One of the truisms of trading, which is particularly relevant to forex, is that the most successful traders tend to be the best at mitigating risk. This makes the market particularly skittish if not outright paranoid. The market will suddenly retrace and investors will jump into safe havens at the slightest rumor of a problem.
This is the principle behind the “buy the dip” philosophy. There are constantly dips, as a result of that tendency of professional traders to be constantly looking to avoid risks. This is great for traders looking for an opportunity to get in the market at a discount. But it also means that if we want to be successful traders, we do have to consider the worst case scenario to be prepared. That doesn’t mean it will happen. It doesn’t mean that it is even likely to happen. Just knowing what to look for and being prepared, however, might make all the difference.
So, A Recession?
The worst case scenario for traders right now is that the tariff war will cause a recession, which will be preceded by a market crash. With the market dump last week, the worry of a crash became very clear and present. On Tuesday, markets tried to stage a rebound, but it will be some time before we will know if that is successful or not. In the meantime, what signs could we expect that would tell us that the crash is imminent?
There are plenty of reasons to suspect a market crash might happen, beyond just the tariff issue. One point is the high valuation of the stock market, with the benchmark S&P 500 trading at a PE ratio of 25 – after the latest correction. It has gotten as high as 29 just a few weeks ago. The normal ratio is around 15. The last time it was this high, there was a market crash. And the time before that? Also a market crash. It also implies that the market could fall as much as 40% before it “normalizes” in a worst case scenario.
Finding the Trigger
Ultimately, what causes a market crash is a lack of liquidity, forcing traders to sell their assets at a discount. It’s an extreme case of being overbought. When no one wants to buy, sellers have to keep offering increasingly lower prices to entice people to buy. This triggers first stop losses, meaning more people jump in trying to sell. Then margin calls, which force even more traders to sell. Traders have to sell other assets to cover their losses, adding to even more selling pressure. As a result, there is just no way for the market to recover.
The US stock market is the most vulnerable than it has been in over two years in this respect. We can see this in the reverse repo holdings of the Fed. This is “extra” cash that banks, investors, traders have that can be almost immediately shifted into the market to cover losses. These holdings have fallen to the lowest they have been since the pandemic, as the Fed has been rolling off its balance sheet and keeping interest rates high.
Finding the Liquidity
Depleted cash reserves and high interest rates are the typical conditions ahead of a market crash. The signs of low liquidity are erratic price action, as traders shy away from riskier assets, but are still willing to trade opportunistically. As the market diminishes, traders then try to increase their “runway” by selling off non-core assets to recover funds.
This translates often to higher Treasury yields, as investors sell bonds in an effort to raise cash. Gold prices tend to suffer at this stage as well. For example, in the current situation, gold might suddenly drop below $3,000/oz. Developed markets might manage some gains while emerging markets, commodity and other risk assets fall. A substantial drop in both risk assets (say, stocks) and safe havens (say, gold) at the same time is often a tell-tale sign of a liquidity crisis.
Stay Safe!
Not every liquidity crisis leads to a market crash, but every market crash is the result of a liquidity crisis. Once it gets bad enough, the Fed will usually try to step in with extraordinary liquidity, but by then it’s too late. By the time the press starts talking about a market crash, it has already happened.
A market correction is often a great opportunity to buy the tip, but the current circumstances point to increased risk. Careful monitoring of the factors mentioned above and handling of stop losses would likely help most traders avoid the worst parts of a market crash, if it were to develop.
