XIV Implosion & the Implications for Gold
This week we saw the beginning of the implosion of one of the most crowded trades in the world. We’re talking, of course, about the short VIX trade. I say “the beginning” because the short VIX trade is multi-faceted and has deep roots in the business cycle that we’re in. Like most stories in the market, you need to back up from the tree-line in order to get a view of the forest rather than the trees.
First, think "implosion" is too strong of a word?
What is VIX, and what is being “Short VIX”?
The Volatility index was developed by Brenner and Galai in 1986. The calculation of the VIX is complicated, but the interpretation of it is more straightforward. I’ve read a lot of misconceptions in the financial media this week regarding the VIX, so we’re going to lay out what we think is the appropriate interpretation here so we have a foundation for the rest of the commentary.
The VIX is often referred to as the “Fear” index, but this is one-sided and not representative of the original calculation. The VIX is quoted as a percentage and represents the expected trading range over the following 12-months with a confidence interval of 68% (one standard deviation of a normal distribution). If the VIX has a reading of 20, it means that the expected annualized change of the S&P 500 has a 68% probability of moving up or down by 20% or less.
The effect of this is that over time one would expect the average value of the vix to reflect the average annualized returns of the S&P 500.
How does the value of the VIX rise and fall? The VIX is calculated from a blend of option prices for the S&P 500 index. Because the pricing of options reflects the future expectations of market participants with regards to the direction of the S&P 500, the VIX also derives its value from the expectations of market participants. But how does this work?
The main classes of options are puts and calls. Both instruments afford the buyer of the option the right, but not the obligation, to take a certain action on an underlying security. Using an example pertinent to our readers, if you bought a GDX call option it’s likely that you expect the price to rise in the future. If you buy a GDX put option it's likely because you expect the price to fall.
Options, in general, are more attractive when the underlying security is more volatile. Why? higher volatility makes it more likely that an “out of the money” (OTM) option will be in the money by the expiration date. If volatility diminishes, the premium on existing options diminishes because the likelihood of OTM options being in the money also diminishes. Like everything else, the probability (or, expectation, more accurately) of these instruments being profitable affects the supply and demand, which affects the price, which affects the VIX.
Options are complicated instruments and for the sake of this article that’s as deep as we’re going to go. The key-take-away is that the VIX derives its value from the prices of options, the prices of which are affected by the volatility of the underlying asset (The S&P 500).
It’s actually an excellent and valuable measure, but through the process of financial engineering it has been turned into a financial instrument. “VIX as an asset class” is what precipitated the shock we saw on Monday. Up until Monday, short VIX was one of the most crowded trades on Wall Street - for years its been an easy way to make huge profits. But why?
When you get down to the brass tacks every trade in the world is, either implicitly or explicitly, “short volatility” or “long volatility”. This is an important paradigm to view the investment landscape through, especially when analyzing the impact central banks have on market dynamics.
Because of VIX as an asset class, being “implicitly short volatility” could mean simply being long the S&P 500. Being “explicitly short volatility” would mean having a position in a financial instrument like XIV (The short VIX ETF that imploded on Monday). Other implicit short volatility strategies include equity momentum following strategies, risk parity strategies, and risk premia strategies. Most of the outsized gains that have been realized since QE3 have had a sprinkle of implicit leveraged short volatility. This is a fancy way of saying, “I’m going to buy assets on margin that will go up because the central banks have my back”.
Central banks, quantitative easing, and the ‘Fed Put’ have all driven the profitability of the short volatility trade (either implicit or explicit). My readers have heard me say this before, but action/reaction is the most important phenomenon in the markets, as well as the physical universe. Extreme diversions always result in extreme inversions. Fast rises result in fast falls. The amplitude and duration of market moves is commensurate with the amplitude and duration of the subsequent fall. If you identify the predominant action in a market (and its effect) then you can usually accurately identify what the subsequent reaction will be - even if timing it is difficult.
The net effect of central bank quantitative easing has been to drive the profitability of implicit and explicit short volatility trades upward. The reaction to this when QE is removed and replaced with quantitative tightening (QT) - which has already occurred - will be the reversal of the profitability of that trade with amplitude and duration that is commensurate with the action. Even corporate share buy-backs are a form of the implicit short volatility trade. Those have been facilitated by record low borrowing costs for corporations who are bound by a fiduciary duty to act in the interest of shareholders.
The implosion of the XIV that we saw on monday was the rupturing of the explicit short volatility trade that has been facilitated by central bank accommodation. The market cap of the XIV instrument is the tip of the iceberg of the total short volatility trade - both implicit and explicit - that will be unwound when QE is unwound.
The other major effect of QE, which I have written about in the past, has been the compression of risk premia - defined as the spread between the yields of risky assets (equities) and risk-free assets (US treasuries). QE, by driving the short volatility trade, had a major compressive effect on this spread. The reaction when QE is removed will be a decompression of these risk premia. If we’re moving into a bond bear market, which means yields will be persistently rising, then the required drop in equities that will be required to re-establish normalized risk premia is likely to be significant.
By the law of action-reaction, the removal of QE from the system will be utterly disastrous for the financial assets that have benefited from it. This begs the question, is the removal of QE just a bluff? The full reaction of the system is inevitable - when they see the patient dying on the table will they just administer another dose (QE4). Is there politics at play here? Trump has routinely taken credit for the records in the DOW Jones - is quantitative tightening a way to completely undermine the Trump administration? There is no surer way of removing a president from office then to have the stock market collapse on their watch. This is the realm of speculation, but it is interesting to consider.
Unsustainable trends can't, and won’t, be sustained. What better way to exit years of financial mismanagement than to use your political opponent as a scapegoat?
Politics aside - the situation is clearly untenable, and we haven’t even talked about the debt bubble. But everything is intertwined with the short volatility trade. For reference, here is a monthly chart of 10-Year US treasury yields going back fifty years. We have already had one monthly close above the thirty year down trend-line. I typically only talk about my debt-market concerns behind closed doors with close friends, but the negative implications of a bond bear-market with global debt at record levels cannot be overstated. At this point the bankruptcy of most national governments is a mathematical certainty, including the United States.
What is the implication for Gold?
The short volatility trade has sucked up virtually every dollar of investable capital since QE was firmly established. In hindsight, these strategies were a "gravy train". The conventional wisdom in 2008 was that the TARP bailouts would put a rocket booster under gold. For a couple years it did - but it can be argued that the main contributors of that rally were simply the extreme oversold condition from the financial panic, coupled with the resumption in the primary uptrend that was established almost 7 years earlier.
The first two QE programs had quantifiable bounds and timeframes. I think market participants suspected that QE was something that might continue much longer than anticipated. But it was QE3 that came with an “open ended promise”. Everyone needs to remember that the third quantitative easing program was open ended. I’ll quote it straight from the horse's mouth from the announcement in September of 2012:
The Federal Reserve said that it would “buy $40 billion worth of mortgage-backed securities each month on an open-ended basis.”
It’s hard not to laugh when reading that with the benefit of hindsight. Once market participants realized the primary and secondary effects of those asset purchases it became a never ending rush to front-run those asset purchases. Who wouldn’t want to own the assets the Fed is guaranteeing $40 billion of demand for per month? This explicit demand promise completely alters both the actual and perceived risk of these assets downward. When the risk of an asset falls, the risk premium demanded on the cash flows from the asset falls with it until it reaches something called the “risk free rate”.
This is an extremely powerful force entering the market. Any demand for gold from those worried about inflation or currency debasement was dwarfed by the capital flows into bonds and the other secondary beneficiaries. And it wasn’t just gold, it was virtually all commodities. And the crazy part is, you would have been stupid not to join in. The central banks, through their asset purchases, facilitated the entry of extremely excessive “risk” taking into the markets. By guaranteeing demand for an asset on the open market, you make irrational behaviour rational.
Assets compete for capital. When capital leaves or is deferred by another asset class, it can have profound negative consequences for those involved in the neglected asset classes.
Where am I going with all this? Remember that in order to understand what the market reaction might be you need to try and nail down exactly what the primary action was and what the consequences were, to the best of your ability.
Everything we just talked about was primarily facilitated by the Federal Reserve’s asset purchases. Now they’ve removed it, and are reversing it. It stands to reason that most things that existed because of it will now cease to exist in its absence. This means capital is going to get redirected elsewhere. What areas get flooded first when the tide rolls in? The answer is it doesn’t matter. There’s going to be a broad-based revaluation of virtually every asset class when/if central bank influence is removed.
We may have already started a bond bear market that could last decades. Bond yields look to have made a major double bottom and look to have broken out of the long term down trend on a monthly basis. This remains to be confirmed, but is a significant even nonetheless. A breakout of yields is only a matter of time.
It’s interesting to note that this trend line breach was the immediate precursor to this week’s implosion of the short volatility ETFs. At the very least, it looks like the algorithms think something is wrong. The situation in the bond markets is the biggest story in finance right now, but it’s getting almost no airtime.
The Gold Market:
Weeks ago we informed members that gold was approaching our AI-generated distribution zone. VanAurum was projecting that gold would have difficulty with the multi-year neckline resistance, and that is exactly what we've seen.
This week we saw an explosion of relative strength in gold, despite it suffering a sell-off of its own:
Since then we've seen the gap get filled in. It remains to be seen if the relative strength will continue now that we've seen the gap filled. We've seen follow-through today with another extremely rough session for equities. This is how this looks on the quarterly chart of SPX versus Gold. As an aside, it's amazing to see how much value the S&P 500 has lost relative to gold, despite it hitting all-time nominal highs.
I alerted members last week that the VanAurum AI has given us an official bull-market signal for Gold. Everybody in the financial community seems to be squabbling amongst themselves over whether or not this is the case. These are the situations when the "cool head" of an artificial intelligence can guide you. In the markets it's import to act only when you receive reliable signals, and be patient otherwise. Even if you're not sure how to proceed from a trading perspective, it pays to sit tight while bull-market signals are active. The short-term situation in gold is different, and we'll be reporting on that to members tomorrow, but the long-term situation is more clear.
Knowing whether or not an asset is in a bull market is critical to knowing how you should trade it. We had the VanAurum AI scan the history of long-term trend indicators and decide for itself which indicator best insulates you from downside while allowing you to participate in the upside. In the initial iteration of VanAurum's programming we hard-coded the definition of a bull-market. The most recent iteration has VanAurum decide its own definition of a bull-market (It's better at it). This indicator is active right now, and we will alert members going forward as to its status. Trading off this bull-market indicator alone would have yielded the following portfolio performance since 1975 (green) compared to a buy-and-hold strategy (blue):
This portfolio had a starting value of $10,000. Trading costs are set at 0.1% of the portfolio value, slippage is ignored, and no fractional purchases are permitted.
Will this signal roll-over and be invalidated? Maybe. But investing and trading the markets is all about acting on the best information you have available.
Members can stay-tuned for our weekly market update for Gold - we'll be releasing that tomorrow after the market data is settled and consolidated. We have important information to deliver regarding our outlook for the next 6-8 weeks.
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