The main culprit being singled out for the collapse is the Credit Suisse issued VelocityShares Daily Inverse VIX Short-Term ETN (XIV). This is an Exchange Traded Note, not an Exchange Traded Fund. A financially engineered instrument. After much fanfare for over a year, it lost the majority of its value in hours causing great wealth destruction not only for its owners, but market participants globally. In examining the disruptive market tendencies of XIV, we have to go back to high school physics to Newton's First Law:
"Every object will remain at rest or in uniform motion in a straight line unless compelled to change its state by the action of an external force."
With Quant Hedge Funds programming investor sentiment and momentum into their algorithms, investment managers made fortunes as the S&P 500 went up in a straight line with low volatility for almost 15 months. Then that low volatility spiked. The external force occurred in the form of the liquidation of XIV as traders jettisoned the ETN. According to Jim Collins in Forbes:
"While some news outlets are describing XIV as an "obscure" security, the market value of XIV was nearly $2 billion last week, so it is clearly a meaningful name to professional traders...XIV holds no assets; the value of the notes is determined by an underlying index that represents the inverse of futures linked to the VIX volatility index...In two trading days XIV went from hedge fund darling to effectively a defunct security."
XIV lost 80% of its value in one day.
The liquidation of XIV caused an industrial strength chain reaction in the entire global marketplace because of that same foil in The Crash of 1929 - margin calls. In a Washington Post article, Steven Pearlstein gives a succinct explanation concerning the circular trading logic and the margin calls that ensued:
"It apparently created a vicious cycle in which selling begat more selling and wound up wiping out nearly $3 billion in valuation for investors...the amount of trading done with borrowed money is higher than it has ever been...major central banks that allow hedge funds to borrow $4 or $5 for every one of their own they put at risk. When prices start to fall rapidly, the funds are forced to sell their positions to pay back the banks and brokerage houses, driving down the price even further."
Although there is some discrepancy between the two preceding quotes as to how much money investors lost in XIV to the tune of a billion dollars, you can clearly ascertain that a significant amount of assets eroded. To paraphrase an old Wall Street idiom: "A billion here, a billion there, pretty soon, you're talking real money.".
Even though I don't condone or engage in financial engineering, especially after the Great Recession of 2008-2009, I'd like to point a few things out concerning the recent market drop.:
- The market was way over its skis, gaining close to 7.5% since New Year's and in need of a long overdue correction. Ten percent corrections happen annually on a historic basis, and we hadn't had one since early 2016. Additionally, we've had a reduced amount of both 5% and 10% pullbacks since the market bottom in March 2009. Investors got used the the gravy train.
- Things aren't what they used to be. In the recent movie "All the Money in the World", Christopher Plummer playing Jean Paul Getty circa 1973, continuously checks stock quotes via a Ticker Tape Machine. That world is dead and buried. Laymen now get split second access to stock quotes on smartphones from globally connected financial exchanges. In fact, not only did the recent correction effect the domestic markets, but the international markets sold off 10% in concert.
- In the Stock Market Crash of 1929, the DOW fell 20% in two days in an analogue world. Traders were exchanging buy and sell orders manually on pieces of paper, not via bits and bytes through mainframes and servers. Fiscally painful corrections happen, sometimes without the threat of recession during bull markets.
| YEAR | LOSS |
| 1939-40 | (31.9%) |
| 1941 | (34.5%) |
| 1943 | (13.1%) |
| 1947 | (14.7%) |
| 1961-62 | (26.4%) |
| 1966 | (22.2%) |
| 1967-68 | (10.1%) |
| 1971 | (13.9%) |
| 1978 | (13.6%) |
| 1983-84 | (14.4%) |
| 1987 | (33.5%) |
| 1998 | (19.3%) |
| 2002 | (14.7%) |
| 2010 | (16%) |
| 2011 | (19.4%) |
| 2015 | (12.4%) |
(source: A Wealth of Common Sense)
If you examine the chart, you can see that some of these double digit corrections occurred during boom times. The one most investors may relate to because it's the most recent excluding the current advance, is the run the S&P 500 had from approximately 1974-2000. I would be remiss if I didn't mention the Crash of 1987 transpired in the middle of the run, but it's included in the chart above. Three other non-recessionary selloffs happened during this period - 1978, 1983-84, and 1998. Those were good times for investors, and these are, too.
You need catalysts to keep the economic engine running and we've got many of them now - artificial intelligence, 5G, and, blockchain just to name a few. Even with interest rates rising, this market has room to run. As I have mentioned before, the hashtag is ten years old, Best Buy will discontinue selling compact discs and The Village Voice no longer has a print edition. We're not quite in Fahrenheit 451 territory, but times have changed. The market should reflect that in an era of rapid technological advancement although there will be bumps along the way.
Conclusion
Credit Suisse is closing VelocityShares Daily Inverse VIX Short-Term ETN. By next month, it will be a footnote in the annals of Wall Street. However, financially engineered instruments are like the city bus - there's always another one coming around the corner. They will make hedge funds and investment bankers a lot of money, but Main Street investors will be left holding the bag. Avoid them. That said, you can't avoid computerized stock exchanges. They're here to stay, so use diversified S&P 500 and Total Market index funds. You will lose principal during market selloffs, but historically you gain close to 10% annually if you reinvest your dividends.