Another Flash Crash?

The S&P500 crawled up another one percent last week , with virtual all of the week’s gain coming in on Monday.  Volume picked up, but mostly in relation to the anemic holiday weeks in late December.  The VIX index fell only slightly. 

A large batch of economic news was released, starting with the ISM manufacturing survey, which was slightly lower than expected.  While ISM services was slightly better, its prices paid component shot up; its employment dropped, and inventories rose.  All are leading indicators of future weakness.  Initial jobless claims were a bit worse than expected, and back in the recessionary 400,000 range.  Even worse, the unadjusted claims soared to almost 600,000, rising over 50,000.  Nonfarm payrolls disappointed…..again.  They rose far less than expected, and far less than needed to absorb the natural rise in the working age population.  While the U-3 (headline) unemployment rate fell, it did so only because 260,000 unemployed folks were so discouraged, they dropped out of the workforce, and thus were no longer counted as being unemployed.  Also grim were the average workweek hours which did not rise, and the average hourly earnings which inched up an anemic 0.1%.  The labor force participation rate fell to 64.3%, a 25 year low, and a sign of how bad the employment situation is for Americans.

Technically, the Fed-fueled melt up in stock prices is continuing to create all sorts of bearish divergences, where momentum, breadth and money flow indicators are breaking down–even as prices keep rising. 

Eerily, the charts are showing signs of echoing the pre-Flash Crash formations.  Back then–in March and April 2010–the Fed’s QE1 was still pumping out billions of dollars of newly printed (electronically) dollars into the capital markets monthly.  The primary dealers sold Treasuries and mortgage-backed securities to the Fed; in return, the dealers took the billion of dollars and bought riskier assets, mainly stocks.  

But valuations were becoming stretched as high frequency trading helped propel prices to higher and higher levels.

The markets were becoming fragile; they became exceptionally vulnerable to a sell-off from even seemingly minor trigger events.

That event, or series of events, was ostensibly the Greek funding crisis and the sell-off of many other PIIGS sovereign debt and the Euro itself.

But it’s important to remember that there was NO one specific trigger that was 100% responsible for the panic sell-off.  Any one, or a combination of several, events could have been the trigger.

Today, very similar conditions have developed again.  Does this mean that we will certainly have another Flash Crash?  Of course not.

But it does mean that the equity markets, and risk asset markets in general, are today much more vulnerable to a panic correction.  And the wise trader will prepare for one–to protect against losses and to take advantage of the price drop.

Be prepared!

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