Restoration Hardware Shorts Annihilated After Company Announces 50% Of Stock Repurchased

Restoration Hardware shorts had it too good for too long.

After reporting abysmal numbers in Q3 2016, Q1 2016, Q4 2015 - when the company went so far to blame its own crashing stock price for poor earnings - RH stock more than doubled after its better than expected Q4 2016 numbers as long-suffering investors (not to mentioned squeezed shorts) assumed that that was finally it: that the company has finally turned the corner. It all came crashing again last quarter, when as we reported "Restoration Hardware Imploded After Terrible Guidance, Bizarre Disclosures."

Sadly for the shorts, who doubled down on their efforts to slam the stock, it all ended last night with a bank, not a whimper, when the company reported better than expected Q3 ESP and revenue and lifted its sales and profit forecasts for the year. On the subsequent analyst call, CEO Gary Friedman said he expects that RH, which has faced concerns about its high debt level, would generate about $400 million in free cash flow in 2017, once again reverting to the company"s infamous optimistic posture. That “should address any concerns about our balance sheet and debt ratios,” he said.

More importantly, the company also unveiled a full blown war with shorts, when in its press release it announced that since the beginning of the year, the company had repurchased an unprecedented 49.5% of its shares outstanding, spending a record $1 billlion on buybacks in the 6 months ended July 2017. To wit:

We have reinvested the $282 million of free cash flow generated in the first half, and the $263 million of cash and investments on our balance sheet at the beginning of the year towards the repurchase of our stock, which we believe is an excellent allocation of capital for the long-term benefit of our shareholders. We have repurchased 20.2 million shares to date in 2017, or 49.5% of the shares outstanding at the beginning of the year. Outside of the convertible notes that are due in June 2019 and June 2020, we had aggregate debt of approximately $504 million at the end of the second quarter, including a $100 million second lien bridge loan that we expect to repay in full by year end.

And here is what may be the most amazing cash flow statement we have ever seen: the company borrowed $460 million in 2017, and used virtually all of its available cash and working capital to repurchase stock.

The company also said that "we believe that our shares remain undervalued, and we will continue to evaluate further share repurchases based upon market conditions and our capital allocation priorities"even if it means conducting half a management buyout of the company just to punish the shorts.

That is all the panicked shorts needed to hear, and as of this morning, a historic short covering squeeze has ensued, with RH stock exploding higher by over 40%, on pace for its best day since the company went public nearly five years ago.

And speaking of short pain, there is plenty of it to go around: there was roughly $528 million in RH short interest at last check, and following today"s mauling, shorts are poised to take $231 million in paper losses if the share price closes at these levels, according to S3 Partners, quoted by the WSJ. That’s likely to encourage some shorts to get out of the trade, according to Ihor Dusaniwsky, head of research at the financial analytics firm.

Until today, RH was the second most heavily shorted stock among home furnishings brands, behind only Williams-Sonoma, although perhaps sensing the turn, the value of the short interest had declined rapidly since July, when short interest was at roughly $1 billion.

That"s eased up the cost of borrowing, which had been as high as 71% of the share price on an annualized basis but has since dropped to about 12%, according to S3 Partners. Still, that fee for most stocks is below 1%.

While the chart below shows now-dated information, management"s plan was clear: buyback as much stock as possible, and crush as many shorts as possible before reporting modestly good numbers and a sterling outlook. For now, it appears to have achieved its mission.

Still, the war between longs and shorts is far from over: between the end of last year and July 19, when the stock hit its highest closing level of 2017, shares climbed more than 150% as the company executed a share repurchase program. That was right around the time that short interest peaked, and the stock subsequently dropped 36% through Wednesday.

Naturally, chasing price, the WSJ reports that some analysts said they’re finding a lot to like in the stock after the earnings report. Bradley Thomas and Sameet Desai, analysts at KeyBanc Capital Markets, said in a note to clients that, “while our July downgrade to Sector Weight was predicated on valuation and leverage, we find ourselves increasingly positive on RH.”

And so, here come the sellside upgrades, dutifully following the surge in the price, just in time for the company to massively disappoint again in three months when it once again misses its wildly optimistic forecast, sending the stock crashing yet again and resetting this rather entertaining (if not for the shorts today) cycle.

Meanwhile, one question that has emerged: with RH repurchasing half of its outstanding stock, will there be naked shorts who are physically unable to cover their bearish bets, in the process prompting speculation of yet another Volkswagen-type event, as a scramble begins to cover at any price?

How Stocks Reacted To The Biggest Geopolitical Shocks Since World War II

As Deutsche Bank warns in a note over the weekend, the S&P 500 is "long overdue for a pullback" for one simple reason: the BTFDers (and central banks) have overextended the current rally in the S&P 500 to the point where it is now one for the history books. Traditionally, 3-5% selloffs in the S&P 500 have occurred on average every 2-3 months. By comparison, the current rally has now gone 10 months without even a moest a 3% correction, "making it the 3rd longest since World War II without one." In fact, as the chart below shows, the only times an equity rally ran longer without a 3%+ selloff was in 1993 (11 months) and 1995 (1 year).

Not surprisingly, so far in 2017 virtually all of the (quite modest) selloffs that occurred, were associated with US political and geopolitical concerns and events—around the French election; the Comey dismissal; tensions with North Korea; US administration turnover and terrorist attacks.

However, as a result of the nearly $2 trillion injected by central banks YTD, all of these market "shocks" have so far proved to be fleeting and an invitation for the BTFDers to jump right in, and fill the gap within days if not hours.

So assuming the market is indeed poised for a correction, will that be the beginning of something more serious?

According to Deutsche Bank, the answer is no, because the bank"s chief equity strategist, Binky Chadha expecs the economic and market context to dominate. On the economic front, Binky sees further upside to global growth, with PMIs having further to recoup pre dollar and oil shock levels, a strengthening in the US labour markets and capex, while the he also expects earnings growth to sustain in the double digits. On the market front, he sees the demand-supply picture for US equities becoming more supportive with inflows on a turn up in data surprises and higher rates as inflation picks up.

Chadha points out something else notable: aggregate short interest -  or the cumulative shorts across cash equities, ETFs and futures by asset managers and leveraged funds positioning in S&P 500 futures - is now back to the bottom of the post-2007 band. Furthermore, as DB adds, the rally in the S&P 500 since the election has been notably driven by positioning, with the aggregate shorts as a proportion of the S&P 500 market cap have been fluctuating within an elevated band of 1.8% to 2.8% since the start of the Great Recession in 2007, compared to an average of 1% earlier. Since the election, aggregate short interest has moved from slightly above the band to the bottom. This was driven initially by a large reduction in shorts in cash equities and ETFs but since by rising long positions in S&P 500 futures.

Assuming Deutsche is right, and the next geopolitical shock does not cause a market crash, here is what to expect in terms of market response going into, and out of a "typical" geopolitical events.

According to DB"s calculations, the typical S&P 500 trajectory around domestic political and geopolitical shocks since World War II has historically been of sharp, short-lived selloffs with relatively quick subsequent rebounds. Here is the average pathway:

• Down a median -5.7%;


• Then 3 weeks to find a bottom;


• Another 3 to recover prior levels;


• And significantly higher out 3 months (6.5%) and 12 months (13%).

Beyond this average behavior, it is clear that the economic context dominated. So for example the oil embargo of 1973, with clear negative economic impacts, saw the biggest selloff and slowest recovery. By contrast the Vietnam and two Gulf wars, the Kennedy assassination and Clinton impeachment proceedings occurred against the backdrop of economic recoveries and saw sharp short selloffs followed by long-lived rallies.

In other words, of the nearly 30 major domestic political and geopolitical shocks since World War, it took the market on average 31 days - or exactly one month - from onset until the "dip buying" rebound, brought the market back to where it was previously, filling the gap and continuing higher.

One final item worth noting: in recent years the "recovery" duration has collapsed, in some cases to hours not day, as algos rush from one sentiment extreme to the other, making recent market dips a "blink-and-you-missed-it" phenomenon. That said, rarely if ever before has the market had to gamble with the risk/return odds on a geopolitical shock that could metastasize into a global nuclear war. In which case, should a worst case scenario happen, do not expect a 16 day recover from trough to peak, no matter how many stimulative "broken windows" the mushroom clouds unleash.

Bears Throw In The Towel: FANG Shorts Hit All Time Low

At the end of May, when Bank of America looked at some of the most widely held stocks by active managers, it found that FANG stocks (FB, AMZN, NFLX, GOOG/GOOGL) have returned nearly 30% YTD vs. 8% for the S&P 500. More importantly, it found that managers were 32% overweight Information Technology + Internet & Catalog Retail (a Discretionary industry), which was driven by a remarkable 71% overweight in FANG stocks.

This week, BofA"s Savita Subramanian updated the study of most widely held active manager stocks, and found that while fund managers holdings of FANG and FAAANG (which also includes ACVO and ADBE), have modestly declined over the past two months, they still remains remarkably stretched, or as she puts it "active managers" disproportionate overweight in FAAANG relative to the Tech sector and Internet and Catalog Retail is even more dramatic than the FANG stocks."

But more interesting is BofA finding - both then and now - that since long-only funds did not appears to be bidding up FANG (or FAANG) stocks, which had remained relatively constant among their total portfolio hodings...

... the answer was that "the recent move in FANG may be driven more by short-covering than by active buying."

However, as Bank of America also notes, that short covering, if indeed that is the cause of the levitation, is ending as the short interest for both FANG stocks is now down to all time lows.

A separate analysis released today by Bloomberg"s Stephen Gandel confirms as much, and notes that despite the seemingly pervasive negative sentiment against FANGs, everywhere from Goldman to Howard Marks...

Goldman Sachs Group Inc. strategists predicted an "air pocket" was coming in the FANG bubble. After a survey of investors, Bank of America strategists called FANG and other technology stocks the most crowded trade in the market. Oaktree Capital co-founder Howard Marks recently compared the FANG to the Nifty Fifty and dot-com stocks of the 1970s and 1990s, respectively, as well as other bubbles.

... the short interest for the four companies has sunk to a new record low: "collectively, the short bets against FANG stocks accounted for just 2 percent of their traded shares. Exclude Netflix, and the average short interest for the group drops to just 1 percent. That compares with an average of 4 percent for the S&P 500."

Some have pointed to the recent surge in Netflix and AAPL"s blow off to new all time highs on Tuesday after earnings as confirmation that the shorts are right to stay away, others have said that the move in the company - whose growth rate is a mere shadow of what it used to be, and which has now posted declining Chinese sales for 6 quarters - was so acute precisely due to another batch of shorts throwing in the towel and covering, or as BBG puts it, "tech bears shedding their fur has pushed the stocks higher."

And while the lack of shorts may suggest smooth sailing for the group over the near immediate future, over the long term, a lack of skeptics could be bad. Gendel points out why:

The dearth of short interest suggests an enthusiasm for the shares that could be quickly popped if things turn south. And the falling short interest is odd given that the FANG stocks have risen an average of 37 percent this year, potentially setting them up for a fall, or at least a slip. Amazon, after all, trades at nearly 93 times its expected earnings for this year. Netflix"s unending cash bonfire has burned through $2.1 billion in free cash flow in the past 12 months. The expectations for sales of Apple"s coming iPhone are stratospheric even though the price of one model may top $1,000. Any of these situations would seemingly make for a good short bet, if anyone was willing to make it.

For now, almost nobody is, as most traders remain "paralyzed" (or perhaps complacent) and instead chose the comfort of the passive-investing, ETF, CTA herd which continues to grind stocks ever higher with less volatility than the bond market. Then again, with all the FANG bears having thrown the towel, this may be just the right time to go short... again. Judging by the recent price performance of the group, others may have gotten the same idea.

Mediocre, Tailing 7 Year Auction Following Yesterday's Short Squeeze

After two surprisingly strong auctions earlier in the week, when the Treasury sold both 2 and 5 Year paper to unexpectedly brisk demand ahead of the FOMC meeting, which bounced despite a record high short interest in 2Y futs, moments ago the last auction of the week closed when $28 billion in 7 Year paper was sold at a high yield of 2.126%, tailing the When Issued 2.122%, and the highest yield since 2.215% in March.

The internals were mediocre, with the bid-to-cover of 2.54 better than last month"s 2.461%, if right on top of the six auction average of 2.54%.  Indirect bidders took down 67.7%, also better than last month"s 67.4%  and above the 6MMA of 69.3%, as direct bidders were awarded 11.6%, more than the 9.4% taken down in June and the 6 auction average of 10.4%. Finally, Dealers were left with 20.6%, the lowest since April"s record low 8.8% and below the 6MMA 20.2%.

While the auction was not nearly as exciting as the last two, perhaps much of that has to do with the post-Fed rally observed yesterday, which forced short covering, mostly on the short end, but also broadly across the curve. And with less shorts to squeeze, the result was a rather mediocre auction.

A Stock Market Crash Scenario

Authored by Charles Hugh Smith via OfTwoMinds blog,

The one thing we can know with certainty is it won"t be easy to profit from the crash.

After 8+ years of phenomenal gains, it"s pretty obvious the global stock market rally is overdue for a credit-cycle downturn, and many research services of Wall Street heavyweights are sounding the alarm about the auto industry"s slump, the slowing of new credit and other fundamental indicators that a recession is becoming more likely.

Few have taken the risk of projecting a date for the crash, this gent being a gutsy outlier: Hedge Fund CIO Sets The Day When The Next Crash Begins.

Next February is a good guess, as recessions and market downturns tend to lag the credit market by about 9 months.

My own scenario is based not on cycles or technicals or fundamentals, but on the psychology of the topping process, which tends to follow this basic script:

When there are too many bearish reports of gloomy data, and too many calls to go long volatility or go to cash, the market perversely goes up, not down.

Why? This negativity creates a classic Wall of Worry that markets can continue climbing. (Central banks buying $300 billion of assets a month helps power this gradual ascent most admirably.) The Bears betting on a decline based on deteriorating fundamentals are crushed by the steady advance.

As Bears give up, the window for a Spot of Bother decline creaks open, however grudgingly, as central banks make noises about ending their extraordinary monetary policies by raising interest rates a bit (so they can lower them when the next recession grabs the global economy by the throat).

As bearish short interest and bets on higher volatility fade, insiders go short.

A sudden air pocket takes the market down, triggered by some bit of "news." (Nothing like a well-engineered bout of panic selling to set up a profitable Buy the Dip opportunity.)

And since traders have been well-trained to Buy the Dips, the Spot of Bother is quickly retraced.

Nonetheless, doubts remain and fundamental data is still weak; this overhang of negativity rebuilds the wall of Worry.

Some Bears will reckon the weakened market will double-top, i.e. be unable to break out to new highs given the poor fundamentals, and as a result we can anticipate a nominal new high after the Wall of Worry has been rebuilt, just to destroy all those who reckoned a double-top would mark The Top.

Mr. Market (and the central banks) won"t make it that easy to reap a fortune by going short.

As the market lofts to new nominal highs, the remaining Bears will be hesitant to go short, and Bulls will note that despite the dire warnings of analysts and the gloomy data on auto sales, credit expansion, productivity, wages, etc., the market keeps chugging higher.

This will infuse participants with complacency and a general sense that the market has weathered the worst than could be thrown at it.

When the surviving Bears have become wary, and the market"s resilience in the tide of negative news seems to point to further gains--at that point, the market finally rolls over and "surprises" everyone.

Nice, but when will this happen? Nobody knows, but the key is there can"t be a crowd of analysts predicting a decline and begging everyone to go to cash. There can"t be huge short interest and massive bets on higher volatility. Everyone betting the farm on a decline and a spike in volatility must first be destroyed before the market can possibly fall.

The crash has to catch almost everyone off guard--those who lost their shirts betting on the market responding rationally to deteriorating data (i.e. those who bet on rising volatility and a market decline), those steeped in complacency and those secure in their quasi-religious faith that the central banks "have our backs and will never let the market drop."

When these conditions are met, the Crash-o-Meter pegs the upper limit of vulnerability.

Pavlovian training is deeply embedded, so the first drop will trigger a Buy the Dip frenzy. This reverses the downturn and creates the last exit point. But so well-trained are traders, few take the last exit; most feel assured that further gains are just ahead.

Central banks are presumed to be all-powerful, and the past 8 years support the conventional belief that a new central bank policy announcement will always reverse any downturn.

But contrary to expectations, selling momentum builds and the trading bots start selling in earnest, the goal being to liquidate the position entirely to escape risk. Central bank pronouncements steady the market and trigger wild spikes higher--but only for a few hours. Things have changed. Central banks cannot reverse the tide of fear, and spikes higher are seen as selling opportunities.

Alas, every bot has the same goal, and the bid disappears. That"s one crash scenario; there are many others. The one thing we can know with certainty is it won"t be easy to profit from the crash.

Strong 7Y Auction Rounds Off Weekly Treasury Issuance

Following two medicore auction earlier in the week, moments ago the Treasury concluded the week"s issuance of paper with a strong sale of $28 billion in 7 Year Notes, which priced at a yield of 2.215%, (with a 19.2% allocation at the high yield), stopping through the When Issued of 2.219% by 0.4% bps, likely aided by this morning"s ECB news as well as a reduction in corporate issuance leading to less rate locks, which in turn offset the lack of a short interest heading into today"s auction where the repo rate on 7Y paper was a comfortable +0.30%.

The Bid to cover of 2.564 was an improvement from last month"s 2.491, and the highest of 2017, in fact it was the highest since November 2016; it was also higher than the last 6 auction average of 2.52.

Indirect Bidders, i.e., foreign buyers, once again stepped up their interest, taking down 71.1%, above the 63.8% from February, and well above the 65.7% 6 month prior average. Direct bidders declined modestly from 11.4% (and an average of 11.7%) to 8.4%, leaving 20.5% to Primary Dealers, below their average of 22.7% in the prior 6 auctions.

As discussed before, if potential bond buyers are concerned about a rapid rate rise in coming years, they are not indicating as much with declined interest at TSY auctions.

SNAP Plunges As Shorting Begins

As we warned earlier, the shorts have been unleashed in Snap (as T+3 settlement enables "borrow"). Snap is down 12% today and down 30% from Friday"s highs as S3 Partners says short-interest in the "camera" company has reached $100 million...

• BROKERS LENDING SNAP SHARES TO SHORT SELLERS AT RATES BETWEEN 20 AND 40 PCT – S3 PARTNERS


• SNAP SHORT INTEREST APPROACHING $100 MLN – S3 PARTNERS

And the result..

Next stop $17?

Weight Watchers Stock Soars After Oprah Announces 40 Pound Weight Loss

Just over a year ago, Weight Watchers shorts were crushed when Oprah Winfrey announced she had purchased a 10% stake in the diet company, sending its stock soaring following a furious short squeeze. Following that news, we noted that "going forward every move in the company stock would be a reflection, literally, of what Oprah Winfrey looks like, and certainly her weight, at any given moment is" as she, both a stakeholder and the most prominent customer of the company"s products, would also become its biggest, pardon the pun, proxy.

To be sure, while the fundamentals of WTW remained lousy and the company"s growth prospects were limited, the biggest danger was in sudden, unexpected short squeezes whenever Oprah"s weight would become a topical feature.

Sure enough, having declined consistently since Oprah"s investment last October, and trading near 52 week lows, today Weight Watcher stock soared by 15%, after Winfrey announced that she’d lost 40 pounds using the program. The diet company, whose shares had fallen 54% this year before Thursday’s surge, is unveiling new TV ads featuring Winfrey that tout her weight loss Bloomberg reports.

Though all previous rallies in the stock have faded, any time Winfrey makes an endorsements of Weight Watchers, or updates her weight, the stock gets a temporary jolt. The shares gained 27% over two days last December when Oprah tweeted a video about using the weight-loss program, and there was a 20% bump in January after Winfrey said she had lost 26 pounds while still eating bread every day.

The latest marketing push begins next week, just before the New Year’s holiday. The coming weeks are critical for Weight Watchers: The company typically adds about 40 percent of new customers in the first quarter, when resolutions push people to seek out diets. The stock climbed as high as $12 on Thursday, its biggest intraday gain Since Nov. 4.

Today"s surge is also catalyzed by the substantial short interest overhang, which at 51% of the float, scrambles to cover on days like today.

That said, the long-term thesis remains poor: Weight Watchers has been hit hard by the rise of free fitness apps, and a move away from strict calorie counting among dieters. But Winfrey’s wide-ranging influence has brought new life to the brand. Weight Watchers has added subscribers for three straight quarters after years of declines.

The New York-based company hopes that Winfrey’s new ads, which emphasize that she still enjoys pasta and tacos, will convince dieters that its updated program is an effective weight-loss tool.

"It’s vitally important that Oprah is living the program and articulating it in a way that’s authentic,” said Maurice Herrera, the head of marketing at Weight Watchers. “It really connects with prospective members.”

Despite the subscriber gains, it’s been a rocky year for Weight Watchers. The company has billions in debt, and its stock is heavily shorted. In September, Chief Executive Officer Jim Chambers announced he was leaving after about three years at the helm. That sent the shares plummeting to their lowest level in nearly a year.

As Bloomberg adds, following Chambers departure, Weight Watchers is now being run by a trio of executives who constitute the “interim office of the CEO.”

The ads rolling out next week show Winfrey doing yoga and cooking pasta. As consumers have changed their perception of wellness, Weight Watchers has pivoted to emphasize that weight loss and indulgence aren’t necessarily mutually exclusive. Winfrey will hammer that message home, Herrera said.

“People want to know what’s on her mind and how she’s living her life,” he said. “This will definitely get people’s attention.”

It will also invite a whole new set of shorts who will pressure the stock to new lows, until Oprah next weighing, at which point the cycle will repeat from scratch.

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

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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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