Stop me any time:
For months and years, various outlets warned about the low volatility fad that was taking over the markets. As recently as this past October, the IMF warned:
"The IMF has issued a warning on low volatility products, saying they could present an "unknown risk" to financial markets, and may prompt a severe shock."
Of course that warning fell on deaf ears and seemingly didn't matter, right up until February 5th when the VIX doubled and the inverse volatility trade lost -90% overnight. Handmaiden to the low volatility trade has been the mass inflow into passive ETFs. They have been a "symbiotic" pair trade wherein passive inflow has been a key factor in generating persistent low stock market volatility. And while the short vol trade may have just imploded, gamblers in passive ETFs took no notice.
For months now I have warned that due to passive indexing the market was becoming increasingly top heavy, as indicated by the Russell / Dow ratio. However, that too didn't matter until February 5th:
Here we see that the Russell / Dow ratio has not improved much at all during this recent rally:
The consequence of this large cap overweight is that large cap volatility exploded relative to small cap volatility, despite having been comatose for two years straight. Which also explains why the S&P VIX had an outsized move relative to the drop in the S&P. For example, when the S&P dropped -20% in 2011, the VIX hit 50. On Feb. 5th, VIX 50 was reached on a -10% drop. Basically double sensitivity:
Putting it all together is where it gets interesting. Because, recent events have proven that the "low volatility" passive ETF fetish actually created higher volatility. But don't take my word for it:
"Trading in ETFs designed to buy less volatile stocks, known as minimum volatility ETFs, are suggesting a trend more ominous right now: There's no place in the market that's safe to hide"
This inevitable outcome was already long since predicted of course:
July, 2017:
Flows from active to passive funds increased to nearly $500 billion in the first half of 2017.
"From an aggregate point of view it is frightening. It means that at one point you will not have the active end in the market to stabilize it. You would have just the passive guys getting into herd mentality,"
Investors into passive funds can choose risk strategies allowing them to sell out completely if their investment drops by a certain amount, and this can cause a cascade effect, where small market moves are amplified if passive funds automatically sell off assets."
What he is referring to are stop losses at the 200 day moving average, just as there were in 2015. First off, they didn't work that well, since the S&P was plunged below the 200 day. Secondly we see that two weeks ago was really just the warm-up. Thirdly, volatility is going to be a tad elevated.
Now we know why Skynet hates the 200 day:
Well, at least some people got the memo that "passive" investing is a disaster wanting to happen.
