U.S. Stock Market - Is Another Flash Crash Possible?

Disclaimers usually come at the end in blogs like this one. However, given the title of this week's column, I think it's appropriate to let the reader know immediately and upfront that I have a substantial position in the double-short S&P 500 ETF (symbol SDS) in my largest managed account.

On the afternoon of May 6, 2010, the Dow Jones Industrial Average plunged approximately 600 points in about 5 minutes and was down almost 1,000 points (9%) intra-day before rebounding. There are dozens of theories about what happened that day and there were investigations by the SEC and the Chicago Mercantile Exchange, among others. As more than a casual observer at that time, I saw many similarities between the Flash Crash of May 2010 and the Black Monday Crash of October 1987. One common denominator was the so-called "tail wagging the dog" phenomenon involving the S&P 500 futures contract. When the near-term S&P 500 futures contract trades at a significant discount to the cash S&P 500 Index, arbitrageurs sell component stocks and then buy the futures in an attempt to lock in profits. Both crashes were marked by massive selling in the S&P 500 futures contract at discount prices to the cash index which then triggered massive liquidation of underlying component stocks which then cascaded into even more selling of futures and even greater liquidation of underlying component shares. The downside spirals that resulted were unprecedented in both cases. The October 19th Crash of 1987 saw the largest single day percentage decline in the history of the Dow Jones Industrial Average, 508 points or 23%. The May 6th Flash Crash of 2010 saw the largest intra-day point decline in the history of the Dow Jones Industrial Average, 999 points or 9%.

Is a "Flash Crash" like the one that unfolded on May 6th, 2010 possible today? 

The answer is yes, of course. However, given the recent widespread negative publicity for high frequency traders (HFT's), the odds are probably low. If another flash crash unfolded right now, HFT's would surely be blamed and the regulators would change the game forever (against them). While that may happen anyway, for now they are less likely to be involved if intra-day volatility suddenly ramps up.

If not a flash crash, then how about an '87-type crash? From the top on August 25th, 1987 to the bottom on October 19th, 1987, the S&P 500 Index fell 36% in 55 days, with most of the loss sustained on October 19th, the last day of this decline. Again, I don't think an '87-type crash will unfold here. The Federal Reserve and other major central banks will almost certainly intervene on any meaningful correction.

So where does that leave us? 

Remember Long Term Capital Management? In 1998, this infamous hedge fund lost $4.6 billion in less than four months on leveraged bets gone sour in Russia. The damage was so bad that the Federal Reserve actually brokered a $3.6 billion bailout on fears that a LTCM failure might take the whole system down (i.e. a Lehman-type event risk). From the S&P 500 peak in July 1998 to the low in October 1998, the S&P 500 dropped 22%. The players look eerily similar today to those back in 1998. Hedge funds are reeling right now with losses on their long positions in the high-fliers year-to-date so far. Russia is more than saber-rattling in Ukraine, and the G-7 is about to ratchet up sanctions against Putin. The Federal Reserve is trying to reign in its monetary accommodation known affectionately as QE, historically high corporate profit margins right now look vulnerable to me, and margin debt for stock purchases is now at a record. And to add insult to injury, the next five months are seasonally the worst period of the year to own stocks!

Bottom line: A stock market correction of at least 20% is forecast right now, just like the one that took place in 1998, between July and October of that year. 

U.S. Stock Market - Dow Jones Utility Average Sell Signal !

A Daily Chart Sell Signal was triggered at today's close in the Dow Jones Utility Average (see chart below). The yield on the 10-year T-note surged more than 8 basis points today to about 2.72%. While this level must still be consider low by historical standards, it was 1.61% in early May 2013 and bottomed out at 1.39% in late July 2012. In other words, the 10-year T-note yield has gone up 68% in less than one year and has almost doubled in less than two years. To add insult to injury, daily and weekly chart buy signals were triggered today in the double-short T-bond ETF (symbol TBT).

Dow Jones Utility Average with Computer-generated Buy & Sell Signals

So what does this all mean? If we listen to my computer system, then interest rates will soon be trending higher and T-note and T-bond prices will soon be trending lower. And today's sell signal in the Dow Jones Utility Average strongly suggests that stocks with high dividend yields should be liquidated by investors.

On a personal note, I have a fairly long commute to work everyday and my car is not a hybrid or electric powered. The price of gas is therefore a variable in my weekly budget. In Chicago, where I live, the price of regular gas has gone from $3.40/gallon to $4.20/gallon IN LESS THAN A MONTH! THAT'S A 24% INCREASE!! 

The following chart is borrowed from an article entitled "If The Smart Money Is Selling, Who's Buying?" as found on today's zerohedge.com website:

AAII Investor Asset Allocation History 1987 to Date

While this chart probably speaks for itself, it would appear to me that the average main street investor is loaded upon on stocks and has no more cash. Maybe this time is different, but this chart doesn't seem to bode well for stock prices. With mid-term and longer-term interest rates rising and gas prices squeezing family budgets, perhaps corporate profit margins (which have been at record highs) will also be squeezed?

In the interest of full disclosure, I significantly increased my position in the SDS double-short S&P 500 Index ETF in mid-afternoon trading today. Most major U.S. stock indexes have now been up for four days in a row, but today's last hour profit-taking was a key negative change in daily pattern. The Dow Jones Industrial Average actually posted a loss on the day today, along with the Dow Jones Utility Average. 

Bottom Line: The U.S. financial markets are closed tomorrow in observance of Good Friday, but next week is expected to be a nasty down week for stocks. And unlike earlier this week, when both the Nasdaq Composite Index and the Russell 2000 Index bounced nicely off their respective 200-day moving average lines, I don't believe that investors can expect the same kind of support the next time down. One particular stock market adage that his served me well over the years is: "First time bounce, second time trounce!"