Maximum Ruin Scenario for the Stock Market

[Higgenbotham]

I moved this post from the other thread to its own topic.

Here's a scenario I've thought of that combines several thoughts that have been posted in various topics in this forum: Maximum Ruin, stop losses, shorts getting paid, flash crash, real value of the stock market, etc.

First a couple thoughts.

Yes, short term the stock market is a game but long term it is not. Long term, stock prices are based on underlying value but as we all are finding out the market can ignore underlying value for what seems like an eternity. While not a fan of Buffett, I think he put this idea best: "In the short term the market is a voting machine, in the long term it is a weighing machine."

In 1857, there was a generational panic and big recovery, but what is little known is there was a less severe panic in 1859. This would also fit somewhat into scenarios that have been discussed. It's also interesting in that the common wisdom today is back to back panics never happen, so it's impossible for another panic to occur at this time.

Let's say a more serious flash crash were to occur for whatever reason. Nobody really knows why the last one occurred anyway so consistent with that there doesn't have to be a reason. Stop loss orders get hit, blah, blah, and the S&P ends up down 400 points within one or a few days. Complete chaos and everyone is worried it's the big one. The shorts are looking left and looking right and saying, you know what, I'd better cover these shorts right here because if I don't the exchange may go bankrupt and I may not get paid. So all of a sudden a massive short covering rally takes off and drives the index back up to close to where the panic started. Before the public is done blinking in amazement, their stop loss orders have been hit near the lows or they have panicked out, and they have lost 1/3 of the value of their holdings once again. They blame the "Government Sachs" manipulators for it, riot in the streets, and want nothing to do with the stock market for the rest of their lives. The HFT machines are immediately ordered shut down, Bernanke is kicked out, and Glass Steagall is reinstated. Then the market begins a long, slow, steady 5-10 year grind down to real value.

[vincecate]

I don't see stocks bouncing back up to anywhere close to the current level. I think it will be bonds dropping that causes/triggers the stock market to drop. I don't see bonds bouncing back, so I don't see stocks bouncing back. After the 30 year bond yield crosses 5%, I don't think it will ever look back.

I think we will be seeing more and more signs that inflation is going up and more and more the dollar will weaken relative to real things (commodities, gold, oil) though maybe not relative to other paper currencies. As interest rates go up and bonds go down stocks should go down too. Eventually inflation will bring stocks up but the initial impact on P/E ratios will cause them to go down.

Stocks overshooting to the downside seems more probable. A small bounce from the overshoot is reasonable.

[Higgenbotham]

I don't see stocks bouncing back up to anywhere close to the current level. I think it will be bonds dropping that causes/triggers the stock market to drop.

For some reason I never noticed this, but after reading your post I looked at the charts of the 5, 10, and 30 year treasury yields. It's especially noticeable on the 5 and 10 year yields that there is a series of lower interest rate peaks. Every time the 5 and 10 year yields get up close to the previous peak, the stock market runs into trouble. All of the yields are getting up close to the previous peak from April 2010.

If what you're saying is true, that the yields will quickly shoot up higher than their previous peaks, then I'm quite sure you will be right - the stock market will fall hard and not come back. My tendency is to think the stock market will start to fall even before yields get back up to their previous peaks. At least, that's what it has been doing thus far.

[OLD1953]

Generally, people either leave bonds looking for better yields, or they leave stocks looking for security. The stock and bond markets are yoked together in this sense.

If bonds are regarded as insecure, and stocks are regarded as the domain of cheats, it's cash in the mattress time. And that leads to collapse that you can't get over for decades.

[Higgenbotham]

Mark D Cook is an expert independent trader who was featured in one of the "Market Wizards" books. I just ran across his 2011 forecast and found this excerpt very pertinent to our recent discussions/comments above.

http://blog.markdcook.com/?cat=5

I sincerely hope that your open mind is now saying, “Wow, I had not thought about these specifics”. I have always tried to look beneath the surface of why things are not what they appear. This leads to my next projection which is an awareness of the financial environment. More of the same with a lack of balance? Ponder this phrase as the introduction into my next projection.

My next projection is that the computer world will have a glitch that will shake Wall Street, Main Street, and Capitol Hill. I have seen the S&P futures evolve into an environment where the bobby pin is going to short circuit the main frame. They called it the fat thumb trade in May of last year. A momentary glitch that sent billions of dollars into cyber space away from peoples’ account statements. Did we learn from that? No. The old adage fool me once, shame on you, fool me twice shame on me. This glitch in 2011 has to have a backdrop that allows a void to materialize. The ‘void’ creator is Benny B. and his academia buddies that I will refer to as the ‘Rascals’.

The S&P was up almost 13% in 2010. Not euphoric or is it? The comparisons to the 10 year environment may make you think it is euphoric. The past 10 years has had a gain of between 7-8% total not annually. The month of December was up just shy of 7%. Wow, one month made as much as 10 years! How is that possible? The ‘Rascals’! December 2010 was the biggest gain since 1991, 19 years ago! The ‘Rascals’.

Here is my next forecast. The S&P futures will have at least a 22% correction from the highs to the lows this year equating to a movement of 250 to 300 actual points. More importantly, we will have volatility. My Daily CCT is reading at warning levels not seen in years. The stock market needs energy to hold and escalate from many sources not just the “Rascals”. The market correction will need a catalyst to shock reality back into a Camelot minded investment world. Watch closely how this new Congress deals with the Fed. No longer is the Congress and the Fed bedfellows and bed gals! Some very key positions in Congress are now held by some very adversarial personalities to the ‘Rascals’ . The Fed has been an uncontrolled teen-ager on speed, it is time to be taken to the woodshed where Ron Paul has a big stick.

The next projection is rampant inflation that becomes a tsunami over the next 5 years. The ‘Rascals’ still stinging from derriere adjustments will actually raise interest rates in 2011. The ‘Rascals’ will be viewed much differently by everyone in 2011. Understand the transformation!

The 2011 strategy is to see the big picture as understanding the environment is paramount. Goldman Sachs will finally be shackled by regulation not conscience as their front running the Fed QE2 money will end. The bond market took it on the chin in 2010, the stock market will take it on the chin in 2011. Commodities will continue to emerge as favorites, stock and bonds as tools of the ‘rascals’ to be shunned.

[Morgan]

I have read the article and it seems real that stock market is facing the worst case scenario right now and this phenomenon is global effects as financial crisis has engulfed all the nations of the world .