All Eyes Turn to Jerome Powell…

It’s been a wild run lately. Watching U.S. stocks plunge at one point over 10% in the past 10 days has certainly been a sobering experience for investors.

After a nearly nine-year bull market, stocks have just experienced their fourth 10% correction. But as I’ve been reminding people, it wasn’t the end of the world. U.S. stocks suffered 10% corrections in August 2015 and January 2016 and bounced back quickly both times.

Yet this correction is the most mysterious of all, since there is no easily identifiable cause such as the Chinese devaluation that triggered the stock market corrections in August 2015 and January 2016.

At the same time, interest rates are surging and bond prices are plummeting, yet there are no signs of inflation. Finally, gold has mostly been moving in a narrow range, which is actually quite bullish considering the head winds arising from Fed rate hikes and higher interest rates generally.

So what’s going on? How can we connect all of these dots?

On Feb. 8, I had an interview with Stuart Varney on the Fox Business Network. I make the point that the catalyst for the stock market correction is much higher interest rates.

But higher interest rates are not due to inflation. In fact, there is no inflation anywhere in sight. The jobs report on Friday, Feb. 2, was much weaker than was widely reported.

The reason for higher interest rates is the sudden fear of huge deficits arising from the Trump tax cuts, the congressional budget-busting deal and surging defaults on government-guaranteed student loans.

The deficit implications of this triple-whammy are so horrendous that gold is showing strength despite higher rates, on fears that huge deficits and credit downgrades will erode confidence in the U.S. dollar itself.

So there you have it.

Higher deficits = higher interest rates = lost confidence in the dollar = plunging stock prices = higher gold prices. It’s all connected.

As I mentioned, in August 2015 and July 2016, stocks quickly rebounded after suffering corrections. But I also caution that this time may be different.

Stocks may have further to fall and may not bounce back so quickly, especially if the “Fed put” does not materialize on March 21. That’s the date of the next FOMC meeting.

As of now, the Fed is expected to raise rates. But if disorderly markets continue, the Fed could give the market a boost by not raising rates. Janet Yellen did this in September 2015 when she delayed the “liftoff” in rate hikes to end a stock market correction. She did this again in March 2016 when she delayed a rate hike to help stop another stock market correction.

That’s what professional investors mean by the “Fed put.” The Fed is always there with a helping hand when markets head south.

But the new Fed chair, Jay Powell, is unlikely to offer the Fed put, at least not yet. He will want to raise rates in March to show that he is not a pushover for market forces. Given that and other interest rate-related head winds, U.S. investors should expect the stock sell-off to continue for some time.

Get used to volatility.

And that brings me to the biggest story to emerge from the recent stock market action: the return of volatility after a period of record calm.

We all recall Mary Shelley’s novel Frankenstein, written in the early 19th century. It tells the story of Dr. Victor Frankenstein who creates a grotesque monster in an experiment and then brings it to life. The creature seems civilized at first, even reading books, but then falls into fits of rage and goes on a murderous rampage, partly as revenge on his creator.

Now a similar story is unfolding in capital markets.

The Chicago Board Options Exchange (CBOE) Volatility Index, is traded in derivative form as VIX. For many years, VIX served as a useful guide to market views on volatility and as an early warning of choppy markets.

VIX is the basis for a host of derivative products, exchange-traded funds (ETFs) and exchange-traded notes (ETNs), some of which use extreme leverage and offer returns promised to be the inverse of the VIX itself.

This structure means that if VIX rises 100%, the inverse VIX product falls 100% and is totally wiped out. These products are now traded all over Wall Street and are embedded in many portfolios.

This perse, leveraged and opaque group of contracts now produces unforeseen destruction when volatility spikes as it did last week.

Selling volatility is a trading strategy that can make consistent profits for very long periods of time only to see those profits wiped out seemingly in the blink of an eye.

Most markets are orderly most of the time. If that were not true, markets would not be able to fulfill their price discovery and liquidity functions. But periodically, markets become disorderly. When that happens, market moves are extreme and sudden.

And lately VIX has turned into a monster.

In circumstances like we’re seeing now, traders who are short volatility are like insurance companies that sold hurricane insurance the day before a hurricane. They suffer huge losses very suddenly before they’ve collected much in the way of premiums.

We’re now beginning to discover those firms that were hurt most badly in the recent market meltdown. A $500 million hedge fund that lost 82% of its value in the past week and closed its doors to new investors. Presumably, the fund will unwind what’s left of its book and distribute pennies on the dollar to existing investors before shutting down the fund for good.

But that’s not the only casualty. Gillian Tett, writing in the Financial Times, tells the story of a trader who started with $50,000 and made $4.2 million selling volatility on a leveraged basis over the past 2 and a half years before losing everything over the past week. No doubt more such stories will emerge in the days ahead.

The reality is that complacency breeds complacency and low volatility breeds lower volatility until suddenly and violently the market shocks investors out of their collective daydream.

Devesh Shah is an applied mathematician and hedge fund manager who formerly worked for Goldman Sachs.

Shah was one of the creators of the Like Dr. Frankenstein, Devesh Shah now has regrets about his creation. Shah says, “In my wildest imagination I don’t know why these products exist.”

Shah deserves credit for candor, but unfortunately, the monster is still on the loose. Many more portfolios will be destroyed and hidden losses will emerge before the VIX monster is finally constrained.

The lesson for investors is stay persified, stay alert, don’t use leverage and don’t sell more volatility than you can afford to lose.

And don’t forget to get some gold.

Regards,

Jim Rickards
for The Daily Reckoning