We have given up 1000 points on the Dow in the last six weeks - a milestone of sorts in my opinion. The-1000 point drop doesn't surprise me at all. I have been warning investors for two months now that this was coming. What does surprise me is the relative lack of fear. The VIX is at 16.96 as I write this. With the exception of the 300-point drop on November 7 - the day after the election - we haven't had a really significant one-day decline in stocks. Rather, we have just slowly eroded off 1000 points on the Dow.
It has been a sector-driven decline led by tech stocks. The broad market measured by the Dow is down 7.3% as of this writing. XLK by contrast is down 11.7%. Apple (NASDAQ:AAPL) is down a whopping 23%. Financials, as measured by XLF, have fallen 8.5% since the September high and it's off 5.4% in the last week.
One has to wonder when fear actually grips the market participants and selling accelerates. In a legitimate bear market we should be moving much higher on the VIX shouldn't we?
I have heard numerous pundits argue that the VIX is no longer relevant. I agree that the VIX is not a good indicator of future market direction. I will add to that a caveat - it is an excellent indicator of fear. Consider what happened to the VIX in the 2011 crash. During that period - and only when the market began its rapid descent - the VIX climbed from 17.52 to 47.56. The Dow fell 15.7% and the VIX climbed 171% in a matter of a few weeks.
As fear does take over expect the VIX to accelerate to the upside very rapidly but don't use the VIX as an indicator of anything but fear. The question is what will finally ignite that fear and result in the capitulation sell-off that is characteristic of all market crashes.
I don't have an answer regarding the catalyst that finally tips the scale and induces a market collapse. I just know that day is coming and soon. It could be something like a decision by Greece or Spain to exit the eurozone. It could be a final determination to go over the "fiscal cliff." A more likely scenario is a simple realization that the market isn't doing what everyone expects it to do. It could develop as Stephen Utkus suggests:
At some point, observed data becomes so overwhelming as to call into question the excessively optimistic forecasts of market participants. In the case of bubbles in stock prices, this occurs at the point where expected revenue and earnings growth rates fall somewhat short of optimistic expectations.
Observed data in this case involves an irresolvable dilemma facing Congress as it attempts to deal with the "fiscal cliff" and the upcoming debate on the debt ceiling. No need to rehash all these issues again today. I have written extensively on the problems facing us - both in the U.S. and globally.
The problems are much bigger than the marketplace wants to consider. We are at a tipping point and all the optimism in the world will not alter the downward trajectory of the market at this point. It is an inconvenient truth that we are in a fix - the worst situation I have witnessed in over 40 years in this business.
Again, I don't want to rehash what has already been said. Rather I want to focus on the mindset that has prevented the capitulation sell off. Stephen Utkus talks of that mindset and explains it this way:
Groupthink is a form of poor decision-making usually associated with fiascos. When under the influence of groupthink, a particular group begins to feel invulnerable; it rationalizes its behavior; and it systematically ignores external and contradictory sources of information. Groupthink is also characterized by a failure to examine alternatives, poor information search, and a failure to work out contingency plans. Late-stage asset price bubbles would seem to have many of these characteristics.
Nassim Taleb, in explaining the nature of his "black swan" event states much the same thing:
- The event is a surprise (to the observer).
- The event has a major impact.
- After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs. The same is true for the personal perception by individuals.
The point I want to make here is that the "relevant data" is available today and being ignored. Doug Friedenberg published an article on SA today that I recommend highly but my reason for referencing the article is to acknowledge that Doug is the one that brought this quote to my attention. It is so appropriate to this discussion that I had to use it and far be it from me not to give credit where credit is due:
It is difficult to get a man to understand something when his salary depends upon his not understanding it.
I think Sinclair said it perfectly. I am getting so tired of listening to the litany of prognosticators and pundits who suggest that a solution is forthcoming. We aren't talking light weights here either. We are talking economists, CEOs, members of Congress, icons of the investment world and the President himself. As Sinclair states - their "salary depends upon not understanding it."
The truth is we do have the "relevant data." We know what the Congressional Budget Office said. The following excerpt from the Congressional Budget Office report - "Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013" (pdf) - explains the "Catch-22" dilemma facing Congress:
Growing debt would increase the likelihood of a sudden fiscal crisis, during which investors would lose confidence in the government's ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates. Such a crisis would confront policymakers with extremely difficult choices. Again, the current high level of debt relative to the size of the economy means that further substantial increases in debt would be especially risky in this regard.
Therefore, eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years would have substantial economic costs over the longer run. However, as shown earlier in this report, allowing the full measure of fiscal restraint now embodied in current law to take effect next year would have substantial economic costs in the short run.
In other words, we should avoid the "fiscal cliff" for a little longer. If we follow this course we avoid the recession resulting from the fiscal restraint initiatives but end up in recession due to fiscal irresponsibility. If we go ahead with the planned tax hikes and spending cuts we go into recession due to these austerity measures.
The inconvenient truth is there is no solution that avoids recession. The market has been pricing this inevitable outcome into stock prices since Ben Bernanke announced QE 3 back in September. Still, there are a good number who continue to cling to the hope that this just can't be true.
Those who listen to me know what my forecast is for the coming months. On September 24, I made the following statement in an article dealing with the 2011 crash that coincidentally occurred as the result of a credit downgrade following the Congressional debacle on the debt ceiling debate in 2011:
I have been challenged for my ideas, disparaged and called an "idiot" by one or two readers. I am fine with that and the truth is that sometimes I do feel like an idiot - nobody gets it right all the time. On the other hand I've been at this game for 40 years and I've seen a lot of markets crash. I have learned to have a healthy fear of irrational bull moves. These moves can last a lot longer than one would think and go a lot higher than anyone would think but when they end they end with a vengeance.
Since Bernanke announced QE3 we have been moving toward a market collapse. The truth is there are no buyers out there. I am being redundant as I have said this before but no one wants to get in and buy this market. Many investors are willing to hold but few are willing to buy. Markets move higher on buying pressure - that is, buyers want to buy more than sellers want to sell. Since no one is willing to step in and buy this market continues to drift lower.
What the market is currently starting to price in is the impact to the economy on the scheduled spending cuts and tax hikes. Consider that we have injected $1 trillion into the economy each year for a number of years now. Even so, GDP growth is only running at about 2%. $1 trillion represents 6.25% of total GDP.
Do the math - if we weren't borrowing and spending $1 trillion a year GDP growth would be a negative 4%. That, of course, would result in more costs cuts and lay offs, which would reduce the tax base and the consumer pool. In other words we end up with an economy that ends up spinning down on itself.
This is just simple math. We have reached a tipping point where we are almost assured of another credit downgrade if we don't deal with what has become run away deficit spending and unsustainable debt. How we deal with the "fiscal cliff" really doesn't matter at this point but there are those who don't seem to realize or accept this inconvenient truth.
In spite of all the headwinds the VIX is telling us that all is fine in the minds of investors and that a 1000 drop in the Dow is no big deal. I expect that to change rapidly as we finish the week and move into next week. Downside momentum is accelerating and moving ever closer to that day of capitulation.
Since the election the Dow has been down four out of six days. The down days were minus 313, minus 121, minus 59 and minus 186. We had one day that was up 4 and a day that was unchanged. The Dow has come down over 670 points since November 7, with only one up day in six. That is the kind of sell-off that instills fear and begins to feed on itself. We haven't seen the capitulation sell off yet but it is coming and you will recognize it for what it is when it comes.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short tech stocks, financial stocks, crude oil and long the VIX.