In One Chart: When the ‘herds get spooked,’ this is what a stock market crash could look like
Every time the market seems to be caught in a death spiral these days, buyers are quick to step up to nab the discounts. That buy-the-dip mentality has, again, been bolstered by the idea that the Fed is ready to step in with a rate cut.
But Charles Hugh Smith, the writer of the Two Minds blog, says the central bank, which he describes as “the Plunge Protection Team,” is what will ultimately be the undoing of this fragile bull market.
“Irony of ironies: Such complacent confidence in the efficacy of central bank interventions is actually setting up a crash scenario,” he wrote on Monday. “Crashes and melt-ups are both manifestations of herd sentiment.”
In simple terms, that describes investor greed and fear, Smith wrote, though it’s really more about confidence in what comes next. Or the lack of it.
“Confidence in the absolute efficacy of Fed intervention breeds complacency, which is the essential backdrop of stock market crashes,” he wrote. “Crashes don’t arise from a skittish herd, they arise from a complacent herd.”
Here’s how Smith sees it potentially playing out:
The chart illustrates eight stages of Smith’s crash scenario:
- Bears / short sellers bet that weakening fundamentals will trigger a decline.
- Markets climb this wall of worry, moving higher, crushing bears.
- Every air pocket / dip caused by skittish punters selling is bought as traders are confident in the Fed’s complete control of the market.
- Bears / short sellers bet big that various technical patterns will play out, most importantly that previous highs will hold, yielding a bearish double or triple top pattern on the price charts.
- The market surges to new highs, forcing short sellers to cover, pushing the market higher. Bears / short sellers give up and short volume plummets.
- As volume fades and confidence in the permanence of the melt-up rises, the next sharp drop “surprises” participants, but they dutifully buy the dip.
- This rebound reaches a lower high, and the sell-off resumes. Unbeknownst to most participants, the herd’s confidence in the Fed’s omnipotence has eroded. Rather than manifesting a wall of worry that the market can climb to new highs, the herd is undergoing a loss of confidence.
- On the next decline, momentum accelerates the drop, and Fed pronouncements and emergency interest rate cuts do little more than reverse the downtrend for a few hours. The very fact that the Fed has to resort to emergency measures fatally weakens confidence, and selling begets selling.
Basically, “herds get spooked and run,” he said.
No sign of spooked herds on Monday, however, with the Dow DJIA, +0.72% , S&P SPX, +0.95% and Nasdaq COMP, +1.80% all logging solid gains.
Related: The next time the economy tanks, the Federal Reserve should give people, not banks, free money