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Everything You Think You Know About the Flash Crash Is Wrong


What caused the flash crash of May 6, 2010? If you want to understand why the Dow fell 1,000 points in minutes, you have to first ask why junk debt broke down over one hour before.


No amount of experimentation can ever prove me right; a single experiment can prove me wrong.
-- Albert Einstein

It seems like it has been ages since the infamous May 6, 2010 flash crash took place in the US stock market, which saw the Dow Jones Industrial Average (DIA) utterly collapse in minutes. The search for why the Dow dropped by nearly 1000 points in such a short time frame has led to multiple inquiries by the Securities & Exchange Commission (SEC), which has enacted "circuit breakers" in response in an effort to prevent a repeat of those scary moments when money evaporated in the blink of an eye. A joint report by the SEC and the Commodity Futures Trading Commission blamed the decline on a large number of S&P contracts being sold, combined with high frequency trading algorithms that all at once stepped away from the market.

It sounds appealing to believe that "the machines" caused the flash crash in stocks. Negative feedback loops and butterfly wings flapping in a chaotic system can certainly create fat tail/Black Swan/extreme events. But I simply can't understand why no one has addressed what really caused the flash crash in equities. Courtesy of Minyanville's very own Michael Sedacca on my request, take a look below at two intraday 1 minute charts. The first is the S&P 500 ETF (SPY) up top; the second is junk debt (JNK) on the bottom. It is obvious where the flash crash occurred in the S&P 500 ETF, but what about junk debt?

Click to enlarge

What do you notice? Junk debt was down more than 5% in its own mini "flash crash" over one full hour before the stock market flash crash. A decline of that magnitude in junk debt that has volatility characteristics different from equities is the equivalent of a crash in junk debt, and a credit event that occurred before the stock market realized it.

My point? Whatever you know about the flash crash in stocks is wrong. If you want to know what caused the flash crash, you have to first determine what happened to junk debt over an hour before intraday that caused a breakdown in prices and spike up in default risk/rising yields. Given that junk debt is higher up on the capital structure scale and at least has a claim on assets (which equities do not until all liabilities are paid), the magnitude of the decline in junk debt foretold of a coming stock collapse. Now if only someone would investigate that...

Twitter: @pensionpartners
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No positions in stocks mentioned.

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