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The Big One?

Mother's Little Helper portfolio was UP today +$1,711.40 (1.68%).

Overall GAIN YTD: +$1,599.45 (+1.60%).

Our benchmark index, the S&P 500 is UP +0.81%

"By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."

- Warren Buffett (1993)

I made my buys for the year on December 28, 2018, see the new portfolio here (Click Here).

Was That The Big One?

Nope. Surely a 1,600 point drop must have been the big one, the crash we've all been hoping for! This has been the most hated bull market I've ever seen. The stock market is always full of negative outlook, but this one nobody wants to believe. Yesterday's massive decline had nothing to do with our economy, interest rates or the synchronized global growth breaking down.

  • Investors fear that 10-year bond yields are soaring. Well, we got to 2.84% and all day yesterday rates were falling. We got down to 2.756% around 2:30pm before settling out at 2.8%. Yes, rates got to current levels pretty quick but we're still at very low levels.

  • The jobs report was so good that a fear of wage inflation finally became a fear for investors. There are two ways of looking at wage inflation 1) wage inflation puts more money in peoples pockets and they spend it, invest it and save it. Since 75% of our economy is based on consumer spending this should be a good thing, 2) wage inflation erodes the future value of stocks. Investors went with the later perspective yesterday.

Look For The Black Swan

So what the hell happened.

Black swans are unpredictable events, something that couldn't or shouldn't happen. Earnings are strong, the economy is still growing, interest rates are low, taxes are low and we still have lots of cash overseas to repatriate, but suddenly the markets seem to go haywire and produce the largest single day point decline in the DOW's history?

The black swan in the market yesterday was a group of funds known as 'inverse volatility funds'. These funds or technically Exchange Traded Notes (ETN's) proclaim to earn investors a profit when volatility is absent from the market. Because we've had a low volatility market for a long time, some clever investment bankers dreamed up these funds as a sort of insurance policy for professional investors, but they sold them to anyone who wanted them. When the market went down more than expected these funds were not structured to handle the decline. Nobody buys insurance for a zombie apocalypse, which is basically what we got. Investors tried to dump their shares as fast as they could, but that also requires someone on the other end to buy them. The primary culprit in my view was the VelocityShares Daily Inverse VIX ST ETN (XIV). The investment seeks to replicate, net of expenses, the inverse of the daily performance of the S&P 500 VIX Short-Term Futures index. The index was designed to provide investors with exposure to one or more maturities of futures contracts on the VIX, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. The calculation of the VIX is based on prices of put and call options on the S&P 500 Index. The ETNs are linked to the daily inverse return of the index and do not represent an investment in the inverse of the VIX.

Hmmmm. Everybody clear now?

The XIV had a 52 week high of $146.44, on February 5th it was trading at about $116 and then began to plummet. Overnight it dropped to $6.37 and currently trades at about $7.35. Investors saw their holdings in this fund evaporated. And those investors who bought shares of the XIV on margin got hurt the worst.

But the fund didn't just collapse because the market saw some volatility, it and other inverse ETN's caused a massive rush on the options market that further through the VIX up to ever higher levels, signaling that investor fear was off the charts. Why? The VIX, or the fear index uses PUT option volume as a measure of investor sentiment. This is where the machjine trades most likely kicked into full gear and started a race to the bottom. In fact most of the destruction happened with reasonably low stock selling volume, meaning, most of us just sat it out and waited for the damage to be done. Good job investors, sometimes the best thing to do is nothing.

Personally I blame the SEC. They have a responsibility to every investor and the nations financial well being to not approve products like the XIV. This is just another type of derivative investment that nobody really understands. Just like the credit default swaps that got us into trouble in 2007, we are going to see more days like yesterday because of these ridiculous financial products. I've been reading about these crappy products for over a year now and even after studying them for this post, I still can't proclaim to really understand these things. Stay away, if you don't understand what you're buying just stay away.

The Machines

The final culprit was computer trading, specifically the algorithms that trade automatically based on a programmed set of conditions. For instance, I can set a 'STOP LOSS' level on any stock I own which will automatically sell my shares in a company if it falls below a specified price. This is a way of protecting my down side risk. When I sell a few hundred shares the market doesn't take notice, but when big institutional investors sell using this method, the markets get moved. The real algorithms are far more complex and also rely on high-speed trading. Add those two together and you have a wild fire just waiting for some event to trigger a rush into or out of stocks.

Bargain Time

The good news is the parabolic increase in stock prices should be over or ending soon. Lots of companies have been temporarily miss-priced, so there are all kinds of opportunities out there to buy, but I'd like to suggest that anyone who decides to buy, just nibble. Buy a few shares, wait a day or two and buy a few more if the price goes down again. I like technology stocks a lot right now and there are names in defense, aerospace and industrial that look great. The banks are really out of favor because of the Fed's action on Wells Fargo, so look to pick up some shares of banks that benefit from higher interest rates.

Crazy stuff is going to happen in the stock market, always has and always will. The way to stay sane and make a profit is to invest for the long term, don't let these short-term events scare you out of the market.

As Always

Stay Invested

Clay Baker

Disclosure: I am personally invested long in some or all of these funds that appear in the Mother's Little Helper portfolio or manage these investments for my Mother's portfolio and may purchase or sell shares within the next 72 hours. I am also invested in other stocks and funds that do not appear in the MLH portfolio. Since I may on occasion discuss Bitcoin and other cryto currencies I disclose here that I personally own investments in the cryto-currencies listed here: VTI, VWO, VEA, VIG, XLE, MUB, TBT, GLD, Bitcoin, LiteCoin

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. This article is not intended to offer investing advice, guarantee 100% accurate predictions, or to be interpreted as providing a personal recommendation.

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