Concerned About A Stock Market Crash? Listen To Bernard Baruch’s Timeless Wisdom
Current financial technology is simply outstanding. We rely on our ability to place an order on our smartphone, move cash from our bank to our brokerage account and back again, and sell anytime we’re hesitant about the markets. Instant electronic communication puts Wall Street at our fingertips, and it gives us a feeling of comfort.
However, a market phenomenon called a “Flash Crash” might limit our ability to sell stocks. We saw our first “Flash Crash” on May 6, 2020. That day, the Dow Jones Industrial Average fell 1,000 points in 10 minutes. For those of us who were watching the financial markets that day, it was a shocking event, to say the least.
Suddenly, everything seemed to plunge. Bids, the purchase orders that provide a floor to the markets, disappeared. Normal market function, the matching of buyers and sellers, was gone. Then, almost as quickly as it came, markets regained their composure, began to rally, and the terrible storm was over.
The Flash Crash was all anyone could talk about for the next several days. Traders and analysts were abuzz with this new and entirely unexpected event. It would take weeks before a culprit was identified. A London Trader named Navinder Singh Sarao was convicted of entering fraudulent orders designed to manipulate the markets. Called “spoofing,” this type of chicanery has been outlawed in the US since the 1930s.
The Securities and Exchange Commission recognized that they had a problem. The Circuit Breakers, initiated after the 1987 Crash, failed to mitigate the rapid price drop. A Circuit Break is a brief halt in trading designed to stop just such a drop as we experienced on May 6, 2010. A new set of Circuit Breakers came into effect with shorter triggers thereafter.
The new levels call for the First Breaker to halt trading at a decline of 7% in the S&P 500 — at current levels, that would be a drop of roughly 400 points in the S&P. The second Breaker would currently be at 13% or approximately 800 points. Both of these breakers called for a halt in trading for 15 minutes. The third and final Breaker would occur with a 20% decline, about 1,200 points in the S&P, and then trading would be halted for the rest of the day.
While this discussion may seem like an interesting piece of history, certain current factors make a review of the Flash Crash relevant today. Whether we like to believe it or not, the financial markets are living under a constant “hair trigger,” which, if activated, could see prices move precipitously.
Three factors allow another Flash Crash to occur at any time. Like the Great California Earthquake, this threat is constant.
The first factor is the threat of high-frequency trading, a trade executed in a micro millisecond. Immediately after that 2010 Flash Crash, HFTs came under great scrutiny as investors realized that Mr. Sarao was operating in a world many didn’t know existed. High-frequency traders are in and out of the market (buying and selling) before most of us can get our phones out of our pockets.
Fortunately, HFTs often offset each other, with a rough balance between those purchasing and those selling. But Sarao’s objective, which worked, was to move to an imbalanced market, more on the sell side. This would drive prices lower, and Sarao could buy very cheaply.
The second Flash Crash risk factor is the preponderance of Index Investing — many mutual funds using the S&P 500 Index will need to adjust when the Index declines. A significant price drop, like the one in 2010, will compel the funds to sell, compounding the decline.
The final Flash Crash Risk Factor is the dominance of algorithms in trading systems. These semi-autonomous computer systems automatically make purchases and sales for mutual, hedge, and private equity funds. This is a boon to passive investment managers, including some of the world’s most significant managers, such as BlackRock and Vanguard. Unfortunately, in a Crash Scenario, passive managers like these funds may add to the decline by placing sell orders upon sell orders.
What to look for
A Flash Crash should be understood rather than feared by the savvy investor. Like a summer thunderstorm, we need to recognize it and raise cash to the degree we can. Acknowledging that a Crash is caused when most market players change their outlook. Historically, Crashes have occurred when the “Big Guys” change their projections from positive to negative, from bullish to bearish. This drives the initial wave of selling.
The time to become a contrarian is when most investors become overly optimistic.
Bernard Baruch told the story of getting his shoes shined. Knowing Baruch was a major investor, the man shining his shoes was dying to tell him about the latest “hot tip,” “couldn’t miss” opportunity. “Yes, sir, that Stock Market is the place to be.” At that moment, Baruch knew it was time for him to sell — the market had become one-sided, and when that optimism would change, something terrible was bound to happen.
As it turned out, Baruch was having his shoes shined in early 1929, just before the Greatest Stock Market Crash in our history. Baruch sold and never looked back.
When everyone feels the market “can’t miss,” you’ll know it’s time to raise some cash.
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