May 17, 2010 – The Real Cause of the ‘Flash Crash’

Featured Trades: (SPX), (YCS), (TBT)

1) The Real Cause of the 'Flash Crash.'
When I boarded my plane in San Francisco on Thursday morning, May 6, the Dow was down an uncomfortable, but tolerable 150 points. When I arrived in New York that night I was greeted with headlines screaming 'CRASH: DOW PLUNGES 1,000.' I was not surprised. In a letter sent to my premium subscribers the day before I predicted a fall in the S&P 500 to 1,050 (click here for the call), although I thought it might take two months to get there. Instead, we got it in two hours!
Since then, I have heard every possible explanation for the instant death spiral. A fat fingered trader accidentally entered an order to sell not one million shares at market, but one billion. Al Qaida hacked into the NYSE mainframe. High frequency traders ganged up on a thin market to generate some windfall profits. I heard every possible theory, except the one that was the true cause-- stocks are too expensive! The US economy is in the midst of an epochal transition from a long term GDP growth rate of the 3.9% rate we saw during the last decade, to maybe 2%-2.5% this decade. If you don't believe me, look at the chart below showing a rapid deterioration of the leading economic indicators for most of the OECD. The 'V' is rapidly turning into a 'square root.' That does not support the PE multiple of 23 the market was sporting a few weeks ago. Maybe the lower growth rate supports a 16 multiple, but only on the best of days when buyers are feeling wonderful about themselves. When the fall came, all risk assets moved south in unison, while Treasuries exploded through the roof on a flight to safety bid, along with the dollar. This was also as I expected (click here for that call). Let me spell this out more clearly. When I say there is a massive risk reversal at hand, what I really mean is 'Run, Forest, run!' (Forest Gump for international readers). It is not the time to be too clever by half by staying short the yen (YCS) or the 30 year Treasury bond through the (TBT) (click here for my pleading with you to heed the wake up call to tighten up your risk controls). Those of you who took my advice to pile on the cheap downside protection while volatility languished at 16% (click here for that call), made an absolute killing as it raced to 42%. Suffice to say that as the euro breaks $1.25, the dust is still flying in great impenetrable clouds, and the sidelines seem more comforting by the minute. Remember, there is no law that says that you must always keep a position on, no matter how hard your broker argues to the contrary.
Leading.gif picture by madhedge