The Simple Reason This Market Drop Makes Sense

The Simple Reason This Market Drop Makes Sense

When something bad happens in the economy, it’s important to remember an unpleasant but eternal truth: somebody is making money off it. 



The Simple Reason This Market Drop Makes Sense
The Simple Reason This Market Drop Makes Sense

The drop in stocks can be explained in a lot of ways—China, oil, manufacturing, various bubbles—but the plain, see-the-forest-not-the-trees explanation is supply and demand.

The trend is down right now and has been since the US markets hit an all-time high on May 19, 2015, with the Dow Jones Industrial Average topping 18,350 two days in a row. In the seven-and-a-half months since then, the markets have posted lower highs and lower lows, which is the Trading 101 definition of a downtrend.

 

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The large drops in late August and again in late September (with a lower low than August’s) showed where the big buyers were waiting. For traders who look at support and resistance levels, that 1850-1870 price level was familiar: it was support in October 2014 and resistance for much of Spring 2013.

Spring 2013 was when the market meandered sideways before its first run up to the psychologically important number of 2000 in the S&P 500. October 2014 was the dip before the markets rallied back up to S&P 2000 and then to another meaningless but still significant threshold, Dow 18,000. To reach those highs, the market first needed to gather steam.

That steam comes in the form of large institutions and funds buying at wholesale prices. And right now, they aren’t doing much of that. That’s why global stocks are dropping. Though we might say it’s the manufacturing crisis in China or the Fed’s raising of rates, people buy stocks even during crises—but only if the price is right. Right now, there is still too much supply of stocks seen as overpriced. When they’re cheaper, demand will go up.

Some people, however, are making money off the down market. Some institutions and traders are short selling and using put options on index futures and ETFs to profit from this supposedly terrible drop in global stocks. 

Bloomberg reports that last year’s darling, the financial sector, is getting some shade in the form of put options on the SPDR Financial Select Sector ETF, for example, which lost $1.7 billion in the last quarter of 2015. P Banks including JP Morgan Chase, Morgan Stanley, and Goldman Sachs have had drops in revenue. Citigroup and others resorted to cutting expenses (ie employees) to boost profits.

The worse things get for them, the more profitable it is for those holding put options. Though it’s a reasonable bet that those banks are themselves using such puts to hedge against the drop in their own sector’s stocks. When you’re losing, it can be smart to bet against yourself.

Since the fate of the stock market and that of the financial companies that exist to support it are tied, it makes sense that one would drop when the other drops. But no one expects the drop to be indefinite. The buy stop orders are waiting further down. No one knows exactly where, because orders can be taken off and put back on in milliseconds. Traders often place ghost orders or use other tricks to keep from showing their hands. But the wholesale price level is down there, at 1850 or somewhere else.

When we reach that turning point, expect some analysis about how investors are optimistic about this or that. One thing to be optimistic about is that the Eurozone looks likely to see a wave of hiring thanks to sustained economic growth—a timely development as Germany ambitiously and compassionately welcomes over a million Syrian refugees. But the real reason will be that the demand, especially from big players, has finally exceeded supply.  That’s what pushes prices back up.

Sometimes traders have to avoid thinking too much about why things happen, and just focus on what is happening. Ours is not to reason why, ours is but to sell and buy.


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