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Why the Stock Market Crashed on Thursday

/ Financial Crash May 07, 2010 - 09:42 AM GMT

By: Q1_Publishing

Best Financial Markets Analysis ArticleLet the speculation begin.

With the Dow falling farther and faster than it ever has before, the financial media begins its search for the “reason” it happened instead of what we really need to know about.

Was it the riots in Greece?

Remember how just a week ago Greece’s problems were good for U.S. stocks? The prevailing reason du jour for stocks going up was investors would pull out of Europe and put their capital to work in the United States.

Or was it the British elections, a “fat-fingered” trade, or China’s monetary tightening measures earlier this week?

Or did a big fund made a highly-leveraged bet that Greek bonds would rebound after the bailout was announced and when they didn’t, it imploded?

The most likely culprit, however, was part of something we touched a few months ago. Back when Goldman Sachs’ traders were booking profits on 98% of trading days, high-frequency trading (HFT) was the hot topic.

While the big traders running the computer-assisted trading programs were banking remarkably steady profits, we looked at the big risk that came with HFT systems controlling 70% of all trading volume:

At some point in the next five to 10 years, another out-of-the-blue crash will likely happen again. Sure, there are limits on how much the major indices can move, but rules and regulations don’t always prevent the next problem, they usually only add to it.

Today was just a taste of what automated markets will bring eventually on the random and unpredictable day.

For now though, we’ll wait for the full details to come out for the who’s and why’s of the whole ordeal. We’ll look at the real impact of the sell-off.

Return of Risk-Aversion

Before today, investors’ confidence was steadily growing stronger. The lessons learned the hard way from 2008 about risk and over-leverage had nearly disappeared in the rear-view mirror.

To top it all off, today researchers at Rasmussen announced its Investor Index hit a 2-year high:

The Rasmussen Investor Index, which measures the economic confidence of investors on a daily basis, climbed five points today to its highest level in more than two years (since Feb. 6, 2008). At 105.4, the Investor Index is up seven points from a week ago, up eight points from a month ago, and up 25 points from a year ago.

Among investors, 45% say U.S. economic conditions in the country are getting better, while 31% say they're getting worse. These findings show a dramatic shift from last year when 34% said economic conditions were getting better and 42% said they were getting worse.

With confidence comes an appetite for risk.

Today’s sell-off will go a long way to reminding investors and traders of the adage: stocks go up stairs and down elevators.

Today was an elevator day of record proportions. It was like the 1987 crash crammed into 10 minutes. It reminded everyone how risky stocks are and is going to be doing a lot to dampen runaway confidence.

Wall Street Reform “Success” is a Lock

If there were any doubts about Wall Street reform passing this year, they’re not there anymore.

We can already picture a junior White House staffer trolling e-mails for the perfect constituent wanting government to “do something” about a bad decision he or she made.

It’s only a matter of time until we hear some story about a Mike Jackson from Springtown, USA who had his entire savings in Proctor & Gamble shares.

The proponents of the proposed regulations will plea, “How can we let Wall Street take 25% of someone’s savings away in 10 minutes…we must pass this now.”

(Side Note: stocks are not for savings – that attitude will change someday and it will be the biggest buy signal of the past 50 years)

As a result of the reform, the biggest banks will get bigger. Losses will be socialized. Too big to fail will be law. And let’s not forget about all the hidden “goodies” in the bill. Like the regulation of dentists who finance their patients’ care.

The Wall Street reform bill was probably going to pass anyways, but now it’s passage is practically guaranteed.

The Rally’s New Lease on Life

Finally, from a contrarian perspective, today’s sell-off will likely extend the current rally even further.

That’s right…today was good for the markets.

Over the last couple of years we’ve kept a close eye on mutual fund inflows and outflows. A consistent trend emerged. Investors want bonds, not stocks.

Investors are still feeling the sting from 2008. They’ve consistently turned to the “safety” of bonds. They’ve done so despite now being the worst time in 30 years to buy bonds because they lose value when interest rates rise.

Most of them have not come back into stocks in a meaningful way. If history is any precedent, they will.

It took them nearly two years after the tech bubble burst. This time around it will probably take a good bit longer.

The Big Opportunity

In the end, today’s record-setting decline is a chance to really learn how comfortable you are with your portfolio.

Were you worried about a sharp decline in the stocks you hold?

Did you buy them because they had a low P/E or because they are in a sector with years of growth ahead of it?

Did you buy any of them looking for a quick flip even though that kind of strategy usually involves taking big risks for small rewards?

These are just a few of the questions to ask now.

After all, despite all the volatility and the endless “I told you so” from the perma-bears who mostly missed out on this entire rally, the Dow is still down just 6% from its highs. It’s only down 6%.

Meanwhile, the fundamental driver of the entire rally – near-zero short-term interest rates – are still low and will be low for the foreseeable future.

That’s why I wouldn’t be too quick to call this all over just yet. And in the next Prosperity Dispatch we’ll look at why this type of volatility is here to stay and how stocks could go much, much higher from here.

Good investing,

Andrew Mickey

Chief Investment Strategist, Q1 Publishing

Disclosure: Author currently holds a long position in Silvercorp Metals (SVM), physical silver, and no position in any of the other companies mentioned.

Q1 Publishing is committed to providing investors with well-researched, level-headed, no-nonsense, analysis and investment advice that will allow you to secure enduring wealth and independence.

© 2010 Copyright Q1 Publishing - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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