Understanding the Recent Market Turmoil

 | Feb 12, 2018 | 10:00 AM EST
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Stock quotes in this article:

VXX

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viix

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viix

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TVIX

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svxy

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XIV

With all due respect to CNBC, we are going to try and put our arms around the current turmoil that is suffocating markets and players. Indeed, the recent downdraft has been uncomfortable at best and quite scary at worst. Never in market history have we seen 1000 point drops in the Dow Industrials, and it happened twice last week. As so much wealth creation happened in 2017 about 1/3 of it was wiped away in a few short days.

There are all sorts of reasons or excuses for the selling. We'll say about 90% of it was due to short sellers of volatility products imploding in their faces. This was a very heavy and successful play for several years (and may still be, too, when conditions get better). When the VIX (volatility index) rose 100% on Monday, that was IT for the (XIV) , (SVXY) and other short volatility products.

They were put down and in some cases terminated. The reason being is effectively with a 100% move up in VIX, these would go to zero, and beyond that they would go negative. That can't happen, and these products have an 'out' clause, which says they can terminate at an 80% loss. I doubt if anyone who was long these inverse products really knew what could actually happen, or thought about the consequences -- which was a massive loss. It was truly a ticking time bomb, the black swan that all the 'smart money' knew would happen but wasn't sure when.

This won't continue for too much longer, but I have no idea when it will end. But it will, and we'll see/feel it -- and a massive rally will likely take place that most will end up missing or coming to in the very late stages. Much like what happened in 1987, 80% of those massive losses were recovered in about two weeks.

Make no mistake -- there is some technical damage to the chart, and we are going to have a tough time exceeding the highs reached just a couple weeks ago. Fortunately, the fundamental picture looks strong and is improving.

But how did this effect our market and why was it so widespread? Put simply, the trade needed to be unwound, which takes time. Further, the offset to going long volatility (which is the unwinding that needed to take place) was to short SPX futures. That continued for the entire week, as the rising volatility was a result of piling in on the other side, which are long volatility products. Check out the charts of (VXX) , (VIIX) , (TVIX) and others to see what I mean. When you see further the machine-drive trade piling on (algo trading) then you can understand how/why such big moves can occur.

This sort of activity is unsettling to everyone, including the big money players -- the ones we like to follow. Down 1000 points in the Dow, down 100 points in the SPX 500 and volatility in the 30% area is not a place for the big money to buy stocks. Further, we saw heavy mutual fund outflows last week -- naturally. When conditions improve the big money will come back to the party.

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