Jim Cramer is confident that he's pinpointed the real cause of the market-wide sell-off that has weighed on stocks for much of the week.
The pain dragged the Dow Jones industrial average down more than 1,000 points on Thursday, with the index closing near correction levels, down 1,032.89 points.
"The real culprit behind today's decline is the same miscreant that's weighed us down for the last couple of days: the unspooling of these obscure products that allowed ... idiotic money managers and neophyte investors to bet against what's known as volatility," the "Mad Money" host said.
Volatility, most commonly tracked by the CBOE Volatility Index, or VIX, refers to the amount of uncertainty in the size and direction of changes in the stock market. It is typically measured by the deviation of returns.
In 2017, a record year for the stock market, the bet against volatility served investors well. Shorting the placid VIX through levered trading instruments like the XIV, the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, was a lucrative way to play the low-risk environment.
But now, with volatility spiking, trading products like the XIV are coming back to bite.
Worse, Cramer figured that most of those owners bet against the VIX with borrowed money, meaning they would have to sell S&P 500 futures to raise cash and cover their losses.
To his surprise, the "Mad Money" host found 17 different trading products like the XIV that allow people to make leveraged bets against volatility.
"Now they're all imploding," he said. "I swear, some of these dopes never learn. The current situation is like a similar version of what happened in 2008 after hedge funds levered up — borrowed money — to bet on mortgage-backed bonds."
Very few stocks can withstand hedge-fun-led pain like this, Cramer warned. Big dividends don't help because the market is declining all at once, valuation is no defense because stocks can always go lower and stock buybacks only help "sop up" the shares being sold, he said.
The only stocks that really work are ones that are able to deliver drastic surprises to the upside, like Twitter after its Wednesday earnings report or GrubHub and Nvidia after their Thursday reports.
"Here's the bottom line: we've seen this movie in bear markets before. When the market breaks down like this, the culprit is forced selling. ... This time, it's caused by the breakdown of these leveraged bets against volatility, and it won't stop until the bets are unwound," Cramer said.
"We don't know when things will get placid again, but until these traders get wiped out, finding winning stocks will be like finding a needle in a haystack. That's why I say you want to identify high-quality companies and use the weakness to scale into them gradually on the way down, betting that the VIX madness will end at some point. But the key is that you need to leave room to buy more at lower levels ... because where this thing stops, nobody knows, although if you stick with me and this show, I'll give you the best clues I know at least to try to find out."
Source: Bloomberg Pro Terminal
Jr Trader Alexander Kumanov
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