Economic guru Ron Insana warns sharp-thinking investors to learn a lesson in the recent stock-market volatility: Wall Street has yet to learn that it can get burned when you play with fire.
Until early last week, ”volatility in the stock market had remained at historically low levels. In fact, stocks had traveled to new all-time highs since the day after the 2016 presidential election without a 5 percent, or even a 3 percent, correction. That is the longest stretch in market history without such a major pullback,” Insana wrote for CNBC.
Insana's comments come after BlackRock Inc, the world’s biggest asset manager, urged more regulation of the so-called inverse volatility-linked products that were hammered during a stock meltdown that wiped out $4 trillion in market value worldwide on Monday.
Investors using exchange-traded products to bet on the VIX, Wall Street’s so-called fear gauge which measures expectations for near-term S&P 500 swings, were pummeled on Monday when the index posted its biggest single-day rise since August 2015, Reuters explained.
The S&P 500 plunged 4.1 percent Monday, making for almost an 8 percent drop over six trading sessions since Jan. 26 and triggering a wider sell-off in Asia and Europe. The U.S. market bounced back 1.7 percent Tuesday but remained volatile.
“For many months now, the single most popular and, thus most concentrated, trade on Wall Street was to ‘buy the dip and sell the VIX,’” which Insana explained means that big investment houses, which also include large insurance companies, have purchased stocks at every opportunity and during every minor pullback.
“Shorting the Cboe's VIX, Wall Street's fear gauge, was a bet that volatility would continue to stay low,” the CNBC and MSNBC contributor wrote.
“Such compressed volatility can eventually lead to an ‘accident’ in the equity market. With such a record run and a historic lack of volatility, markets can either breakout, or breakdown. In the last 14 months, we have now witnessed both. The market soared 40 percent since Nov. 9, 2016, and gained 8 percent this January alone,” the author of four books on Wall Street explained.
In the wake of Monday's financial carnage, New York Fed President William Dudley has raised questions about whether some financial products tied to market volatility were well put together.
“Some of these VIX products, I think, people now are going to look at this with the benefit of hindsight and say, ‘Were these really well designed?’,” Bloomberg cited Dudley as saying. “This wasn’t that big a bump in the equity market and these products actually blew up.”
The VIX index uses derivatives to track expected volatility in U.S. stocks. After months of calm, it spiked in recent days, causing substantial losses for investors who had been making returns betting against its rise.
Dudley’s views were largely shared by his fellow central bankers who were not surprised by the swoon because they’ve considered stock valuations stretched for a while. The steep price decline also shows scant signs so far of posing much of a risk to the stability of the financial system or the durability of the economic expansion.
“Corrections are healthy” after extended rallies, Dallas Fed President Robert Kaplan said Wednesday in Frankfurt. “What I look at is whether it has implications for financial conditions or the health of the underlying economy and I would say, I don’t think so.”
After Tuesday’s close, the S&P 500 remained about 9 percent higher compared with its level in late July, when Fed staffers first deemed asset prices to be elevated.
Meanwhile, Insana said that a major tripwire with the VIX, and associated derivatives, is that they behave erratically when volatility explodes. “This is a key risk when trading derivatives more suited for professionals than individual investors,” Insana said.
“As was the case in 1987, complex hedging strategies exacerbated an overdue market correction. The salient question that remains amid the recent wreckage is will Wall Street never learn?”
To be sure, the largest one-day decline in U.S. stocks in more than six years punished fund managers large and small on Monday, leaving just one actively managed large-capitalization stock fund positive for the day.
Those that suffered the steepest declines were those that used leverage, made concentrated bets in only a few stocks, or focused on thin slices of the market, all strategies that were richly rewarded during the 19 percent rally in the S&P 500 that left the index starting the year with record highs, Reuters explained.
Instead, fund managers are starting to feel the first cracks in the nine-year long bull market as interest rates rise and the era of cheap money appears over.
Left behind during the meteoric rise in the S&P 500 and Dow last year, short-sellers, who make money by wagering that a company's share price will fall, finally pocketed some profits during Monday's downdraft.
Overall, the lone actively managed large-capitalization stock fund that posted a gain Monday was the $115 million Arin Large Cap Theta fund, which blends a long-equity portfolio with a buy and write option strategy that allows it to collect extra income while limiting its swings up or down.
The fund, which gained 0.68 percent yesterday, is up 4.5 percent over the last year, trailing the S&P 500 by approximately 10 percentage points.
"We have been stuck in the mud, working very hard and producing very little, and then you have days like yesterday where the market sells off and we're able to stay out of harm's way," said Joseph DeSipio, the chief market strategist at suburban-Philadelphia based Arin Risk Advisors.
"This may be the thing that convinces people to stick to more traditional ways of investing and buy and hold great companies."
(Newsmax wire services contributed to this report).
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