Guest Post: “I Love Catching Falling Knives – Don’t Tell My Kids”

Guest Post: “I Love Catching Falling Knives – Don’t Tell My Kids”

Via Kevin Muir of “The Macro Tourist” fame


Do you remember the opening scene of the movie Trainspotting? Renton tries to give up heroin. He decides to kick his junk habit cold turkey, and boards himself in his room. Even before he starts to feel the symptoms of withdrawal, Renton has ripped off the boards and is desperately searching the streets of Edinburgh for another hit.

Well, I too have an addiction I can’t seem to leave behind. No, I am not a smack addict, but sometimes I think my vice is equally destructive. You see, I love catching falling knives. Yup, I am not proud of it, and please don’t tell my kids.

I put in place trading rules to keep myself on the straight and narrow.


But like Renton, it isn’t long before I am ripping the boards off the door, searching for the next security in the midst of free fall.

Like any good drug dealer, the market has recently dangled an outstanding opportunity in front of me, and I don’t think I can stay on the straight and narrow.

A month and a half ago I wrote about the problems facing VanEck with their Vectors Junior Gold ETF (GDXJ). My piece “The real message from the GDXJ mess” highlighted the risks from the forecasted index changes. The rebalancing of small cap precious metal companies that made up the index was unprecedented.

I was concerned about the massive amount of shares that would need to be traded. Many of the forecasted index flows represented 10+ days of average volume for some stocks.

Well, this opportunity proved too tempting for the street. Traders have beaten the stocks coming out of the index with an ugly stick. Actually, that description doesn’t really do justice to the true extent of the carnage.

TD Index Specialist Peter Haynes recently wrote a report where he described the rebalance as “the single greatest wealth destruction event in index history.” He included a great chart that showed that the stocks with forecasted weight reductions have declined 15.7% while the adds are down only 3.3%.


One only has to look at a table of the performance of these stocks to realize the extent of the damage.


Look at the far right column. That number represents the return from Apr 12th (the rule change announcement date) to May 31st.

I haven’t seen that much red since I pulled up Fannie Mae’s portfolio in the depths of the great financial crisis. Those are some f’ugly numbers.

In all my years of trading indexes, I have never witnessed that sort of selling in front of a rebalance. These stocks have been pummeled. Devastating.

I realize the actual official index announcement has not even been released. It would usually make sense to wait for the selling to crest in the days a little closer to the actual rebalance. After all, we are still two weeks away from the June 16th rebalance day.

But this situation is different than most other index changes. When S&P makes a change to the S&P500 index, the SPDR ETF trust makes a trade at the closing prices on the day of the index change. The ETF manager wants to minimize tracking error, so the transaction is executed as near the bell as possible on the rebalance day (I assume they just stick the order in the MOC book, but I don’t know for sure).

Yet this not the case for the GDXJ index change. VanEck, the GDXJ manager (and also the index provider), has the ability to make changes way ahead of the rebalance, and in fact, can hold a portfolio that differs greatly from the benchmark. Don’t forget, they already own GDX in the GDXJ trust because they were bumping up against the ownership restrictions in individual names. This is not the same sort of strict tracking index ETF like the SPDR S&P 500 ETF. There is no doubt VanEck will save some of their firepower for the actual day of the rebalance, but I worry the market has gotten way ahead of the changes.Maybe VanEck has already even sold a good portion of these names, after all, they have the ability to stray from their benchmark.

Like any junkie with a problem, I can’t wait for my hit. I suspect we have already seen the low in many of these stocks. I am starting to pick away at buying some of these bombed out small cap junior precious metal companies. Yes, I realize I am catching falling knives. And yes, I realize there will be all sorts of apocalyptic predictions published by Wall Street research departments in the coming days.

This index change is unique in so many ways. From the reason for the change (overwhelming popularity of the ETF causing ownership limit concerns in the underlying stocks) to the way it is executed (the index provider, who is also the ETF manager, has way more latitude to diverge from the underlying portfolio.)This is not a typical rebalance. The chances of this being all-baked-in early is high.

Like any addict, I have created an index of only the highest quality shit. Taking the 10 worst performing stocks in the GDXJ forecasted reductions list, and weighting them equally, I present the GDXJ Worst Performers Index.


Since the April 12th index announcement, these stocks are off by almost 30%!

An argument could be made that we should be buying the stocks that have held up best during this selling onslaught. I am sympathetic to the idea of buying strength instead of extreme weakness. But I am, after all a knife catching addict, and the decline is too hard to resist. Maybe I will buy a little Kirland, Centerra and St Barabara as chasers to my portfolio of hard stuff. I am not sure yet.

But I don’t plan on waiting. We get the official index announcement next Friday, and I am sure there will be lots of chatter about the rebalance, but be weary of the hyperbolic predictions of doom. There is a good chance this all built into the price of the stocks, and the surprise will be how much these names rally into the rebalance, not the other way round.

I know this is contrary to prevailing wisdom, and I understand if you want to take Begbie’s advice and stay away from catching knives, but a the very least be careful of assuming the index effect will make the moves even worse. This has already been an epic rebalance.