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Posted on 5 August 2011 | 6,189 views

Is the Dow Jones Getting Ready for a August 2011 Crash?

If you followed the market crashes of 2000-2002 and 2007-2009, especially the crash of 2007-2009, the 512-point drop in the Dow yesterday (August 4, 2011) feels awfully familiar.

Stock market crashes reminded us that downtrends can last a lot longer and be a lot more severe than most people initially think. (They can also reverse themselves quickly and unexpectedly)

Yesterday as in 2008 and 2010, a buy signal was triggered by the VIX Index (Chicago Options: VIX) but it’s probably still too early to jump back in. Historically, we are entering into some volatile trading months and waiting until November to enter the market might just be the thing to do this time. In October 2008 the VIX topped at 96.4, in May 2010 at 48.2 and after Thursday’s collapse the VIX was at 31.85.

Track the VIX

The CBOE Volatility Index, also known as the “Fear Gauge” and commonly called the VIX, is best used to find market bottoms. It’s more effective at telling traders when fear is so high that they need to sober up and become one of the few buyers of cheap stocks that nobody wants.

Basically, the VIX reflects how overpriced or underpriced options (insurance) are. When traders become more fearful, they buy options. When they are scared out of their minds, they are willing to overpay for options — just like a person who thinks they have a high risk of health problems or death would be willing to pay high insurance rates — and the VIX goes up.

The VIX is better used to call market bottoms than tops because complacency and fear are more gradual, while extreme fear tends to be short-lived, creating an opportunity that you can trade. When VIX spikes too high and reverses, that’s a market buy signal.

VIX from Wikipedia

So, what’s the difference between this latest market crash and the ones a few years ago:

  • The Fed has fired most of its bullets (interest rates are already at zero)
  • Our budget deficit is already out of control, and Congress has had it with “stimulus”
  • The public has had it with bailouts

Why the Fed’s hands are tied with this crash:

In 2000, when the market tanked, the Fed Funds rate was 6.5%. The Fed immediately began cutting rates and eventually took them all the way down to 1%. (Where it left them for far too long, thus helping to inflate the housing bubble.)

In 2007, when the market began to crack, the Fed Funds rate was 5.25%. The Fed immediately began cutting rates and eventually took them all the way down to 0.25%. Where they have been as long as anyone can remember and where they still are today, just as the market is beginning to crash again.

In short, it is different this time and not in a good way.

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