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The Odds of a Crash Are Higher Than You Think

By Jeff Clark
Thursday, October 14, 2010

We've seen some pretty weird stuff this year...
 
There was the "flash crash" back in May, when the Dow plummeted 1,000 points and then recovered it all within just a few minutes. We've seen a persistent bid beneath stock prices, which has held the market up even though investors have pulled money out of equity mutual funds every single month...
 
Interest rates have fallen to historic low levels while the supply of bonds has grown exponentially. Precious metals and commodity prices have exploded higher as the Fed tries to battle deflation. And the Hindenburg Omen made headlines in the financial press and then fizzled like a wet firecracker.
 
Like I said... weird.
 
But this takes the cake...
 
 
Volatility has collapsed.
 
The Volatility Index (VIX) – the market's best measure of investor fear – is now trading below where it was just before the flash crash.
 
Am I the only one who's scared to death?
 
The economy stinks. The mortgage market is riddled with fraud. Banks aren't lending money to anyone. And taxes are going up.
 
Yet, the stock market is partying like there isn't a care in the world.
 
Of course, I understand the bullish argument. If the economy strengthens, stocks will go up. And if the economy doesn't improve, the Fed will print enough money to force stocks higher.
 
Is it really that simple?
 
Somehow, I doubt it. After all, Internet stocks could only go higher in 2000. And real estate only goes up. Right?
 
Pardon me if I don't believe all of the world's problems can be solved by central banks printing money.
 
But I digress... Let's get back to the point of the day.
 
Despite all the oddities in the financial markets this year, no one sees much risk. The Volatility Index is trading near its low for the year, and investors seem to believe all assets can only go higher. They think it's a one-way bet for stocks, bonds, and commodities.
 
But markets don't work that way.
 
Periods of low volatility are always, always, ALWAYS followed by periods of high volatility. And in the financial markets, high volatility means selling pressure.
 
I was bearish in the weeks leading up to the flash crash. The market's action seemed artificial and manipulated. And I wrote about it until I bored myself with the subject.
 
Then we crashed.
 
Now, I can't tell you we're headed for the same destination this time. Markets are never that poetic. But asset prices are expensive and there's a lot more risk to the stock market than the Volatility Index seems to indicate.
 
Pick whatever metaphor you like... storm clouds on the horizon, or sharks in the water... dangerous risks are lurking.
 
Be careful out there.
 
Best regards and good trading,
 
Jeff Clark




Further Reading:

To read the contrary point of view, check out Steve Sjuggerud's recent DailyWealth essay on the subject. Steve argues either the economy recovers on its own... or stimulus dollars pour in and push up asset prices anyway. Get the details here: Why EVERYTHING Is Up and Will Go Higher Still.
 
A few days ago, Jeff gave readers a quick trade to make on the short side. It's probably going to offend you, but he's using an indicator with an incredible track record. Read more here: Investors Will Hate This Trade. Traders Will Love It.

In The Daily Crux
Market Notes
VIX drops more than 20% in just over a week... hits lowest level since late-April market top.
 
Gold sets new record high above $1,370... Silver at new 30-year high.
 
Railroad giants Union Pacific, Canadian National, and Norfolk Southern jump to fresh 52-week highs.
 
Earnings today... Google (Internet ads), Safeway (grocery stores), AMD (semiconductors).
Market Watch
Symbol Price
Change
52-Wk
S&P 500 1173.81 -0.4% +7.5%
Oil 36.00 -0.4% -6.8%
Gold 134.75 +0.5% +29.3%
Silver 24.03 +2.3% +36.9%
US-Dollar 76.96 -0.4% +2.0%
Euro 1.41 +0.9% -5.7%
Volatility 19.88 +4.3% -13.0%
Gold Stocks 530.33 -0.6% +16.7%
10-Year Yield 2.49 +2.5% -27.2%

World ETFs
Symbol Price
Change
52-Wk
USA 117.46 -0.4% +7.5%
Canada 29.27 -0.4% +9.2%
Russia 20.21 -0.3% -0.9%
India 38.97 -1.0% +27.1%
Israel 16.75 -0.5% +16.7%
Japan 10.22 +0.7% +1.9%
Singapore 13.80 +0.2% +23.4%
Taiwan 13.59 +0.8% +7.5%
S. Korea 55.41 +0.8% +16.2%
S. Africa 70.15 -0.3% +19.9%
China 45.88 +0.3% +3.6%
Lat.America 52.55 -0.4% +11.6%

Sector ETFs
Symbol Price
Change
52-Wk
Oil Service 119.11 -0.3% -5.3%
Big Pharma 66.48 +0.0% -0.5%
Internet 64.96 +1.1% +23.9%
Semis 13.50 -0.4% +5.2%
Utilities 31.80 -0.2% +8.3%
Defense 17.67 -0.6% +7.6%
Nanotech 9.61 -0.3% -12.2%
Alt. Energy 10.42 +0.8% -6.0%
Water 17.41 -0.6% +3.6%
Insurance 15.65 -0.6% +10.2%
Biotech 20.10 -0.5% +17.2%
Retail 17.84 -0.4% +12.0%
Software 23.09 +0.0% +16.2%
Big Tech 50.42 -0.2% +16.8%
Construction 12.23 -1.4% +0.5%
Media 12.97 -0.2% +18.8%
Consumer Svcs 62.37 -0.4% +15.8%
Financials 53.07 -1.4% -4.0%
Health Care 64.25 -0.2% +7.4%
Industrials 59.90 -0.4% +15.4%
Basic Mat 68.41 -0.9% +17.7%
Real Estate 55.08 -0.3% +26.8%
Transportation 84.90 -0.6% +16.5%
Telecom 21.93 -0.5% +18.4%