Opinion: This is what happens when Skynet from 'Terminator' takes over the stock market – MarketWatch

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A massive amount of automated trading helped cause last week’s turmoil in the U.S. stock market.

It reminded me of Skynet. Remember Skynet?

“Skynet is a fictional … artificial general intelligence system that features centrally in the ‘Terminator’ [movie] franchise. Skynet gained self-awareness after it had spread into millions of computer servers all across the world; realizing the extent of its abilities, its creators tried to deactivate it. — Wikipedia

Please see item No. 2, below, for an explanation of how computers are causing volatility in the stock market.

But, first, the Federal Reserve. When the Fed provided quantitative easing (QE) through bond purchases, it dominated the Treasury auctions and suppressed long-term interest rates as well as bond and stock market volatility. When the Fed began to reverse QE and started quantitative tightening (QT), it began to reverse its short volatility position in the bond market (see chart), which also affects stock market volatility. Discussing this scenario in my Jan. 11 column, I ended by asking what readers thought would happen to bond and stock volatility under this scenario.

This was not a prediction of the fastest explosion in stock market volatility in history, but I am not surprised by the developments over the past week. But it is overly simplistic to think that there is one root cause for this mess. Here are three reasons that come to mind.

1. Record inflows into stocks in January

January is typically a strong month over longer periods of time because of the tendency for a lot of pension funds and other institutional money to enter the market. This year was no different, as equity funds have enjoyed their biggest monthly inflows on record, attracting about $102.6 billion in January, according to EPFR. January’s total came in well above the previous record haul of $77 billion in January 2013. This gush of money caused the stock market to post its best January returns since 1987.

When so much money entered the stock market, it is not surprising that it became the “most overbought” market on record, as defined by more than one popular technical indicator. The trouble is the inflow rate slowed in February, creating an air pocket under the market. It is no surprise that February is an exceptionally weak month if one looks at historical data over longer periods of time, like 50 years. This year February has been much weaker — and it is far from over yet — because the air pocket under the market was much bigger, courtesy of the record inflows into stocks in January.

2. Computers and leverage

Those worried that Skynet (of Terminator series fame) has conquered financial markets are urged to read “Flash Boys” by Michael Lewis, who describes the proliferation of high-frequency trading. I believe the speed of the decline over the past week was driven by computers trading with other computers on high amounts of leverage. High frequency trading (HFT) routinely surpasses 50% of volume on most stock exchanges, and it may have made up more than 50% of volume last week. Early warnings of problems HFT proliferation have been consistently given by ZeroHedge.

The 1987 crash in the stock market was blamed on “portfolio insurance,” a form of computerized trading in which the lower the stock market went, the more the computer programs sold into the move lower, which created a quick avalanche effect. Some of last week’s moves felt like small avalanches.

3. The effect of (short) volatility ETFs

The exchange traded product (ETP) space is over $3 trillion. As that space has grown, so has the use of computerized trading that helps manage ETP securities. Much of the blame over the past week has been put on short volatility ETFs, which among other things take short positions in front-month Cboe Volatility Index VIX, -22.71%  futures.

Also see: XIV trader: ‘I’ve lost $4 million, 3 years of work and other people’s money’

The explosion of stock market volatility causes those ETPs to reverse their short VIX futures positions, causing a record surge in VIX futures buy orders after-hours, when such ETPs typically square their positions. On the day the Dow Jones Industrial Average DJIA, +1.04%  declined 1,175 points, a surge in VIX futures buy orders created a surge in S&P futures sell orders as they are inversely correlated. Because of the record buying of VIX futures, their prices rose quickly after-hours, which caused many ETPs whose portfolios are short VIX futures to suffer record 80% declines after-hours, in effect blowing up their portfolios (see chart).

While most of the assets in short-volatility ETFs have already been liquidated over the past week, there are still over $3 trillion in assets in all ETPs, so I am sorry to say that Skynet is still lurking in the stock market. It looks to me like the regulators allowed a monster to grow in the face of the ETP industry and they will have a very difficult time reining it in. Some of our own research on the ETP boom was presented in MarketWatch in 2015.

While this latest avalanche effect may have been triggered by the air pocket of inflows in stocks in February catalyzed by spiking long-term interest rates and imploding short-volatility ETPs, there is likely to be more volatility for the rest of 2018. The Fed is slated to keep reversing its own “short volatility” position in the bond market by intensifying QT operations, so the roller coaster we experienced in January and February may repeat — more than once.

Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates.