When the Music Stops

Last Thursday the S&P 500, a typical benchmark for the US stock market, hit a technical correction by falling at least 10% from a prior high. In just less than two weeks the index seemingly went from happy and content to sad and disillusioned, leaving long-term investors' heads spinning.

Stocks recovered somewhat on Friday and through yesterday, but we're likely not out of the woods yet as bouts of volatility typically take at least a few weeks to burn off.

While there are always catalysts for market corrections, what's interesting about this one is the strange dynamic where inflation and interest rates were labeled as the primary culprits, but the real blame should be laid on the markets themselves. After more than a year of very low volatility the stock market was primed for a bout of profit taking, and that's what happened, although other issues helped spur sellers on.

Through last Friday the S&P 500 had grown almost 16% in the past 12mos, even with the correction. The Dow was up 23% in the same timeframe and foreign markets were up the same or more. And as we're all aware, these returns occurred during abnormally quiet markets. So, at the first whiff of anything negative many investors, especially short-term traders, were ready to flee with profits in hand. The result was the quick negative turn we've been witnessing, with major indexes giving back what they earned in January plus a little bit more. Year-to-date through this morning, the S&P 500 and Dow are both down less than 2%.

Wait, down less than 2% year-to-date? Doesn't that seem strange with all the volatility and headlines lately? Unfortunately, fast-moving markets are the "new normal" as computerized trading algorithms at large trading firms and hedge funds account for most of the trades each day. These firms can buy and sell so rapidly and so frequently that they can exacerbate market volatility. And trading isn't just during daytime market hours. Trading goes on very actively after hours and in foreign markets while we're asleep.

Nearly all this after-hours trading is short-term in nature and has little, if anything, to do with market fundamentals and the health of the broader economy. Excessive trading is a boon for brokerage houses that make money on transactions, but it can create pockets of risk that are hard to see until they go pop.
Along these lines, you may have heard how some of the market's recent downside was fueled, ironically, by a subset of investors betting the stock market would stay stable.

These investors used investments such as an exchange traded note based on the VIX, the market's fear gauge. This ETN (like an ETF but very different), was meant for investors to benefit while market volatility was low. The returns had been impressive and would remain so assuming markets stayed quiet. The investment was moving along fine and investors, chasing performance without understanding the risks, were piling in more money. But then the correction hit suddenly and the VIX shot up over 100% in a day. Since the ETN was meant to offer the inverse, or opposite, return of the VIX day-to-day it immediately fell by a chunk and then collapsed during after-hours trading. The investment in question, VelocityShares Daily Inverse VIX Short-Term ETN, began 2018 at almost $140 per share and is now worth about five bucks, with most of the decline happening within a week. Yikes.

Investments such as this are often like a house of cards, getting more fragile the longer they're in use. They tend to operate on the Greater Fool Theory, where you should pay any price for an investment you could later sell to a fool for a profit. While that makes sense to somebody, it doesn't work very well long-term and can often leave the investor feeling like the fool. Maybe this investor should join in the game of musical chairs the next time they're at a child's birthday party. It could be instructive.

I don't wish huge losses on anyone, but these kinds of occurrences should help others by scaring them away from short-term trading and investments lacking substance. Let's be investors, not short-term traders. That's the only way we can look beyond the typical headlines and day-to-day craziness during a market correction.

Have questions? Ask me. I can help.