Why the market is so volatile right now

Key Points
  • The sell-off continued Tuesday, with market participants concerned about a number of factors both technical and fundamental.
  • A highly successful trade against market volatility unwound Monday when the Vix "fear index" spiked and two products that bet against tumbled.
  • Most market strategists believe the current dip should be bought.
5 strategies you should use to protect your portfolio
5 strategies you should use to protect your portfolio

When it comes to the recent market tumble, causes range from the usual suspects to the unusual suspects, and it looks like the latter are causing the most damage now in part because they're harder to pinpoint.

The usual suspects, of course, are worries about rising interest rates, elevated valuations and political uncertainty in Washington, all of which can be expected to give investors the jitters and turn a routine drop into a mad dash for the doors.

But over the past several days, the unusual suspects have been playing a big role. They are focused mostly on market structure and the arcane world of securities that actually trade, not on the fundamentals themselves but rather the market's reaction to them.

The world of volatility

These are the volatility-related funds and notes that have populated the world of exchange-traded products. They move up and down often in reverse with the market.

The most well-known is the VIX — the Cboe Volatility Index that is pegged to S&P 500 options, a product also known as the "fear gauge." Over the years, VIX trading has gotten so popular that it's spawned a whole line of other products that trade on movements of the VIX itself.

Two of these took focus Monday during a wacky day that saw the Dow industrials tumble nearly 1,600 points late in the session before finishing down 1,175 for the day. These are the
VelocityShares Daily Inverse VIX Short-Term exchange-traded note and the ProShares Short VIX Short-Term Futures exchange-traded fund.

Traders work on the floor of the New York Stock Exchange (NYSE) on February 5, 2018 in New York City.
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Without getting into all the ins and outs of how these two work, suffice to know that when the VIX rises, these products fall and vice versa. Collectively, this group is known as "short-vol" funds, which means that they are betting against market volatility and on the calm that has pervaded over the past year or so. They've been hugely profitable, collectively returning 180 percent in 2017, but fell apart Monday when the VIX spiked.

Nick Colas, co-founder of DataTrek Research and an expert on exchange-traded products, provided this explanation of the day's action in his daily report Tuesday:

"• After the close ... (XIV and SVXY) gapped down 80% from their 4 pm closing price on heavy volume. ... The returns are supposed to be 1:1 for those moves. If the VIX rises 5% from open to close, these products should decline 5%.
• The CBOE VIX Index opened [Monday] at 19 and closed at 37, a 95% move. You can see the problem here: a 1:1 relationship between the asset values for XIV and SVXY versus the underlying VIX index doesn't leave much value for tomorrow.
• As of Friday morning, these two funds had combined assets under management of $3.2 billion. They were also among the most heavily traded symbols at Fidelity's retail website [Monday], with Buys outnumbering Sells by over 2 to 1. In addition, over the last year they were popular with hedge funds as an easy way to short volatility. Their returns in 2017 were +180%. No, that's not a typo.
The upshot: this development could well be why the VIX doubled [Monday] and equities took it on the chin. In a market already up to its eyeballs with fundamental questions of valuation and interest rate uncertainty, seeing $3 billion of value evaporate is no one's idea of a good thing. Who owns these assets today? How will volatility trade tomorrow on any unwind? What other volatility products are at risk?"

These are important questions to ask. Peter Boockvar, chief investment officer at Bleakley Advisory Group, declared Tuesday morning that Monday "was the day the short volatility trade died."

One more unusual suspect: the specter of another "flash crash" that sent the Dow spiraling after 2:40 or so Monday. While trading floors pretty much everywhere said there was no indication of a "fat finger" trade or another market malfunction, the rapid fall, in which the blue-chip index was losing hundreds of points in seconds, brought back memories of the first full-blown flash crash.

From Greg Valliere, chief global strategist at Horizon Investments:

"We've talked with technical experts who believe much of yesterday's move was 'forced selling,' dictated by electronic risk management models; it was not about inflation fears or the Fed, which were factors last Friday. The panicky selling yesterday sent S&P bid/offer spreads as wide as $50 (typically they are $1 or less), and there were times when prices simply weren't quoted, a phenomenon not seen since the 'Flash Crash' on May 6, 2010."

Now, onto the usual suspects.

'Disconnected from fundamentals'

While worries about rising rates and a tightening Fed are very real, they come at a time when the economy is moving along at a nice clip, earnings are nothing short of superb and Washington, for all its political chaos, remains firmly pro-business.

Still, one of the oldest market truisms is that buying begets buying and selling begets selling. So when the doors are suddenly flung open on a market that has been on such a breathtaking tear higher, it's only natural that many participants will follow the crowd outside looking to get a breath of fresh air.

Dubravko Lakos-Bujas, head of U.S. equity strategy at J.P. Morgan Chase, took note of both the usual and unusual suspects, and noted how the current market action suggests that market psychology rather than the usual sell-off suspects is taking hold:

"We see the market selloff entirely disconnected from fundamentals. While the sharp rise in volatility may contribute to further outflows from systematic strategies in the short-term, we believe fundamentals should ultimately prevail as companies continue to deliver double-digit earnings growth on US tax catalyst, global synchronized growth, and weaker [dollar]. Also, we expect a ramp-up in shareholder return to provide support for equity prices."

Indeed, Lakos-Bujas is just one of multiple Wall Street strategists telling clients that this dip is very buyable as valuations suddenly have gotten at least closer to historical norms and the rest of the backdrop remains supportive.

Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, pointed out that in the post-financial crisis era, big market dips have almost always served as solid opportunities to put together a list and go shopping.

She noted that a "pullback may have been overdue" because "nervousness had been building for the past few weeks."

"While the sharp decline in the on Monday was unnerving, it is important to keep in mind that these kinds of moves have tended to be buying opportunities in the post Financial Crisis era. By our count, the S&P 500 has experienced one-day drops of 3% or more 15 times since 2010. These drops have often occurred in the context of choppy equity market conditions in the short term. But six months later, the index has been meaningfully higher the vast majority of the time, with a median gain of 12%."

Still high on the list of the usual suspects, however, is the Fed.

The central bank is watching inflation developments closely. Investors worry that if wage pressures heat up and prices follow, that would push the Fed into tightening policy and choke off the main market story of the past nine years, namely cheap money and easy financial conditions that have allowed the massive market run-up.

The Fed ended its money-printing programs in 2014 and last October started gradually shrinking its balance sheet. Yet for all the talk of tightening, the $4.2 trillion portion of the Fed's bond portfolio that consists of Treasurys and mortgage-backed securities has declined just $15.6 billion since October.

Boockvar, though, said the Fed's "credibility as perpetual bubble blowers is now about to be tested again."

WATCH: Despite the big drop, no evidence of panic selling.

Pro says market sell-off was 'rational event.' Here's why
Pro says market sell-off was 'rational event.' Here's why