What Just Happened?

In January, commentators said that the economy was strong, earnings were robust, interest rates were rising and to expect a correction.  The S&P 500 was up 5.72% for the month. All was well with the world.  

In February, commentators said that the economy was strong, earnings were robust, interest rates were rising and to expect a correction.  Through February 9th, the S&P 500 is down 7.2%.  The sky is falling and panic has set in.

There are several reasons given for the dramatic change in stock market fortunes:

  1. Interest rates are rising.  The yield on 10 year treasury notes has gone from 2.40% at the beginning of the year to 2.83% on February 9th.
     
  2. The economy is heating up and wages are rising.  Inflation will increase which will force the Federal Reserve to raise interest rates even more than was expected.
     
  3. The “short” volatility trade blew up causing traders and hedge funds to liquidate stock positions to pay for their bets.  This forced selling caused stock prices to plummet around the world.


What???  Let me explain this one a little more.  Volatility in the stock market is measured by an index called the VIX.  You can’t actually trade the VIX, but enterprising firms have designed products that allow investors to “bet” on higher volatility or lower volatility.  As you can see from the chart below, volatility had been stable and low for the past year.  Traders bet that volatility would remain low.  When, inevitably, volatility increased, they tried to sell their losing positions all at once.  Much like CDO’s (collateralized debt obligations) in 2008, the products the traders used could not handle the level of redemptions.  The VIX spiked up and the losses quickly rose to billions of dollars.  The only way most traders had to cover their losses was to sell stocks they owned. 

So, your portfolio is down sharply because of some greedy traders who have not learned anything from the last panic they created.  Fortunately, the short volatility trade is minor, relatively speaking, compared to the crisis in 2008.  Selling may continue for a few more days or weeks, but sanity will prevail.  Then commentators will say, the economy is strong, earnings are robust, interest rates are rising and we just had a correction.