Is 'The Big One' Upon Us?

For the umpteenth time in the last five years, the stock market is scaring the bajeebers out of investors. "This is it," seemed to be the battle cry last week as the bears (aka the Goldman Sachs, Virtu, Getco and Citadel algos) hit the sell button at the speed of light during the last half of the week. And by the time the closing bell rang on Friday afternoon, the Dow had plunged 530 points (-3.12%) on the day and more than 1,000 points (-6.2%) on the week. From its most recent all-time high set in mid-May, the venerable Dow Jones Industrial Average now finds itself down double digits (-10.11% to be exact) and in "correction territory" according to the popular media. It is also worth noting that the VIX (the CBOE Volatility Index), which is often referred to as the "fear index," surged an eye-popping 46.5% on Friday alone and more than 184% last week, which amounted to the biggest one-week gain in history. And for those keeping score at home, the VIX now stands at the highest level seen since 2011.

CBOE Volatility Index – VIX

While most of the major indices are faring better than the DJIA at the present time (for example, the S&P 500 is off -7.5% from its all-time high), the difficulty being seen on America's most recognizable stock market index is causing investors large and small to quickly move into panic-mode. It would appear that fears over the state of China's economy is the primary issue causing the fast-money types to be moving to the "Ausfarht" (German for "exit") en masse right now. The Real Question, Of Course, Is… However, the real question at hand is if this is indeed "it?" After a six-year run higher that ranks among one of the best bull markets in history, is it time for the bears to finally come out of hibernation? Will investors now "pay" for the big bull move with a swift decline of 30% – 50% like those seen in 2000 and 2008? Is it time to head for the hills?

S&P 500 – Weekly

Last October, I began to opine that the market had a bearish feel to it. Divergences were apparent and the problems at the time definitely had a fundamental bent. And with the S&P 500 down nearly 10% in late-October, it certainly felt like the bears had returned. But then St. Louis Fed President James Bullard turned dovish for an afternoon, suggesting that the Fed could always back away from "the taper" and keep the money spigot open for a while longer. Then the Japanese more than doubled the size of their QE program. And finally, "Super Mario" (Mario Draghi, head of the ECB) reminded everyone that the European Central Bank was about to start implementing a QE program of their very own. Just like that, the worries about valuations, earnings, and an ebola outbreak were forgotten. You see, investors have learned that QE trumps all in the stock market game. And as long as fresh currency is being printed somewhere, there are always folks ready to put new money to work in the U.S. stock market – especially when prices "dip." Today, investors face a similar situation. There are meaningful technical divergences. Leadership has narrowed rather dramatically. Valuations have reached worrisome levels. Earning growth is going the wrong way. Technical levels are snapping like toothpicks. Many time-tested indicators have begun to flash warning signs. And now, the world's second biggest economy appears to be slowing more than anyone had expected. So, given the combination of all of the above and the length of time that has transpired since the last meaningful correction of -10% or more, it is relatively easy to see the key points emanating from the bear camp. And yes, the argument can be made that it may indeed be time for the long-awaited correction.

Will This Time Be Different?

Lest we forget though, the central bankers of the world appear to have taken a joint oath to "do whatever it takes" to keep the world's financial markets (and the global banking system) safe – until they can stand on their own two feet, of course. So, although China may be slowing more than anticipated, should we really expect things to be different this time around? With the Dow down double digits from its high and the Shanghai index in a world of of hurt, wouldn't it be logical for the PBoC to say something nice to investors soon? Isn't it time for Mr. Bullard or one of his cohorts at the Fed to remind investors that the FOMC could always start buying up bonds again? And yet, there seems to be MANY reasons to be cautious/worried at this time. Heck, even yours truly has been talking about risk being elevated for many months now!

So What's the Answer?

To be sure, the game has suddenly become challenging again. So, what is the answer then? Should investors go bury their heads in the sand (and their money under a mattress)? Or as Warren Buffett might say, is it time to buy because there is some blood in the streets? Unless your crystal ball is functioning perfectly at the present time (mine happens to be in the shop again) there is really no way to tell whether this is the start of a meaningful decline or just another v-bottom, buy-the-dip opportunity.

Have a Plan In Place!

But THIS is why it is important to have a risk management strategy in place in your portfolio BEFORE things start to get nutty in the stock market. Because when things are coming apart at the seams on a daily basis, it is nearly impossible to tell whether this is the "big one" or just another algo-induced freak-out. For example and as I've mentioned a time or two recently, our Long-Term Risk Manager strategy hadn't made a meaningful move since late 2012 – until the middle of May, that is. On May 18th, one of the models flashed a warning signal. Then on June 30th, another model went red. Then on July 9th, a third model waved a yellow flag (which has since flip-flopped back and forth and is could go negative again on Monday). As such, this "weight of the evidence" approach tells us that caution has been warranted for several months now. The key here is that utilizing disciplined market models takes the emotion out of the equation – when it matters most. As one of my colleagues, Chris Magann recently told an advisor, "Just don't worry about the market, the risk management models are doing their jobs." And to be honest, Chris is right. While the game of managing risk can be tricky at times and no one ever gets it right all the time in all market environments, the systems we follow that are designed to manage the big-picture risks of the market on an incremental basis do seem to be "doing their thing" right now. So, is this the big one? Or will the central bankers save the day once again? Frankly, nobody knows for sure. But I can say in all honesty that having a plan to unemotionally reduce exposure when risk factors are high does allow me to sleep well at night.

Turning To This Morning

As expected, global equity markets are sharply lower again this morning. Shanghai is leading the move again having fallen a whopping 8.5% overnight, which is the worst day for that market seen since 2007. The dive occurred despite the reports of new PBoC support measures talk of a 50 basis point rate cut in the near future. In Europe, stocks are sliding as well with the indices down more than 2% across the board. At the center of it all are worries about global growth. However, at this stage it is also important to remember that "forced selling" is likely at work as well. For example, reports indicate that the U.S. dollar is under pressure this morning in response to outsized gains in the Japanese yen and euro amid the unwinding of carry trades. Finally, note that the U.S. stock market has a history of being the "white knight" during global panic situations. So, while the indices may open down hard when the opening bell on Wall Street rings, be on the lookout for the energetic rebound that usually accompanies this type of emotional market.

This Morning's Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell… Major Foreign Markets:

• Japan: -4.60%
• Hong Kong: -5.17%
• Shanghai: -8.49%
• London: -2.79%
• Germany: -2.74%
• France: -2.81%
• Italy: -2.88%
• Spain: -2.61%

Crude Oil Futures: -$1.39 to $39.06 Gold: -$4.10 at $1155.50 Dollar: higher against the yen, lower vs. euro and pound 10-Year Bond Yield: Currently trading at 2.030% Thought For The Day: Before you can win, you have to believe you are worthy. -Mike Ditka Read more at Stateofthemarkets.com