During times of market stress, one of the biggest challenges is trying to determine what is real and what is artificial.

When markets spike - in either direction - there is usually some sort of a news event or happening that triggers the move. BREXIT was a prime example of this. My thinking has always been that when markets make outsized moves, there is usually a reason. And when the Dow falls -4.6%, one assumes there was a darned good reason.

However, there didn't appear to be any data, headline, or specific story that triggered yesterday's action. This leads me to believe that there is more going on underneath the surface than meets the eye.

Yes, it is true that investors may be worried about the prospect of inflation heating up. Exhibit A in this argument is Friday's 2.9% wage growth data point. In short, this was the fastest annual increase in worker pay since 2009. Hence, Paul Tudor Jones, of macro hedge fund fame, said recently that inflation is about to come back "with a vengeance."

So, yes, I can see how stock and bond investors may be rethinking their macro thesis a bit here. And yes, this could certainly lead to a "reset," a "correction," or a "pullback" of sorts in the market - especially with valuations at such lofty levels.

Yet, from my seat, a substantial portion of Monday's 1175 point (-4.6%) plunge on the DJIA has to be viewed as artificial. The bottom line is the Dow doesn't dive 856 points in 7 minutes based on fundamentals or a change in the macro view. It also doesn't rebound 796 points in the ensuing 7 minutes based on anything other than programmed, high speed trading algorithms. No, this is the stuff that "flash crashes" are made of.

So, the next task is to identify what triggered such a massive move. The problem here is that sometimes, as in the case of the original "flash crash" seen in 2011, we don't know what caused the computers to go haywire for quite some time.

The good news is this time around, we can come up with a pretty good explanation for the sudden, massive spike in market volatility. The volatility game itself.

According to a BAML (Bank of America Merrill Lynch) survey, the "short volatility" trade had made it to the top of their "crowded trade" list. In short, this means that shorting volatility has become a staple for big traders and with everybody on the planet playing the game, both the risk and the consequence of a mishap in a crowded trade becomes elevated.

In case you aren't familiar with the game, being short volatility via exchange traded vehicles, essentially provides you with a cheap and easy way to become HIGHLY leveraged to the moves in the stock market. In my experience, these ETN's tend to move something on the order of 5X (or more) the S&P on a daily basis.

For example, while the S&P 500 produced a gain of 21.8% last year, the XIV (Velocityshares Daily Inverse VIX ETN) rose 187.6%. Yowza.

But here comes the problem. These are INVERSE securities, designed to provide the opposite return of the VIX. And generally speaking, what happens to a "short" when the underlying security doubles in value? Oh that's right, you lose all your money.

And yes, there are lots of other ways to play the "short vol" game, most of which involve highly leveraged futures and options. As such, the downside risk of this trade is massive - especially when the trade becomes overly crowded and then moves against you.

So, when the VIX spiked even higher after the close yesterday, these "short vol" securities began to "blow up." You see, there are provisions in the funds' prospectuses for the sponsoring firms to terminate the funds once a decline of 80% or more occurs. Cutting to the chase, when the VIX moves from 13.48 to 37.42 in two days, bad things are going to happen to anyone "short" volatility.

Now comes the fun part (well, from an analytical point of view, anyway). The use of the "volatility" (I put the word in quotes to indicate that there are many, many ways to play this game) isn't simply a directional bet made by the fast-money masters of the universe. No, lots and lots of "regular" folks use volatility as a way to hedge or augment portfolios.

And, of course, what happens when your hedge blows up? You have to sell something else. And what do fund managers tend to sell when they are "forced" to raise cash? They sell the most liquid stuff first such as S&P futures, big-cap stocks, index ETFs, etc. And what happens when everybody makes the same kind of trade at the same time? The selling puts further pressure on the market, of course. In sum, I believe this is the essence of what we are seeing now.

At the same time, we can't just blame a 7% two-day decline in the DJIA on the short-vol game. No, we also have to remember that strategies such as volatility targeting and risk parity, just to name a couple, are likely players in the current freak-out. Remember, risk parity rebalances portfolios based on volatility. So, when volatility in the stock market spikes, you sell stocks and buy bonds. Rinse and repeat.

The bad news is the game looks to continue unabated at the open today as the DJIA futures project a decline of nearly 600 points at the open.

The question, of course, is how long the current dance to the downside will last. Remember, artificial and/or forced selling tends to end abruptly. And when it does, we should probably expect to see a furious - and yes, artificial - rebound.

It is from there that the macro picture will come back into play and we can attempt to ascertain what is real.

Thought For The Day:

Expect the best, expect Divine guidance, expect your fortunes to change... expect a miracle. -Wayne Dyer

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research
Serving Financial Advisors since 1989
Serving individual investors since 1980
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Disclosure: At the time of publication, Mr. Moenning held long positions in the following securities mentioned: None

Note that positions may change at any time.

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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

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