Ouch, that kind of hurt. I haven’t felt pain like that in quite a while now. Actually, it was 404 days to be exact, which is a record. We had gone 404 days without a stock market correction of 5% or greater. No wonder this recent equity selloff seemed to hurt so badly. It’s been hard to stay calm; we had gotten used to our accounts never going down.
Betting On the Wrong Side of Volatility
So what happened? Nobody can say for sure exactly, but it seems like we had a short-term market reaction to a lot of money being focused on one kind of trading strategy.
Without getting too technical, these traders (notice I didn’t say investors) were all betting that volatility would not return to the markets because it had been absent for some time as you can see from the chart below from Yahoo Finance.
A great quote from John Kenneth Galbraith reminds us that we tend to ignore our memories and convince ourselves that this time is different, when this time, in fact, it is not different.
So while volatility had been low, it wasn’t going to stay low forever and on Monday, February 5, 2018, it jumped over a 100%.
Who Got Hurt
This quick and large volatility increase in such a short time period literally crushed some traders and had a very negative impact on a couple of investment vehicles that profited from volatility staying low.
One such vehicle is the Exchange Traded Note (XIV) and another is the Exchange Trade Fund (SVXY). They had one-week returns of -96% and -92% respectively. Yes, you read that right; they lost almost everything in one week.
XIV was actually up 81.20% in 2016 and 187.57% in 2017, as shown in the Morningstar chart below, yet in one week almost everything was lost.
Possible Selloff Triggers
When there are huge losses in one particular area they tend to leak out to other areas, in this case equities. You may remember in early 2016 oil prices crashed and equity markets quickly followed suit. In fact, in every year we have gains there are times during the year we have losses as we can see from this work by JP Morgan.
This happens because this type of speculation also involves leverage, meaning they are borrowing money to make their bets. When they gamble wrong, they have to come up with money to pay back what they lost and what they borrowed. Without any cash on hand, the next best option to raise the necessary cash is to sell equities.
That is what we have been witnessing, with markets whipsawing up and down over the past week.
3 Solid Reasons to Remain Calm
Interestingly though, three solid reasons have emerged that should assure investors that staying calm is the right thing to do.
The selling has been limited to equities. Other asset classes haven’t reacted as one might expect if we are in fact witnessing the beginning of a bear market or a recession.
There was no rush to government bonds for safety, or gold to store value.
There was no selling of high-risk corporate debt.
Does this mean the selling is over? I couldn’t tell you, but what I can say is as a long-term investor you will now be able to put new money to work at lower valuations and your dividends will be reinvested at lower prices, meaning you will be able to buy more shares.
As long as you keep a long-term perspective, this in the end will be good for you, as much as it may be painful in the short-term.