American Consequences - April 2018

How to Protect Your Portfolio

Ups and Downs of Volatility

End of the Anti-Fear Trade

I D E A S T H A T M A T T E R E D I T E D B Y P . J . O ’ R O U R K E AMERICAN CONSEQUENCES

VOLATILITY IS BACK...

THE

IN

ARE YOU READY TO TAKE THE PLUNGE?

APR I L 2 0 1 8

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CONTENTS

APRIL 2018 : ISSUE 10

LOST? CLICK HERE

24

50

60

82

76 32

AMERICAN CONSEQUENCES

4 Inside This Issue

50 What Will Trigger the Next Crash BY DAN DENNING

BY STEVEN LONGENECKER

Editor in Chief: P.J. O’Rourke Editorial Director: Carli Flippen Managing Editor: Steven Longenecker Contributing Editors: Dan Denning, Turney Duff, Dan Ferris, Anne Goldgar, Alan Gula, John Podhoretz, Buck Sexton, Matt Weinschenk Newswire Editors: Scott Garliss, John Gillin, Greg Diamond Assistant Editors: Chris Gaarde, Laura Greaver Creative Director: Erica Wood Cartoon Director: Frank Stansberry Contributing Cartoonists: Hank Blaustein, William Hamilton, James Stevenson General Manager: Jamison Miller Advertising: Sam DeCroes, Jared Kelly, Jill Peterson Editorial feedback: feedback@ americanconsequences.com

6 Letter From the Editor BY P.J. O’ROURKE

56 Tulip Mania

BY ANNE GOLDGAR

10 What Moved the Market

60  What Did YOU Do When the Market ‘Corrected’? BY AMC EDITORIAL 64 Ups & Downs of Volatility BY TURNEY DUFF

12 What Could Possibly Go Wrong?

14 From Our Inbox

18 End of the Anti-Fear Trade BY DAN FERRIS

70 Greed and Fear BY P.J. O’ROURKE

24 Volatility Insight FROM OUR CROX

76 Wall Street on the Big Screen BY JOHN PODHORETZ

30 STRIKE!!!

BY P.J. O’ROURKE

80 Read This

32 Use Volatility to Make Triple-Digit Gains BY ALAN GULA

82 The Final Word BY BUCK SEXTON

40 How to Protect Your Portfolio BY MATTWEINSCHENK

86 Featured Contributors

46 RandomWalk

BY P.J. O’ROURKE

American Consequences 3

INSIDE THIS ISSUE

W e expect one thing, no matter what happens next... Whether a serious bear market begins or whether the long bull market continues for another year or more... you can at least count on more major spikes in volatility in the months ahead. In our “Volatility Issue” of American Consequences , we’re exploring what the heck happened in February when the market plunged... and why a 500- or 700-point daily move in the Dow Jones Industrial Average is becoming commonplace. Editor in Chief P.J. O’Rourke tells why he roots for the Dow like he roots for the New England Patriots... and shares some career advice he’s given his children. Financial analyst Dan Ferris breaks down why February 5 was the day he was warning about... and why the “Fear Index” matters for all investors. The man of mystery who we call Chief Risk Officer X spills about volatility. He shares why volatility has increased... why investors are stuck in a “damned if they do, damned if they don’t” world... but ends with some optimism (if only politicians would get out of the way). Two financial analysts share their trading strategies in volatile times: Alan Gula details how to use volatility to make triple-digit

gains... while Matt Weinschenk shows how to protect your portfolio and keep an incredible 95% win rate. Dan Denning details what is likely to trigger the next crash – and shares five things you can do to get ready. Professor Anne Goldgar shares research showing that the classic story of “Tulip Mania” is mostly wrong. And we share feedback from you, our readers, about what you did during the February correction. Bestselling author Turney Duff has a tale of why some days you lose a million... while other days you find six figures on the sidewalk. Of course, don’t miss P.J.’s essay on the so- called “random walk” hypothesis in finance... and he thanks his stars that the market isn’t efficient. And P.J. also takes apart greed and fear – the two so-called driving forces behind the market. John Podhoretz looks at why finance is the great neglected subject of American art. And finally, former CIA analyst Buck Sexton looks into the dark side of Facebook’s global social domination. Enjoy the issue. And tell us what you think at feedback@americanconsequences.com. Regards, Steven Longenecker Managing Editor, American Consequences

4 April 2018

A gentleman never cuts corners.

Age may make you a man. But being a gentleman is up to you. Shave like a gentleman | onebladeshave.com

From Editor in Chief P.J. O’Rourke

OCKTAIL AND VENN DIAGRAMS CAREER ADVICE FOR MY KIDS WHY I’M NOT RICH AND YOU WON’T BE EITHER IF THE ONLY THING YOU DO IS LISTEN TO ME

6 April 2018

LETTER FROM THE EDITOR

M y advice for what to do in these times of economic volatility? I have no idea. If you’re looking to claw your way up the corporate ladder, succeed beyond your wildest dreams, and amass an enormous fortune, you’re reading the wrong part of this magazine. That stuff doesn’t come from humor columnists. I am a humor columnist. If wealth came from humor columns I’d be too rich to be writing them anymore. I have no idea where power, success, and a big pile of money come from. Probably from somewhere awful, such as hard work, or from somewhere impossible, such as being much smarter than I am – like the other American Consequences writers are. You should go read them. Meanwhile, I’m having a lot of fun watching people frantically try to make – or keep from losing – money. I love economics the way I love the NFL. A great thing about professional football is seeing the guys who stuffed me into my high school locker break each other’s legs. A great thing about economics is how it’s like live crabs in boiling water. If one of them almost makes it out of the pot, the others will pull him back down. And I say this, not as some kind of anti- capitalist commie nut, but as a firm believer in the free market and a great fan of economic liberty. I root for the Dow Jones like I root for the New England Patriots. But if the guys who hoovered my investment portfolio in

the 2008 financial crisis go to bankruptcy court or jail, that’s a lot of fun. Economics is a blood sport that I really enjoy – as a spectator. Of course, like everyone else, I am, at some level, a participant. But I got myself off the field and into

a luxury skybox by marrying a woman who was a business major and is much smarter than I am. I leave everything to her. I

If wealth came from humor columns I’d be too rich to be writing them anymore.. “ have no idea what’s in my investment portfolio now, and I haven’t called a play since 2008. It might be 1000 shares of Berkshire Hathaway. It might be a crypto-currency that Jim Cramer pulled out of his butt on “Mad Money” – Buttcoin . I don’t know, and I don’t want to know. I just want to have fun. Or I did just want to have fun until my kids became adolescents and I began to feel that it was incumbent upon me to give them some fatherly advice about how to claw their way up corporate ladders, succeed beyond their wildest dreams, and amass enormous fortunes (with which to take care of me in a luxurious fashion in my old age).

CLICK HERE TO READ THEWEB VERSION

American Consequences 7

LETTER FROM THE EDITOR

“ I told them that the best way to do well in life is to find a job that combines what you love to do with what you’re good at doing with what people will pay you for.

“Ask your mother,” I said. Their mother said, “Work hard and be much smarter than your father.” (My kids were discouraged by the first part of this advice.) So I tried again. I told them that the best way to do well in life is to find a job that combines what you love to do with what you’re good at doing with what people will pay you for. “Take me for example,” I said. My kids said, “ You ?” I said, “Well, children, you’re not starved to death and naked. Although you...” (I said to my eldest daughter) “...should wear a sweater over that Forever 21 top. Anyway, I have made a living.” I told them, “Think of What You Love to Do and What You’re Good at Doing and What People Will Pay You For as three circles. Technically, a Venn diagram. Try to find a place where those three circles intersect, then go there.” I drew the “Me” diagram on my cocktail napkin...

“But, Dad,” said my kids, “The National Lampoon was, like, forty years ago.” “Right!” I said, “And I’m still riding its coattails. But I can give you more up-to-date examples.” I mixed another cocktail and got a new napkin...

WHAT PEOPLEWOULD PAY HIM FOR Knowing Steve Wozniak

8 April 2018

“You’ll have to leave by nine o’clock,” said my wife. “I’ve called an Uber.” “Uber?” I said. “Some twerp with a nose ring who plays in a K-Pop cover band on weekends driving his mother’s Honda Civic. That’ll never catch on. Can’t you get me a Yellow Cab?” “They’re out of business,” said my wife. Then she turned to our children. “If you really want to get rich,” she said, “listen to your father. Listen especially carefully when he says, ‘That’ll never catch on.’ “For example, your father said, ‘A phone that connects to the Internet? What for? I’ve got a computer at home. That’ll never catch on.’

WHAT HE LOVED TO DO Be the Biggest Math Nerd in His High School

WHAT PEOPLEWILL PAY HIM FOR Futzing With All Those Computer 0s and 1s That Nobody Else Wants to Bother With

“He said, ‘A face-book? Why would anyone want a book full of faces? That’ll never catch on.’

“And he said, ‘What the heck is this bird noise, this peeping or cheeping or chirping or twittering I keep hearing about? That’ll never catch on.’ “Just listen to your father. And whenever he says, ‘That’ll never catch on,’ invest every penny you’ve got .”

WHAT PEOPLEWILL PAY HIM FOR As It Turns out, Practically Everything

“ My wife looked over my shoulder at my doodles and said, “Don’t forget, dear, you’re supposed to address the NAP-WTF Conference in New York on Monday.” “The ‘National Association of People Who Think They’re Funny,’” I explained to the kids.

If you really want to get rich, she said, listen to your father. Listen especially carefully when he says, ‘That’ll never catch on.’

American Consequences 9

WHAT MOVED THE MARKET THE BIGGEST STORIES THAT MATTERED FOR THE MARKET LAST MONTH...

(PMI) data were weak. The German economy has lost a step, and this is a bad omen for the economic health of Europe. U.S. Treasury debt offerings for the month were the largest monthly offerings on record. The bond market held, but given the increase in the deficit, the Treasury will be running this spigot at full volume as our debts come due. This is another reason for concern regarding China – it is the largest holder and buyer of our sovereign debt. Oil has rallied 10% over the past month, and the Saudis and OPEC are dead set on getting prices for North Sea Brent to $80. Some positive developments included a pickup in deal activity. There were deals in specialty chemicals, pharmaceuticals, REITs, and technology. The Spotify Technology (SPOT) IPO was successful and bodes well for more $1 billion “unicorns” to come public. The next catalyst for markets is the start of the second-quarter earnings season. Citigroup (C) and JPMorgan Chase (JPM) kicked things off last week and both are ideal proxies for the health of the U.S. economy. THE MARKETS ARE CLOSELY FOLLOWING PRESIDENT TRUMP... The markets are always searching for new investment patterns. They look for triggers that can help identify when to buy and sell during every cycle. Today, investors are paying close attention to the pattern developing out of the White House regarding President Trump’s style of

MARKETS HAVE HAD A HAIR TRIGGER... 1% MOVES HAVE BECOME THE NORM. The trade and tariff war of words between the U.S. and China has been a dominant headline this month. Fortunately, the last message from President Xi of China was constructive and met with praise from the White House. But there are months of negotiations to come... and that means massive market moves are only a tweet away. The Federal Open Market Committee met March 20-21 and Fed Chairman Jerome Powell delivered another confusing message. Investors are most concerned about inflation gathering steam and that the Fed will jack up interest rates to steady the outlook on future asset returns. Congress passed the $1.3 trillion omnibus bill, and public response was underwhelming. It was a win for the military, but a huge disappointment overall. The rancor between the parties is at a fevered pitch, and many question whether Republicans can hold the House of Representatives in November. A sea change in leadership would ensure gridlock for years to come. The Facebook/Cambridge Analytica saga dragged on and wiped out billions of dollars in Facebook (FB) market cap. Privacy concerns have been simmering for months and the debate over personal-data protection and responsibility has only begun. Amazon (AMZN) also had a rocky month when President Donald Trump called out the company for tax abuses and taking advantage of the U.S. Postal Service.

EDITORS

Scott Garliss

John Gillin Greg Diamond

The global flash Purchasing Manager’s Index

10 April 2018

WATCH THESE DATES For real- time market updates from some of Wall Street’s most plugged-in analysts, CLICK

governing. The market worries that current rhetoric could escalate into a full-blown war. This in turn could inhibit the recent pick-up in global economic growth. The timing could be unfortunate as global central banks tighten their policies. President Trump signaled a willingness to raise Chinese import tariffs from $50 billion to $150 billion. China said it would counter U.S. protectionism at any cost. The major market indices all dropped over 2%. White House officials then hit the airwaves, trying to walk back the trade war rhetoric. Economic adviser Larry Kudlow stated negotiations could resolve the dispute. Treasury Secretary Steven Mnuchin said he doesn’t think there will be a trade war. Trump also said China would take down its barriers because it’s “the right thing to do.” The pattern developing out of the administration is to present the worst-case scenario and then back off. We saw similar style tactics used in budget negotiations... The situation became difficult with compromise seeming unattainable, but in the end, everyone come to an agreement and moved forward. This pattern keeps with the negotiating style laid out in Trump’s book, The Art of The Deal . “My style of deal–making is quite simple and straightforward,” Trump says. “I aim very high, and then I just keep pushing and pushing to get what I’m after. Sometimes I settle for less than I sought, but in most cases I still end up with what I want.” Trump sets difficult terms in the initial stages to walk away with a softer victory in the end. The market will be playing close attention to see how this pattern plays out.

April 23 Markit releases its preliminary manufacturing, services, and composite PMI data in the U.S. and the eurozone. This is a vital gauge for judging the state of global growth. April 26 The European Central Bank makes its policy announcement. The market will examine commentary on stimulus withdrawal and the path of rate hikes. Speculation continues to swirl that the central bank will move to a more aggressive tightening path (raising rates) going forward. May 1 The Institute for Supply Management releases its Manufacturing, New Orders, Prices Paid, and Employment data. It’s widely followed and judged to be an important near-term barometer of economic activity. The data are based on the responses of 300 purchase and supply chain executives across the country. May 2 The Federal Reserve makes its policy announcement. It’s not expected to raise rates but investors will study guidance on the rate path going forward – specifically, whether we’ll see three rate hikes this year or move up to four.

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American Consequences 11

WHAT COULD POSSIBLY GO WRONG?

Financial follies and disaster in the making

China intends to do better is welcomed, but this rhetoric is nothing we haven’t heard before. Trade talks and skirmishes are going to go on for months... And so will the volatility that follows them. If the markets have felt unusually erratic of late, it’s not just you... By mid-month, the S&P 500 Index was on pace for an incredible 100 sessions with a daily move of 1% or more. There’s no guarantee this pace will continue, but it would place 2018 in rare company. In fact, this has only occurred in five previous years over the past 70. Two of those years – 2001 and 2008 – occurred in the middle of a serious bear market decline. The other three – 1974, 2002, and 2009 – marked significant multiyear bottoms. But all five were incredibly volatile periods for investors. Speaking of volatility...

Trade wars and tariffs...

Stocks fell early in the month following new trade remarks from President Donald Trump. And they soared again later that evening following a speech from Chinese President Xi Jinping. In the 40-minute speech, Xi promised foreign companies greater access to China’s financial and manufacturing sectors. He also committed to lifting more economic restrictions despite rising trade tensions. President Xi never mentioned the trade conflicts with the U.S., and his remarks seemed to draw a contrast with Trump’s “America First” agenda. While Xi’s remarks were conciliatory, the celebration could be short-lived... The speech promised little that China hasn’t already proposed, and it offered no clear schedule or timetables for implementation. Barring concrete progress on a trade deal, it’s simply a matter of time before tensions rise again. The news that

12 April 2018

That said, if you’re betting on higher volatility today, there’s something you should know... Stock-market swings in the past month have many investors scrambling to profit from the return of turbulence after a prolonged period of tranquility. So-called “long volatility” trade has suddenly become popular. Investors believe that continued volatility is the one thing that’s almost guaranteed... and both hedge funds and asset managers have all been buying futures contracts pegged to the CBOE Volatility Index, known as the “VIX.” In other words, the same folks who were making record bets against volatility earlier this year – many of whom suffered huge losses during February’s “volatility panic” – have flipped sides. These speculative traders are known as the “dumb money” for a reason. They tend to be wrong at extremes. When they’re all making the same bet – whether they’re all super- bullish or super-bearish – it’s a sign that the trade is “crowded” and a short-term reversal is likely. The recent extremes don’t mean the VIX can’t move higher in the near term... But speculators are suddenly super bullish, which suggests a greater risk is to the downside.

by President Trump during his presidential campaign in 2016, many speculate this data directly informed his campaign’s strategy during the election. This news follows Facebook’s disclosure about six months ago that Russian-backed propagandists exploited its site to create political divisions in the U.S. before the 2016 election. Topping it all off, Facebook now estimates that Cambridge Analytica harvested the data of about 87 million users. Eventually, Facebook CEO Mark Zuckerberg appeared before Congress where he repeatedly apologized for the scandal, while blaming the data breach on a researcher who violated the platform’s terms of service. Zuckerberg also said he only found out that the data was sold to Cambridge Analytica after The Guardian reported on the issue. Zuckerberg claims that Facebook users have control over their information. That users can choose what data is collected, are able to delete any of it, and can leave Facebook at any time. But is it really that simple? Longtime Facebook users know just how difficult it can be to navigate the site’s ever- changing menus and privacy settings. And controversy, but it’s likely that any long- term effects will be minimal. Considering the number of data breaches we’ve seen in the last six months alone, it probably won’t be long before we’re reading about and reporting on another one. again, 87 million users were affected. Facebook’s shares tumbled on the

Another data breach...

Last month, news broke that London-based data-analytics firm Cambridge Analytica improperly gained access to the private data of more than 50 million Facebook users. And since Cambridge Analytica was then hired

American Consequences 13

FROM OUR INBOX

Re: Our Newest Readers Weigh In

and Laura Greaver, and everyone one else at the magazine, especially our contributors. Good luck with American Consequences . Good luck to America. Something wicked this way comes. – Clark W. P.J. O’Rourke comment: I just wish I knew what direction it’s coming from! I don’t know whether to take shelter from the “Thunder on the Left” or the “Storm on the Right.” Maybe I’ll just let it rain while I wallow in the “Mud Puddle of the Middle.” Re: ‘Winner Take All’ Economic Transitions January 2018 issue of American Consequences I do not understand the religious faith in the so-called “free market.” As I listen to P.J., he seems too smart of a guy to believe this imaginary fantasy, which causes so much suffering for millions, and results in wars, environmental devastation, pollution, disease, and generally exposes the free market as something by which people seek to dominate others not within their own sphere (whether that be a family, a tribe, a political party, whatever). Yeah, it’s making a few unbelievable rich. It’s giving millions of others a good enough life economically... And it’s giving billions a pretty miserable life. And somehow, the “free market” is supposed to do, what? – Mark B.

Thanks for what you do, I think you are a PATRIOT. I am impressed for sure. God bless you and keep up the good work. – Conley F. Right or left, absurd is absurd. Couldn’t agree with you more. I’ve been saying that for years. I love and admire that approach. – Steven V. Been a fan for a great many years. Great that you’re doing this as your brand of humor I get. – Chris K. P.J. O’Rourke comment: Gosh. I’m blushing. And let me be quick to say that – appearances to the contrary – I don’t pick the “Inbox” letters. Managing Editor Steven Longenecker sends me a batch and I answer them in the order given. (Steven, I hope you aren’t trying to tell me I need to work on my self-esteem!) Thank you very, very much, Conley F., Steven V., and Chris K. It’s words like yours that keep me writing in these patriotically challenged, absurd, and (sort of ) humorous times. Please know how much I appreciate it. And also please know that American Consequences is very much a group effort and wouldn’t be possible without the like-mined input from our patriotic, absurdity-alert, and very funny Managing Editor Steven, Editorial Director Carli Flippen, Creative Director Erica Wood, Assistant Editors Chris Gaarde

14 April 2018

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P.J. O’Rourke comment: It’s not that you don’t have a point, Mark. Free markets can lead to misery. And so can every other kind of freedom. This is sad, but not as sad as what a lack of freedom leads to. If we’ve learned anything from history (and sometimes I wonder), it is that property rights, like religious rights and free speech rights, are at the foundation of all freedom. Look at the people who have disdained free markets and taken property rights away – Lenin, Stalin, Hitler, Mao, Pol Pot. This caused suffering for hundreds of millions . Re: Why today feels like the late 1920s March 7, 2018 issue of American Weekly Consequences What is it about you “free trade” guys? The only country that is involved in Free Trade is the U.S. Virtually every trade “partner” has barriers to U.S.-made products and services. Some are tariffs, taxes, content requirements, red tape, subsidies and many others. Our one-way free trade over the years has unfairly sanctioned U.S. goods and devastated many U.S. industries. The President has finally recognized this and has given a voice to U.S. manufacturing of some products by threatening some retaliation for these unfair trade practices. All you “free trade” guys see is Trade War.

American Consequences 15

FROM OUR INBOX

The President is attempting to insert some fairness into our trade policy by calling out those who violate the principles of, so called, “free trade”. – Scott M. P.J. O’Rourke comment: It’s not that you, too, don’t have a point, Scott. But let me paraphrase something I wrote about free trade in the February issue of American Consequences : In the 1980s America had a huge trade deficit with Japan. The Japanese kept giving us radios, TVs, stereos, and cars. In return, we kept giving them little green pieces of paper. The Japanese erected trade barriers against everything American-made. This left the Japanese with lots of little green pieces of paper. Then the Japanese decided to buy America itself. They bought Rockefeller Center. They bought Pebble Beach. The Japanese bid up the price of American real estate until the bubble burst. By the 1990s America had all the radios, TVs, stereos, and cars that Japan had given us, plus we’d repossessed Rockefeller Center and Pebble Beach and gotten all of Japan’s little green pieces of paper back. Meanwhile the Japanese had stuck their economy in a place where the Rising Sun never shines. THE PARABLE OF JAPAN

This is not 1920. In the ‘20s the U.S. was an industrial giant with lots of manufacturing jobs. Today, after losing more than 100,000 manufacturing facilities in the last 25 years we are close to becoming a third- world country. We will be selling oil, gas, minerals, agricultural products, and some airplanes. We need to start manufacturing value-added products not only for our own consumption for the other countries in the world. Capital is flowing out of the U.S. at a rate of $800 billion a year. That must be reversed or we are dead as a country. How long will the rest of the world let us print as much money as we need to buy their products? When they realize the dollar is worthless we will be Zimbabwe. – MatthewM. P.J. O’Rourke comment: Don’t book that flight for Zimbabwe yet, Matthew. America is already doing what you suggest. See the following from Forbes : “Forty-nine of the world’s largest tech companies in 2017 hail from the United States...” “Apple is not only the largest tech company in the world, but also the 9th largest company in the world...” “Fifteen of the top 25 largest tech companies are from the United States, with eight in the top 10.”

Send us a message, question, or criticism at feedback@americanconsequences.com

16 April 2018

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Gartner Research predicts this new technology will reach a massive $3.1 TRILLION in just a few years.

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Gartner Research predicts it will reach a massive $3.1 TRILLION in just a few years. That’s a growth rate of 77,000%.

THE EN

WHY THE ‘FEAR INDEX’ MATTERS FOR ALL INVESTORS... ANDWHAT IT REALLY IS. ANTI-

18 April 2018

By Dan Ferris

OF THE EAR TRADE

The day I warned about arrived on Monday, February 5.

The CBOE Volatility Index (VIX) closed 115% higher than Friday’s close. And some investors lost everything ... Before we get to the hairy details, I bet most investors who lost money trading VIX exchange-traded products had no idea what they were buying and selling. So let’s start there...

CLICK HERE TO READ THEWEB VERSION

American Consequences 19

How to Calculate the VIX We’ll keep the math to a minimum here, but it’s important for basic analytical purposes to know the VIX is a square root. It’s the square root of the combined weighted averages of 150 to 200 near-term options and far-term options that will expire in more than 23 days and less than 37 days. (The CBOE updates the VIX options basket every minute.) Those two components are added together, then the square root is calculated and multiplied by 100 to attain the annualized VIX number you see quoted every day. Though this number is an annualized percentage, it’s traditionally published without a % symbol. Say this calculation gives you a VIX of 20. That means the market expects the S&P 500 to move up or down at an annualized rate of 20% over the next 30 days. To partially avoid the complex math involved in the VIX, you can use the trader’s “rule of 16” – in which you divide the VIX by the square root of 252, the number of trading days in a year. That’s approximately 16. And you also need to understand the VIX is stated at a 68% probability. (For math geeks, the VIX is assumed accurate to one standard deviation. For the rest of us, that just means that it’s assumed there’s a 68% chance the amount of implied future volatility expressed will occur.) So going back to our example... At 20, the VIX says there’s a 68% chance (one standard deviation) the S&P 500 will rise or fall by 1.25% (20 divided by 16) tomorrow .

The VIX is the result of a mathematical calculation designed to reflect the future volatility of the S&P 500 Index. Volatility is the size of price swings. Big price swings equal high volatility. Small price swings equal low volatility. The VIX is called the “fear gauge” because it moves up a lot only when the S&P 500 moves down. Most equity investors don’t normally own put options or sell short stocks (two ways to bet on lower stock prices). They’re totally exposed to the downside with no protection. So when stock prices drop, they get scared, rush into the market, and buy put options to protect against further losses. That quickly shoves put-option prices higher, causing the VIX to move up sharply. That’s why the VIX works so well as a fear gauge, rather than a way to measure the size of market moves regardless of direction. The volatility index tied to oil, for example, behaves differently because a falling oil price isn’t bad for everyone in the market. It’s bad for oil companies; it’s great for airlines. So a falling oil price doesn’t mean everybody starts selling oil. Some people buy more when it gets cheaper. It’s only in a market like equities (where few participants benefit from lower prices) that a volatility index works well as a fear gauge. According to the CBOE, the VIX moves opposite the S&P 500 about 80% of the time. So you’ll occasionally see the VIX moving in the same direction as stock prices during small moves. But statistically speaking, a bet the S&P 500 will drop a lot is a bet the VIX will rise a lot .

20 April 2018

WHY THE VOLATILITY GAUGE IS ITSELF VOLATILE... As you can see from the below chart, the VIX itself is fairly volatile... Even in the relative lulls of the 1990s, early 2000s, and since about 2013, it was normal for the VIX to spike upward frequently as the fearmongering headline of the moment easily influenced jittery investors. Perhaps the most salient feature of the VIX’s historical chart is not the spikes, but its long- term sideways motion. It seems to spend most of its time between 10 and 20. This too suggests that being a VIX contrarian can yield large profits – buying when it’s down around 10 and shorting any big upward spikes above 20. Lately, it seems the vast herd is convinced equity prices won’t fluctuate much in the future... though the recent huge upward spike could be the rude awakening they’ve failed to anticipate – signaling a period of greater volatility to come.

Is it unreasonable to expect the VIX to settle in at some lower level, at least for the next few years? Not at all. Is it unreasonable to expect more huge spikes like today in the next few years or even a generally higher level of volatility? Not at all. So while I’m not interested in trying to predict the VIX or any other market... the behavioral advantage tells me to do the opposite of the vast herd. Now is the time to construct an investment portfolio so well balanced, it can withstand or even benefit from higher volatility ahead. WHAT THE HERD IS DOING, ANDWHAT YOU SHOULD DO INSTEAD Before February 5, the herd wanted to be short volatility. That means it expected fear to decrease or at least remain low and the S&P 500 to climb.

Over the long term, the VIX is virtually guaranteed to find new highs, new lows, and new periods of extended stays at some particular value – just as you’ll eventually see longer streaks of heads and tails the longer you flip a coin. We can’t know

VOLATILITY INDEX (1990-2018)

when those extreme values and extended lulls will happen.

American Consequences 21

The herd looks in the rearview mirror and sees calm in the immediate past. And, indulging its recency bias, the herd expects more of the same. But shorting volatility as a strategy is a lot like picking up nickels in front of a steamroller. You make a little bit of money... until you get crushed. And the herd’s belief is that “the trend is its friend.” They feel good. After all, they had been right about low volatility since the “Brexit” spike in late June, and generally right about volatility since about 2012. So they stuck with the short trade... Until, that is, they wound up like the proverbial turkey who sees the farmer as a benefactor, providing him with ample food, water, and shelter in a peaceful, pastoral setting – until Thanksgiving comes around and the turkey is, as it were... ruined. Only highly experienced traders have any business messing with the VIX. At best, a VIX bet is a hedge. At worst, it’s a gamble. So before you click “buy” or “sell” on a VIX trade, you’ll want to think about where it is today versus where it has been and where it might be headed in the future... And as I said earlier, February 5 marked a day of massive losses for many “volatility investors.” Take the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), for instance – the short VIX exchange-traded note (ETN). XIV closed at $99 on Monday, February 5... but

crashed more than 80% in after-hours trading. It closed at $7.35 the next day, a 93% drop. Products like XIV have a provision that if they fall more than 80% in one day, they have to liquidate. Credit Suisse, the company that issued the product, knew the worst possible outcome was probable. It included the following language in the June 2017 XIV prospectus, which it bolded and underlined so nobody would miss it... The long-term expected value of your ETNs is zero. If you hold your ETNs as a long-term investment, it is likely that you will lose all or a substantial portion of your investment. There are 64 occurrences of the word “zero” in the XIV prospectus, each one making clear this type of product can go bust. You had to be illiterate or financially suicidal to own XIV . Not to mention, ETNs like this are essentially a scheme big banks run to borrow money they’ll never have to repay... XIV is a debt instrument. When you buy it, you’re lending Credit Suisse money. You’re agreeing that you’ll never get an interest payment and that your principal will likely go to zero. Most retail investors don’t read prospectuses. They didn’t know XIV could go to zero. And they got into it with everything they had... At least one person on social media site Reddit’s “Trade XIV” group managed other people’s money and apparently had a lot of it in XIV. He posted the following... I’ve lost $4 million, 3 years’ worth of work, and other people’s money. Should I kill myself?

22 April 2018

I started with 50k from my time in the army and a small inheritance, grew it to 4 mill in 3 years of which 1.5 mill was capital I raised from investors who believed in me... The amount of money I was making was ridiculous... Was planning to get a nice apartment and car or take my parents on holiday, but now that’s all gone. What’s worse is that this won’t be the last time that volatility investors get crushed. Higher volatility lies ahead. And even those who didn’t get crushed this year aren’t out of the woods. The VIX can and will go much lower and much higher. It’s just a matter of when. When it goes much higher than it ever has, the VIX shorts will get crushed – again. HIGHER VOLATILITY AHEAD Long-duration assets like stocks and long- term bonds are still way overvalued. The longest-term cash flows in any reasonable valuation model for those assets have the lowest value because time adds risk. You can’t predict the future. So you can’t predict you’ll Dan Ferris is the editor of Extreme Value, a monthly investment advisory that focuses on some of the safest and yet most profitable stocks in the market: great businesses trading at steep discounts... His strategy of finding safe, cheap, and profitable stocks has earned him a loyal following – as well as one of

receive that cash flow at all, let alone the amount you expect. Even with the most recent volatility, stocks are still within spitting distance of all-time high valuations. Those future cash flows are valued way too highly. That’s why you saw the huge volatility spike this February. And that’s why there are many more spikes to come over the next couple years. I continue to recommend three primary actions for you today. These guidelines should help you take advantage of higher volatility while muting its effects on your portfolio... First, hold plenty of cash . This is the easiest way to reduce risk of permanent loss and volatility in an equity portfolio. Having plenty of cash will let you take advantage of lower asset prices after volatility has done its damage. Second, sell short the stocks of weak businesses in weak industries . Third, buy only when you find a good business trading at a reasonable discount to intrinsic value . the most impressive track records in the industry. And his work has been covered extensively in Barron ’s and other respected news outlets. He recently recommended a stock that could make you 20 times your money over the long term, with minimal risk. To learn the details, click here.

American Consequences 23

INSIGHT FROM OUR CHIEF RISK OFFICER

A TOP CROWEIGHS IN ON VOLATILITY

24 April 2018

American Consequences 25 American Consequences

INSIGHT FROM CHIEF RISK OFFICER X

R e gulators, central banks, and politicians are all The reality is that this situation is far more complex. Yes, the change in the underlying structure of the financial markets has materially increased short-term volatility. But it’s the systemically risky actions of central banks and politicians that have created an environment with the potential for long-lasting reductions in value for virtually all asset classes. And it’s that environment and the very real fear of adverse outcomes that’s driving heightened volatility in markets. shocked!! by the volatility that we have seen recently in the markets. And they’re searching for big, bad, nasty financial-institution culprits who must be making themselves rich by creating instruments that have taken advantage of retail investors and magnified liquidity.

Let’s start our analysis of heightened volatility with the implications of current policy and then examine the subtler implications of the evolution of the structure of markets.

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26 April 2018

is currently running at an annual rate of more than 4,000%. Argentina and Brazil – two countries that should be much richer than they are – have both suffered multiple episodes of hyperinflation. In Germany, during the Weimar Republic, such inflation had catastrophic effects not only on asset valuations but on societal structures and political systems. Investors feel this fear of inflation acutely and as a result many have become central- bank watchers. The analysis of an individual company’s relative performance matters less for its valuation than the implications of heightened interest rates on that valuation. Investors are truly in a damned-if-they-do and damned-if-they-don’t world. Betting against the central banks’ ability to print money continuously without reducing its value has been a fool’s errand for 30 years. And those who made that bet are now no longer managing money. At the forefront of investors’ minds is the very real fear that at some point the 30- year lowering of rates must end. Then the effects of central bank market participation will create a rapid change in the supply and demand equation for government debt and drive rates higher and asset values lower. Investors hold stocks and bonds but are ready to react at the first whiff of a back- up in rates. This is a recipe for heightened volatility that will, absent a severe market correction, continue unabated.

Irresponsible Central Banks and Complicit Politicians Central banks keeping interest rates at historic lows for prolonged periods of time to avoid recessions and create growth seems like a great idea... unless it comes at the cost of unprecedented market participation by those banks. In Japan, almost all of the new government debt is purchased by the Bank of Japan and held on its balance sheet. While this is quantitative easing taken to the extreme, similar (although less all-encompassing) constructs have been at work with European central banks and the Fed, with quantitative easing broadened to include purchases of other asset classes such as mortgages, corporate debt, and even equities. The danger of this is that we have created a system of distorted values across virtually all asset classes. Very low interest rates change expectations of return and drive valuations higher. Discounting cash flows at 3% instead of 6% doubles the valuation. Why is this a problem? Because the activities of the central banks are sustainable only if we live in a world where their ability to print currency is infinite – and without a change in the currency’s value . Indeed, this has seemed to be the case over the last 30 years in developed countries. And many economists will try to convince you that it can continue indefinitely. It cannot. There are many, many frightening cases of this story not ending well. Inflation in that economic-disaster zone, Venezuela,

The danger of this is that we have created a system of distorted values across

virtually all asset

classes. Very low interest rates change expectations

of return and drive valuations higher.

American Consequences 27

The Evolution of Volatility Well into the late 1980s, there were INSIGHT FROM CHIEF RISK OFFICER X

Consider broad-base challenges today. Everyone can get in or out of markets in a heartbeat. Also, the instruments available have changed... You can buy and sell the index... futures on the index... in a nanosecond... You get the idea. In 1929, if you wanted to lever a stock you had to borrow the money to do so. Of course, in those days there was virtually no constraint on how much money you could borrow. Today, you can only borrow 50% of a stock’s value, but the margin process remains every bit as volatile. As stocks fall, you must instantaneously post collateral. Pooled investments in “40 Act” funds routinely carry leverage through the so-called “130/30 Strategy” of using proceeds from short sales to go long on stocks that are supposed to outperform the market. Why is leverage a problem? Because it creates irreversible trends when prices start to fall. As the market declines, people are forced to sell to cover collateral calls. One type of forced selling begets other types... sales by individual investors who put in stop-loss provisions to sell an asset when its value falls 10 or 20 percent. Another type is sales by volatility funds controlled by the idea that when the VIX climbs above a certain level, you sell. Or sales resulting from the algorithm that tracks 200-day moving averages, or from any of the other “technicals” that supposedly indicate when to buy or sell. Plus, you’ll have sales from programmatic trades that follow valuation metrics. And so on... Nearly every wholesale market participant has some version of an “automatically triggered

significant frictional costs in trading stocks and bonds. The costs came both in dollar terms and in terms of the technology used. Back then a certificate would have to be found, notated, and delivered to the window at the exchange, then traded, then reissued – pretty painful stuff. Today all that happens in the blink of an eye with frictional costs in time, money, and effort so small that I would almost say we are frictionless. Many brokers offer free trades on the retail side, and on the wholesale side very large blocks trade today for very low cost. And on the physical side... The physical side no longer exists! Delivery and notation of certificates has been replaced by electrons flying

through space with instantaneous outcomes, and by assets moving Harry Potter-style through the air from one account to another. Shorting stocks has become far easier, with many instruments available so that one can synthetically reproduce the outcome. News cycles have gone from

lengthy to instantaneous, and the proliferation of market “news” programs has made everyone aware of what is happening at all times.

28 April 2018

to exacerbate short-term market volatility, the chances of these changes leading to lower valuations through time are very low. In fact, it is far easier to make the argument that valuations will be higher due to the democratization of markets and the confidence given to investors by their ability to manage downside risk. The bad news is that it is hard to see an end to the heightened volatility brought on by central bank and policy actions over the last 30 years. And, what’s worse, those actions have the very real potential to convert heightened short-term volatility into a very long period of reduced valuations which will have real consequences for the economy.

sell.” And also, of course, an “automatically triggered buy.” Leverage pulls one trigger. Then an algorithm pulls the other. Volatility comes at a machinegun rate. Yet it is important to remember what drove these changes and who has benefited. The drive to reduce the frictional costs in trading and execution has ultimately benefited the retail investor. NYSE specialist firms and floor brokers with seats on the exchange have become largely irrelevant to the market and wholly irrelevant to the economy. Large broker-dealer firms have watched the bid- ask spreads shrink to where it is almost impossible to make a living in the execution business. The beneficiaries of this are, in the end, investors. Digitalization of order flow and stop- loss orders have, again, reduced the cost for investors while creating dynamic risk protection schemes as markets decline. Algorithm and volatility fund investment schemes are another means for end investors to participate in markets while managing the risk of a potential decline. So, while frictionless market participation, undoubtedly increased short-term volatility, they have also made markets more democratic and safer. Yes, the chances for short-term market dislocations have increased, but the ability for markets to repair themselves has expanded. The good news is that while the changes in market structure have and will continue digitalization, and the proliferation of downside protection schemes have

James Stevenson / The New Yorker Collection/The Cartoon Bank

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