No matter on which side of this market investors are, they have probably observed two disturbing patterns. First, there's low volume. Even before the summer arrived, trading volume was unusually low. Second, trading activity is concentrated in a few sectors and a few momentum stocks, creating "crowded trades." This means that the market is dominated by professional traders who try to profit by buying up these selective stocks with the expectation to find other investors to sell them at a higher price.
But what would happen if prospective buyers realize that they won't be able to find other buyers to sell? They will stop buying; and the market would be in for a "flash crash" like the one that of May 2010. So far, this hasn't happened, however, as the market is bounded on a trading range. But it can happen if at least one of the following events occurs and scares buyers away:
1. A "credit event," which is the failure of a major institution or a country to stand up to its debt obligations by missing an interest/principal payment. In a highly interdependent world, such an event could fuel a domino (Lehman-style) effect that results in big losses for major credit institutions that have direct or indirect exposure to the failing institution. A failure of Portugal to pay the coupon on its bonds, for instance, could result in losses for German banks, which hold Portuguese bonds — undermining the capitalization of these banks.
2. A sharp appreciation of the dollar that could reverse a popular "carry trade," and short the dollar/buy commodities. After dropping for more than two years, the dollar has been showing signs of stabilization, and even a reversal against major currencies like the Australian dollar that was one of the targets of carry trade. Popular trades are further crowded trades, and a trend reversal will find too many traders on the wrong side of the trade, causing a panic buying of the dollar.
3. A downgrade of US debt by US credit agencies. S&P and Moody's have already placed US government debt on the watch list, but investors have already discounted this prospect, as a political ploy to put pressure on politicians to extend the national debt limit. There good reasons, however, to believe that credit agencies are dead serious with their warnings, and they may eventually carry them through if the US debt situation deteriorates, as they do not want to be "behind the curve," as was the case with the subprime crises and they do not want to be biased, taking a hard stand against European sovereign debt, and a soft one against the US sovereign debt.
4. A lackluster earnings season. Earning seasons can make or break markets. As the market looks well past the Great Recession, when corporate earnings took a big hit, earnings surprise on the upside become increasingly difficult. A downside surprise by bellwether stocks -- the likes of General Electric (GE), Microsoft (MSFT), Apple (AAPL), IBM (IBM) and Intel (INTC) -- will set off a sell-off.
These factors aren't independent from each other, magnifying their overall impact on financial markets. A credit event outside the US could strengthen the dollar, and a strengthening of the dollar could penalize US exporters.
But what should investors do? How can they protect their portfolio? Conservative investors that have been on the right side of the trade may want to trim off their positions and may want to buy insurance against volatility by buying iPath S&P 500 VIX Short term Futures (VXX).
Additional disclosure: I'm short in GLD, SLV