What Will Stabilize Used Vehicle Sales? (Hint: Nothing Good)

Authored by Daniel Ruiz via Blinders Off blog,

Until this point, a lot of what I"ve shared with you is theoretically based on my knowledge and experience of used vehicle values and how I believe they affect new vehicle sales velocity. Today, I am going to share some some hard data that I"ve been researching with a great deal of effort.

I genuinely believe that used vehicle values have a very significant effect on new vehicle sales velocity. I have explained it on Twitter and on a previous blog post through the concept of trade cycles. Because of this, I am certain that used vehicle values can be used as a leading indicator for inventory management at the manufacturing level, at the retail dealer level and certainly as an investment tool. However, I humbly hold that current used vehicle value indexes sources are not good enough.

There is a very specific group of vehicles that can be monitored in order to better project results. The Manheim and NADA index both have too much noise in the data. For example, the Manheim Index has no model year restrictions and includes new vehicle price inflation in the calculations. NADA goes up to 8 model years. Both average the data over multiple months and include vehicles which, in my opinion, have little to no impact on new vehicle sales velocity. Therefore, I have decided to make my own index.

For now, I"m going to use Ford as an example please ignore the red residual line until later.

I have said numerous times that passenger vehicles are at a different points in the value cycle than trucks and SUVs.

This is common knowledge at this point, and most have placed their faith on trucks and SUVs. This includes manufacturers shifting production and rental car companies changing their fleet mix to the better performing SUV and truck sector. Most analyst are looking at fuel prices to mark the top of the SUV and truck market. Here"s what they"ve missed:

Here"s WHY this matters:

Now back to residuals. What I want to drive home, in simple terms, is that assuming no change in demand, supply precedes price changes. When used vehicle values underperform residual values, the return rate of leases goes up. The opposite is also true. Less vehicles returned means less auction volume supporting higher prices. More vehicles returned means more auction volume supporting lower prices. Look at the charts again and note the acceleration of used vehicle value declines when used vehicle values fall below residual values. So where do we stand today? You tell me if this looks supportive of higher used vehicle values:

You might wonder what will stabilize used vehicle values going forward. Consider this, a used vehicle is nothing more than a new vehicle transaction that drove off the dealer"s lot.

The answer, years of declining new vehicle sales and we are just getting started.

If you feel that my insight might be a useful part of your investment decisions in the automotive sector, I offer phone consultations as well as in-person presentations through GLG.

Plunging Used Car Prices Wreak Havoc On Rental Car Bondholders

Once hedge fund darlings, almost no one is more perfectly aligned to get obliterated by falling used car prices than America"s auto rental companies, Hertz and Avis.  As Bloomberg notes today, on a combined basis, Hertz and Avis dump about 400,000 vehicles per year into the used car market and operate fleets that are multiple times larger. 

And with used car prices plunging, bondholders are starting to get slightly anxious about the collateral impact of writing down billions of dollars worth of capital assets.

Debt issued by Hertz Global Holdings Inc. and Avis Budget Group Inc., which had traded at or above par in recent years, tumbled to new lows earlier this month amid signs that used-vehicle prices are dropping twice as much as expected. That’s bad news for companies that collectively have to dispose of about 400,000 vehicles a year, and especially for Hertz, whose junk-rated debt is teetering close to a downgrade.

Hertz and Avis typically buy the cars outright from manufacturers or get them on a contract with a buyback agreement. The latter, called program cars, cost more because manufacturers assume the resale price risk. Vehicles that Avis and Hertz buy outright are called risk cars because rental companies make their own assumptions about what the cars will be worth when it’s time to sell. Combined with closely held Enterprise Holdings Inc., the three companies control more than 95 percent of the U.S. rental fleet, according to Manheim.

Program cars made up only 20 percent of Hertz’s U.S. fleet last year, according to a company filing, less than half the 44 percent for Avis’s total fleet. Hertz will try to buy more of those this year, Chief Financial Officer Tom Kennedy told investors during a February earnings call.

Of course, as J.D. Power pointed out in it"s most recent "NADA Used Car Guide Industry Update," the flood of lease returns has just started to push used car prices lower....

...and, unfortunately, the volume of lease returns is only expected to grow...

...all of which Morgan Stanley thinks could spark a 50% decline in used car prices over the coming of years. 

All of which begs the obvious question of who is right...auto supplier equity holders or Hertz bondholders?

The Auto Industry Is About To Drive Off A Cliff, Again

Submitted by Gordon T. Long of MATASII

SELF INFLICTED ABUSE

In the fall of 2015 we released a video study entitled: "The Coming Global Auto Abyss - Too Much Supply, Too Many Brands; Combine with Too Much Credit!".  We concluded that low interest rate monetary policy for the auto industry was like handing crack cocaine to a drug addict. The auto industry would rapidly and irresponsibly abuse it, to such an extent that it would once again "spin out" and careen back to what can only be termed the Washington "substance abuse center". Whether mis-management or clever strategy we are unfortunately being proven right and are now witnessing the reality.

The Washington Keynesian planners mistakenly believe that cheap money still stimulates demand. It historically did this before it became a legally addicting substance, but even its original tenet was essentially based on bringing demand forward. By design this creates a demand hole in the future, but as Keynes himself famously rationalized: "in the long term we are all dead" ... so not to worry when the economic need is urgent! Setting aside for a moment this critical structural reality, we need to remember that cheap credit additionally fosters structural ramifications seldom elucidated:

• EXCESS SUPPLY: Cheap and readily available credit creates excess supply as manufacturer have their capital costs reduced allowing them to competitively pursue market share in the wanton beliefs they can gain competitive advantage due to increased volumes, buyer financing, supply chain leverage, aggressive advertising etc.,


• INDUSTRY CULTURE: Sustained periods of cheap credit unintentionally changes buying behavior patterns, expectations and financing structures of industries.

FORD INADVERTENTLY SIGNALS THE REALITY

During Ford Motor company"s latest earnings call, while defensively attempting to justify a massive 50% shortfall in earnings (falling to $0.30-0.35 from $0.68 in Q1 2016 and versus expectations of $0.48), they disclosed that sales volumes are now expected to fall off this year and next with used car prices dropping for several years!

How could this be with US industry sales at historic levels approaching 18M units per year and no one anywhere with any credibility, even remotely suggesting  that a US recession was imminent?  The answer is that "hole" we referred to above has arrived but it is a much worse chasm because of the industry financing options that have been foisted on the unsuspecting, tapped out US buyers since the "cash-for-clunkers" slight of hand.

The industry has created a minimally two year hole in the market that will flood used and new auto supply inventories while buyers are effectively locked out!

This is not how a well managed industry strategically and responsibly plans, unless of course the game is actually government regulatory arbitrage (think: "Cash-for-Safety" to justify new expensive regulatory features)?

HOW IT WAS ORCHESTRATED - GIVE BUYERS ONLY TWO CHOICES

Auto Leasing has exploded since 2015 and now approaches 35% of all sales. The Lease terms are normally 2-3 years with questionable residuals being used to achieve low lease rates on highly priced units. We have now entered the period where those initially leased units are being returned - in massive. Meanwhile, those Buying versus Leasing have been financing over much longer terms. Ford detailed this with the following charts for their units sold.

THE FORD MOTOR EARNINGS PRESENTATION

Vehicles prices since 2008 are dramatically higher. A $28,000 vehicle in 2008 is now $50-$55,000 and loaded down with new standard equipment features such as backup cameras, WIFI, Seat Warmers etc to justify the higher prices. Prices that can only be sold via cheap credit financing terms.  It was to be an expected marketing strategy to drive profits higher while money was cheap.

As a result:

1. Vehicle Purchases were financed out over periods that bordered on the useful life of the vehicle (based on non- warranted maintenance costs),


2. Vehicles were increasingly leased on 2-3 year leases with high residual values and mileage limitations.

The government wanted it, the central bankers wanted it and the industry wanted it. To achieve this it meant a sustained period of cheap money and creative financing. But it comes with a price tag that must soon be paid!   All of this is now hitting as Ford inadvertently warned!

THE COMING CHASM IN AUTO DEMAND IS "BAKED-IN"

CONSIDER THE FOLLOWING 7 INDUSTRY FACTS

1. HISTORIC SALES LEVELS: Motor vehicle sales have boomed in the years since the Great Recession.

• 2016: U.S. sales of new cars and trucks hit a record annual high of 17.55 million units.


• 2017: J.D.POWER / LMC AUTOMOTIVE: Industry consultants J.D. Power and LMC Automotive reiterated their forecast for a 0.2 percent increase in sales in 2017 to 17.6 million vehicles.


• 2017: MOODYS: Moody"s on the other hand says it expects U.S. new vehicle sales to decline slightly to 17.4 million units in 2017.


• 2017: EDMUNDS: For the full year, Edmund says sales appear to be falling short of last year’s record of 17.55 million vehicles. Edmunds is looking for a 2017 total of 17.2 million vehicles amid softer consumer demand for both cars and utilities as the year progresses.

2. PEAK AUTO SALES: Moody"s Investors Service said in a report  that U.S. auto sales have peaked, competition to finance car loans is set to intensify and drive increased credit risk for auto lenders.

3. TRADE-IN TREADMILL:  Typically, car dealers tack on an amount equal to the negative equity to a loan for the consumers" next vehicle. To keep the monthly payments stable, the new credit is for a greater length of time. Over the course of multiple trade-ins, negative equity accumulates.

• LENDERS = >TERMS: Lenders have supported automotive credit growth with "accommodative financing," including longer loan terms, Lenders could further lower annual percentage rates and keep extending loan terms, though the latter would increase their credit risk.


• MANUFACTURERS=>INCENTIVES: To ease consumers" monthly payments, auto manufacturers are subsidizing lenders or increasing incentives to reduce purchase prices, though either action would reduce their profits.

4. LENDING CREDIT RISK: "The combination of plateauing auto sales, growing negative equity from consumers and lenders" willingness to offer flexible loan terms is a significant credit risk for lenders," Jason Grohotolski, a senior credit officer at Moody"s recently told Reuters.  In the first nine months of 2016, around 32 percent of U.S. vehicle trade-ins carried outstanding loans larger than the worth of the cars, a record high, according to the specialized auto website Edmunds, as cited by Moody"s.

5. INCENTIVES
• Incentives currently average 10.4% of a new-vehicle’s MSRP, which is the highest percentage since March 2009 when rebates averaged 11.3% during the Great Recession.
• SUVs and pickup trucks—with a combined market share of 61.5%—still dominate the sales mix in a market that is bolstered by rich incentives averaging $3,768 per vehicle, according to a March sales update from J.D. Power and auto forecasting partner LMC Automotive.

6. USED CAR PRICES

• A decline in used-car prices is a bad sign for dealerships, which typically see better returns on used vehicles versus new ones.


• Limited supplies have driven up prices in recent years, but analysts have warned that used vehicles would increase in number as leased vehicles are returned to dealer lots.


• Since 2015, consumers looking for lower monthly payments have leased new vehicles at a record pace. Many of those cars, trucks and SUVs that were leased at the start of the recent U.S. sales boom are now reaching the end of their terms.


• Ally, the former finance arm of General Motors (GM), noted in a recent presentation that full-year earnings growth would fall short of expectations, citing the anticipated price drop for used cars.  “We’ve seen a pretty dramatic move in 2016,” said Ally CFO Chris Halmy, adding that the downward trend is expected to continue.


• The used-vehicle price index from the National Automobile Dealers Association posted a 3.8% decline in February compared to the prior month. NADA also said wholesale prices fell 1.6%.


• In the first quarter of 2017, Ally saw used-car values retreat 7%, a steeper move compared to the company’s projection for a 5% drop in 2017.


• Falling used-car prices are a troubling trend for manufacturers, dealers and financial services firms, including Ally and in-house lenders such as Ford (F) Credit. Some bargain hunters will be swayed by affordable used cars, thus reducing demand for new models. When sales begin to slow, automakers often ramp up discounts to attract buyers, a strategy that cuts into profits.


• Incentive spending in March rose 13.5% month-to-month, hitting $3,443 per vehicle, based on data from ALG, TrueCar’s (TRUE) research division. Those gains were slightly offset by an increase in transaction prices.

7. INVENTORIES

Car Inventories Swelled to 13-Year High - highest level since 2004, a potentially troubling sign for automakers.

In February, new vehicles waited in dealer inventory for an average of 74 days before a sale, the most “days to turn” since the government’s Cash for Clunkers program in 2009.

Passenger cars accounted for roughly 38% of all new vehicles sold during the first two months of the year, reflecting a sharp decline.  Sedans have fallen out of favor with many consumers enticed by roomy and fuel-efficient crossovers. Although manufacturers have cut production of some small cars, supplies remain at elevated levels.

Caldwell noted Banks are stretching out loans to make payments more affordable for buyers, extending loan terms as high as 84 months.

The average loan term in February marked an all-time high at 69.1 months, beating the previous record set in September 2016, based on Edmunds data.

For the full year, sales appear to be falling short of last year’s record of 17.55 million vehicles. Edmunds is looking for a 2017 total of 17.2 million vehicles amid softer consumer demand for both cars and utilities as the year progresses.

WHAT WILL WE DO WITH THIS INVENTORY?

There are now approximately 265 million light vehicles registered in the US today compared to 255 million driving age people, or just over 1 car eligible driver. How many cars can we absorb, especially since useful age of vehicles has been increasing by one year every 6.7 years over the last 20 years.

We have a massive problem looming and the auto industry knows it. We are fully expecting broad based problems to emerge over the next 18 months in multiple areas of the auto industry:

1. The US Dealership Network,


2. Auto Manufacturers,


3. Lenders & Financiers,


4. Securitization (ABS, CLO, Synthetics etc) Investors

This is all as predictable as a drunken sailor on shore leave.  We knew cheap money would be too much for auto executives to refuse and oversupply was a sure bet! So will be the industry"s return to the Washington "substance abuse center".  Expect the industry to be back at the government feeding trough asking for help.

Is This The Sound Of The Bottom Falling Out Of The Auto Industry?

Authored by Wolf Richter via WolfStreet.com,

Not quite, not yet, but it’s not good either.

Let’s hope that the problems piling up in the used vehicle market - and their impact on new vehicle sales, automakers, $1.1 trillion in auto loans, and auto lenders - is just a blip, something caused by what has been getting blamed by just about everyone now: the delayed tax refunds.

In its March report, the National Association of Auto Dealers (NADA) reported an anomaly: dropping used vehicle prices in February, which occurred only for the second time in the past 20 years. It was a big one: Its Used Car Guide’s seasonally adjusted used vehicle price index plunged 3.8% from January, “by far the worst recorded for any month since November 2008 as the result of a recession-related 5.6% tumble.”

The index has now dropped eight months in a row and hit the lowest level since September 2010. The index is down 8% year over year, and down 13% from its peak in 2014.

The price decline spanned all segments, but it hit the two ends of the spectrum — subcompact cars and the luxury end — particularly hard. The list shows the change in wholesale prices from January to February in vehicles up to eight years old:

NADA blamed three factors:

1. The surge in new vehicle incentive spending. Automakers, drowning in unsold inventories on dealer lots and desperate to move the iron and keep their plants running, increased incentive spending by 18% to the highest level in over a decade. This made new vehicle more competitive with late-model used vehicles. So this would be on the demand side.


2. The growing flood of used vehicles going through auction. Over the first two months this year, volume of vehicles up to eight years old rose by about 5% year-over-year. Volume of late-model vehicles – the supply from rental car companies and lease turn-ins – jumped 10%. So that’s on the supply side.


3. The IRS tax refund fiasco. Restaurants, retailers, and others are already blaming various February debacles on these delayed tax refunds. After the IRS was hit with millions of fake e-filed tax returns last year that claimed the Earned Income Tax Credit and the Additional Child Tax Credit, Congress required the agency to delay sending out refunds this year.

It’s big money. According to the IRS, refunds issued through February 10 plunged 69% from the same period a year ago. That’s $65 billion that didn’t make it into consumers’ bank accounts. But then the money was unleashed. In the week ending February 17, the IRS sent out a record $74 billion in refunds. By the week ending February 24, refunds were down only 10%, or $15 billion, year-over-year. So most of the problem was resolved by the end of February.

That might explain part of the problem on the demand side, at least at the lower end of the scale. But it’s hard to explain the plunge in prices at the luxury end. Also, these are wholesale prices. They don’t react instantly to a brief consumer cash crunch caused by tax-refund delays, now resolved. Something else appears to be going on.

The report, in attempting a forecast, cautioned:

February’s unusually soft showing makes pinpointing where used prices will go over the next few months a bit more challenging. However, given the slower than usual rollout of federal tax refunds, it’s assumed prices will be somewhat stronger in March and April than originally anticipated.

The Used Vehicle Index by Manheim, the world’s largest wholesale auto auction, didn’t pick up a massive drop in used vehicle prices over the past few months, though it too is showing some weakness. The index edged down 0.2% in February. The report pointed out that, “given a sharp decline in pricing in February of last year, the Manheim Index now shows a year-over-year gain of 1.1%.”

The index has dropped in six of the past seven months (chart), but in small increments, and as it says, “stability remains the watchword.” It too acknowledge headwinds for the market, including the “heavy new vehicle inventory and incentives,” and “a crazy tax refund season.”

Why are used vehicle wholesale prices important?

For one, they matter to lenders. Used vehicle wholesale prices determine the value of the collateral for $1.11 trillion in auto loans that have boomed on higher prices, higher unit sales, longer maturities (the average hit a new record of 66.5 months in Q4), and higher loan-to-value ratios (negative equity):

Dropping wholesale prices increase loan losses for lenders as recovery is lower. Declining wholesale values of lease turn-ins, if the trend persists, impacts how finance companies structure the lease terms, thus raising the costs for the customers and putting a damper on leasing activity.

All this puts pressure on new vehicle sales, further pushing automakers to pile on even larger incentives in order to move the units, grapple with inventories, and keep plants open. This works for a while – there’s nothing like big-fat incentives to bring out reluctant buyers. But incentives, when everyone is doing them, are front-loading sales. This is ultimately self-defeating and gets very costly even as sales begin to decline. It was a contributor in the collapse of the industry during the Financial Crisis.

And there are well-established patterns of customers switching between new vehicles and late-model used vehicles. Large incentives by automakers put pressure on late-model used vehicles. In turn, falling prices on the used vehicle side cannibalize sales from the new vehicle side. In other words, they compete with each other, often on the same dealer lot. Especially if demand is lackluster despite the incentives, these patterns can trigger a downward spiral that is difficult to get out of.

First oil & gas, then construction, then new vehicle sales. Read…  How Auto Sales Are Getting Crushed in Houston

Soaring Lease Returns Set To Wreak Havoc Used Car Pricing and Auto Industry Profits

For months we"ve warned that declining used car prices could spell disaster for subprime auto securitizations (see "Slumping Used Car Prices Spell Disaster For Subprime Auto Securitizations").  While it"s always difficult to predict the exact timing of when bubbles will burst, a combination of record-high lease returns in 2017 and 2018, combined with rising interest rates could imply that the auto bubble is on the precipice.

As Bloomberg recently pointed out, strong used car pricing is a critical component required to prop up the overall auto market.  While American"s love their brand new cars, if used car prices become too soft then substitution can hurt new car sales.  Add to that the impact of falling residual values on the finance arms of the auto OEMs and you have all the ingredients required for an auto market meltdown.

A glut of used vehicles has started to depress prices. That trend will intensify as Americans will return 3.36 million leased cars and trucks this year, another jump after a 33 percent surge in 2016, according to J.D. Power. The fallout has already begun, with Ford Motor Co. shaving $300 million from its financial-services arm’s profit forecast for this year.

“Ford is the canary in the coal mine,” said Maryann Keller, a former Wall Street analyst who’s now an auto industry consultant in Stamford, Connecticut.

This drag may be hitting the rest of the industry, too. A National Automobile Dealers Association index of used-vehicle prices declined each of the last six months of last year. If used values weaken more than anticipated, it can lead to losses across the industry, hitting carmakers, auto lenders and rental companies.

Unfortunately, the volume of lease returns is only expected to grow even more in 2018 with returns expected to approach 4mm units.

As J.D. Power points out in it"s most recent "NADA Used Car Guide Industry Update," the flood of lease returns is driving used car prices lower.

Of course, how we got here is fairly obvious.  The majority of Americans buy cars based on one factor: monthly payment.  And when it comes to managing your monthly payment to the lowest level possible, leasing is the way to go.  Per the Bank Rate calculator below, buying a $30,000 car comes with a monthly payment of around $600 while leasing the same vehicle might only cost $420 per month. 

Of course, why buy a $30,000 Ford for a $600 monthly payment when you could lease a $40,000 BMW for $560?  You can afford it so long as you can cover the monthly payment, right?

Not surprisingly, these dynamics have caused lease share of U.S. vehicles to skyrocket in the wake of the "great recession" as people seek to maintain their excessive lifestyles on smaller budgets.

Of course, the problem is that leased vehicles get returned to their originating lenders every 3 years for brand new leases...we wouldn"t want anyone driving around in a 5-year-old clunker now would we?  But, as we all know, vehicles have useful lives of 15-20 years.  Therefore, it doesn"t take too many excessive lease cycles to flood the market with used supply and bring the whole ponzi crashing down. 

Is A Short Squeeze Coming From This?

By Chris at www.CapitalistExploits.at

Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.

Welcome to this week"s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all it"s glorious insanity.

While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the "World Out Of Whack" as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.

Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.

Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar - because, after all, we are capitalists.

In this week"s edition of the WOW we"re covering volatility ETPs (Exchange Traded Products)

Before we get into what exactly is Out Of Whack with volatility linked ETPs let"s cover what the heck a volatility ETP actually is.

What are Volatility ETPs?

Since it"s probably the most commonly known animal in the zoo we"ll turn to the iPath S&P 500 VIX Short-Term Futures ETN (VXX) for an explanation:

The iPath® S&P 500 VIX Short-Term Futures™ ETN is designed to provide investors with exposure to the S&P 500 VIX Short-Term Futures™ Index Total Return. The S&P 500 VIX Short-Term Futures™ Index Total Return (the "Index") is designed to provide access to equity market volatility through CBOE Volatility Index® futures. The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500® at various points along the volatility forward curve.

In English now:

Any ETP including VXX is a derivative of some underlying asset so let"s take a look at the underlying "asset". In this case it"s the VIX futures. The VIX itself is actually a calculation based on the implied volatility of a basket of options on the S&P 500. Included in the calculations are options which are about to expire and those with 30 days to expiry. The net result is what amounts to a best guess as to what the market believes is in store for the next 30 days trading.

Attentive readers will realise that the VIX is therefore not the actual volatility of the S&P 500, but rather a forward looking best guess of what it is. For example it"s possible for actual volatility of the S&P to be low while traders are freaking out about something they see in a months time which would send VIX higher.

You can buy futures contracts on the price of VIX and they"re actively traded but like any futures contract you"re betting on a where a price lands on a future date, in this case 30 days out.

Volatility ETFs are particularly strange animals since you"re buying a derivative (ETF) on a derivative (the futures contract) which itself is based on a derivative (the implied volatility of options) and those options themselves of course are derivatives which themselves are based on the S&P 500.

So what"s going on with Volatility ETPs?

Volatility ETPs can provide investors the ability to be bullish or bearish. In other words those expecting low volatility can buy something like the ProShares S&P 500 Low Volatility Portfolio (SPLV) and those expecting high volatility can buy something like the VXX mentioned above.

It"s one thing that investors are expecting continued complacency and thus buying the low volatility ETPs but there is a perverse craziness that makes it all the more dangerous (more on that in a moment).

To explain why there has been such a rise in the popularity of low volatility ETPs just imagine driving the Eyre highway which takes you across the Nullarbor plain in Australia. For those unfamiliar with what this is, it"s a 1,675km stretch of road that is pretty much dead straight and has nothing to see - nada. It is I assure you, more boring than watching grass grow and takes 2 days at high speed.

The thing is you land up clocking speeds that would get you arrested anyplace else, in large part because it doesn"t feel like you"re going that fast and certainly doesn"t feel like you"re getting anywhere at all. It"s why when accidents happen on the Eyre highway they"re more often than not fatal.

Every 50km or so the road kinks a little and so one minute you"re hurtling along and the next thing you know, the roads not there anymore and you"ve got to control a ton of metal and rubber screaming through the outback at 180km/h. The rental car guy I spoke to told me that about 10% of all his cars are never resold, they"re rolled.

What does this have to do with volatility ETF"s?

Everything.

Long periods of complacency are often interspersed with brief but frightening jolts of "holy sh** where did that come from?"

Betting on increased volatility has been a losing bet. Below is the VXX in blue (long Volatility) vs SPLV in red (Short Volatility). 

VXX in Blue and SPLV in green/red

Now there are structural reasons why VXX is such a pig of a long term ETF to buy, and I"ll cover why that is in a future article but the point I want to make is that going short volatility has been a winning trade.

I"ve written about this so much that my fingers are going to bleed, more recently when discussing how bonds no longer trade based on yield but based on a future price but the hunt for yield has created some truly amazing set of circumstances and this brings us squarely to low volatility ETF"s.

Enter the beast - When the Cure Becomes the Poison

As reported recently by Market Watch:

"More than $50 billion has poured into low-volatility indexed exchange-traded funds over the past five years or so, in the wake of the 2008-09 market meltdown. There are now 14 “lo-vol” ETFs with assets exceeding $100 million each, and many more with less. Whenever the market hits a pothole, these ETFs enjoy a bump-up in assets."

Now this is where the perverse part comes in. Bear with me on this - it"s important.

Every time you sell volatility you get paid by the counter-party who is typically hedging the volatility (going long) of a particular position and paying you for the privilege. This is not unlike paying a home insurance premium where the insurer takes the ultimate risk of your house burning down and you pay them for the privelage. The difference however between selling volatility in order to protect against an underlying position and selling volatility in order to receive the yield created is enormous. And yet this is the game being played.

The central banks have managed to create a sense of calm in the markets exhibited by record lows in volatility and for their part Joe Sixpack investor has used linear thinking extrapolated well into the future assuming ever greater risk ignoring market cycles and extremes at their peril.

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Two things are happening here:

1. When the proverbial house burns down the insurance company (ETF) can"t cover. It"s all in and was never designed to protect holders for the inevitable reversal.


2. Investors have been selling volatility in order to achieve yield and thus treating these structured products like bonds, when they are in fact similar to bonds in the same way that the iPhone is similar to a water buffalo.

Traders are aggressively hunting for yield and finding it in selling volatility. This works wonderfully... until it doesn"t.

Remember equities are something like 7x more volatile than bonds (depending on what you"re looking at) and these ETPs are inherently more volatile than the underlying equities upon which they"re ultimately priced. Treating them like bonds and buying them for yield is quite simply INSANE.

What"s interesting is that the VIX is trading near all time lows at the same time that short interest on low volatility ETFs is at record highs.

While I"m not predicting it though we are due a recession purely based on the business cycle, a market crash would almost certainly wipe out the entire low volatility ETP complex, and a market correction (overdue) will see a scramble amongst those who"ve been treating an ETP as a bond. It could be more entertaining to watch than the current clown show US presidential race.

The question is:

Cast your vote here and also see what others think

Know anyone that might enjoy this? Please share this with them.

Investing and protecting our capital in a world which is enjoying the most severe distortions of any period in mans recorded history means that a different approach is required. And traditional portfolio management fails miserably to accomplish this.

And so our goal here is simple: protecting the majority of our wealth from the inevitable consequences of absurdity, while finding the most asymmetric investment opportunities for our capital. Ironically, such opportunities are a result of the actions which have landed the world in such trouble to begin with.

- Chris

"To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward." — Sir John Templeton

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