Why This Sell-Off Could Be a Repeat of August 2011

We’re less than a week into the new year, and already the S&P 500 is down over 6%. The Dow Jones is doing even worse, down nearly 7%, judging by futures. Myriad catalysts are being blamed as culprits. Is it oil falling to yet new lows or North Korea detonating a hydrogen bomb? Perhaps Federal Reserve Vice Chair Stanley Fischer announcing that market expectations of the number of rate hikes for 2016 are “too low”? Or maybe China devaluing the yuan again and tripping its stock market circuit breakers for the second time this week?

When trying to work out what exactly is going on, it’s helpful to think quantitatively. Since buyers and sellers always match at equal volume, as securities change hands at lower and lower prices, some counterparty is always hitting the buy button. Strong moves downward tend to encourage bargain hunters to place limit orders at prices below the bid/ask spread in an attempt to capitalize on selling frenzies. When those orders are filled way below the bid thanks to a panicked seller or two trying to meet a margin call, prices drop even further. The real question is, what happens when the panic, whatever ultimately caused it, is over?

At bottom, if the quantity of money in the economy is still increasing at a steady clip. The money will fall somewhere. A new H.6 Money Stock Measures report is due from the Fed at 4:30 p.m. and should be monitored carefully. Besides stocks though, new money could also fall on bonds, commodities or else be used for consumption. While the bond market has performed decently this week, it is nothing to write home about. Commodities are not rallying much either. That means the dollars both being added at the source from the Fed, and those being put away by sellers, are either being used for consumption, or they are sitting idle, waiting for a buying opportunity.

The chances they are being used for consumption is nil. The way to roughly measure that is to look at inflation indexes, and these are quite muted. Neither is there any sign that money velocity — the number of times one dollar is used to buy completed goods and services — is rising. This brings us to the conclusion that all that extra cash is sitting idle, waiting to buy something.
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We have seen sharp drops like this before with money supply expanding rapidly. The last time it happened was in August 2011. On August 9 of that year, the S&P fell to 1,100, with the VIX spiking close to 50. In the closing minutes of trading however, the index shot back up to 1,172 and the bottom was in. Given the current environment, we may see something similar by the end of the week or early next with sudden and intense buying pressure being released into the close.

We know the money is there for it. It isn’t going into bonds or commodities or consumer goods. It’s likely just waiting for an opportunity to fall right back into stocks.