First things first: Don't panic. The raging, grinding bull markets are "officially" in correction territory.
It's a healthy thing.
Though I've been consistently bullish in my outlook over the past year or so, I've said that a 3% to 5% dip in the markets might be in order and that a correction like this would be welcome.
Why? It's not that I enjoy watching stocks fall... unless I'm planning to recommend that my readers play the "rubber band snap" (although, I did, and they made a quick 50% gain).
Rather, this downturn is good for the simple reason that we needed to see that capitulation.
Let me show you what I mean, and why this week's rough sledding has been a good thing, even in the very short term.[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
The Market Has Dropped. Round Up the Usual Suspects...
Like I said, markets needed to see a capitulation for the buyers to get wiped out, give up, and clear the way lower for stocks to go.
In that way, we hit a short-term bottom, which clears the way for stocks to go higher.
In this case, I think, much higher.
I'll tell you why I think that.
BIG, FAST PROFITS: This one move paid 100% in seven days, then 205% the next day, and 410% by the next week. You've got to see how it's done...
It has to do with what's likely causing the selling, or, more to the point, what isn't causing the selling.
As my friend Charles Payne noted on FOX Business Network's "Making Money" recently, it seems like every other day since selling started on Feb. 2, we've been hearing about a cast of "usual suspects" in the whodunit of plunging markets.
First, we heard it was anxiety over the U.S. Federal Reserve possibly raising interest rates - a return to the old "good news is bad news" market narrative we've seen play out over the past three years. The thinking here goes that any positive economic news will spur the Fed to tighten up policy, restricting the flow of the low-cost money that's propelled stocks since quantitative easing began.
Then suspicion turned to the bond market, which saw yields hit four-year highs briefly, but which, on closer inspection and a few days of quiet, does not seem to be sliding into flaming bear market territory just yet. The fear here is that money will start flowing into other investments, because stocks are no longer the "only game in town."
I think rising rates and trouble in the debt market can be discounted easily and safely. If they were the serious problem causing this sell-off, we'd see banks and utilities leading the race to the bottom. That's just not happening.
The media focused on the implosion in the so-called "ultra-short" products. Here, at least, we've got a plausible modus operandi, though as you'll see, it does nothing to color the long-term outlook in a negative way.
Now Here's Whodunit... and Why
You see, the past 17 months of unprecedented placidity and upward momentum have made it just too tempting for speculators to short S&P 500 volatility, as measured by the VIX, with a whole host of products that pay more as the VIX declines.
These trades got a little crowded, to say the least, as the months and months of good times spawned a whole cottage industry of traders who did little else but short the VIX.
What's more, plenty of these are (or, in this case, were) leveraged products, which use a complex financial calculation to return a multiple, between one and three usually, of the inverse of the VIX's performance - so when the VIX spikes, as it did last week, the losses can be catastrophic.
And indeed, they were in many cases.
Some of these instruments lost as much as 96% of their value when the selling started and volatility came roaring back into the room. It blew up several exchange-traded products, most notably Credit Suisse's VelocityShares Daily Inv VIX Short ETN (Nasdaq: XIV) and Nomura's Next Notes S&P 500 Short-Term Futures Inverse Daily Excess Return Index ETN (NIK: 2049). Both of these ETPs are "offline" right now; regular investors can't trade them.
I think the classic "mini-bubble" in the crowded, year-long volatility trade, and the rapid, rapid unwind in those trades, are leading us lower.
Now, some folks are drawing comparisons to the October 2008 crash because of the involvement of leveraged derivatives. In 2008, of course, it was mortgage-backed securities. That exposed the entire global economy to deadly systemic risk.
Today, it's short VIX products issued by a handful of companies and used by a relative handful of speculators and day traders.
I don't think the similarities stand up to scrutiny, and that's why I think stocks have much higher to go from this bottom.
In fact, I'm excited. Not only are there lots of isolated opportunities to make money on the violent snaps in individual stocks, but prices are starting to get to the point where companies that looked at least modestly overvalued 10 days ago are downright irresistible today.
That's what the capitulation gives us. It's all good.
The economy, at least over the next 12 to 18 months, looks strong. Corporate earnings, which should be all we're talking about at this time of year, are as strong as they've been in decades.
In other words, the business case for owning U.S. stocks and being bullish on U.S. and global growth isn't diminished by the implosion in semi-exotic exchange-traded products that give inverse volatility returns.
It's like this: the Kansas of finance.... For over a year, we've been taking a leisurely, easy walk across the flat, open plains of Kansas, picking up profits from the fertile ground along the way.
We've come to a ditch - a deep ditch, an ugly ditch. It looks scary, because all we've seen is flat, easy, rich terrain.
But at the end of the day, it's just a ditch.
I borrowed a line from "Casablanca" earlier, and now I'll borrow one from Winston Churchill and say that there are "broad, sunlight uplands" just on the other side of the hole in the ground.
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About the Author
D.R. Barton, Jr., Technical Trading Specialist for Money Map Press, is a world-renowned authority on technical trading with 25 years of experience. He spent the first part of his career as a chemical engineer with DuPont. During this time, he researched and developed the trading secrets that led to his first successful research service. Thanks to the wealth he was able to create for himself and his followers, D.R. retired early to pursue his passion for investing and showing fellow investors how to build toward financial freedom.