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2 Words Of Caution For The VelocityShares Daily Inverse VIX Short-Term ETN

There are some articles on SA which have recommended purchasing the XIV, based on its pronounced outperformance of the market. However, investors who are tempted to initiate a position in this ETF should be very well aware of its extremely high risk. XIV can go to zero on a single day. It lost 71% in the summer of 2011, while the market lost 16%. There are some articles on SA which have recommended purchasing the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). These articles emphasize the exceptional returns of this ETF since its introduction 5 years ago, as well as its pronounced outperformance of the S&P (288% vs. 78%). However, investors who are tempted to initiate a position in this ETF should be very well aware of its extremely high risk. Therefore, I consider it irresponsible of those who recommend it without mentioning its risk. First of all, XIV aims to replicate, net of expenses, the inverse of the daily performance of the S&P 500 VIX Short-Term Futures index. Therefore, XIV exhibits great performance when the market rises and volatility is low. Even better, when the market is in a calm status, the VIX futures exhibit a marked contango structure (the prompt futures are much cheaper than the distant futures) and hence XIV gains about 5% per month only from rolling its futures (buying back the ones that are about to expire and selling those of the next month). This is the strength of XIV; even if volatility is flat, XIV gains about 5% per month thanks to the contango structure, which is an exceptional return. Unfortunately, reality is not so simple. To be sure, there have been periods in which the market has remained fairly flat, along with the volatility index, but XIV has not made a profit. For instance, last summer the market remained flat from July to September but XIV lost about 5% during that period. This weakness comes from the fact that XIV buys additional VIX futures when they increase in value and sells more VIX futures when they decrease in value. This inefficient operation of buying high and selling low is dictated by the primary goal of the ETF, which is to replicate the inverse of VIX on a daily basis. To make a long story short, XIV has to buy high and sell low on a daily basis just to accomplish its official goal and this handicap can fully or partly offset its profit from contango, depending on the magnitude of the daily moves of VIX. While this is an important handicap that has not been mentioned in any article, the main weakness of XIV is its extremely high risk. More specifically, when the market experiences a significant correction, XIV collapses. For instance, while the S&P lost 16% in the summer of 2011, XIV lost 71% during that period, plunging from 19 to 5.5. This is an extreme loss, particularly given that it resulted from a normal market correction of just 16%. It would be interesting to check the performance of XIV during the bear market of 2008 or the flash crash but unfortunately (?) the ETF was introduced only in late 2010. Nevertheless, as a 16% market correction led to a 71% dive of XIV, it is reasonable to assume that the bear market of 2008, with a total loss of about 55%, would have destroyed XIV. Indeed the issuer of XIV explicitly warns investors that the ETF can go to zero on a single day (!) with extreme volatility. Therefore, the ETF holders should not use it as a long-term part of their portfolio but only as a hedging instrument on a small scale. To sum up, XIV greatly profits from the contango structure of VIX futures, particularly in a strong bull market like the ongoing bull market of the last 6 years. However, the ETF is obliged to buy high and sell low only to accomplish its stated goal of replicating the inverse of VIX. Even worse, the ETF will be completely devastated on a single day with extreme volatility or during a strong bear market. Therefore, investors should weigh the risk/reward ratio before initiating a position in this ETF. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Patience And Liquidity

The continued drop in commodity prices raised fears in the financial markets that global growth was slowing to a crawl. The result? Bond prices rose while stock prices fell. It is clear that there is overproduction relative to demand in most commodities. This is highlighted by energy. Prices continued to decline last week. Each commodity has its own dynamic but in virtually all cases production is increasing year over year at a rate surpassing demand growth. The key takeaway is demand and production are increasing. Major producers are finally cutting back production to levels equal to or beneath demand growth so that inventory levels stabilize or actually decline, which is a prerequisite for pricing power moving forward. It will take time and patience. Unfortunately there is a lot of speculation in the commodity markets and continued weakness in prices initially led to margin calls and now outright liquidation. Markets typically move too far each way. Fear of a further collapse in the commodity markets has spilled over into other financial markets creating opportunities for investors who have been patient and maintained their liquidity. I have stated that lack of or no growth was my biggest fear. But let’s put all of this in perspective: the U.S. economy is improving led by the consumer; China reported 7.0% growth last quarter and its stock market has rebounded of late; Greece is settled, at least for now, lifting a big cloud over Europe which will lead to renewed growth; Japan is doing fine led by exports; India is continuing to accelerate and will grow over 7% this year however many third world countries are suffering. The world is growing over 3.0% this year which may be less than in the past. Global growth should improve in 2016, too. Don’t forget that the drop in oil prices recently from $60 dollars per barrel to around $48 per barrel will boost consumer disposable income around the world and lower inflationary expectations boosting bond prices from what they otherwise would be at this point in the economic cycle. Beside the consumer, the drop in energy and other commodity prices are good for corporate margins in the aggregate but of course not for the commodity producers themselves. By the way, we added to our energy shorts after it appeared that a deal would be reached with Iran, which we discussed in previous pieces. It was an easy call. Over 70% of companies reporting so far have exceeded their forecasts for the second quarter and maintained or raised numbers for the year. Not too bad. Rather than reviewing events by region as we have done in the past, I’d like to review my core beliefs and see if there are any changes that may influence my investment policy: Monetary policy remains easy virtually everywhere and the supply of funds is exceeding the demand for funds, which is favorable for financial assets. It is clear that the Fed is on hold until year-end or early 2016 at the earliest removing an immediate concern in the marketplace. The dollar has remained the currency of choice, which may impede U.S. economic growth but also lowers inflationary expectations. Positive capital flows from abroad continue to reduce our interest rates from what otherwise they would be. The yield curve will steepen but the degree may be less than initially thought due to the sharp drop in commodities, weakness overseas and strength in the dollar reducing inflationary expectations further. A new conservatism permeates governments, corporations and individuals is clearly true. Just look at new Fed rules for the banks and at corporate cash flow reported for the second quarter so far. Hillary Clinton’s tax proposals are not good for the economy, capital formation and investment but may improve the Republican’s chances in the next Presidential election. Profits will surprise on the upside clearly occurred with second quarter results reported so far. Financial leverage and capital ratios will continue to improve. Clearly this is the case as most corporations are capping capital spending at depreciation therefore generating a lot of free cash. Banks continue to raise capital ratios and reduce leverage and risk. M & A activity will remain strong. Just look in the newspapers every day to see deals of all sizes. Both the acquirer and the acquired company’s stocks rise, as most deals are anti-dilutive day one. Commodity prices continued to decline as producers remained slow to cut back production at levels to or beneath demand growth so inventories continued to rise and prices fell. But lower commodity prices are good for inflation, interest rates and profit margins. Not for commodity companies though. Corporate managements are acting as their own activists recognizing that change is a necessity to survive and thrive in a globally competitive landscape. A Greek default was contained although I doubt that Greece can live up to the terms of its new deal with the ECB. The can was kicked down the road. I still doubt that the Fed can begin raising rates until 2016 and overall policy will remain easy. Future rate hikes will be small and spread out unless there are major changes in the outlook for the U.S and global economies. The economic cycle will be extended with lower highs and higher lows. Still valid. There are few, if any, excesses. Speculation exists today in real estate, private equity and art. Still valid. My beliefs remain for the most part intact. I continue to be pleasantly surprised by how managements are adapting to this global competitive environment. Management is everything to me. There is a reason why Alcoa, Dow Chemical, GE, Honeywell, Nucor, JP Morgan Chase, Wells Fargo are best in class. Then take a look at Facebook, Google, Apple, Starbucks, Visa to name some more. I am long 25 of the best managements in the world who have winning long-term strategies regardless of the economic environment. And that is the key to be a successful investor. Be patient and maintain ample liquidity at all times to take advantage of market moves like last week. While change is in the air it does not happen overnight. Follow your beliefs and challenge them at all times. Invest in stocks, not markets. Invest accordingly! Share this article with a colleague

Frustrated Yet?

The last year has been a tough one for investors. There are a few places one could have booked a double-digit gain in the last 12 months but not many and certainly not in assets that are in the standard portfolio. Currency hedged ETFs for European and Japanese stocks produced big gains, but a lot of the gain was from nothing but currency movements. And most investors shouldn’t be trying to make their yearly return punting on currencies. Stocks for the most part have been disappointing with Nasdaq as a notable exception. Notable because a lot of the action there is reminiscent of the last time that index was leading the market back in 1999/2000. The recent big moves in Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), Netflix (NASDAQ: NFLX ) and Amazon (NASDAQ: AMZN ) – based on not much – provided a eerie sense of deja vu for anyone who lived through that giddy time. The S&P 500 over the last six months is barely positive, up about 2% (or it is as I write this Friday afternoon; but if things keep going in the current direction, that could be a lot closer to 0 by the close). The average doesn’t do justice to what is really going on though. Only about half the stocks in the S&P 500 are trading above their 200-day moving average right now. Even for an index like the Nasdaq that has performed pretty well this year, less than half the stocks in the index are still in uptrends, trading above their 200-day MA. These are capitalization weighted indexes and at least right now, size does seem to matter. A similar message is sent by the advance/decline stats which show the decliners winning by a pretty wide margin. New highs/new lows also looks less than healthy with new highs increasingly scarce. So the internals of the stock market are deteriorating notably, something that doesn’t generally bode well for the immediate future for stock prices. There are other signs of stress as well. Junk bonds essentially peaked almost a year ago in price and have been trading sideways with a downward bias which has recently accelerated. With Treasuries generally well bid all week, the spread between junk and Treasury yields widened on the week, continuing the longer-term trend that started last summer and reversing the shorter-term narrowing trend that started at the beginning of this year. Credit spreads are highly correlated with the stock market, so ignore the junk market at your portfolio’s peril. Other signs of stress have emerged over the last couple of weeks. Commodities have resumed their downtrend and unlike some other recent periods, it isn’t just a function of a rising dollar. The dollar has been fairly steady but was down last week even as gold and other commodities plumbed new lows for the move. Oil is breaking toward its lows and that is undoubtedly the source of at least some of the selling in the junk bond market. The fracking companies are still struggling and lower prices aren’t going to help them make their interest payments now that their hedges are expiring. The Treasury market also is pointing to some stress with inflation and growth expectations both falling a bit recently. The frustration of the diversified investor actually goes back quite a bit further than the last 6 months or last year. If you have been following an investment plan that includes international stocks and bonds, a smattering of commodities and/or anything else that isn’t US stocks, your personal pain is now running into more like two years and maybe a bit more. I track a long list of passive portfolios and many of the globally diversified ones are working on their third consecutive year of low-to-mid single-digit returns – assuming this year turns out to have a positive number. It isn’t just the US stock indexes that have been narrowing; it is the entire investment universe. This winnowing of the investment universe to a few winners, turning diversification into a risk factor, is just one more example of the negative consequences of the modern form of economics in which common sense has been relegated to quaint notion and nonsense elevated to learned discourse. It is an Orwellian discipline where borrowing and spending have replaced thrift and investment as the drivers of economic growth, prudence is punished, speculation celebrated and rewarded. Is it any wonder that our economy continues to struggle when we’ve spent decades urging the population to be irresponsible, to ignore the future so that our present can be more comfortable? Monetary policy is a cudgel, a blunt tool used for more than a mere nudge, to make investors feel obliged to chase returns, to take excessive risks to achieve even their mundane goals. If you can’t achieve those goals with safe investments – and economic policy has made that nigh on impossible – you move out on the risk scale until you can because the alternative – spending less, saving more – has been deemed un-American, economically unpatriotic. The unspoken agreement – unspoken by the Fed certainly but widely accepted and believed – is that the monetary powers that be will maintain risky assets at the high prices that have, according to the Fed, produced or at least enhanced whatever meager recovery we’ve had since 2009. A permanently high plateau , if you will. The problem is that this unspoken agreement, this economic wink and a nod, has produced moral hazard on an epic scale. People do stupid things when they think their rewards are deserved and any losses will be absorbed or prevented by others. If you doubt that, just take a few moments to remember the structure of the mortgage system that produced the last crisis. It was a system where government policy didn’t just implicitly relieve lenders of the risks of their loans, they did it explicitly by either guaranteeing the loans or buying them outright. Now we apply that lesson to all investors, the Fed equally concerned about the stock index and the price index. It has “worked” so far in that risky asset prices are high but the economic payoff is less clear. It may be that the US and global economy is better off today than it would have been without the exertions of the world’s central bankers, but you’d be hard pressed to prove it. Considering the moral lessons being taught by these policies one can’t help but wonder if the gains are worth the potential losses. Markets, individuals, will eventually see through the Fed’s illusion of control and mark assets to a real market. The list of winning investments – risky investments – has been pared down to just a few over the last two years and the list gets shorter every day. Most recently the junk bond market has been quietly deleted or at least partially erased from the winners list. With oil prices falling again, the fracking companies bankers are balking of course, but it isn’t just energy companies that are being denied financing. Several deals have been canceled recently that had nothing to do with fracking. And it isn’t just junk bonds that are getting marked down; the high grade corporate bond ETF (NYSEARCA: LQD ) has actually performed worse than its junk bond cousin over the last six months. You certainly can’t call it a credit crunch yet but the new normal economy may not need a full blown crunch to fall into recession. It is a frustrating time for investors and one that is fraught with danger. The risk isn’t from without, from some unknown black swan, but rather from within, from ourselves, the self-inflicted financial wound caused by greed and the very American desire to win, to do better than the next guy. It is tempting to discard the investment methods that have withstood the test of time in favor of the fad of the moment, the church of what’s working now. But in every investment cycle there comes a time when winning is accomplished by not losing, by ignoring the sirens of risk and lashing oneself to the mast of safety. Now would seem a good time to at least find the rope.