Oh No... We Were Right

Details

Created on Friday, 07 October 2011 07:00

Published on Friday, 07 October 2011 07:00

Written by Andrew Snyder, Editorial Director, Insider Investing Daily

Hits: 4042

We asked a complicated question and got a simple answer. Volatility is here to stay.

Our piece on the most dangerous form of inflation -- speculation inflation -- could not have come at a better time. Just as we showed the markets were getting overloaded with speculative dollars, things went haywire.

The day after we ran the story, the markets melted up... yes, up.

Picture the 2010 flash crash -- but in reverse.

On Tuesday, stocks when from ho-hum to yowzers in less than 30 minutes. There was no news. No Fed announcement. No bailout chatter.

... just lots of good ol' speculation.

These kind of moves are why the market is so dangerous... yet so lucrative. The market no longer rises and falls based on fundamentals -- those long-loved metrics that let us gauge a company's real worth.

Nowadays, it moves in one massive clump, like a rain-soaked cake of mud.

"It tends to result in some market participants feeling like the market is uninvestable," said Michael Marrale of RBC Capital. "It's not good for mutual funds or hedge funds."

We say he's wrong. Or at least part wrong.

To be sure, lots of investors are ready to run for the hills. Many have. But it certainly is not the mutual fund or hedge fund boys... they are the cause of the problem.

As we said on Monday, there is too much money chasing too few assets. When the phenomenon occurs, it leads to massive volatility. In a traditional market, it sends prices soaring higher. But in the stock market -- where investors can bet for or against an asset -- the glut of cash creates huge price swings.

For proof, let's peek at some numbers from the ETF market.

Yesterday, I told Insiders Strategic Review (our e-letter to paid subscribers) readers how dangerous the supposedly safe ETF market has become -- in particular, Europe's market is about to implode in spectacular Lehman Bros. fashion.

To prove our point today, let's look at the SPDR S&P 500 ETF (SPY:NYSE). It's a beast of a fund with $92 billion in assets. In other words, it's bigger than half of the companies that make up the Dow 30.

It is big. And powerful.

But what happens when all that money, controlling all those stocks starts to move in one direction? The simple answer... we get what we saw Tuesday.

Get this. In the middle of last month, some 536 million shares of SPY were short. That's nearly 75% of the total float... all betting against the U.S. market.

It's how all those hedge funds, mutual funds and institutional investors removed the risk of a major downturn. Their portfolios were long, so they hedge with the simplest, most-liquid asset they could find.

But then we reached a technical trigger; just hours before the "melt up," we officially entered bear market territory. The S&P had dipped 20% from the May 2 high.

Boom... it triggered a wave of activity. Algorithms kicked in. Trade limits were hit. The shorts hit their mark.

But before the shorts could count their gains, they had to exit their trades. They had to buy the shares they borrowed. For a massive ETF like SPY, that means a huge amount of money had to switch directions. Suddenly sellers were buyers...

"It was the perfectly executed short squeeze -- launched in the final 30 minutes of trading, revealing why being short in a bear market can suddenly cause you to bleed," said Ken Polcari, an insider at the NYSE.

In a market filled with so much speculative money, it doesn't take much to shock the system.

But it's not just equities at risk. In fact, the rush to gold is equally dangerous. The go-to ETF for the shiny metal, SPDR Gold Shares (GLD:NYSE) is worth over $70 billion, with a volume worth over $27 million each day.

This single ETF controls just shy of 1% of all the world's gold -- a staggering figure when we compare it to some of its competing gold stashes.

In other words, these days it is tough to tell what moves what. Is gold moving the ETF? Or is the ETF moving gold?

If it is the latter, like so many experts say it is, we're in trouble. When a lone derivative controls the price of its underlying asset, it is proof there is too much money chasing too few goods.

On Monday, we asked if the theory will prove true. Just a day later... we got our answer. Uh oh.