What Drove the Markets Higher Is Now Knocking Them Down

Good corporate fundamentals (meaning rising revenues), margins, and profits drove big-cap technology stocks higher. Those factors drove their respective indexes higher, which attracted millions of passive investors into indexed mutual funds and ETF products.

Now, the virtuous cycle that caused markets to spiral upwards could be morphing into a negative feedback loop. But markets in the U.S. aren't going down because fundamentals are deteriorating.

They're going down because market-moving tech darlings stalled out – then rolled over.

I have good news, and I have bad news. The bad news is the selling's probably not over and could get worse.

The good news is, if we fall far enough and fast enough, this sell-off could be a generational buying opportunity.

Here's what's really going on, why this sell-off (if it's big enough) will be the time to go all in, and what you can do to shield yourself from any market disaster...

What Fueled the Negative Feedback Loop

What started with profit-taking in big-cap tech stocks, when an increasing number of analysts and talking heads warned of tariff wars and lofty markets, led to short sellers piling on to try and knock stocks down.

This time around, sellers weren't met by billions of incoming dollars from passive investors.

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Net inflows into mutual funds and ETFs were down 46% in the third quarter, according to Morningstar. Through September, $281.7 billion flowed into the market, down from $517.2 billion over the same span a year ago.

Actively managed funds saw $42.9 billion in outflows in the third quarter, the highest amount exiting since the fourth quarter of 2016. Meanwhile, passive investors ponied up 35% less in the third quarter than they had a year ago.

The net amount of money flowing into the market, chasing the tech darling leadership stocks and the rest of the stocks under their cover, suddenly wasn't enough to absorb selling when profit-taking increased as short sellers tried to knock the big names through support levels they had all quickly bumped against.

When those support levels broke last week, profit-taking ratcheted up, shorts piled on, and, more importantly, so-called passive investors actively started selling.

Passive investors turning into active sellers became 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 made new highs.

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 sell-off of more than a few weeks.

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

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.

How the Negative Feedback Loop Works

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A lot of the money that's gone into passive investing strategies was money that finally came off the sidelines. 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's worrisome.

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.

The problem is, when passive investors in indexed ETFs sell, sponsors of the trusts that hold all the stocks in the indexes they are selling must sell those stocks in the open market.

However, sponsors don't manage ETF portfolios – "authorized participants," big broker-dealers, and big bank trading desks buy and sell on behalf of sponsors.

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Here's how the negative feedback loop works:

  1. As ETF shareholders sell their index products, the heavily weighted big-cap names are sold in proportionately larger numbers. As they have more influence on the indexes they're in on the way up, they'll have the opposite negative influence on the way down.
  1. As investors in the big-cap stocks see the share prices that they chased up when momentum buying drove them higher (thanks to ETF inflows) suddenly start to come down, they'll start selling them. They'll take profits and short them, putting more pressure on those names.
  1. As shareholders sell their ETFs, those sell orders are followed by "authorized participants" – the trading desks that fund sponsors hire to create units of ETFs (a creation unit is 50,000 shares) and to unwind them as sellers reduce the need to hold underlying shares in trust. Those trading desks, knowing they're going to have to liquidate underlying shares and accumulate potential losses as prices continue to fall, aren't going to wait for ETF sell orders to come in. They're going to short the underlying shares and cover their shorts with the shares they buy from liquidating ETF shareholders. Aggressive shorting by authorized participants will push down underlying stocks, hitting the prices of ETF shares, causing more selling by ETF shareholders.
  1. The cascade of these events, occurring on top of each other, each trying to get ahead of more selling, causes a negative feedback loop.

We're seeing that a lot during the day. But we haven't seen a continuous, multi-day, non-stop bout of that kind of negatively reinforcing action.

If that happens, markets could fall 20% to 40% in a matter of days.

Don't hate me for saying this, because I'm mostly in cash now, but if that happens, it will be a monumental buying opportunity.

You don't have to pick stocks. Buy the market, buy the index ETF most beaten up, the big ones like SPDR S&P 500 ETF Trust (NYSE: SPY) and SPDR Dow Jones Industrial Average ETF (NYSE: DIA).

Because there's nothing wrong with the fundamentals, the "technical" selling that could knock markets down will be temporary.

They'll bounce back like they did after the 1987 crash.

I'm not calling for a crash, but if we get one, you need to be prepared.

In fact, my friend and colleague, Money Map Press's Chief Investment Strategist Keith Fitz-Gerald, has a strategy he's developed that can help protect you from any impending crash that could be brewing.

Now, if you don't know Keith, here's a snippet of what he's done in the past: In 2000, he called that tech stocks were about to crash, and would drag the economy down with them. Then in 2007, he warned anyone and everyone who'd listen that mortgage companies would fail and crush stocks. And he's seeing all the same signs in market conditions now.

While the fat cats on Wall Street will do everything they can to protect themselves and only themselves in crisis, you'll be left out in the cold. You need someone on your side, and Keith can give you the information that no one else will.

He's compiled his years of research into a short presentation, and if you've been paying attention to anything in the markets, you should know that now's the time to get ready. If you're not prepared, well, good luck with that.

If you arm yourself with the right knowledge today, not only will you be one of the lone folks who will have their assets covered, you could also see explosive profits.

Because if and when a crash does come, I'm loading up the truck and borrowing another.

The post What Drove the Markets Higher Is Now Knocking Them Down 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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