The New Crash Will Be the Same as the Old Crash, but Worse

The mechanical causes of the Oct. 19, 1987, crash, which wiped 22% off the value of the Dow Jones Industrial Average in a day, are now a frighteningly large part of the fabric of equity markets in the United States.

So is something else that didn't exist in 1987.

Something that, at the exact worst moment in the trajectory of a crash, will rip the heart of liquidity out of the market without blinking an eye.

In fact, the very nature of the crash will target the people who think they are the safest.

Here's how regulators fed the monster sleeping under passive investors' beds...

The Myth of Portfolio Insurance

Today there isn't just one form of "portfolio insurance," which regulators and academics tagged as the principal accelerator of the '87 crash.

There are thousands of equally suspect portfolio insurance strategies employed by tens of millions of investors that cover trillions of dollars' worth of stocks.

Back in 1987, portfolio insurance amounted to shorting S&P 500 futures against long stock portfolios. According to Paul Tudor Jones, whose hedge fund Tudor Investment Corp. made a small fortune on the '87 crash, about $60 billion in portfolio insurance had been put in place before the crash.

There are still money managers whose trading systems are set up to short-sell index futures if markets start falling. But there are much bigger and more systemic hedging and insurance schemes in effect today.

Risk parity is a portfolio management system that, instead of incorporating outside insurance or hedging devices, aims to rebalance the mix of diversified asset-class investments within a portfolio whenever risks become lopsided. For example, if equity prices were falling, they'd be sold, and the allocation to bonds (which would presumably be rising as traders buy them in a "flight to quality") would be increased.

Target volatility is another internal portfolio balancing strategy that sells assets whose volatility rises (increased price dispersion indicating greater risk) and reallocates capital to less volatile assets or cash.

If you think risk parity and target volatility are similar strategies, you're right. They're both based on volatility. The risk in risk parity is mostly measured by volatility.

Then there's volatility itself.

The VIX, the CBOE Volatility Index that measures how volatile the market is, has become a measure of fear. When the VIX rises, it indicates the risk of a market sell-off or worse.

Besides being an important stock and portfolio metric for Wall Street money managers and traders, volatility's been embraced by Main Street.

There are several tradable volatility instruments based upon the VIX that professional and "retail" traders and investors use to hedge their portfolios, but also to speculate on the actual level of the VIX itself.

What made portfolio insurance so incendiary in 1987 is the same thing that's going to turn all the new stock and portfolio insurance schemes into a fireball one day.

They're all rules-based, and rules don't care about what following them might do.

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If This, Then That

When stocks start to slip, some insurance schemes will kick in. If they fall farther, more will kick in.

If they fall far enough, and no one knows where fear levels or "stop" levels are, they'll trigger more and more rules-based selling programs, a lot of which will include index-shorting programs.

In other words, the next panic will have rules-based insurance schemes, exponentially bigger now than in '87, feeding on themselves with the same devastating effect they had on the market 30 years ago.

The market's exposure to rules-based trading programs is huge.

The biggest hedge fund complex in the world, Bridgewater Associates LP, which alone has over $160 billion under management, employs risk parity strategies in its giant All Weather fund and other funds.

According to HFR, a hedge fund industry tracker, rules-based quantitative strategies are used to manage $933 billion held by hedge funds.

Extraordinary things can happen when you know how Wall Street really works. You just need someone who's been on the inside who knows exactly how the game is played. Shah sets the record straight in his twice-weekly Wall Street Insights & Indictments, sharing how to trade the bigger picture for maximum gains. Click here to get Shah's Insights & Indictments for yourself, and you can start beating the Street at its own game. It's completely free.

And that's just hedge funds. There is no way of tallying the amount of money being managed by Wall Street trading desks, bank trading desks, insurance company trading desks, institutional money management companies, and millions of retail traders and investors employing rules-based stock and market selling strategies that will automatically go into effect as conditions warrant.

It's in the trillions.

And inherent in those trillions is the one thing that most insurance strategies have in common... volatility.

Volatility has become so subdued, as measured by the VIX and almost every other measure of portfolio, market, or systemic volatility, that:

  1. Risk parity funds are massively leveraged-up in equities
  2. Target volatility funds are loaded to the gills with assets with the lowest volatility profile: stocks
  3. Bets against the VIX rising are at record levels, meaning there are massive shorts on the VIX
  4. Hedge funds and speculators are selling both VIX call options and VIX call option spreads for "free income" because they don't believe the VIX will rise much

What if it does? What if a bout of fear hits the markets? What happens to volatility then?

What happens if volatility starts rising?

All of those volatility-based insurance schemes will start kicking in.

And as "diversified" as everyone thinks they are, the truth is they're all "correlated" by volatility.

Of course, if you're a "passive investor," one of the investors in the almost $4 trillion worth of index funds sold as the safest way to invest in the market, you're going to be all right, right?

No, you're not.

Next, I'll tell you about the secondary cause of the crash of 1987 and how its modern counterpart is going to go up like kindling.

So, stay tuned...

Up Next: This Win Rate Is Incredible

The U.S. retail sector is crumbling. There have been more than 6,400 store closures in 2017 alone.

These doomed-to-fail companies could be your ticket to windfall gains.

You see, I have a list of 40 retail stocks. I know exactly when each one is likely to terminate. And I've pinpointed specific trades that could help you net up to $1.6 million as they fall into bankruptcy.

I'm sharing this research exclusively with my Zenith Trading Circle subscribers. Since April 21, I've shown them over 3,318% in total winning gains, including individual returns of 179%… 324%… and 995%.

Click here to learn how you can take part.

The post The New Crash Will Be the Same as the Old Crash, but Worse appeared first on Wall Street Insights & Indictments.

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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