The Real Reason for Yesterday’s Stock-Market Sell-Off

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On Aug. 11, 2010, the Dow Jones Industrial Average plunged 265 points, or 2.5%.

This Tuesday – almost exactly one year later – the Dow dropped … 265 points.

Those carbon-copy stock-market sell-offs weren't a coincidence. – as yesterday's (Thursday's) 512-point drop and further weakness will prove.

Although the Dow is more than 700 points higher than it was at this time a year ago, U.S. stock prices are currently following virtually the same trading pattern that they did in 2010: Last year and again so far this year the early-year gains came to a halt in May, and the markets then fell through August.

But here's where the story gets scary.

Last year, the U.S. Federal Reserve halted the stock market's summer swoon by opting for a second round of quantitative easing – an initiative most of us refer to as "QE2."

A year later, even after a week heavy with stock-market sell-offs, there's no guarantee we'll see another Fed rescue mission. And this time around, without a massive injection of quantitative easing – the much-ballyhooed QE3 – it could finally be all over for the stock market.

Where the Stimulus Really Went

Stocks have endured a real beating in recent days – yesterday's stock market sell-off was the worst one-day plunge in U.S. stock prices since December 2008.

When the Dow plunged 265 points on Tuesday, it was because of an unexpectedly large drop in the Institute for Supply Management's (ISM) Purchasing Manager's Index (PMI). The 265-point August 2010 sell-off was precipitated by the U.S. Federal Reserve's negative outlook on the American economy.

But both the August sell-offs were preceded by strong run-ups in stock prices. Those run-ups weren't sparked by an improved economic outlook – which is how it usually works.

Instead, the bull market that powered U.S. stocks off their March 2009 bear-market lows was the result of the massive monetary stimulus put in place by Washington and the U.S. Federal Reserve.

The U.S. monetary stimulus – billions of dollars worth- went into banks and other financial institutions – and not into the economy.

That's why stocks have benefited – even in the face of an economy in which growth has been lackluster, if not downright flat.

Generally, stock prices are a reflection of corporate profitability. Sometimes rising stock prices lead economic activity and sometimes price appreciation trails economic growth. But historically, stock prices don't rise if the economy isn't growing.

This time around, however, there was a "trickle-down" benefit that boosted stocks, but bypassed the economy.

The monetary stimulus trickled down from banks, where it was initially injected, onto corporate balance sheets. From there, thanks to a weakened U.S. dollar, the stimulus enhanced export-driven corporate profitability.

Lest you think this occurred by happenstance, let me assure you: This all happened by design.

The Ugly Truth About the American Banking System

Most U.S. banks were in dire straights and all of the too-big-to-fail banks (the largest banks in the U.S.) were insolvent as a result of the credit crisis that hit in 2008. Both the U.S. Treasury Department and the Federal Reserve (which is run by bankers, essentially for banks) recognized that they had to save the banks at any and all costs – otherwise the U.S. economy and the global economy would collapse into a depression of catastrophic proportions.

Money was pumped into the financial system by means of several government and Federal Reserve programs. Interest rates were kept so low that the overnight rate that banks charge each other, which is engineered by the Federal Reserve Bank of New York, was, and still is, at historic lows in the range of 0.00% to 0.25%.

With money borrowed at essentially no cost, banks bought risk-free U.S. Treasuries. The banks used the Treasuries they bought as collateral to borrow more money in the short-term "repo" markets. And with those additional borrowed funds, the banks bought even more Treasuries.

The interest that the banks collect on the Treasuries (which you and I as taxpayers are essentially paying) created a profitable "interest-rate spread" – the difference between the interest they earned on the bonds they held and the almost-interest-free "loans" they took out in order to leverage their balance sheets.

Banks play a key role in the U.S. economy. By lending money to the private sector, they make it possible for new companies to be formed and existing ones to grow – all of which creates jobs and helps the economy grow.

But banks aren't lending to the public. Why should they? They make good, safe money on a risk-free basis running the Treasury-spread trade.

Besides, U.S. credit demand has been anemic.

Corporate America Joins the Party

Because interest rates are being held down at artificially low levels, corporations also turned to the bond market to borrow cheaply. In such a low-rate environment, fixed-income investors were forced to scramble for any additional yield they could get above that of U.S. Treasuries – meaning they were only too happy to oblige corporations by lending them money.

Corporate America was able to quickly retool its collective balance sheet, and now sits on about $2 trillion in "cash equivalents" – Treasury bills that companies use to make sure that they collect at least a tiny bit of interest.

The key direct consequence of this massive monetary stimulus has been a weak U.S. dollar. As the dollar falls in value, it makes U.S. exports cheaper on global markets.

That's why corporations with healthy balance sheets and substantial overseas sales have been reporting great earnings. And it's also why these corporate heavyweights – and many mid-sized companies, besides – have enjoyed a nice run-up in their share prices.

It doesn't end there, either. When such strong stock-price gains are posted in a couple of sectors, investors turn to "underperforming" sectors to ferret out bargains, hoping to get in ahead of the inevitable share-price rebounds that result from the money that floods in after investors "rotate" out of fully priced stocks into their undervalued brethren.

One Long Stock-Market Sell-Off?

The bottom line is that the stock and bond markets have been big beneficiaries of the trickle-down policies of the Fed and the Treasury. This is exactly what Fed Chairman Ben S. Bernanke said he wanted to see happen in order to stem the threat of deflation. It has been an articulated policy (except for any admission that they wanted to knock the dollar down – which, of course, they knew would happen).

That brings us to the state of the U.S. economy.

By this time you've no doubt heard the term "The New Normal."

The New Normal – as espoused by PIMCO's Mohamed A. El-Erian – is pictured as an American economy with a chronically anemic growth rate of 1.0% to 2.5%, and structural unemployment in the 8% to 9% range.

It's not a pretty picture.

Already this year, first-quarter gross-domestic-product (GDP) growth was adjusted from an initial estimate of 1.9% all the way down to 0.4%. The second-quarter number just came in at 1.3% -well below the 1.9% rate analysts had been expecting.

It's not just the GDP numbers that have been all over the place and slipping dangerously. Many other economic indicators and data points are turning down.

Investor sentiment and consumer confidence are at multiyear lows. Unemployment remains stubbornly high and is likely to rise. Private-sector employment has been horrible and new deficit-reduction plans will lead to reductions in government spending and layoffs in the historically stable government-jobs sector.

It's no wonder, then, that when the Purchasing Manager's Index came out on Tuesday at 50.9% (its lowest level since October 2008, and its first contraction since June 2009), already-skittish markets plunged. And they've continued to fall – as we saw with yesterday's 4.78% plunge in the Standard & Poor's 500 Index and 4.31% dive in the Dow.

Just like last August, if the economy continues to falter, the markets will pay more attention to economic reports than to company-earnings reports – no matter how good those earnings reports might be.

And unless we get another round of stimulus – in whatever form we're able to get it – the aborted stock-market sell-off of last August will come home to roost today.

As this week's stock-market sell-off underscores, last summer's QE2 rescue mission has only postponed the inevitable.

Investors better be defensive. The financial markets have been long overdue for a major correction. And without some new stimulus that actually makes sense for the economy – and doesn't just pump up asset prices – the protracted stock-market sell-off that will carry us through autumn will forever be remembered as "The Fall."

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. Keith | August 5, 2011

    100's of Trillions is not correct, this much money does not exist!

  2. Ken barclay | August 5, 2011

    Nice to see Shaw articulate in his excellent article above what the president should have been telling the American people when he first came into office, inheriting the overindulgent financial mess left by the Bush years. They should have been told that the deleveraging process at the banks would take years and all at the expense of domestic economic activity and employment. While families, state and municipal governments, all who have to live within a balanced budget, struggle with their deleveraging essentially accepting a lower standard of living, Washington with it's printing press, is still in the self perpetuating mode. Three cheers for the Tea Party wakeup call.

    • Juan | August 11, 2011

      Its funny no sad Bush faced the first in a long time attack on the US mainland from a guy who Bill Clinton released from jail and sent on his way after 2 failed attempts to destroy the towers. In turn he went after the culprits rightly or wrongly and this came with a big a bill- very big bill granted. Ok then how come Obama excasterbated the spending for the effort and jumps up and down now that he blundgoened the guy Clinton let go in the first place. I guess this whole part of the 800 bllion war spend could have been avoided if we just turned our heads. I cant sleep much thinking of the two family members lost in NY so I really dont have a problem with either of the efforts. We didnt get here turning our heads. We got here financially because Obee spent or gave away trillion to every other liberal or cronny liberal scheme on the planet, He didnt, and has not and will not do anything to meaningful to create jobs and hlep housing, because it means capitalism will be better restored which goes against the grain of his desire for a socialist america – government does all

  3. Peter Walsh | August 5, 2011

    Finally, the days of earning income producing nothing are over.

  4. Guy from Canada | August 5, 2011

    "The U.S. monetary stimulus – hundreds of trillions of dollars worth- went into banks and other financial institutions – and not into the economy. "…………….Perhaps that should have just been TRILLIONS OF DOLLARS WORTH. Just as dramatic, but a lot more accurate. Apart from that, it was a well written piece and one of the reasons articulated are why I'm liquidating much of my portfolio so I can use the cash like I did back in January 2009 to buy good assets cheaply.

  5. craig | August 5, 2011

    Welcome to the full blown start of the agenda to bring about the destruction of the Western World by the Guelph's and Knights of Malta controlling Worldwide banking through the Crown at the sovereign state of the City of London covertly controlled from St John's Wood, England having governed the Crown since the 14th Century being commanded today from Via Condotti, Rome in Italy. Study the Universal Postal Union in Berne, Switzerland and of course The Worshipful Company of International Bankers and finally TheCityUK etc these are the Crown Maltese replacing the Crown Temple or Templar which took over the Crown 100% in 1215 due to the signing of the Magna Carta. When the Knights Templar were suppressed in the 13th Century all there powers were handed to the older Knights of Malta. The current Grandmaster Matthew Festing who's a Cardinal controls all recognized Knights of Malta orders (Protestant divisions) via his minion in Geneva, Switzerland commanding The Alliance of the Orders of St John of Jersualem. Geneva canton is controlled by Knight of Malta, Vittorio Emanuele IV the head of the House of Savoy and loyal to the Pope of Rome. All businesss Worldwide is conducted under Uniform Commercial Code of 1933 and Vatican Canon Law last adapted in 1984 which Admiralty Law is based upon, actually going back to when the Roman Empire perfected this ancient merchant law from Phoenicia.

  6. Voiceless in a democracy | August 5, 2011

    Yes, Ken barclay, but let's not forget it was Clinton's idea to get lots of folks into mortgages they could not afford …

  7. Mike P | August 5, 2011

    We face some hard days ahead but if we all keep our heads we will be ok maby not the same but ok . As a people we need to get tough and off our ass and take the bitter pill tell washington NO MORE!!! and ride out the wild storm .then we can see still waters again.

  8. David | August 5, 2011

    Keith is correct–you must have meant "billions", no?

  9. Johanna Lipford | August 5, 2011

    I too noticed the 100s of trillions and supposed he meant billions, but it still made me wonder about the reliability of the whole report, with such a glaring mistake made at the beginning

  10. Seth | August 5, 2011

    I beg to differ that QE3 is not the answer; what QE3 will do is just buying us time as QE2 did. The reality is, the Bush administration with Paulson's Treasury did the Country a great disservice by exchanging the Wall Street woes with the Country's peace, and Obama followed suit.

    The Country needs a major structural adjustment, and not QE3 which consequences are likely to cause the US Dollar to lose its dominance as the World Currency. The negative effect of loosing that privilege may not be repairable in our lifetime, and the result may be catastrophic.

    Increasing the Debt Ceiling now is okay, at least, to temporary calm nerves. What we need now is to stay the level of our debt, and initiate drastic policies that are likely to accelerate job creation such as significant incentives for manufacturing through major investment tax cuts, opening up our shore for oil and gas exploration, and reasonable deregulation of our financial markets ie a repeal of Sarbox and Dodd Frank; with that the economy may respond positively.

  11. Aprov | August 5, 2011

    A very nicely done article! Thank you!! :)

  12. William Patalon III | August 5, 2011

    Dear Keith and David:

    Great catch … you are both correct. It was an editing mistake made on deadline. We've actually made the fix in the story. Thank you very much for taking the time to write.

    Respectfully yours;

    William Patalon III
    Executive Editor
    Money Morning

  13. KiwiGandalf | August 5, 2011

    Tax credits and tax cuts will do zilch to increase job creation without an increase in consumer demand.
    Companies will not invest in expansion until they have orders or a workload they can no longer handle with current resources. Why should they? The focus needs to be on creating jobs and getting people spending, and that will need government expenditure to kick start it. Without that, people would rather sit on their cash than invest it in production expansion or spending it. Cutting budgets in this environment will do nothing other than prolong and deepen the pain. So… whose going to start organising the masses to demonstrate on the streets. It is time for the US to have its own Arab Spring.

  14. rich | August 5, 2011

    kenbarclay u sound like u should be working for obama himself! the blame game 3 yrs later is weak and lame, so get over it. obama promised us things he could NEVER deliver and thats how he got elected.blaming others is a sign of weakness and aloser. bush inherited a stock market crash,a recession, and hit with 9-11 and I NEVER HEARD HIM BLAME CLINTON ONCE!! also the pressure on freddie and fannie to impoverished people motgages came from clinton administration and barney (porky pig) frank

  15. Hick | August 5, 2011

    Good article.
    Time to ocme back to realities or at least 25% correction.
    Nothing fundamental allowed investors to earn so much in the last two years.
    Smart guys – sell your share and keep cash.

  16. James | August 5, 2011

    Another great article by Shah Gilani!

    What happens when the Federal Reserve embarks on QE3?

    Banks will repeat what they did in QE2 as explained in the article by "not lending to the public" because the funds will be used to buy treasuries to make comfortable risk free profits. What Shah forgot to mention was that these funds were also used by the banks to play the commodities market to speculate on oil, gold, silver and other metals, agricultural products etc. that resulted in run-up in prices to artificial levels that lined bankers pockets.

    Quantity easing is a temporary fix. Afterwards, another one is due and then still another one. The U.S. is already so deep in the hole it is going to take a miracle to get out of the shackles of this huge financial hole. U.S. is just another Japan mired in debt.

    The wheels of government turn slowly, but they turn. The tea party is a canary tweeting in the coal mine. It represents the power of public voters and it is going to be a bigger force in the coming years turning the wheels of government in another direction. What's needed are hard-nosed fundamental reforms to our tax, financial and political systems. They are way out of balance. Currently, our tax system (too many tax loopholes favoring the rich and corporations), our financial system (too much influence from Wall Street banks working for their own gain at the expense of the public) and our political sytem (rich lobbyists buying out politicians) are broken and need to be fixed. These are real issues impacting our lives and our nation's health. Until they are addressed, and from recent events, voters are so dissatisfied with our government and the shenanigans going on, they will take it upon themselves to make necessary changes. A balanced budget is just a first step. More will come.

    Cheers!

  17. Mark | August 6, 2011

    Let us not forget the freddy and fannie situation neglected by the notorious Chris Dodd, the Democratic Party's Chair with oversight on the home lending market and the cause of our current financial problems. As Shaw stated earlier…without a health home lending market and sales, we are seeing the ramifications. To all the Bush blamers…please quit. There are no grounds to keep harping on a past president when the current has done NOTHING!!! …and our Democratic Congress is doing less…

  18. AVELÃS COELHO (Portugal) | August 6, 2011

    Excelent article!

  19. voteright2012 | August 6, 2011

    Instead of QE3; how about instituting a retro-active (to Jan 1, 2011) 15% Flat Income Tax on all earned income over $50,000 per year. Reduce Corporate Tax to 20%, eliminate all loopholes whereby companies like GE pay no taxes. Eliminate the double taxation of dividends, minimum wage laws and Estate Tax permanently. Make the whole United States a Right to Work environment.

    Treat Political Contributions by Unions in the same restrictive manner as those made by Corporations and Individuals. Reduce Washington DC Expenditures by 30% – 50%. Eliminate all Foreign Aid. Reduce our payments to the UN, IMF, World Bank etc to a sane level determined by our Y to Y Private GDP Growth (Do not include Government Growth in this calculation).

    Some pro Big-Government Bureaucrats & Politicians will say these steps would stall the Economy — to that I would say definitely not. Rather I believe the Economy would recover and accelerate and make the US an Economic Power again. These steps will also bring back money and jobs that in foreign countries.

  20. colt | August 6, 2011

    Sounds like @Rich had the blinders on.

  21. Curtis R. Bell | August 6, 2011

    This is a really good article ! I see clearly the rain is here.

  22. Ken Franks | August 6, 2011

    Interesting Article. You are aware that 1) 2% of the top dollar earners pay 38% of all federal income taxes collected; 2) that 10% of the top dollar earners pay 72% of all federal income taxes collected; 3) that 51% of those working do not pay any income tax at all; and that even if you are a millionaire or a billionaire that in any given year if you don't EARN a dollar you don't have to pay any income tax and you are still considered to be a millionaire or a billionaire. I personally believe that we should do away with the IRS, all tax lawyers and the current federal and state tax codes….and have a flat federal sale tax on everything bought (or sold)….no more loop holes, no more deductions, no more tax breaks of any kind….just a national sale tax of say 2%. States could also have a like sales tax of say 3%, since they should be running their state rather than looking to DC for federal nickel$ here and federal nickel$ there. Counties a 1% sale tax. Cities a 2% sales tax. Furthermore, each city, county, state or federal budget for "next" year should, can not, exceed the total taxes received from the year before. Real emergencies would be an exception, but clearly spelled out. That's 8 cents per dollar spent (or earn). Most everyone I know (and I have relatives unemployed, on welfare and SSDI) could afford this. Now, they might have to buy one less recreational drug, pack of cigarettes, or six pack every month, but that's OK. That's my take. What do you think?

  23. td sellers | August 7, 2011

    Am I missing something here…..I read this article cause it said ag to go to $250……it never even mentioned silver.

  24. Ventureshadow | August 7, 2011

    What can you trust to preserve the value of your money? Paper dollars…nah, they're just printed at whim. Euros…likewise. Chinese Yuan…the government's unstable, once they can't export they choke, and they'll choke anyway. Swiss and Singapore currency…too many elephants are crowded into a tiny room. Stocks…maybe a few. Bonds…maybe a few. Silver and gold…get out the shovels and hope the neighbors aren't watchng. Ammo, liquor, and canned food…and beware Mad Max. Toilet paper…nah, you can use leaves or old newspapers. Antiques and artworks such as shown on "Antique Road Show"…should make good kindling. Government officials and bankers have robbed us blind and we ain't got nuthin' much left. Money and government service are fantasies, they all depend on faith and deception, they deceive we believe.

  25. Jack | August 7, 2011

    Why didn't you post my comment, did I hit a nerve?

  26. GrandestR000 | August 7, 2011

    All the politicians have succeeded in doing is driving out real investment toward safe havens. They can’t stop this bleeding to gold and the franc, and now the yen? C’mon. I've been trying to figure the coming trend for gold for some time, and while it's fairly easy to read the fundamentals – at the moment – the technicals are sparking off mixed messages. Been using this to get a grip – I am recommending this small, stellar analysis company: http://tinyurl.com/3wvd2mz
    Be sure to try the free subscription. It actually is free and they don’t bug you. Nothing to lose, I’m just saying, Gary Wagner of the Gold Forecast is shockingly accurate. It is truly uncanny.

  27. Thomas G. Kroger | August 7, 2011

    This excellent piece – and much of the thoughtful commentary that follows it – reminds me of a quote from President Reagan – "Perhaps there are some simple answers. There just aren't any easy ones."

    Ron Paul is the only public figure who's had the courage and tenacity to take on the heart of the problem – namely the Federal Reserve System. This system – foisted by deliberate deception upon the American people in 1913 – claims to be "defending" the dollar. Since its inception, the dollar has lost approximately 96% of its purchasing power, and what little is left is dwindling rapidly. The "Fed" is undemocratic and aloof from the American people – witness Bernanke's arrogant response to Congress when asked where the bailout money went – "I'm not telling you." This kind of unaccountable power is precisely why the Founding Fathers opposed a central bank. Instead, the wanted a national bank – accountable to Congress – and a debt-free currency.

    We won't have domestic tranquility – nor prosperity again – until we rid ourselves of this corrupt and evil system, and reinstitute money. It is NOT our economy that has failed, nor the American Experiment or people. What has failed, is our evil and corrupt money system, which is a private monopoly. It did not arise from natural market forces. It was, and remains, a contrivance by which plutocrats control society and exact a pound of flesh from the rest of us, which they view as cattle.

  28. jakP | August 9, 2011

    Forget the typographical error, 100's of trillions. there instead of their, and concentrate on WHY you go to the trouble of posting a message!

    Try and realise that ALL politicians are "dumkopfs" and they are what they are because they are no good at anything else either. Bankers are ALL crooks & why they are allowed to get away with billions in bonuses when they have been the originators of this crash in the first place; added and abetted by the "dumkopf" politicians who, instead of pointing a "yuman rights" finger at the Chinese, should concentrate on the wellbeing of their own people! Greenspan, Bernanke, Brown & others should have regulated the financial sector… what has happened has been going to happen for decades.

    In 1992 Gerald Corrigan (then President of the NY Fed Reserve) addressed a meeting of Bankers in NYC and told them that he was worried about the enormous and growing trade in "financial instruments" which had already reached a volume of 1.2 "trillion" $'s & if they thought his message was a warning "it was".

    Through the subsequent years obvious signs of "scullduggery" in the financial sector should have got our politicians to take a long hard look…Enron, Barings, and many others including the man with the get out of jail card, Bernie Madoff. 'But what did we get… condemnation & sacking of whistleblowers who were trying to point to the dangers, even people like the risk manager of HBos who in 2004 suggested that the company should change tack as their financial safety was at risk. He was castigated and eventually sacked by the CEO whose committee of a** kissers had pooh poohed his statements.

    4 years later they had to be saved from bankrupcy by another bank, the stress of which caused the government to takeover the bank to avoid a Lehmans type collapse.

    Gordon Brown the financial "guru" who organised this disasterous "marriage" whilst not noticing the growing collapse of the British financial sector has since had the gall to put himself forward for the IMF job!!!

    Whistleblowers should be listened to seriouslly, it is very likely that what they have to say is important…
    even Julian assange.

    Jak

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