0 to 10. When market turbulence strikes and volatility explodes higher, no stocks are immune and even the most beloved stocks are sold, especially if those stocks exhibit extremely overcrowded positioning.
4. Higher rates means less stock market buybacks
Probably the impetus that catalyzed the current stock market sell-off - the proverbial "straw that broke the camel's back" - has been the exponential rise of U.S. Yields. This is best demonstrated by the U.S. 10-year Treasury yield, which has risen from 2.30% to 2.85% since mid-December (and from 2.05% in early September), a sharp upward spike considering the extremely low yield environment we've been living in over the past 10 years.
The drivers behind this rise in yields include:
- U.S. Tax Plan that increases the budget deficit and strains debt capacity in the future as the government will collect $1.5 trillion less revenue for the next 10 years
- An unwind of global central bank's Quantitative Easing Program that reduces buying support for government bonds worldwide (the Fed is currently unwinding $4.5 trillion of bonds and other securities on its balance sheet)
- Rising inflationary indicators in the United States ranging from the Fed's favored PCE (Personal Core Expenditures) to 5-Year inflation breakeven rates (chart) to Average Hourly Earnings, which jumped to 2.9% last Friday, spurring speculation the Fed could unwind QE at an even faster pace.
So why is this rise in bond yields important to the stock market? For one, much bank lending and, and hence economic activity, is contingent on the 10-year yield. Think home mortgages, business loans, auto loans, student loans and construction loans. All of these activities now face costlier borrowing rates, potentially spurning a decision to move forward with a loan. However, another reason, and perhaps more directly linked to the stock market, is the fact that many companies have been financing their stock buyback purchases, which have been the highest in history, by issuing debt at extremely low yields. These stock buybacks have amounted to nearly $800 billion in 2017 alone. By issuing corporate bonds at 1%, 2% and 3% yields and buying back their own stock, company executives effectively increase share prices while burdening the company with more debt. This is an excellent strategy to deploy as long as stock prices keep rising, not to mention C-Suite executives are incentivized to do so (rightly or wrongly) as their compensation is directly tied to stock prices. However, once yields start rising precipitously, it could signal a halt to this strategy or at least a significant retrenchment, removing a significant supporting mechanism that has driven stock prices to records over the past few years. Beyond inflation concerns, this "backstop" has been underpinning any stock market corrections but Buyback activity could be put to the test should yields continue to rally.
To be sure, we've seen sharp rises in U.S. Yields in the past, most recently in the second half of 2016, which did not prove sustainable. However, the pace of the move combined with the amount of leverage tied to U.S. interest rates and fact the Fed is reversing Quantitative Easing should give investors and corporate executives a cause for concern when deciding whether to buy back stocks at record-high prices.
While the factors leading to the current market collapse can't be distilled to only a select few factors, we believe these 4 market ingredients have combined to form a toxic recipe for the unsuspecting investor. As these market considerations have been building over the past few years, we have reached a point of extreme leverage in short volatility positions, historically low volatility skew, extremely overweight market positioning and unprecedented stock buybacks from corporations which have combined to prove a lethal market mix, contributing to the current stock market collapse.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.