Stock Market Crash 2014: How a Correction Could Turn Into a Meltdown

Instead of the healthy correction that many market watchers have been expecting, several hard-to-see cracks in the market infrastructure could instead give us a full-blown stock market crash in 2014.

A 317-point drop in the Dow Jones Industrial Average July 31 - as well as a 140-point drop Tuesday and 75-point fall yesterday - seemed to confirm that we're on the verge of, if not in the middle of, a market correction.

Money Morning Capital Wave Strategist Shah Gilani is not surprised, as he has been predicting a 20% stock market correction for weeks.

To Gilani, the signs were clear to see.

stock market crash"Everybody sees the divergence between the market and the economy - the market was trading near its highs, while the economy hasn't been doing nearly as well. That needs to correct at some point," he said.

Among the reasons the markets have been out of synch with the economy are the Federal Reserve-engineered low interest rates that have kept borrowing incredibly cheap for such activities as paying out dividends and buying back stock.

The stock buybacks result in fewer shares, and have given the illusion that companies are delivering more earnings per share. And, as artificial as it may be, higher EPS numbers have played a big role in driving stock prices higher, Gilani said.

And as the Fed gradually has let the air out of the balloon of its bond-buying program (officially known as quantitative easing, or QE) - another factor that has propped up the markets - the psychology of an increasingly jittery market has started to shift.

"Any kind of existential threat to the market could trigger a large round of profit-taking," Gilani warned. He said the Fed lacks the tools to act as market savior now that it has committed to ending QE.

But that's not even the biggest risk lurking in the markets...

Gilani, a former hedge fund manager who understands the mechanics of how Wall Street works, said there are problems with the structure of the markets themselves that could escalate an ordinary correction into a bigger market crash...

How a Stock Market Correction Becomes a Stock Market Crash

"Fundamentally, the markets are not sound because of the mechanisms that the markets are built upon these days," Gilani said. "There are so many moving parts. And any number of these parts could end up seizing up."

For example, he pointed to the parent company of Portugal's Banco Espirito Santo SA, which touched off fresh fears about the health of the banking system after it missed some short-term debt payments.

"This is Portugal's second-biggest lender," Gilani said. "This happened even after all the stress tests. Where were the regulators? How could no one see this coming?"

He finds the episode disturbing because it comes so long after a 2008 financial crisis that was supposed to be in the rear view mirror, and because it may not be an isolated case.

"It could happen here," Gilani said. "What is being hidden from us in terms of the health of our banks?"

Then there's HFT - high-frequency trading, an issue that Gilani has been speaking out against for years.

High-frequency traders use computers to send out thousands of buy and sell orders each second to "feel out" the market and then execute only the fraction of those trades that will earn a profit for the HFT operator.

Gilani worries that the false liquidity the HFT operators provide would dry up in a major market correction and greatly amplify the plunge.

He recalled the "flash crash" of 2010 when the HFT operators shut down their computers when they sensed trouble, draining the markets of most of its liquidity and sending the Dow Jones Industrial Average down 1,000 points within minutes.

He's also worried about something that one would not believe all that troublesome: Exchange-traded funds (ETFs).

How ETFs Could Help Fuel a Stock Market Crash

"ETFs play a much larger role in the market than people realize," Gilani said, and that they have a built-in risk few consider.

He worries that in a stock market crash, the way ETFs are structured could add more fuel to the selling momentum. That's because the ETF price at any given time doesn't always match the precise value of the securities it holds, unlike a mutual fund, which recalculates its net asset value (NAV) at the end of each trading day.

This can become a problem in a stock market crash as investors start selling large numbers of shares of the ETF, Gilani said. Since the amount of securities that an ETF holds needs to correlate to its shares - it's not a stock, there's no fixed float - the ETF must start selling shares of the underlying securities.

That feeds the overall market sell-off, which drives more selling of the ETF, amplifying the stock market crash.

Add in what the HFT operators will most likely do in this scenario - pull the plug on their computers and suck out most of the market liquidity - and it's easy to see where real panic could set in.

"There are ghosts in the machine," Gilani said. "We've already caught glimpses of them."

So what does this mean for investors?

What Investors Should Do Now

While Gilani says a correction is coming soon and that the market has structural flaws that could make it worse, he knows that the long-term outlook is still strong as we're in a "generational bull market."

While preparing for any kind of stock market crash is a challenge, Gilani says dumping everything is a bad idea.

"I'm a strong believer that you have to be in it to win it," he said.

The most important thing for investors to do, Gilani said, is to always have a plan: "You need to know when you're going to get out, or add more if stocks go down."

As for specifics, he recommends big cap, high-dividend stocks.

"They'll hold up in a big sell-off, and will go back up when the market recovers," he said. "And in the meantime, you'll get the dividend income."

For those comfortable with options, Gilani also recommends buying puts, which he likens to buying insurance.

One policy endorsed by all Money Morning experts is the use of trailing stops, which limit losses. Even then investors need to keep an eye on the market so they can get back in at bargain prices.

"Stocks need to clean out some of the dead brush," Gilani said. "But you need to stay in because after that there's nowhere to go but up."

Are you ready for a stock market crash, or sharp correction of 20%? What are you doing to prepare? Let us know on Twitter @moneymorning or Facebook.

UP NEXT: If you listen to the central bankers of the world, deflation, not inflation, is the worst fate that can befall a currency. They whip up false fears of deflation to defend their inflation-feeding policies while ignoring critical lessons from the past. But these lies could trigger another market collapse...

About the Author

David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.

Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.

Dave has a BA in English and Mass Communications from Loyola University Maryland.

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