Blain's Morning Porridge 8th Feb 2018 - Astrology, The VIX tumble, and what will be next shoe to

Blain’s Morning Porridge – February 8th 2018

“See how the sun shines brightly in the city, on the streets where once was pity….”

The Morning Porridge is unrestricted market commentary freely available to all investors on an unsolicited basis. It is not investment research.

Something clanging on the River Thames woke me early this morning. I peered out the window onto a clear night-scape. (See attached photo.) I ended up out on our balcony with my tripod-mounted binoculars admiring Mars, the Moon, and Jupiter. As the sky lightened, a plane neatly bisected the gap between the Moon and Jupiter, its con-trail glinting in the sunlight from beyond the horizon. What does it mean – a barrier betwixt the two? I’ve read enough cod-Astrology to know the Moon rules our mood and emotions, while Jupiter is about luck, growth and wisdom. Strikes me this morning’s conjunction says it all about current markets: a split between our emotions and the fundamentals of growth. However, I’m worried luck is out the window.

On one hand, I’m taking this morning’s stars as a good sign. Growth fundamentals – the Global Macro Alignment – remains on track for a strong economic performance this year. Markets have staged a minor relief rally, but are wobbly on fears of higher inflation, rates, and all the usual elevated doubts swirling around uncertainty, etc. This morning we’ve still got stock wobbles around the globe. Although folk are breathing sighs of relief, there isn’t yet clear direction to markets in stocks, bonds or commodities. Many folk are still sitting on the sidelines… despite Trump warning us we’re making a big mistake… .

A lot of the market noise yesterday was around the rumours on just how much markets have lost trading Short-VIX strategies. We’ve been here before - just about any major market “event” in history traces its roots to some whoosh financial product triggering a collapse. In 1929 it was Florida Land Speculation, in 2008 it was sub-prime and CLOs. This time its Short Vix.

My Macro buddy Martin Malone summed it up: Global Real Estate markets are worth upwards of $200 trillion, yet a hiccup in sub-prime of less than $1 tillion triggered a massive crash in 2008. Or look how global currency markets – conservatively a $100 trillion market was disrupted and roiled by the cryptocurrency Ponzi-scam of less than $8bln. And today, it’s the global equity market of around $88 trillion that’s taking a shoeing from Reverse Leveraged Volatility Structured Notes with a total outstanding of less than 1% of the whole market?

Yet, it happens. Dimly understood financial products have the power and abilty to disrupt market function. Why? I still suspect one aspect we are under-estimating are the invidious effects of QE. Artificially low rates have created all kinds of unintended consequences – which are just waiting their opportunity to sink their teeth into our soft bits.

Yields are so low its’ chased investors out of their comfortable zones in search of return. As a consequence “yield tourism” has not only caused massive spread compression in credit markets as guys who once bought on AAA now buy Junk, but across asset classes with senior lenders now delving into subordinated debt, mezz and equity. As a result, every asset class got distorted and value has become a subjective topic.

Meanwhile, everyone assumes distortion doesn’t really matter because its inflated the price of all financial assets. At worst, maybe it’s a short-term conundrum, because infinite liquidity means yield tourists can simply exit their exotic purchases whenever and return to analysing their core competency risks. Er. Not so. Liquidity is a scare commodity – and will get even more selective as markets turn.

It’s made even more complex because much of the yield tourism market is on packaged holidays – buying tracker ETFs that are simple to lever and buy on margin.

A good number of folk are wondering where and when the next shoe falls. My guess is credit spreads – they simply don’t make sense. I’m wondering about fixed income ETFs – credit ETFs are convenient plays for yield tourists, and easy to lever or trade on margin. Effectively, strip it down to basics and they are securitised, levered derivatives of credit markets – remember the weapons of financial mass destruction of 2008. While the short VIX ETNs everyone is talking about are very specific cases, we’re worried about the illusion of liquidity across the product spectrum. Conceivably the same could happen in credit EM, HY or IG ETFs or other levered ETFs that are sector based or things like 2x short 30-yr? If these are held on margin on the basis of perceived overnight liquidity, then perhaps we should worry. Its complex.

Meanwhile, what is it that drives scatty products like levered short-Vix? Apparently, loads of “smart” (really?) retail has been hit. Many Financial “scams” prey on investor emotions – convince them its’ a no lose money-machine, and the gullible ones will buy and spout the babble about how good it is – cryptocurrencies are a great example. They work because folk desperately want to believe they are going to make money and lots of it. Of course, it helps if the marks are so utterly convinced they are banging down the doors to buy it.

As investors become more sophisticated, they see through the obvious scams, yet their greed and belief they know better means they still buy products that are basically rigged legalised gambling. Such products are dressed up and designed to appeal to more sophisticated marks – and prey upon their vanities and the conceit they have “expertise”.

In the case of the Short-VIX products the buyers believed their superior skills, and ability to correctly predict any rise in VIX would enable them avoid losses. They were spectacularly wrong.

Basing your investment strategy on your ability to correctly “Time the Market” is never a smart move. I remember going into see a German bank in the early 1990s who were telling us their borrow short, lend long strategy was perfect and riskless because they knew exactly what the Bundesbank was going to do. They didn’t, and they don’t exist any more.

Get over it.. Watch the Skies!

Bill Blain