Monday, 12 February 2018


The global turmoil in stocks over the past week has left many scrambling to find a neat, credible explanation. Perhaps it was the US jobs data. It did coincide with the new Fed chairman's first week on the job - fear of more hawkish policies? There were a couple of blowups in volatility linked investment products - was the selloff triggered by algorithms disposing positions indiscriminately?

Or perhaps everybody's missing the point. Here's one thing that nobody bothered to find a neat, credible explanation for - how did volatility remained at record lows for so long? It shouldn't be a surprise, or a concern, that last week marked a return to normalisation. Low volatility points to a dysfunctional market, not a normal one. The real concern is on what happens next.


 Wall Street on Valentine's Day.

Analysts, pension fund CEOs and the financial media have a vested interest to tell you to 'buy the dip' - nobody wants to hear the music stop. Investors are preconditioned with a bullish bias with a healthy dose of arrogance - we are not wired to anticipate or think about crash scenarios.

While I don't claim to know what's going to happen next, what I'd rather do is weigh the possibilities equally : either now's a good time to buy the dip or it's a good time to sell stock (and buy put warrants). But the first part is well covered; look up any financial website or business newspaper and chances are that our pre-existing positive biases are well-satisfied.

What I will not discount is the likelihood of a painful, sustained decline in the stock market. The aforementioned historic low volatility is just one of the weirdness that we have become accustomed to. There are a lot more and they should all be considered warning signs, because we might never get a neat explanation to the recent stock selloff.

Now let's have a look at the global volatility benchmark and what it means for the KLCI (and your portfolio).

How the KLCI Reacted to VIX

I Ctrl+V'd this from Wikipedia : The CBOE Volatility Index, known by its ticker symbol VIX, is a popular measure of the stock market's expectation of volatility implied by S&P 500 index options, calculated and published by the Chicago Board Options Exchange.

Also known as the 'fear gauge', the VIX has a real and discernible impact on global markets. It has been trading at historic lows over the past year (until now), and in the past any sudden spikes tend to be easily explained. But to put the latest one in context let's have a look at this chart:

Weekly chart : 2014 - present.

Important things to note:

1) The first ??? in October 2014 was the last time such a big spike in volatility wasn't so easily explained. There were a lot of ideas floating around (First ebola case in the US, weak US economic data, protests in Hong Kong, the anniversary of Black Monday, etc) but ultimately the sudden decline in the Dow and S&P 500 had no easy explanation. The markets did quickly recover despite crude oil prices beginning its precipitous decline later that year.

2) The yuan devaluation in 2015 was the last time we encountered such a big spike in the VIX. There was a genuine selloff across asset classes and a flight to safe haven assets during this time as the news has real global implications (in terms of economic growth and trade, among others). Gold was the sexy thing to own during this turbulent period - newswires lustily reported about the latest incremental moves in the asset daily, similar to how they're treating bitcoin now.

3) Nobody's calling the current selloff a 'flash crash' yet. But if it is, you'll likely see a return to stability within a span of four to five weeks. The decline cannot just be attributed to the 'inverse vol exchange traded products' that just blew up : the selloff is more broad based.

The February decline was the worst selloff in US stocks in six years. Let's look at another chart - a comparison between the VIX and the S&P 500 since the global financial crisis.

Weekly chart : S&P 500 in blue.

It is partly true that US economic growth contributed to the S&P's ascent to all time highs. But it's equally true that access to cheap liquidity and low bond yields drove capital into the stock market.

And quite plausibly, the presence of historic low volatility lay the foundation for stocks to break new highs. Economic growth reaffirmed investors' confidence, and they continue to buy stocks amid a lack of market turmoil, thus improving confidence further in a self-reinforcing cycle.

"Other investors may have been lulled by the years of relative serenity in the stock markets. The average volatility rate for 2017 was lower than every single trading day from Dec. 22, 1995, to June 20, 2005. The VIX finished below a level of 10 -- super quiet! -- on only nine days before May 2017 and 68 days since." - Bloomberg story

Buying the dip, or shorting volatility, are both strategies that have worked for many years. But how do you know for sure that what happened last week wasn't a historic shift? You don't.

Now for the KLCI. When was the last time you've seen a chart like this?

In charting parlance the isolated candles that you saw throughout last week are known as 'gap downs'. There was no orderly trading or sufficient liquidity in the prices of the KLCI's component stocks. The entire market shifted quickly and severely, such as during one hair-raising period when it fell by 4% in three days.

Daily chart : KLCI year-to-date (up to Feb 9, 2018)

The last time such a gap phenomenon happened was here in 2014, when oil prices began its historic decline. This was also a 4% decline in three days :

Is there a takeaway here? Is it a fair comparison? The truth is, I don't know. But as a reflection of volatility it is clear that the KLCI is taking its cues from the US markets and by extension the VIX itself.

Both periods were part of a global selloff, even though the current one lacks a clear explanation (so far).

Weekly chart : KLCI, December 2014 - January 2015

I was emphasizing the gaps as a measure of volatility. Another comparable period was during the yuan devaluation.

Note that despite the frightening 11% decline in four days, there was more liquidity and what looks like an orderly selloff. The presence of buyers and sellers indicate a less dysfunctional market than what we saw last week.

Therein lies the question : why the panic last week? Why was there a clear loss of liquidity and unwillingness to support the market?

My theory : it seems to have been a repricing of risk and the recognition of added uncertainty. The desire to buy the dip is outweighed by the desire to stay in the sidelines for now. As of last week we are still taking the cue from US markets (which rebounded on Friday) but the extreme decline in Chinese and Hong Kong stocks is not an encouraging sign for market bulls.

Weekly chart : KLCI, July - October 2015

So what are your options

1) Buy the dip now : History is on your side when it comes to declines of 5% in the stock market. You may profit if everything goes back to normal. Malaysia's economic prospects remains positive - at the very least you can always accumulate good value stocks.

2) Reduce market exposure : Sell part of your holdings. Focus on positions that are highly correlated to the broader market - these are the ones that will trouble you the most in times of volatility. Keep some cash in hand to capitalise on buying opportunities.

3) Sell the market, prepare for a decline : Hedge your exposure by buying put warrants :  you can profit from a crash scenario if it happens. There are many actively traded puts in the market right now that are linked to the KLCI, the S&P, the Hang Seng or the China A50. Alternatively you can sell short a few KLCI futures contracts as a hedge. It's just insurance against a market catastrophe.

4) Do nothing : Perhaps this is all just noise. Stay invested for the very long term. You're probably laughing at the panicky herd right now. On a 10-year timeline none of this really matters.

The spike in volatility is worrisome, but time will tell if this will be sustained. Either we're experiencing a brief market hiccup or we're staring at the abyss from the top of the longest bull market in history. How cool is that?