Stocks Have A Flash Crash Thanks To Volatility

Stocks Crash & Volatility Spikes

Monday was a terrible day for stocks because there was a big blow up in some of the complex volatility instruments. The S&P 500 was down 4.10% which was the worst day since August 2011 and the VIX was up 115.6% to 37.32 which was its biggest percentage increase ever. As you can see in the chart below, the VIX hit its highest level since August 2015. This was a historic day for people focused on stocks, but not big enough to be mentioned in any general history books unless there is a further decline. For context, the flash crash in May 2010 caused the Dow to fall 9% temporarily and close down 3%. On Monday, the Dow’s low was down 6.6% and it closed down 4.6%. For short time, the Dow entered correction territory which is a 10% move lower.

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There are many people in the media worried about Dow points, but that’s silly because points are smaller on a percentage basis now that it’s higher. From the peak on January 29th, the S&P 500 is down 7.79%. It is now down 0.92% year to date. Those who said they would buy a 10% pull back should do so because the market isn’t down for any fundamental reason. I’m bullish on the short term, meaning the next month, but I expect some more selling on Tuesday because the volatility instruments crashed after hours.

It was a broad based sell off in stocks as 6 sectors were down 4% or more. The worst was the financials which was down 4.99%. The energy sector had another terrible day as it was down 4.35%. The stock market decelerated after the S&P 500 fell below its 50 day moving average. The 10 year bond became a flight to safety as the yield was down 13.55 basis points to 2.7056%. Clearly, increasing yields weren’t the cause of the sell off since stocks crashed and bonds rallied on Monday. Oil fell 2% to $64.15. I have been expecting a sell off in oil for a while just like stocks. This decline in oil isn’t enough for me to switch to bullish like I have on stocks. Gold actually acted as a good hedge today as the yellow metal was up 0.4%. The JNK, junk bond index is down 2.67% since January 5th.

Complete Volatility Blowup

Most market watchers believe the stock market crash happened because of the action in the volatility market. The trade to go short volatility blew up. There was a sharp demand for S&P 500 puts which hurt the market. The two short volatility ETNs in question are the SVXY and the XIV. Their moves were sharp during the day, but the real destruction occurred overnight. The SVXY went down 82.19% after hours and the XIV went down 85.49% after hours. This could trigger more put buying on Tuesday which could cause stocks to fall further. These ETNs are supposed to be for sophisticated traders to manage daily trading risks. It will be interesting to see what that after hours move will do to the market. As of September, Credit Suisse owned 5 million shares of XIV which would make this a $500 million loss. As I mentioned, these are short term hedging vehicles, so it’s unlikely that Credit Suisse owned that amount heading into today. However, the stock was down 6.59% after hours, so traders are worried about its exposure.

It’s scary to see that a small correction in the stock market catalyzed the volatility indexes to blow up because, in a virtuous cycle, the volatility indexes caused stocks to fall. This is a complicated version of the euphoria trade unwinding, since only very bullish investors would go short the VIX in the single digits. The VIX had been increasing this year even when stocks were rising which made some weary of what was to come. Those who warned about this short volatility trade unwinding were correct.

This crash is like the mortgage backed securities market crashing housing and stocks. The derivatives markets need to be watched closely in any trade that goes to far in one direction. Essentially, the stock market crashed itself without an economic catalyst, a problem with corporate earnings, or a geopolitical issue. It’s amazing to see that after all these months without a sell off in stocks, the catalyst of the first sell off was nothing fundamental. This is fitting since negative economic and political news haven’t phased the market in so long.

Reflexive Effect

Investors are often wonder what economic changes will affect the stock market, but since stocks have moved first, we need to question how stocks can impact the economy. The chances of rate hikes fell modestly. For example, the chance of a rate hike in March fell from 76.1% to 69.0%. A real crash in the stock market of 20% could wipe away the benefits of the tax cut. We’re still far away from that. In summary, the decline on Monday did almost nothing to the overall economy, but a further correction, will have negative effects.

Bitcoin Crash Continues

Bitcoin has been crashing for about a month as the euphoria reached stratospheric levels in January. I have been bearish on this space for a few months, so I missed out on the last huge jump in these coins’ valuations. The ripple cryptocurrency has been hit relentlessly as it peaked at a market cap of $140 billion and now has a market cap of $25 billion. The price of bitcoin has fallen ever since I called the $19,400 peak. It’s now at $6,500. The total cryptocurrency market has fallen from $826 billion to $300 billion. The reason I am mentioning the latest deceleration in cryptocurrency prices is because they have fallen in tandem with stocks. The two riskiest trades of this bull market: long crypto and short the VIX have blown up. I wonder if that is a signal of the beginning of the end of the overall bull market. On the other hand, if the market survives this turmoil in a few weeks, it might do fine until the end of the cycle in a couple years.