Weekly Observations for 2/9/2018 — Welcome Back Volatility!

Where to begin with this week’s observations! Books will be written on Monday’s spike in implied volatility in the stock market. But my job is to keep this short and to the point until my next in-depth client letter is published.

Volatility came back rapidly to all asset markets this week, and, as is often the case, there was no particular reason for it — no war with North Korea, no (new) scandals, no surprise from the Federal Reserve. The popular narrative seems to be the rise in interest rates, but that’s rather old news. My take? All parabolic price increases eventually break — and they don’t need a reason. Eventually, the math just quits working.

Let me share a few very important observations with you, then I’ll print a couple charts of the broken parabolas this week.

1)  Nothing terrible happened this week. Markets go up and down. It’s part of the process.

2)  Many interesting things are happening in the markets right now. Perhaps the most relevant is the fact that since the stock market peaked on January 26th, both stock and bonds have declined simultaneously. That’s a difficult environment for portfolios — only cash provided protection from this particular dip.

3)  Stocks (S&P 500) are down around 10% from the peak. The current level is where it was in November — and everybody was very happy in November.

4)  A typical 60/40 (S&P500/BCAgg) balanced portfolio is down about 3% year-to-date. This is well within normal volatility expectations.

Where to from here? Of course, we can’t know — a rebound is just as likely as a continued decline. But now is an excellent time to gut-check your plan and the embedded risks of your investment portfolio. My October 2017 client letter outlines that process.

Now for a couple of broken parabolas:

First up is the “Short Volatility Trade”, or short VIX, on Monday, which is what books will be written about. You’ve never heard me discuss this derivative trading strategy because it should never have existed and was never appropriate for individual investors. On Monday, certain short VIX investments lost nearly 100% of their value and closed shop. For example, here is the “XIV” fund issued by Credit Suisse:

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In my January 20th client letter, I posted a chart on page 6 showing the parabolic advance developing in the S&P 500 and cautioned that exponentially rising markets do not correct by going sideways. Here is the same chart updated to show the back side of the S&P’s recent parabolic rise:

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I have a full reading list for this weekend, but a light meeting schedule next week. Please feel free to call me anytime to discuss questions or financial matters as they come up.

Have a great weekend!