This Bubble Has Officially Burst

This bubble has officially burst... The 'short vol' trade is in tatters... Six years of gains, gone overnight... In the mailbag: How are you weathering the volatility?

For the past several years, it has been a 'no lose' proposition...

Investors have made billions and billions of dollars betting on lower stock market volatility, as central banks flooded the world with liquidity.

But as regular Digest readers know, we've warned again and again that it was simply a matter of time before this bubble blew up. Sooner or later, volatility would shoot higher, as it always does. And many of those betting against volatility – the so-called "short vol" trade – were likely to lose their shirts. As we noted in the Digest last February...

Record numbers of individual investors have been piling into the "short volatility" trade via exchange-traded vehicles like the VelocityShares Daily Inverse VIX Short-Term Fund (XIV).

As you can see in the following chart, XIV shares have more than doubled since November's presidential election as volatility plunged...

These investors are probably feeling smart right now. But you'll also notice XIV has quickly plunged by up to 50% multiple times as volatility has spiked... including a loss of nearly half its value in a single day in the fall of 2015. We suspect these folks may be surprised by how quickly their gains can disappear when fear inevitably returns.

But the dangers extended beyond the risk of a violent drawdown...

These popular vehicles themselves held a serious risk that few investors were even aware of. As Porter explained in the October 16 Digest...

The biggest problem with this particular bubble is that these bets are all pro-cyclical. Folks in these positions can't hold them through a rough patch in the market. Instead, as the market falls, these investors must sell immediately. They are highly leveraged to the market.

Remember in May, when the S&P 500 Index fell just 1.8% over a few days? Volatility jumped almost 50% in that same period. One of the exchange-traded funds (ETFs) that investors are using to short volatility contains an interesting clause that few investors seem to have noticed: If volatility jumps more than 80%, the fund will liquidate with a net asset value of zero.

In other words, one day – who knows when – this fund, which holds billions in assets, will simply cease to exist. Investors won't lose a lot... They will lose everything.

Why do we bring this up?

Because last night, shortly after the market closed, that's exactly what happened.

You see, yesterday's big decline in stocks caused volatility to surge. As you can see in the following chart, the CBOE Volatility Index ("VIX") – the market's "fear gauge" – jumped more than 115%, for its largest one-day gain on record...

And just as Porter warned, this move caused the two most-popular "short VIX" vehicles to crater. As the Wall Street Journal reported last night...

The stock market's sudden downturn wiped out much of the value of two exchange-traded products that investors had used to bet $4 billion on continued stability of stock prices...

Both ETPs allow investors to bet that the volatility index, known as the VIX, would fall. When the volatility index surged Monday, the share price of both the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY) collapsed in after-hours trading.

During trading hours Monday, XIV fell 14% while SVXY dropped 32%. In after-hours trading, they continued to bleed, with each losing over 75%, according to FactSet data... The precipitous drop raised speculation that [XIV] had triggered a provision in its prospectus that would force its liquidation.

This morning, investment bank Credit Suisse – which owns XIV – confirmed the news...

It will be liquidating this vehicle later this month. Those still holding shares on February 21 will receive cash for the market value of XIV on that date. Shares, which were trading well above $100 yesterday, closed at just $7.35 today.

Meanwhile, ProShares – which runs SVXY – announced that it has no plans to liquidate. It intends to "continue to manage the fund as usual." Unfortunately, its investors didn't fare much better... SVXY shares closed near $12 today, down from more than $95 on Monday.

The following chart puts these moves in perspective...

"Investors" in SVXY lost nearly 83% of their money today. Those holding XIV lost 93%.

Altogether, holders of these vehicles saw six years of gains – and nearly $4 billion – evaporate overnight.

We hope you weren't among them.

So far, it appears any 'fallout' from this bust will be minimal...

After touching new lows this morning, all three major market indexes closed higher today. And the VIX fell nearly 20% to close back below 30.

Of course, further downside is possible. As we've discussed, the market is long overdue for a correction of 15% or more... and we still haven't met that threshold.

But for now, we continue to believe this is simply a pullback in the ongoing bull market, rather than the start of a more serious bear market.

Stay long, but stay smart.

Finally, if you're interested in more detailed coverage of the ongoing market volatility...

We'll remind you to check out the real-time news and analysis from our colleagues at the Stansberry NewsWire.

Scott Garliss, John Gillin, and Greg Diamond provide regular updates and commentary on all the market action throughout every trading day. And you can follow them for FREE on the Stansberry NewsWire app. Click here to learn more.

New 52-week highs (as of 2/5/18): KraneShares E China Commercial Paper Fund (KCNY).

Another busy day in the mailbag: More feedback on Steve Sjuggerud... and several readers tell us how they're handling the recent volatility. How are you doing? Let us know at feedback@stansberryresearch.com.

"Good Evening, you asked for feedback on our experience investing alongside Steve. We use [True Wealth], [True Wealth China Opportunities] and [True Wealth Systems]. Steve's insight has been just invaluable and our results have been terrific. Three of the first things I ask myself when evaluating any potential position are: is it Cheap, Hated AND in an Uptrend, is it moving from Bad to Less Bad AND in an Uptrend and do I have a 3:1 upside/downside delta. I really can't say thank you enough." – Paid-up subscriber Michael George

"Today the DOW was down 4.6%, the S&P was down 4.1%, and my account was down just 1.3% percent using recommendations from five of your services and your never ending advice about risk adjusted position sizing and trailing stops. You're doing great work, thank you all." – Paid-up subscriber Jeff Wakefield

"A few observations about my portfolio management and your wise words over the past month (longer but urging by everyone there during January). Your constant warning of volatility, corrections, and insulating your portfolio with proper stop losses and position sizing have not been lost on me. I've begun evaluating your Total Portfolio solutions and figuring out how to implement one or more in my stock portfolios. Unfortunately, I didn't get that done quite in time.

"However, the warnings plus my sense (perhaps driven by all your warnings) prompted me to take some serious profits off the table to reduce potential negative impact. I was overinvested related to cash reserves anyway, so it was a good thing to do regardless. Of course, as hindsight tends to be, I wish I had been more aggressive at taking massive profits and reducing volatility of the portfolio.

"Overall, I took a 13% hit... Certainly, more than I should have. But there are still plenty of profits in my holdings thanks to China Opportunities, Melt Up Millionaire, Retirement Trader, [Stansberry's] Credit Opportunities, and [Stansberry] Gold & Silver Investor.

"Interestingly, while I was aware this was all happening, I was unusually calm, knowing TradeStops was watching for things hitting the magic sell price. I had a ton of 'yellow' warning, but only a few 'red' get out messages.

"This isn't my first rodeo but, this is the first time I wasn't glued to the screen, sweating every tick and panicking on what to do. Now that I have a clear object lesson in portfolio volatility staring at me, I can reconfigure my investments to produce the kind of results I know I can get with your services.

"Thanks for all you guys do. You continue to demonstrate a comprehensive commitment to 'telling us what you'd want to hear if you were in our shoes' and being right about the more important aspects of investing. I'd like to say my cowboy days of investing are over. But, at least, they're under much better control." – Paid-up subscriber Bill Kadlec

"Porter, oh my! The sky is falling, the sky is falling!!!! Well, just couldn't resist... My portfolio, be it what it is, only went down .84% today. Some things actually went up. Hmmm.

"A few days ago, to do a bit of rebalancing per TradeStops, I sold some of the stock in one company that was almost up 200%, something one of you guys said buy. This stock was approaching its yearly peak. I put a limit order in for just a bit over the last close and it sold the next day. This stock has been going down a bit ever since... Sometimes you get lucky? Maybe I've learned a bit?

"Thanks for writing the latest Friday Digest about you and Steve, and also the one about your dog Ringo a few weeks ago. Notes like this tell me as much or more about the man than your quality work. You have a lot of integrity, something that is sometimes in short supply with business people.

"Regarding you getting into finance, it could be that Steve saw your potential for finance but set it up to let you find out for yourself. While you may be a klutz in some ways, your mind certainly isn't. I listened to the Jim Rogers interview [on the Stansberry Investor Hour podcast], and from what he said I believe he has a lot of respect for you. Coming from someone like him, I think that means a lot. By the way, I am an Alliance Member. I consider it the best investment I've ever made. Keep up the good work." – Paid-up Stansberry Alliance member Bert D.

"Glad to be sitting on a beach in Belize, with limited internet access to the markets. Pullback? No worries – I have just been following all the excellent advice provided by the Stansberry team. Keep it up..." – Paid-up Stansberry Alliance member Dan C.

"I liked Stansberry NewsWire before. Now that I have experienced reading the NewsWire during a pullback, I love it! Well done to the entire team. No emotion. Just solid analysis based on charts and prior experience. I am so impressed and grateful for everybody's hard work." – Paid-up subscriber Rusty R.

Brill comment: Thank you for the note, Rusty. Again, if you're interested in real-time market news and analysis throughout the trading day, be sure to download our FREE Stansberry NewsWire app right here.

"The one thing I am mad about in all this chaos – which you told us to expect, thank you – is that you kept bashing funds like the VXX. I thought I had very cleverly kept picking some shares up at lower and lower prices as a hedge against this kind of volatility. But after several messages about how these funds were trash and would never pay off, I dumped them at a loss. Today I would not only have had my investment in VXX paid off, but would have covered several of my other losses. Why, oh why, did you say that, and why did I listen?" – Paid-up subscriber Jean T.

Brill comment: Why have we consistently warned folks to avoid exchange-traded funds ("ETFs") and notes ("ETNs") – like the iPath S&P 500 VIX Short-Term Futures ETN (VXX) – that are designed to "track" the Volatility Index? Maybe this chart will help us explain...

The reason – as you can clearly see – is that they simply don't work as intended. The specifics are complicated, but because of the way they're structured, these vehicles consistently lose value over time.

This means that unless your timing is absolutely perfect, you're guaranteed to lose money no matter what happens to market volatility along the way.

As we mentioned earlier, yesterday's move in volatility was historic. The VIX more than doubled – from around 18 to more than 38 – in its largest single-day increase on record. Yet VXX shares rose less than 40%.

Sure, that's a terrific one-day gain. But take another look at the chart. Even with this move higher, shares are still down nearly 90% over the last two years alone... And everyone who bought shares more than a handful of months ago is still underwater.

So feel free to blame us for missing out on this "investment" if you'd like, but we certainly won't apologize for our warnings.

Regards,

Justin Brill
Baltimore, Maryland
February 6, 2018