Revisiting The Stock Market Crash Of 2011

Includes: SPY
by: Joseph Stuber

Ken Sweet wrote the following article on July 22, 2011, summarizing the market's action and the news of the day. The market had rallied nicely in the preceding months and was consolidating near the tops. Tech stocks were outperforming the broader market. Caterpillar had reported disappointing earnings but the tech sector earnings were strong and leading the broader market higher.

Some bearish traders felt that Cat's earnings were an indicator of things to come. Congress was fighting with the debt ceiling. The day before the market had surged higher on news that eurozone leaders had worked out a deal to address the debt problem in Greece. A little good news, a little bad news but for the most part it was business as usual. Just another day in the market. SPY closed at 134.58.

Three weeks later, on August 11, 2011 this article appeared on a stock blog pontificating on the recent sharp sell-off. The Dow was off 519 points on that day and the question the writer was asking - is this now an official stock market crash? The Dow had given up over 2,000 points in just 14 days.

Another article took note of the fact that $2.8 trillion dollars in market value had been lost in a matter of just a few weeks.

I have written extensively on what I see as the coming stock market sell-off along with several other contributing authors on SA. My most recent addition to the bear argument noted several indications that we are getting very close to the beginning of a sell-off that I believe will test the post recession lows on the S&P. I have noticed a strongly bullish sentiment being expressed by those commenting on my articles. Kevin Flynn made a similar observation in an excellent article that he wrote for SA on the subject:

Is there an experience gap going on as well? Our completely unscientific sense is that older investment professionals are being skeptical on balance about what "QE-infinity" might accomplish, while younger professionals seem to be more enthusiastic.

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.

John Coates, a former hedge fund trader turned neuroscientist, wrote an excellent book - "The Hour Between Dog And Wolf" - on the physical transformation that takes place just prior to a fall. The title refers to that moment. Coates describes traders in this mind state:

They become cocky and irrationally risk seeking when on a winning streak.

I understand that phenomenon very well as I have experienced it over and over again. Coates makes the point that a chemical transformation actually occurs in these situations. With success comes confidence - a confidence that is derived from increased testosterone levels and it is much more prevalent in men than women.

Coates notes that women have a more healthy fear in risk situations than men. For men it is an adrenaline rush - a "fight or flight" response is triggered and with recent successes the tendency is to show no fear - in other words to choose the "fight" response.

I am sure there are a lot of bulls in the markets today who have made a really nice profit over the last several weeks and expect it to continue. After all, Ben Bernanke and the Fed have virtually guaranteed it. Their logic - repeated over and over again - is that you've got to be invested and you've got to ride the Bernanke bull. You can't fight the Fed and if you do you are just an "idiot." That is a perfect example of a "dog to wolf" moment.

Over my 40 years of trading markets I have had many of these "dog to wolf" moments. Trading suits my nature. I love the competitive aspects of pitting my skills and talents against others and I admit to being overtaken by the irrational "risk seeking" Coates refers to. Still, after a number of these boom-to-bust moments I have come to recognize this simple fact - every good run in the markets is followed by a bad run. In a book I recently completed I make the following comment and it is worth committing to memory:

There will be times when you are making money hand over fist. Just know that it will soon come to an end. There are also times when everything you do is wrong. Again, just know that this too, will soon come to an end.

That is the nature of investing in the stock market. The truth is long-term success in the markets is dependent on becoming more fearful as your profits build and becoming more courageous as your profits fall. That is not the way most do it though. As Coates points out it isn't the natural response.

The chart below shows what happens in a "bubble" bull market when the market finally capitulates. It is a vicious thing and it happens really fast. The first response of irrational bulls is to conclude that the down days leading up to the capitulation sell-off are just a normal correction in a bull market - a temporary pause before the move continues. The natural response is to buy the dips. In a "bubble" crash buying the dips is akin to reaching out and trying to catch a falling knife. You will get cut doing that.

Inevitably, one day the market will fall like there is a vacuum underneath it - the capitulation sell-off - where everybody surrenders. At that point you will realize that you have indeed made a tragic blunder but it will be to late.

The crash of 2011 was up from its base low of 25% on July 22. On August 9, it was down by 3% - a 28% drop in value in about 3 week's. The market did bounce off that low and then resumed its descent moving to -11% on October 4. From top to bottom was a 36% drop in a little over 2 months.

The chart below was used in another article I wrote referring to the divergence in the SPY and the Transport ETF. I am using it here to show you the massive and rapid fall in the market during the period from July 22, to August 8, and then on to October 3.


There are a number of reasons this rally is unsustainable. I will list a few:

  1. Decades of overspending and excessive use of leverage by government, businesses and the citizens have created an unsolvable problem without a completion of the deleveraging process and a final bottoming out.
  2. Failed fiscal policy that sets up the "fiscal cliff" issues virtually guarantee a recession in 2013.
  3. A failed monetary policy where all countries are playing a game of musical chairs with currency devaluation that do nothing but cancel each other out.
  4. Depression era unemployment levels that will take the unemployed out of the consumer pool in 2013 as spending cuts go into effect
  5. A massive debt burden and deficit spending problem that must be dealt with in 2013.
  6. A liquidity trap spawned by fear that is driving people to save rather than spend.
  7. A recession in Europe that is being dealt with by bailout and austerity measures which is the right approach but will result in deepening the recession.
  8. China's economic contraction resulting from the economic contraction of its trade partners.
  9. Record low interest rates stifling any chance of increased bank lending - the reason being that the risks are not commensurate with the reward.
  10. Substantially reduced earnings for those who rely on reasonable interest rates to supplement their income leaving them with less money to spend.

These are real issues that we are faced with and central bankers have no solution nor do our lawmakers. We are past the point of return and although their efforts are valiant they are still no more than an exercise in futility at this point.

Fed policy could have worked and I thought it would. The truth is that it hasn't worked the result being that this failed policy ends up making the problem much worse than it would have been had we just allowed the normal business cycle to complete the deleveraging that was badly needed.

The idea that is repeated over and over is that the "fiscal cliff" will be avoided. The truth is that the "fiscal cliff" can't be avoided. Yes we can extend the tax cuts and delay the spending cuts that are scheduled to reduce deficit spending by $600 billion dollars next year but there are consequences to doing that. The problem still exists - massive deficit spending and out of control debt levels.

If we do just postpone the problem for another year our debt will climb to well above 100% of GDP and we are guaranteed a credit downgrade. That isn't a wild guess - that is an absolute certainty. Our debt to GDP is as high as the collective debt to GDP of the euro zone today. Adding to it is simply not an option - at least a reasonable and logical one. Of course even it we do go over the "fiscal cliff" with scheduled tax hikes and spending cuts we still end up increasing our debt to GDP as these moves are not sufficient to bring us to a balanced budget.

If we do simply delay action for another year or try to piecemeal something together we will certainly find our carrying costs going a lot higher in much the same way as the euro zone countries have experienced. Investors will begin to demand more for the risk they take when buying U.S. debt. When bond values start to fall an additional wave of panic will engulf stock and bond traders.

For those who really believe that there are painless solutions to these problems I suggest you do a little research. Our politicians will suggest that a recession is avoidable but that is what politicians do. They know better - at least some of them do -and they will simply put the blame for the recession on the other side of the aisle or with the President or wherever they decide to put the blame to get it off their own shoulders. That is the nature of politicians. It doesn't change a thing - we are still going into a recession.

What that means is that we have created a stock market bubble by believing in Ben Bernanke and the Fed. We already have a number of companies reporting that their 3rd quarter will disappoint.

The signs are all around us but as of today we are still in a safe zone on stock prices. It's not going to last and a word to the wise should be sufficient. Recent history is about to repeat itself.

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 crude oil, tech stocks and financial stocks.

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