The break in the stock market starting January 29 thru the low on Feb 9th stunned a lot of people. I remember watching CNBC’s Closing Bell and I honestly thought that at one point Kelly Evans was going to lose it. You could just feel the fear.
It was Monday February 5th when the Dow Jones Industrial Average (DJIA) was down nearly 1600 points at its low before closing down 1,175 points. We had not seen this kind of selling in a long time as the market has been in a trance of low volatility, no fear, passive investing.
We’ve had a few bouts of intense selling in August – October 2015, August – October 2011 and certainly in 2008. But that two week downdraft was one of the more intense since 2008. So how bad can it get when fear runs amok?
Government Has Your Back
After the 1987 crash when the DJIA lost 22% in one day, the U.S. Securities and Exchange Commission (SEC), installed circuit breakers in the system to help protect us from another day like that day. So the government has your back…relax. Right?
The thinking behind circuit breakers was that they would allow for a cooling off period and possibly slow down any avalanche of selling. But when you think about it, it may also cause people to become even more fearful. Like they’re trapped.
Circuit Breakers
So how does the system work? The circuit breakers are based on the S&P 500 Index (SPX). The first threshold, Level 1 is 7%. If the stock market drops 7% from the previous close, before 2:25pm CT, the stock market will shut down for 15 minutes. This includes a trading halt for all U.S.- based equity index futures and options including the E-mini S&P 500 and S&P 500 futures and options.
Then after 15 minutes, the stock market would re-open and trading resumes. Now if the SPX were to drop to a level that was 13% below the previous day close, before 2:25pm CT, then another 15 minute shutdown period would kick-in as described above.
And again, after 15 minutes, trading resumes. If the market were to continue selling off, then trading will be halted for the remainder of the day if the SPX hit Level 3 which is 20% below the previous close. At this point, everything is shut down including overnight futures trading. Nothing opens until the equity market starts trading the next day.
Note that after 2:25 CT the market will not stop for Level 1 or 2. It will only shut down if Level 3 occurs.
How Bad?
So the circuit breakers are based on the SPX but the media has a tendency to lead with the DJIA. So if we apply the same math to the DJIA what would this mean? Based on Friday’s close, a Level 3 circuit breaker would shut down the stock market after the DJIA dropped about 5,000 points in one trading day.
So think about that. The evening news leads with the “Dow Down 5,000 points. Fear Runs Amok on Wall Street”. Now what is everyone going to do? The market just took back a year’s worth of gains in one day. Now what? What could happen?
In a worst case scenario, the market opens the next day and proceeds to hit Level 1, Level 2 and Level 3 circuit breakers all over again. That would put the Dow down about another 4,000 points. And it all could happen by 10:30am CT in the morning or earlier.
If you are at all familiar with the futures markets, you know that various futures have sold limit down, day after day after day. Limit down is a situation where the selling hit the limit and trading was stopped. I would not say it’s a common occurrence but it has and does occur.
Fear Runs Amok
I am talking about the circuit breakers because I believe an avalanche of selling could trigger these circuit breakers and create a real nightmare scenario. It could absolutely happen. We’ve never had a Level 3 circuit breaker kick in. But we have had the DJIA drop 22% in a day before. And it wasn’t pretty.
I’m also talking about this so that you are aware of just how big the moves in the market can be before anything will kick-in to break the selling. A Level 1 circuit breaker is about 1,775 points on the DJIA.
As I’ve mentioned many times before, know at what point you will exit your position. Know how you will lock in your profits or minimize your losses. Plan ahead of time.
People say they are in the market for the long haul. But when fear runs amok in the stock market, how well will you be able to handle the fear?