Porter: This is by far the biggest bubble in the market

From Porter Stansberry, Founder, Stansberry’s Investment Advisory:

On Friday, I told you this bull market is hiding a huge risk. I told you that if you want to understand it, you must first spot the biggest bubble in the markets right now.

What financial asset has completely lost its grip with reality?

Only one kind of financial asset is trading at all-time levels…

Last month, I attended the speakers’ dinner at the Grant’s Interest Rate Observer fall conference in New York.

The room was filled with billionaires and a few folks who “only” manage billions. I had a long conversation with Frank Brosens, one of the founders of Taconic Capital, a major hedge fund. Brosens spent the 1980s serving as the head of risk arbitrage at investment bank Goldman Sachs, where he was a general partner.

At the conference, Brosens told the story of how his group made billions on the crash in 1987.

Back then, they perceived how the so-called “portfolio insurance” programs that were being sold (essentially dynamic put-buying) would lead to a cascade of selling in the stock market as too many market participants had adopted “pro-cyclical” strategies – meaning positions that tend to propel market reactions into overreactions – instead of “counter-cyclical” strategies.

You see, the guys buying the “portfolio insurance” didn’t understand that not everyone can hedge their portfolios at the same time. Someone has to be willing to sell the put on the other side of the trade.

Brosens and his team started calculating what would happen in the event of a 5%-6% correction in the stock market as these trading programs kicked in, and they began buying massive amounts of put options at the same time. He explained that they calculated there would have to be a 25%-30% correction in the markets, based on the amount of puts that would be purchased.

Few people perceived this risk…

Almost nobody considered the fact that lots of insurance companies and pension funds had entered into pre-programmed dynamic hedging strategies. But these orders represented a gigantic “stop loss” point that was sitting just below the market. Trip over that level, and look out… Billions and billions of stocks would be dumped on the market. Everyone would try to exit at once.

Brosens’ team did something brilliant. It began offering insurance firms an extra percentage point in annual return on their entire portfolio in exchange for the right to sell them a percentage point worth of stocks at the current (fixed) price.

The insurance firms were so excited about an extra point of return that they began to bid the deal higher. Soon, Goldman Sachs was getting three points’ worth of stocks (at the current price, fixed) in exchange for only one point of extra return for the insurance companies.

You might not understand the math… but the impact of these deals was that Goldman would get a return of up to 300 times on its money if the stock market fell by a certain amount.

You know what happened next…

But you’ve probably forgotten why.

On Thursday, October 15, 1987, Iran hit a super tanker in the Persian Gulf with a Silkworm missile. The ship was U.S.-flagged and carrying crude oil bound for the U.S. market. On Friday, October 16, it happened again. Iran attacked another super tanker.

The market responded badly. Selling led to more selling… and then even more selling. The dynamic hedging programs were driving more and more money out of the market as it fell. The market fell more than 300 points by the end of that week, down about 12%.

The sell orders piled up over the following weekend as the London Stock Exchange didn’t open because of a freak storm. A hurricane hit southern England and northern France. More and more investors began to panic. When trading opened in New York on Monday, October 19, it seemed as though the entire world wanted to sell stocks at virtually any price. The market crashed an incredible 22% in one day.

Brosens and his team at Goldman Sachs saw what was going to happen…

They were ready. And they made billions by hedging Goldman’s other trading losses. They probably saved the firm.

Brosens explained to me at the conference that the exact same forces are now at work in the U.S. equity markets… thanks to massive bets against volatility.

The bubble in this market – the biggest bubble of them all – is the size and amount of bets against volatility.

These bets have made investors billions and billions of dollars as central banks’ liquidity has crushed all measures of risk. Inexperienced investors have come to view this trade as a “can’t-lose bet” in the same way firms believed that dynamic portfolio hedging could remove all risk from their equity investments back in the 1980s.

One anecdote making the rounds in the market today is about Seth Golden, a logistics manager at retail chain Target. He has made $12 million in the last five years by simply shorting volatility.

But it’s not just these kinds of stories. The amount of capital betting on low volatility has driven the Volatility Index (“VIX”) – the Chicago Board Options Exchange’s measure of market volatility – to record lows. (Early last month, it closed at 9.19, its lowest closing level ever.)

For almost 30 years, this futures contract rarely closed below 10. In fact, that has only happened seven times before this year. But in 2017, the VIX has closed below 10 on 35 separate days.

This is by far the biggest bubble in the market

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 lotThey will lose everything.

Normally, that wouldn’t worry me (or anyone else) too much…

What’s different now is the size of the bets on volatility. This part of the market used to be only available to futures traders – generally large institutions. But beginning in 2011, ETFs allowed individuals to own these same futures, probably without really understanding what they own. Today, around $5 billion is invested in VIX-related ETFs.

There are two big problems with these investments that no one seems to understand… yet.

First, even though the nominal amount of money invested in these funds is small compared with the stock market as a whole, these funds are invested into highly leveraged, pro-cyclical futures. These are the exact same kind of instruments that led to the panic in 1987.

But an even bigger danger lies in these particular kinds of futures. VIX futures are only guaranteed to synchronize with the VIX index on the day they expire.

On any other day, supply and demand drive their value. Ergo, if investors panic and sell their ETFs, supply won’t be able to keep up with demand, and the prices of these futures will become skewed. During a real panic, the value of these ETFs will evaporate, producing an even more exaggerated and leveraged impact.

One final thought…

Until 2003, it was impossible to trade futures contracts on the VIX. The CBOE eventually agreed to tweak its formula to allow market makers to build a futures contract that could be traded.

You’ll never guess which investment bank pushed for these changes – Goldman Sachs, of course. Goldman also designed the new contract. This contract exists so that in periods of extreme selling pressure, Goldman can execute the kind of trade that Brosens had to set up with individual insurance companies.

If you’re thinking about buying an inverse-volatility ETF, ask yourself this: Who would you rather be… an insurance company, or Frank Brosens?

Good investing,

Porter Stansberry

Crux note: This is only part of the bigger picture. Porter has warned that very soon, a “Jubilee” is coming – a radical plan to “fix” America’s debt crisis. This event will lead to civil unrest… and will turn the next crash into a national nightmare. That’s why Porter and his team have laid out the ideal strategy to help you protect your portfolio – and even prosper – as it all unfolds. Click here to learn more.

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