STOCKS SLAMMED: Volatility Crushes the Rally…

Investors took a sledgehammer to the face yesterday as the major averages posted their worst drop in more than six years.

The Dow shed 1,175 points (its biggest point lost in history) to close lower by a staggering 4.6%. The S&P 500 wasn’t far behind, posting a loss of more than 4%. In a dramatic shift, the major averages flipped from extremely overbought to painfully oversold in a matter of days.

The stock market carnage is the top story at many major media outlets. Everyone wants to know what pushed stocks down an open elevator shaft. Was it earnings? The Nunes memo? A Trump tweet?

Nope.

The truth is the market has grinded higher without a correction for too long. Stocks were too hot. Volatility was dead. Something had to give.

Check out this chart:

The S&P 500 grinded higher for the past 15 months. You can clearly see the upward channel it carved out during 2017. It was a historically smooth run, with no significant shakeouts spooking investors — just a slow, orderly grind higher.

But look how the trend accelerated in January. Stocks went parabolic as they blasted through the roof almost every single day. Toward the end of the month, the major averages were all higher by at least 7%.

That’s clearly unsustainable. But investors didn’t care. They were making money hand over fist, lulled to sleep by a market that never went down. So it’s no surprise that a 4% drop is sending shockwaves of panic across Wall Street. None of us remember what a drop of this magnitude feels like!

All is not lost, of course. The major averages are now back to levels we haven’t seen since December. Generations of wealth haven’t disappeared into thin air — just seven weeks of gains. That should put this week’s drop into perspective.

Believe it or not, yesterday’s biggest losers weren’t stock market investors. As it turns out, volatility traders are the ones who have suffered the most during the market’s breakdown this week, causing some hidden panic in the markets late last night that you probably didn’t see…

The unusually smooth rally has encouraged big bets against volatility using inverse VIX funds such as the VelocityShares Daily Inverse VIX Short Term ETN (XIV). These trading vehicles go up when the Volatility index goes lower. Naturally, many traders have viewed this as a “sure thing” trade every time the market drops. They simply bet against volatility, the market bounces, and they collect their winnings.

That’s not what happened on Monday. Instead of a bounce off Friday’s lows, stocks tumbled and volatility spiked, sending XIV lower.

But the real panic happened after hours. XIV traders slammed the sell button as fears of a volatility event spread. XIV was eventually halted, down a staggering 80% after hours after dropping just 14% during Monday’s session.

We don’t have any complex bets on volatility in our portfolio. But that doesn’t mean a volatility unwind won’t affect the markets in the days ahead. We’ll have to look for signs of contagion and act appropriately.

Barring any of these nasty volatility concerns creeping into the stock market, we should look for a potential relief rally to materialize soon. When and how the market bounces should give us some clues as to what to expect and how we should trade the return of some exciting market action.

Buckle up. It’s going to be a wild ride…

Sincerely,

Greg Guenthner
for The Daily Reckoning