The Big Winner From Yesterday's Market Plunge


Yesterday, the Federal Reserve spooked the financial markets by hinting at the possibility that at some point in the future, it may stop taking the extraordinary measures it has done over the past several years to try to hold up the economy and encourage economic growth. Yet amid the sea of red ink, there was one big winner from the Fed's move: investments linked to market volatility.

After the plunge, the S&P Volatility Index had risen by nearly 20%. Exchange-traded products tracking the move posted smaller but still impressive gains, with the iPath S&P 500 VIX ST Futures ETN higher by 9% and the leveraged VelocityShares Daily 2x VIX ST ETN climbing more than 15%.

The VIX had set new yearly lows on a closing basis after Tuesday's rally, with the exchange-traded notes having set new all-time lows. By contrast, the VelocityShares Daily Inverse VIX ST ETN came off its all-time highs from Tuesday, falling by 9% yesterday.

With many investors having waited patiently for a correction, fear is coming back into the market -- at least for a single day. But the bigger question is why it's been gone so long.

Where has all the fear been?
For months, the stock market has impressed investors by largely ignoring potential problems both in the U.S. and around the world. Consider:

  • During much of 2012, European financial problems persisted, with some successful moves to kick the can down the road but few substantive proposals aimed at a permanent fix to the crisis.

  • A slowdown in growth rates in China and other emerging markets had a big impact on certain segments of the economy, particularly companies specializing in natural resources and services related to extraction of those resources. But even with a big drop in China's stock market, U.S. stocks held up well overall.

  • Even major political uncertainties like the fiscal cliff didn't lead to any lasting damage for the market, and investors haven't seemed all that worried about the current sequestration debate either.

Yet the Federal Reserve has played a much more fundamental role in guiding investment decisions in higher-risk assets like stocks and commodities. For precious metals, a big part of the bullish thesis has been that central banks would find it difficult or even impossible to rein in quantitative easing and other stimulative measures. Any sign of resolve that the Fed might actually take a less accommodative policy stance -- even at the risk of jeopardizing economic growth -- is a direct attack on that bullish argument.

Should stocks really be plunging?
Meanwhile, for stocks, the argument is a bit more tenuous. Certainly, low interest rates have forced some income investors to seek greater cash flow from dividend stocks. But on the whole, investors have been putting their money into bonds rather than taking it out of the bond market.

The fear that rising interest rates would entice investors back into bonds may prove mistaken and could actually end up working to support stocks. Investors tend to chase performance, and they've gravitated to bond funds because their total returns have been impressive. Falling interest rates have produced big capital gains in bond holdings, and that has made their returns rise even as their yields fall. Yet if the Fed's moves cause rising interest rates, that would send bond-fund prices falling. Historically, investors have tended to flee bond funds after those losses, and the stock market could well get some of that departing bond-fund money -- especially from income investors who can't afford to live on what savings accounts pay.

Be careful with volatility
Before you decide that investing in volatility-tracking ETNs is the best way to cash in on a correction, be aware that over the long run, investments that count on rising volatility levels have performed badly. Admittedly, bullish volatility trackers tend to rise sharply in quick market corrections, but for the most part, expecting them to be a viable long-term investment is a risky play. Even after yesterday's victory, there's no guarantee that volatility-based investments will be big winners going forward.

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