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Fear of 'Catastrophic' Crash Rising Despite Bull Market

In an unprecedented move, the number of investors fearing a catastrophic stock market crash is rising even with the stock market at 2 ½ year highs.

The unusual dislocation comes from two distinct reasons: a lack of trust in the U.S. financial markets following the so-called Flash Crash last May and the collapse of Lehman Brothers in 2007.

This means the Flash Crash Advisory Commission that met on Friday has a long way to go in restoring confidence to the point that will bring the individual investor back into a market still ruled by high frequency trading, exchange-traded funds and leveraged hedge funds.

The Yale School of Management since 1989 has asked wealthy individual investors monthly to give the “probability of a catastrophic stock market crash in the U.S. in the next six months.”

In the latest survey in December, almost 75 percent of respondents gave it at least a 10 percent chance of happening. That’s up from 68 percent who gave it a 10 percent probability last April, just before the events of May 6, 2010.

“Even though the market is firing on all cylinders, that fear of big losses still looms large for investors in a way that it didn’t prior to the last bear market,” wrote analysts from Bespoke Investment Group in a report citing the Yale data. “Clearly, the financial crisis and the collapse it caused has impacted investor psyche in a big way.”

In the past, fears of a stock market crash in the Yale survey rose as the market declined because investors lost confidence in the economy and companies as share prices declined, and expected a capitulatory end to a bear market. For example, in March 2009 close to 85 percent of investors gave a crash at least a 10 percent chance of occurring. That record high in distrust and low in confidence marked a 12-½ year low in the S&P 500.

The benchmark has doubled since that low, but investors are not worrying about the prospects for individual stocks as much now now. Instead they are worrying about the still-unchanged system set up by Wall Street and regulators in which equities trade.

The Flash Crash Commission – containing members of the CFTC and SEC – made a series of recommendations for improving market structure Friday, including single stock circuit breakers, a more reliable audit trail on trades, and curbing the use of cancelled trades by high-frequency traders. They still don’t know what actually caused the nearly 1,000-point drop in the Dow Jones Industrial Average in a matter of minutes.

“Nine months after the Flash Crash and the committee is just about getting around to discussing a few things,” said Joe Saluzzi, co-founder of Themis Trading and market infrastructure expert. “This is just the way the high-frequency trading community and their supporters like it. Grind that reform train to a halt. After all, the market has come roaring back and if you didn't sell on May 6th, then nobody got hurt.”

For the agile professional investor, fear of another crash is not really a concern right now. Surveys show bullish sentiment high among the pros. Hedge funds have increased leverage again to pre-Lehman levels. Wall Street banks paid out large year-end bonuses and are about to start paying dividends again. This professional confidence has been reflected in a steady stock market climb since the summer that’s barely experienced a major 1-day drop, let alone crash.

“Though we find the current steady, upward grind in the market to be very unusual, it is important to realize that these low volatility conditions can persist,” said Andrew Barber of Waverly Advisors, in a note. “For instance, from January 2004 to July 2007, 90 day realized volatility in the S&P 500 traded in a range roughly bounded by 7 percent to 13 percent, averaging just above 10 percent for most of that period. Yes, this is 3 1/2 years of volatility roughly equivalent to what we are seeing now.”

Overall volume has been very light in the market though, as the individual investor put more money into bonds last year than stocks in spite of the gains. Strategists said this has been one of the longer bull markets (starting in March 2009) with barely any retail participation. Flows into equity mutual funds did turn positive in January and have continued this month however, according to ICI and TrimTabs.com. Yet the fear of a crash persists.

“Belief in a coming Flash Crash is Chicken Soup for the Underinvested Soul," said Josh Brown, money manager and author of The Reformed Broker blog. “They aren't so much expecting one as hoping for one - so they can rationalize buying into a market that's left them behind.”

For the best market insight, catch 'Fast Money' each night at 5pm ET, and the ‘Halftime Report’ each afternoon at 12:30 ET on CNBC.


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Trader disclosure: On Feb 18, 2011, the following stocks and commodities mentioned or intended to be mentioned on CNBC’s "Fast Money" were owned by the "Fast Money" traders; Seymour Owns (AAPL); Seymour Owns (BAC); Seymour Owns (F); Adami Owns (AGU); Adami Owns (C); Adami Owns (GS); Adami Owns (INTC); Adami Owns (MSFT); Adami Owns (NUE); Adami Owns (BTU); Adami's wife works for (MRK); Terranova Owns (VRTS); Terranova Owns (C); Terranova Owns (UPL); Terranova Owns (GM); Terranova Owns (MS); Terranova Owns (SLXP); Terranova owns (TEVA); Terranova Owns (BAX); Terranova Owns (CVI); Terranova Owns (RSX); Terranova Owns (SU); Terranova Owns (CNQ); Jon Najarian owns (AKAM), is short (AKAM) calls; Jon Najarian owns (AXL), is short (AXL) calls; Jon Najarian owns (CSTR), is short (CSTR) calls; Jon Najarian owns (JNPR), is short (JNPR) calls; Jon Najarian owns (NBR), is short (NBR) calls; Jon Najarian owns (RSH), is short (RSH) calls; Jon Najarian owns (SVU), is short (SVU) calls; Jon Najarian owns (SWY), is short (SWY) calls; Jon Najarian owns (X), is short (X) calls; Jon Najarian owns (CAT), is short (CAT) calls; Jon Najarian owns (AMD), is short (AMD) calls; Jon Najarian owns (BBY), is short (BBY) calls; Jon Najarian owns (CME), is short (CME) calls;’ Jon Najarian owns (CBOE), is short (CBOE) calls; Jon Najarian owns (GNW), is short (GNW) calls; Jon Najarian owns (NYX), is short (NYX) calls; Jon Najarian owns (NVDA), is short (NVDA) calls; Jon Najarian owns (V), is short (V) calls; Jon Najarian owns (WMT), is short (WMT) calls; Jon Najarian owns (ARUN), is short (ARUN) calls; Jon Najarian owns (RIMM), is short (RIMM) calls; Jon Najarian owns (GS), is short (GS) calls; Jon Najarian owns (SPWRA), is short (SPWRA) calls

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