Stocks Crashed the Last Two Times This Happened

wolfstreet.com / by Wolf Richter / August 27, 2015

“Your largest wealth creator for the top end has been inflation in financial assets,” Charles Peabody, a bank analyst at Portales Partners, told the Wall Street Journal. “You’re now seeing wealth destruction,” he said.

On Wednesday, the S&P 500 soared nearly 4%, its largest percentage gain since 2011, after having spent a whopping two days in a correction, its first since 2011.

On Monday, I’d written, “We’re expecting a rally topped off by a majestic short squeeze in the near future.” And we’re getting that. But the index is still down 5.8% year-to-date, and 3% for the 12-month period. Quite a change from the relentless double-digit uptrend of the past several years.

Margin debt is a big force behind stock prices. It’s the great accelerator, on the way up and on the way down. When investors buy stocks with money they don’t have and that the broker creates for them, it drives up stock prices, and makes room for more margin debt as higher stock prices allow investors to borrow even more against the same number of shares. It’s wonderful.

But when stocks tank, already spooked investors may be forced to sell to pay down their margin debt to stay within the limit. Forced selling drives down prices further, which begets more forced selling. Some of that happened last week, and particularly this Monday when the Dow plunged over 1,000 points at the open.

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