The Volatility Is Intense!

By: Kent Engelke | Capitol Securities

The volatility is intense! The Dow swung 900 points in the first 25 minutes of trading… down 550 points, than up 350 points! In late afternoon trading, the Dow surged about 400 points in about 10 minutes. Wow!

This is not investing, but rather blatant technology induced trading.

Yesterday, the two most popular ETFs/ETNs that shorted volatility were terminated. In the big picture, the loss was not of great significance… worth about $3.5 billion on Friday, to $150 million yesterday.

However, I think the termination is significant. One person who I view as an extremely sophisticated investor stated that this is not supposed to happen. The safe guards were in place to prevent such losses.

It is my firsthand experience that it is normally the “insignificant events” that cause systemic event; it is the proverbial canary in the coal mine. The two most prescient examples is the default of the Thai Baht that caused the Long Term Capital Management implosion that almost crashed the world’s financial system.

The other is the 2007 failure of Bear Stearns Mortgage portfolio that was a harbinger of the global meltdown that forever changed the face of American and capital globalism.

Yesterday, Bloomberg reported that the Fed is looking into cross-correlated algorithmic trading that has created “massive market imbalances.”

I have stated many times interest rates are a primary component of valuation models. A major catalyst for the selloff is an unexpected increase in interest rates, the result of greater economic activity. The selloff was greatly amplified by technology based trading.

I rhetorically ask what happens to interest rates and subsequently equities if the Atlanta Fed’s first quarter growth forecast of 5.4% materializes?

Historically, the yield on the 10-year Treasury is about the same as nominal GDP or GDP plus inflation. Today, this yield is about 5% versus the current yield of 2.75%. Wow! Are we in the beginning process of returning back to the norm?

Some have stated tax reform will not cause an increase in growth. There is no historical precedent for this statement. In every instance, tax reform has created higher nominal growth, higher interest rates and earnings.

The bad news in this scenario is it will be difficult for PE ratios to rise, ending the years’ long environment of the markets outperforming general economic activity. But as written so many times, this out-performance was relegated to only a handful of names.

In my view, corporations will spend their greater profits on plant and equipment versus share repurchases as the return on such will be considerably higher. This will increase economic activity.

This expected environment may hurt the valuations of some securities that are already greatly over-valued, but should benefit the smaller and value companies.

Wishful thinking? No, it is Economics 101.

Last night, the foreign markets were up. London was up 1.06%, Paris was up 0.54% and Frankfurt was up 0.82%. China was down 1.86%, Japan was up 0.16% and Hang Sang was down 0.89%.

The Dow should open moderately lower. The narrative is starting to rise about the complexity of ETFs… aka passive investing. It is quickly being acknowledged that no one knows how they are created, the interconnectivity, the leverage, or the extent of their proliferation. A statistic that I cannot fathom is there are more ETFs and indices than listed securities. Wow!

Several times I have commented that ETFs are similar to yesterday’s CDOs and CMOs. In my view, the major difference is I don’t think ETFs will bring down the financial system for the simple fact that the bond market is 10 times bigger than the equity market. The real economy is sharply recovering, perhaps at the cost of Wall Street.

The 10-year is up 4/32 to yield 2.79%.

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