WWII 112: 10% Correction Indeed, Whistle Blower Says VIX Manipulated, VIX ETNs Implode

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Main Topic: 10% Correction Indeed, Whistle Blower Says VIX Manipulated, VIX ETNs Implode

Well, it actually happened! The market, using the S&P 500 reached a full correction of 10% from its most recent peak. The bottom, so far, was on Thursday, February 8, 2018 when the S&P 500's adjusted close was 2,581, compared to the most recent peak on January 26 of 2,872. The difference is 291 and if we divide 291 by 2,872, we get 10%.

Why is good to know when the market has corrected? If you have been listening to my podcast and following the cash management program I have laid out, it is time to put a third of your cash into your buying program.

Here are the cash management rules that I have laid out on this show:

  • We sit with 30% in cash at all times until the market corrects:
  •  Down 10% we put a third of our available cash into our buying program, 
  • Down 20% we put another third of our cash into our buying program, 
  • Down 30% we put the rest of the cash into our buying program.
  • We start to raise cash again to the 30% level as the market passes it’s most recent peak and market cap is more than 140% of GDP.

So because the market has corrected to the 10% level, it's time to put a third of your cash to use and at it to your buying program to be spend over the next two to three months, assuming you can find attractive prospects.

Lets talk about why this opportunity came about, and why the S&P 500 sank to such a level.

In the last episode, show 111, I talked about how I thought that the 4% Monday the 5th of February drop in the market was unusual, and I would't be surprised if it was a market malfunction of some kind. Well, we found out that indeed, it was.

First, a whistleblower has come forward who claims that the VIX, the supposed market volatility index, was being manipulated by large trading firms. 

Whether or not it is true, it is a piece of the puzzle that seems to fit. Large institutional traders had been placing huge bets on continued low volatility. These bets unwound like a coiled spring causing the volatility index to spike and causing chaos in the market. As these huge trades went against the institutionals, it is possible they unwound other long holdings to raise capital, causing tremendous selling pressure on the market.

We normally call that forced selling and it is a very probable factor in Monday's action. It probably started when volatility started to increase with the previous week's smaller drops in the market, leading to the VIX to start to rise.

This initial volatility was probably a result of reports that the Fed may need to raise interest rates faster than expected to keep inflation under control. News algorithm based trading programs probably picked up on this and triggered some sell orders, creating volatility.

Once it was clear that volatility was back, the spring uncoiled in dramatic fashion. The VIX increased so fast that two Short Volatility Exchange Traded Notes imploded and triggered their demise.

Once the market fell that 4%, then all the other retail investors started to panic and sell some of their holdings, and the drop became widespread. This is just my theory, but is a pretty typical scenario for fast market drops. First the elephants try to squeeze through the door, then everyone else follows.

What's even more interesting is that this correction occurred during a period where we have some major economic tailwinds: worldwide economy in recovery, rising but tame inflation, stimulus policies by the current administration, and nothing that would create a recession.

The nice thing about having a cash management policy and having buying programs it will keep us from catching falling knives unless the market drops more than 30% and we are already fully invested. If I had these in place in my early days, I would have far more wealth than I currently do. 

So, it appears that the market correction was do to market structures, largely, not due to a looming recession, black swan, or anything else. Let's take advantage of lower prices to buy into quality businesses at reasonable prices.

Ask JB: Why is inflation bad for stocks?

Why are inflation fears bad for the stock market? (self.investing)

submitted  by mikhael4440

Is there something I'm missing? At any given time an investor can be in cash, stocks or bonds.

If inflation rises, cash becomes less attractive since you are losing X% a year.

If inflation rises, bonds become less attractive because the real yield has decreased.

Stocks have consistently kept track with or beaten inflation, since they represent assets and operations whose values increase with inflation.

JB Says: Inflation being bad for stocks is actually a perpetuating myth. If you study the correlation between stock price performance and inflation, there is no correlation generally. There might be for brief periods of time, but that is just a coincidence.

Inflation can be quite helpful to some companies, including banks, insurance companies, and other businesses that have large portfolios of bonds, especially short term bonds. As inflation rises, the Fed raises the overnight rate, and the banks can roll over their bonds into higher yielding bonds, earning more investment income.

So, my approach to rising inflation is to buy up quality companies that use inflation to improve their performance. Incidentally, companies that have pricing power can counter inflation with price adjustments. 

Ask JB: 

What are the systematic reasons that causes the stock market to go up long term? (self.investing)

submitted  by Boostafazoom

Are there any?

Everybody seems to be pretty confident that the stock market, as a whole, will trend upwards over a long period of time. This is why it is highly recommended for novice investors to dump all their money into VTI/VOO and forget about it for decades.

If I dump money in VOO/SPY, what are the precise reasons that place so much confidence in the idea that its value will be substantially higher in 10-20 years? Just looking at the years 2000-10, the stock market didn't really go up.

I'm not sure if I'm thinking about this the right way. Correct me if I'm wrong, but the only way it can consistently go up is if the underlying companies continually beat expectations. After all, a stock price is supposed to represent the sum of all EXPECTED discounted cash flows. Growth is one thing, but you have to grow beyond the expectations of growth in order for a stock price to increase (if the price indeed is a representation of consensus expectations). But how can this possibly go on forever?

I'm also not sure if I'm thinking about index funds the right way. Even if we grow as a society through consistent technology innovations, the only way for SPY to grow would be for its underlying 500 companies to grow in value. Doesn't this mean that even if our country continues to grow as a WHOLE, I won't necessarily achieve any returns on SPY unless those top 500 companies increase in their market caps as well?

I really want to dump most of my money into a passive index and forget about it, but I'd like to be more convinced. I might be an idiot, I can't quite comprehend how there can be a guaranteed systematic reason for the stock market to go up over the long term.

JB Says: You are off to a good start in the rational approach you are taking. The reason stock prices rise is because the market rides on earnings, to quote Shelby Davis. Companies become more valuable over time via their retained earnings and growing book values, growing intrinsic values. But a company's stock will only truly move up over time if the company produces consistently growing earnings. The P/E multiple is the other factor in this equation.

What I like to say is that we hitch our wagon the best horses and ride them for decades, letting the compounding value of the underlying business compound our wealth.

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Thoughts on this podcast? Disagree with me on some point? Something I missed? Leave a comment!

About the Author

Jeremy Scott Bailey is an investor, author, entrepreneur and host of the "What Works In Investing?" podcast now available on iTunes. He is founder and Chief Investment Officer of Burgeón Group, Inc. an investment advisory firm that provides portfolio management services to families and individuals.

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