"While options can give market participants the protection they are intended to provide, they can also increase the degree of a counter move, once it gets going, as those who wrote the protection scramble to unwind their own exposure."

-- Kass Diary 

A world without risk? Maybe to some, but hardly to me!

I started the day with an interesting take on positioning in VIX futures VIX.X and what it might portend in, "News Flash: The Possibility of a "Flash Crash" is Growing Exponentially."

Fastenal's (FAST) weaker-than-expected margins caused share price weakness -- but the stock rallied from the morning's lows. 

"Tell Me Something I Don't Know About Volatility"

Peter Boockvar had an interesting observation:

"Lastly, the 2s/10s spread is narrower by 2 bps today at a 2 week low at just under 83 bps. I do have to point out again this level vs where it was in December right after the excitement with the Trump victory. It was 136 bps. Any spread below 75 bps would be a 10-year low."

The market had a slight positive bias but was mostly range bound during the day.

I took on no trades today.

* The US dollar sold off after days of strength.

* The price of crude oil rose by +$0.38 to $51.30 a barrel.

* Gold rallied by a buck to $1,295.

* Ag commodities: wheat -2, corn -3.50, soybeans unchanged, and oats +2.75.

* Lumber +2.00.

* Bonds were flat on the day with the ten year US note yielding 2.345% -- after the Fed signaled a likely rate rise in December..

* High yield was weaker in price but municipals caught a bid.

* Banks, insurance and brokerages sold off modestly in front of earnings reports.

* Energy stocks rallied coincident with a small rise in the price of oil.

* Ag equipment was mixed, but Deere (DE) was on the downside after releasing dealer statistics.

* Retail rallied from a few days of weakness with WalMart (WMT) , Costco (COST) , Target (TGT) and Dillard's (DDS) leading to the upside.

* Old tech was down slightly.

* Media was mixed. Disney (DIS) may be rolling over, again.

* Consumer staples were down a bit.

* Pharma was mixed, save Johnson and Johnson (JNJ) (up smartly on an upgrade).

* Biotech lower -- Celgene  (CELG) , Allergan (AGN) and Gilead Sciences (GILD) off fractionally.

* (T)FAANG was higher with Alphabet (GOOGL) and Amazon (AMZN) (price upgrade from Street) standouts.

Here are some value added contributions on our site today:

1. Jim "El Capitan" Cramer on WalMart's rerating.

2. Robert "Boog" Powell on GE and its dividend.

3. "Meet' Brett Jensen on Flexion.

4. RevShark sits but doesn't think.

5. Bruce Kamich cautions on Netflix (NFLX) and Amazon (AMZN) .

Watching paint dry.
No trades all afternoon.

From Peter Boockvar:

10 yr auction better than 3 yr. What's message?

After the ordinary 3 yr note auction, the 10 yr auction was better. The yield of 2.346% was just about spot on with the when issued. The bid to cover of 2.54 was above the 12 month average of 2.42 and the percentage of direct and indirect bidders that took down the auction totaled 75%, above the one year of 69% and thus leaving dealers with the balance.

Bottom line, yields are little changed in response (vs where they were before the results but still down slightly on the day) as we await the minutes from the FOMC meeting at 2pm which I think will tell us nothing new. I think the real news the US Treasury market should be getting ready for is in two weeks when the ECB lays out its 2018 QE end game plan. This because of our close correlation between our market and in Europe. By announcing that NIRP won't end until 2019 will be the ECB's goal in keeping things calm while they end purchases. We'll see it that's like watching paint dry too. As for inflation expectations embedded in Treasuries, the 10 yr inflation breakeven is unchanged at the day but sits at 1.89%, the highest in 5 months.

Lastly, the 2s/10s spread is narrower by 2 bps today at a 2 week low at just under 83 bps. I do have to point out again this level vs where it was in December right after the excitement with the Trump victory. It was 136 bps. Any spread below 75 bps would be a 10 year low.

Regular readers of my diary know I sometimes post things that replicate the theme of the "Tell Me Something I Don't Know" segment on MSNBC's "Hardball With Chris Matthews."

So... "Tell me something I don't know, Dougie."

OK, here it goes:

Yesterday, in "Tell Me Something" and in my opening missive, I wrote about the lack of volatility.

Today, the Dow Jones Industrial Average has had a 26-point range -- the lowest daily range in eight months and among the lowest (percentage-wise) in history.

Thank you for the nice email responses to my opener, "News Flash: The Probability of a 'Flash Crash' is Growing Exponentially."

Distilling the lengthy post into a sentence:

While options can give market participants the protection they are intended to provide, they can also increase the degree of a counter move, once it gets going, as those who wrote the protection scramble to unwind their own exposure.

No trades today. I will be heading out to a lunch away from office in a few minutes.

Fastenal (FAST) , one of my longstanding investment shorts, reported in-line top and bottom lines.

The shares are lower by a beaner, probably caused by a 20-basis-point decline in gross profit margins.

The Lindsey Group's Peter Boockvar offers quick thoughts on the latest job openings data:

There were 6.08mm job openings in August, not far from the estimate of 6.125mm and down somewhat from 6.14mm in July. The internals though were mixed. Hiring's fell by 91k m/o/m (rate fell to 3.7% from 3.8%) but separations were down by 134k. Also of note, the number of quitters fell and the quit rate did as well to 2.1% from 2.2%.

Bottom line, the number of job openings in August is just off a record high and continues the trend of good demand for labor. We know though that there is a shrinking supply of willing and able bodied workers who fit the required qualifications and thus limits hiring's as well as firing's. This data of course is pre hurricane so will get distorted in September. Also, it's never market moving.

"We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.'

--Dr. Richard Thaler, Nobel Prize winner

In an interview with Bloomberg Tuesday, University of Chicago economics professor Richard Thaler went on to say in response to the market's low volatility and continued investor optimism, "It's certainly puzzling... and it's puzzles that attract my attention." He added that he is nervous, and when investors get nervous "they are prone to being spooked."

A World Without Risk?

These observations and, specifically, the quote I started with this morning are much like what I have been saying in my Diary -- namely, that never in history have there been so many potentially adverse political, geopolitical, economic and market outcomes.

I am not alone in this view, as Macquarie's Viktor Shvetz recently wrote:

"Investors are probably suffering extreme mental exhaustion. Historically low volatilities and risks, coinciding with high valuations, would make anyone nervous."

According to the brokerage, the reason for this underlying dysphoria is that "investors understand that there is nothing normal in the current environment of unprecedented financialization and economic disruption. The deadweight of US$400 trillion 'cloud' of financial instruments (backing into assets that are either worthless or are declining in value) must be supported by ongoing financialization."

In a world seemingly without risk and with spreads at all-time tights, Bank of America's David Woo writes in a similar vein that the market is more complacent than it was in the summer of 2007:

"This implies that liquidity must continue to grow, volatilities must be controlled and neither demand nor supply can yield higher cost of capital. Thus, risks facing investors are that either CBs and/or China misjudge extent to which reflation is dependent on inflating asset values and China's fixed investment.

If the market is underpricing the uncertainty with respect to the outlook of US monetary policy, we are even more concerned that it seems totally impervious to the risk of two potentially disruptive, if not dangerous, Games of Chicken likely to unfold in the summer and the beginning of the fall....

"We find it difficult to reconcile the record low volatility in financial markets at the moment with growing political risk in Washington and geopolitical risk in Asia. There are many reasons why we are living in a different world than the one we used to know and we would caution against relying too much on history for forecasting the likely outcome of these risks."

Yesterday I observed the volatility records being made recently:

"Month to date, the annualized realized volatility of the S&P Index is 5.2% -- that's the lowest vol in an October in over 90 years.

By means of perspective, the average October volatility since it has been recorded is 17.0%.

It is interesting that the four other low volatility Octobers all occurred in the 1960s -- a period that preceded a sharp acceleration in inflation and rise in interest rates over the next decade."

So, with volatility at record lows, the S&P 500 climbing to new heights and the Nasdaq higher in 10 of the 11 trading sessions, why do I think the risks associated with a "flash crash" are multiplying?

It is market positioning -- something I and others rarely consider in our market analysis.

Today, speculators have breathtakingly large short positions in volatility futures, so that a relatively small spike lower in the averages, for any reason, of 3% or so could drive volatility much higher and demand (covering) of VIX futures. (The largest S&P selloff when the VIX was under 12 was 3.5% in February 2007).

Let me explain how a short volatility unwind might develop and what its implications are.

If Markets Spike Lower and the VIX Goes Bananas

It is tautological that as volatility moves lower and stock prices move higher, risks rise.

Several buy- and sell-side analysts have done a great deal of work as to what current positioning in the market may have if an exogenous event (from any Black or "Orange" Swan) produces a quick woosh lower in the averages and a spike in volatility.

From Morgan Stanley's Chris Metli:

"It's easy to become numb to the low volatility environment and the risks it presents. While trying to pick a trough in vol has been a fool's errand, focusing on the risks resulting from vol being so low is not. Low volatility has produced a regime where the risks are asymmetric and negatively convex, so being prepared for an unwind is critical. This is not a call that vol is almost to spike, but you need a plan if it does."

The pain of an unwind in VIX futures could be exacerbated in the days following a woosh lower by the dominance of passive investors (quant strategies and ETFs). The deleveraging of highly leveraged risk-parity funds, in particular, represents a risk that may not be easily repaired or reversed after the initial market drop.

Here is a further explanation from Morgan Stanley by way of Zero Hedge of the positioning risks that were in place in July.

Since then, as volatility has declined and the S&P index continued to climb, the risks have grown greater with an even larger base of short volatility futures

Francesco Filia of Fasanara Capital writes about the potential damage delivered by the possible covering of short volatility futures: 

"Market fragility must surely be a concern in the current investing environment. Yet, the psychological damage on investors and their behavioral reaction function to a sudden risk-off environment can never be as certain and direct as a wipe-out risk to a whole cluster of them. That is the nature of the risk that short-vol vehicles are facing today."

And consider this important update on positioning from Morgan Stanley's Metli -- specifically, that more than 400,000 VIX futures would likely needed to be bought if the S&P Index falls by 5% in one day, nearly double what it was in July!

Bottom Line

Though large daily drops in the markets are rare, the factors that could contribute to a quick drop have increased.

Investors have been concerned about the VIX for years, but the positioning has now moved to an extreme. Such positioning could accelerate a market drop as the chances of a flash crash have escalated.

But, Dr. Minsky has warned about the risks of becoming numb to the risks associated with a period of stability amid rising asset prices; it is not only inevitably followed by instability, it inevitably creates it.

In a world in which the chances of an external market shock are rising and at a time when volatility is cratering and stock prices never decline, the risks of a flash crash caused by the one-sided market positioning in VIX futures is increasing and are at a higher probability of occurring than at any time in history.

From the Street of Dreams:
HSBC initiates Mosaic (MOS) and Potash (POT) with buys.

My good friend Peter Boockvar, chief market analyst with The Lindsey Group, discusses rising investor optimism this morning:

Bullish stock market sentiment has gotten extreme again according to Investors Intelligence. Bulls rose 2.9 pts to 60.4 after being below 50 one month ago. Bears sunk to just 15.1 from 17 last week. That's the least amount since May 2015. The spread between the two is the most since March and II said "The bull count reenters the 'danger zone' at 60% and higher. That calls for defensive measures." What we've seen this year the last few times Bulls got to 60+ was a period of stall and consolidation. When the bull/bear spread last peaked in March, stocks chopped around for 2 months. Stocks then resumed its rally when bulls got back around 50. Expect another repeat. I started the year saying 2017 would be a tug of war between the hopes for tax and regulatory changes on one hand and the tightening of monetary policy on the other. Tax reform hopes has certainly trumped the tightening of monetary policy (the ECB and BoJ easing dramatically offset modest Fed tightening and definitely helped), for now. In 2018, we will however see the ECB join the Fed (I view tapering as a form of tightening) but also the actual passing of tax cuts.

As for the ECB and their meeting 2 weeks from tomorrow, ECB Governing Council member Ignazio Visco in an interview last week that was published today said bring on the tapering. "Start of a gradual process of monetary normalization would be welcome news. It would signal the materialization of sizable and self sustained improvements in inflation and economic activity." I'll bottom line this very simply as we approach 2018, where European bond yields go in response to the possible end to ECB QE (in terms of expanding the balance sheet as they will continue reinvestments) may very well drive global interest rates and thus global stocks. Don't forget the epic bubble that is the European bond market. The ECB though will do its best to keep it alive by keeping negative interest rates in place until 2019. On this last point, European banks won't be happy. The Euro STOXX bank index peaked around the same month NIRP began in June 2014.

I don't think we need another reminder that the Fed is raising rates again in December but voting member and typically dovish Charlie Evans this morning said "if anything, US fundamentals are getting better" in his opinion. He however continues to be flummoxed and obsessed in getting higher inflation and said survey expectations on inflation has him "nervous." Charlie, please step into a Wal Mart one night at around 11:50pm right before shopper wages flow into their debit cards and explain to them why higher inflation is a good thing.

With another 4 bps rise in the average 30 yr mortgage rate to 4.16%, the highest since the end of July, refi applications fell for a 4thstraight week and by 4.2% w/o/w to the lowest since mid July and are down 38% y/o/y. Purchase applications to buy a home were unchanged vs last week but are still up 7.4% y/o/y. The pace of transactions has basically flatlined for both new and existing homes over the past year with the issue of low inventories, aggressive 5-6% annual price increases and the high cost of labor, lots, raw materials and permitting that are limiting the supply of lower priced new homes that is most in demand by first time households that are still more inclined to rent than buy.

In what is always a very volatile monthly figure, Japanese August core machinery orders rose 3.4% m/o/m vs the estimate of up 1%. This follows an 8% jump in July and 3 prior months of declines. Since Abenomics took hold, the Japanese recovery has been very uneven with households basically sitting out the rebound. The industrial and export side pretty much drove the bus and that continues. Optimism after today's number sent the Nikkei to a 20 yr high. Another double from here will finally get it above its 1989 peak. The yen is up slightly while JGB yields were little changed.

After a sharp rally in the last two days, the yuan is off by 1/3 of a percent against the US dollar. The daily moves this week have certainly picked up ahead of next week's Party Congress. Chinese stocks were mixed overnight with a slight rise in the Shanghai comp and very tiny fall in the H share index.

In quantifying the relatively solid European economic rebound this year, at least for Germany, its government raised its 2017 growth forecast to 2% from the 1.5% they were expecting in April. They said "capacity utilization is good, employment continues to rise and consumer prices remain stable." The 1.8% inflation forecast remains unchanged. For 2018, the growth estimate is 1.9%. The 10 yr bund yield is up by 2 bps to .46%. The euro is up again after yesterday's rebound on the Catalan delay in making a decision. The Spanish 10 yr yield is down by 2 bps after rising by 2 bps yesterday and the IBEX is rallying by 1.5%.