These Are the Triggers That Could Bring the Markets to Their Knees

There's a real, clear, and present danger with more than $3.3 trillion parked in passive investing indexed mutual fund and ETF vehicles.

If something triggers so-called passive investors into actively dumping the index funds they're loaded to the teeth with, a black swan-like negative feedback loop could send stocks lower and lower and lower.

Here's how dangerous things are, what could trigger initial selling, what a negative feedback loop would look like, what you need to watch out for, and how to prepare for what could turn into a market crash.

Let's get to it.

When it comes to the market, it's all good until it isn't.

Sure, the more than eight-year-long bull market could continue. In fact, based on my analysis and calculations, the market could double in five years.

But that doesn't mean it will continue to climb in what looks like a straight line since March 2009.

Besides the fact that we haven't had a meaningful correction, which typically shakes out weak-link stocks, the passive investing buying spree floats everything higher, including lots of "loser stocks."

Not only does money flooding into index funds lift all leaky boats with the tide, it makes the big-capitalization, market-leading stocks more and more expensive all the time.

That happens because there are so many "indexes" that are now investable products.

There are whole market indexes, broad market indexes, big-cap, mid-cap, and small-cap indexes - even foreign market indexes. There are loser stocks in all those indexes, and they get bought up when investors buy index funds they're a part of.

That's because the sponsors of index funds have to buy all the stocks that make up the index product they're selling. That's how they track indexes.

On the opposite end of the barbell from loser stocks, there are the big-cap leadership stocks, especially the big tech darlings like Facebook, Amazon, Apple, Google, and Microsoft, and the giant money-center banks that have been garnering a lot of attention and have been soaring. The more they go up, the more their capitalization increases, the more weight they carry in the indexes they're a part of.

So when passive investors buy index funds with big-cap stocks weighing so much, sponsors buying all the underlying stocks that make up the index have to buy even more and more of the big-cap stocks that are already big winners.

That makes them more and more "expensive" on a relative basis. In other words, popular benchmark market indexes are getting top-heavy.

That's all good, until it isn't.

These Are The Triggers to Watch Out For

With investors increasingly being made aware (including passive investors chasing the passive investing trend) that indexes are getting top-heavy, that loser stocks are being brought up that don't deserve to be in a portfolio, that leadership stocks increasingly bear the burden of the whole market, if some trigger gets pulled and investors take some of the massive profits they're sitting on, a cascade of selling could result.

Investors would want to take profits to get out of "overbought" stocks, to get out of crappy stocks that have been bought up simply because they're in index products, and maybe get out of the way of the long overdue correction everyone knows is out there somewhere.

Short-sellers would jump on "overbought" stocks, expecting profit-taking in them and sell-short loser stocks that were bid up simply because they're in indexes.

Profit-taking will start with a trigger being pulled. Here are the big triggers to watch out for:

  • North Korea firing a missile and hitting a target
  • A U.S. first strike
  • Chinese military involvement in any conflict
  • North Korea invading South Korea
  • An uncontainable Washington/U.S. leadership crisis
  • U.S. debt default
  • A major country default or currency devaluation
  • A big bank failure
  • A major stock market malfunction, like the 2010 flash crash

Or some other black swan spreading its wings. There are plenty of triggers out there.

And when one of them is pulled, it's going to cause chaos.

Beware the Negative Feedback Loop

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What starts with profit-taking, especially selling big-cap tech darlings that have led markets and indexes higher, could quickly lead to a negative feedback loop.

So-called passive investors turning into active sellers would be the negative feedback loop's fuel.

The passive investing trend, the latest iteration of old-school "buy and hold," is relatively new. It started gathering momentum a few years after the financial crisis when there weren't many stock pickers hitting home runs, but the indexes were making new highs. It became easier to sell investors on the market than on stock recommendations or hedge funds. As markets moved steadily higher, the passive investing trend gathered momentum.

But the reality of the trend's short history is passive investing's new adherents haven't ever been tested. They've never seen a crash, or a correction, or even a sell-off of more than a few weeks.

They've been passive because they've had no reason to become "active."

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But there are plenty of reasons to expect them to hit the brakes, throw their accounts into reverse, and actively sell when things get bad.

A lot of the money that's gone into passive investing strategies was money that finally came off the sidelines, money that was invested in actively managed mutual funds and hedge funds. In other words, the massive amount of money in the new, hot trend is fresh money chasing the next big thing.

These investors don't have a long history following this strategy - and that worries me.

Anyone who knows "buy and hold" is dead (for several reasons, the most important being that new technologies are constantly disrupting, destroying, and remaking industries and companies) knows that passive investing is "buy and hold," and that's been the downfall of a lot of stubborn investors.

Investors are smarter today. They know the passive chase is a self-fulfilling prophecy, but when the market breaks, it will be exposed for what it is: blind-eye buy and hold.

It's new money moving into a new strategy that works precisely because we've been in a steady, one-way bull market, and buying the market moves the market higher.

But everyone knows markets tend to fluctuate and sometimes crash.

No, passive investors won't sit tight when there's panic in the air. In fact, passive investors will be big sellers.

And when they sell, sponsors of the trusts that hold all the stocks in the indexes they are selling will have to sell those stocks in the open market. However, sponsors don't manage the portfolios; "authorized participants," big broker-dealers, and big bank trading desks buy and sell on behalf of sponsors.

Broker-dealers and trading desks are going to short stocks they know are going to be dumped on them by investors selling index funds. They will push down stocks themselves, which passive investors will see when the indexes they're invested in start falling, at which point they'll sell their mutual funds and ETFs.

Those index mutual funds and ETFs, with all those stocks in them, will have to be disposed of, over and over.

That's a potential black swan negative feedback loop.

Here's how you'll know it has started:

  • You'll see stocks fall broadly on high volume on successive days
  • You'll see the futures in the morning pointing to big losses when the markets open
  • You'll see a rapid flight to quality and Treasury bond prices spiking and yields collapsing
  • You'll see circuit-breakers hit throughout the day
  • You'll see ETFs stop trading because there'll be no way to correctly price them

It will be ugly - and you'll be watching from the sidelines.

That's because you've already got your stop-loss orders down somewhere maybe 10% below where stocks are today, don't you?

You better have a plan in place now. If you think you'll be able to put a plan in place once the selling starts, you'll be too late.

Mike Tyson once said, "Everyone has a plan until they get punched in the mouth."

The way to avoid getting hit in the mouth is to be out of the way of the punches when they start flying.

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The post These Are the Triggers That Could Bring the Markets to Their Knees 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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