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What to Do After the Flash Crash this Week

02/07/2018 6:00 am EST


Mike Larson

Editor, Weiss' Safe Money Report and Under-the-Radar Stocks

I’m going to tell you everything I believe you need to know about Flash Crash II – including why it’s happening, how far it could go, and most importantly, what to do about it. Let’s start with the facts, writes Mike Larson, senior analyst at Weiss Ratings.

Just after 3 p.m. Eastern Standard Time Monday, the stock market Flash Crashed ... again!

After falling steadily throughout the afternoon, the Dow plunged an additional 800+ points in a matter of minutes, only to regain a large chunk of that shortly thereafter. It looked every bit like the original Flash Crash that occurred back in May 2010.

But even after the dust settled, the Dow was still down 1,175 points. That was the biggest point decline ever, though far from the worst percentage plunge at “only” 4.6%.

But add that to the Dow’s 666-point drop on Friday, Feb. 2,  plus a decline of more than 500 points at the open Tuesday, and it starts looking like something significant is afoot.

So today, I’m going to tell you everything I believe you need to know about Flash Crash II – including why it’s happening, how far it could go, and most importantly, what to do about it. Let’s start with the facts:

  • All major markets have now erased their 2018 gains. But we’re still only back to levels we traded at in early December.
  • The intraday drop of almost 1,600 points at Monday’s Flash Crash II lows was bad to be sure. But even if we had closed there, it still would’ve represented a drop of only 10% from the January 26 market high.
  • This is now officially the worst correction since August 2011. But whereas that plunge was driven by an identifiable catalyst – the failure of the debt ceiling negotiation between then-President Obama and Congressional Republicans – this one has no clear triggering event.

Or at least not on the surface. But it fits hand in glove with the cycle convergences we’ve discussed repeatedly since last year! Multiple, powerful market and economic cycles have converged in one time and place – here and now.

Those cycles are like a massive tsunami aimed squarely at the capital markets, and now, Wall Street is starting to awaken to the threat.

As you’ll recall, we said the bond market – the market for sovereign debt issued by the U.S. and other overly indebted foreign countries – would be the hardest hit at first. And sure enough, bond prices have been plunging since September.

We said that would initially send capital flying into stocks as (ironically) a “safe haven.” That certainly has been happening for several quarters now.

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But we also warned that, ultimately, the consequences for stocks could also be incredibly severe – with volatility exploding as massive, powerful forces increasingly tug and pull the markets to and fro.

Just look at the gigantic surge in volatility that accompanied the move this week. The CBOE Volatility Index (VIX) has been dormant for several months now – hovering around record lows below 10. Monday and Friday, it exploded higher – hitting 50 at one point. That’s a level we’ve only seen once since the Great Financial Crisis, in August 2015 when China sparked a major market selloff by adjusting its currency policy.

Here’s why I say it is noteworthy: Throughout the market advance of the past few years, we’ve seen volatility get compressed more and more. That has encouraged investors to pursue all kinds of computerized, algorithmic trading strategies.

Those strategies work fine in markets with clear direction, but they can go completely haywire in volatile ones. Rapid-fire adjustments are required, and because we’re talking about machines rather than humans, those adjustments happen so fast they can overwhelm the market.

The resulting carnage can be breathtaking.

One specialized investment designed to rise in value when volatility declines called the VelocityShares Daily Inverse VIX Short Term ETN (XIV) dropped more than 14% in Monday’s regular session. Then it collapsed in the after-market – losing more than 80% of its remaining value. Eighty percent!

So where do I think things settle out? Does this increased turmoil signal the end of the bull market? What should you do in response?

First, we’ve seen several smaller risk flare ups since the bull market started in 2009. That includes the August 2015, August 2011, and May 2010 events I already referenced, but also the overnight chaos when President Trump was elected in November 2016 ... the July 2016 Brexit-driven turmoil … and the energy-driven meltdown in January and February 2016.

None of those managed to kill off the bull market because they didn’t alter the underlying trajectory of the economy and corporate earnings. If anything, Trump’s election and the recently passed tax cuts improve the outlook for both growth and profits.

Yes, that could provoke a policy response from the U.S. Fed and its overseas counterparts. We’ve already seen a handful of rate hikes, and we’re likely to see another three or four increases this year. But “real” (inflation-adjusted) interest rates are still in negative territory – indicating that monetary policy is not yet “biting.”

Meanwhile, none of our recession risk indicators are flashing bright red – yet. Nor are our proprietary Weiss Ratings  indicators. Conditions are always changing, and you can bet we’re keeping a close eye on this action. But so far, we believe the most sensible actions to take are the ones you’ll hear about in your individual investment services. They’re designed to limit your risk in a prudent fashion as this tumultuous period of cycle convergences unfolds.

No one can know with certainty what the future will bring. But anyone who has followed us in recent years knows one thing for sure: We are not shy.

When it’s time to shout from the rooftops “Get the heck out,” we do.

That’s what we did in late 1999 on the eve of the Tech Wreck, when we rated 99.3% of all Nasdaq stocks a “sell.”

That’s what we did again in mid-2005 when we saw the housing bubble beginning to burst.

It’s what we’re already doing regarding all stocks, ETFs and mutual funds that merit a Weiss Investment Rating of D+ or lower.

And never forget: You can also use investments like inverse ETFs to profit from a bear market, should this correction morph into something more serious over time.

Until next time,

Mike Larson

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