Editor’s Note: This article formed the basis of an Alert issued to Capitalist Times Premium and Energy & Income Advisor subscribers. Although this macro outlook omits stock-specific commentary and discussion of our investment strategy, we hope this article helps to put yesterday’s crash into perspective. 

This morning, the Dow Jones Industrial Average plummeted to a low of 15,370.33, down 1,089.42 points from Friday’s close and more than 6 percent from the high hit on May 19, 2015. At its nadir, the S&P 500 had given up about 5.3 percent of its value.

The moves in some blue-chip stocks were truly shocking. Apple (NSDQ: AAPL) gave up 13 percent of its value at it low, while retail giant Wal-Mart Stores (NYSE: WMT) tumbled 7.6 percent intraday and Exxon Mobil Corp (NYSE: XOM) dropped 7.7 percent. Johnson & Johnson (NYSE: JNJ) plummeted 14.4 percent.

The worst of the selling lasted about 30 minutes this morning; the aforementioned blue-chip stocks recovered significantly from their intraday lows.

Investors want to know what caused this morning’s selloff, how they can protect their portfolios and what they can do to benefit from the market’s volatility.

Causes of the Aug. 24 Flash Crash

Three factors contributed to this morning’s crash: leverage, forced liquidations, and stop-loss selling.

At the end of June, the aggregate amount of customers’ margin accounts for firms that are members of the New York Stock Exchange (NYSE) reached a high of $504.975 billion, indicating that investors have borrowed heavily to finance stock purchases.

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And this data set doesn’t capture the leverage involved in using exchange-traded funds that offer two or three times the return (or inverse return) generated by a specific sector or basket of stocks.

Margin and leverage amplify investors’ returns during bull markets but can exacerbate corrections and cause major dislocations during sell-offs.

When the price of a stock purchased on margin drops below a certain threshold, brokers require the investor to post more cash as collateral to maintain the position—a margin call. If the investor doesn’t meet this margin call, the broker would start to liquidate the position to repay the amount borrowed.

Severe selloffs in Asian and European equity markets overnight meant that the S&P 500 opened sharply lower, triggering massive margin calls in the first few minutes of trading and the forced liquidation of stocks held on margin.

Most hedge funds and institutional traders also use risk-management models that require portfolio managers to adjust their position sizes during periods of heightened volatility.

And many retail investors manage their downside risk by setting stop-loss orders that activate when a particular stock falls to below a preset price. Even if a stock slips below that threshold for only a fraction of a second, the broker sells the position at whatever price it can find a bid. In a rapidly moving market, this sale often occurs at an even lower price.

We’ve cautioned individual investors against using stop-loss orders in most circumstances because this risk-management strategy heightens your potential downside during corrections by liquidating your position at the worst possible time.

Let’s say you bought shares of Apple (NSDQ: AAPL) at Friday’s closing price of $105.76 and set a stop-loss order to limit your downside risk to 10 percent. Apple’s stock opened Monday’s trading session at $94.87 per share and had tumbled to $92 within seconds; your broker would have executed your stop-loss order at around $93 per share, saddling you with a 12 percent loss.

Once the panic selling subsided, Apple’s shares rallied to $108.80 in the early afternoon—a $3 per share gain from Friday’s close. Not only would your stop-loss order have locked in a loss unnecessarily, but you also would have missed out on the stock’s eventual recovery later that day.

Setting stop-loss orders is a particularly ill-advised idea for high-quality names such as AT&T (NYSE: T) and Verizon Communications (NYSE: VZ)—stocks that generate huge streams of free cash flow and pay ample dividends, regardless of where we are in the economic cycle. The best stocks always recover the fastest in a flash crash.

Nevertheless, this risk-management strategy has become increasingly popular with retail investors. Many brokerages allow investors to set trailing stops that adjust automatically over time, making it all too easy for individuals to apply this strategy to their entire investment portfolio.

Retail investors also tend to set their stop-loss orders at predictable price points; professional traders take advantage of these poorly conceived strategy to trigger stop-loss orders and buy the stock at bargain prices.

Today’s rapidly moving, algorithm-driven markets make stop-loss orders even more dangerous—especially on lower-risk stocks.

What’s Next

During a market crash, fear and panic are your worst enemies. On the plus side, such pullbacks give investors an opportunity to buy high-quality names on the cheap.

This morning’s correction was swift and painful, but Capitalist Times Premium readers shouldn’t have been entirely shocked.

We’ve warned repeatedly that although the broader market has marched in place for much of the year, narrowing market leadership—fewer NYSE-listed stocks hitting 52-week highs or trading above their 200-day moving average—had increased the risk of a correction dramatically. (See How to Spot a Bear Market, Rising Risks, Looking for a Pullback and What Lies Beneath.)

When the S&P 500 hit a new all-time high at the end of 2014, more than 300 stocks that trade on the NYSE rallied to a 52-week high. At the end of February, only 275 NYSE-listed stocks hit fresh 52-week highs when the S&P 500 closed at a record level. And when the S&P 500 took out this high on May 20, less than 150 NYSE-traded stocks hit a new 52-week high.

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In other words, the group of stocks leading the market higher dwindled significantly.

The number of stocks trading above their 200-day moving an average—a common technical definition of an uptrend—also declined from about 70 percent in summer 2014 to less than 50 percent by the end of May and less than 30 percent by the end of last week.

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Most bull markets exhibit similar deterioration in these technical indicators as they peter out. As the bull market ages, the number of stocks driving the rally dissipates until there isn’t enough support to push the broader market higher.

What’s next? The US stock market looks oversold, and panic has reached levels that suggest the market has reached at least a short-term bottom.

Check out this graph of the Chicago Board Options Exchange S&P 500 Volatility Index (VIX), which measures the market volatility priced into the options market. Higher VIX readings suggest that panicked market participants have purchased puts to hedge their positions. Such behavior often signals a market bottom.

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The past three spikes in the VIX—fall 2011, summer 2012 and October 2014—all occurred near key market lows that turned out to be excellent buying opportunities. Today’s surge in the VIX marked its highest level since the 2007-09 financial crisis and the Great Recession.

We wouldn’t be surprised if the broader market were to sell off again over the next week or two, perhaps retesting today’s intraday lows. However, a second pullback would likely mark a golden opportunity to buy stocks ahead of a subsequent rally in the S&P 500 and other major market indexes to within range of their 2015 highs.

Investors should also keep a level head and wait for a rally in the broader market to unload any riskier stocks.

The S&P 500’s worst bear markets usually coincide with a US recession.

Fortunately, the Conference Board’s Index of Leading Economic Indicators (LEI) hasn’t exhibited signs of an imminent recession, though the July reading declined sequentially. Historically, three or four consecutive months of sequential declines in this forward-look index flash suggest that a significant economic contraction could be forthcoming.

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The Bloomberg US Economic Surprise Index, which tracks how economic data releases over the trailing six months have measured up to analysts’ expectations, has stalled in recent weeks and remains in negative territory. A downtrend in this index and readings below zero indicate that incoming US economic data has disappointed.

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Thus far, strength in consumer spending—a product of lower energy prices—has helped to prop up the US economy and offset weakness in other areas.

We’ll continue to monitor the LEI, Bloomberg US Economic Surprise Index and the Institute for Supply Management’s Purchasing Managers Index for the US manufacturing sector—reliable predictors of economic downturns—over the next six to nine months for signs of deterioration.

Recent market history also suggests that the bull market in US stocks may have entered its final innings.

Consider the last bull market’s dying days in 2007. The S&P 500 performed well in the first half of the year, gaining more than 10 percent between January and mid-July. However, the index gave up about 12 percent of its value between late July and mid-August. The ensuing two months brought another rally that barely topped the high hit in July. Over the next 12 months, the S&P 500 plummeted by more than 40 percent—one of the worst bear markets in history.

The NASDAQ Composite Index followed a similar pattern in the run-up to the tech bubble’s collapse, gaining more than 22 percent from the end of 1999 to its March 2000 high, tumbling more than 40 percent between March and late May, and rallying 41 percent through early July.