This is how the market is supposed to work, at least in theory: Stocks rise and fall based on the performance of their underlying companies.
“But in a vicious down market,” Cramer said, “the connection between a company and its stock can become gossamer thin. And often it can even be severed.”
You’ll see even the best names declining with the bad, regardless of any good news they may have reported. How could this happen? That’s exactly what investors need to know if their portfolios are going to survive these situations.
For one thing, Cramer said, hedge funds have turned stocks into an asset class. In short, they’ve commoditized equities, trading them like timber or corn, and they’ve done so by pouring untold amounts of money into S&P 500 futures. See, individual stocks are too small to handle the cash these funds are throwing around, so they turn to the S&P, or big exchange-traded funds, instead. The drawback to this strategy is that when the market takes a nosedive, the hedge funds sell their positions en masse, and that brings down the entire S&P.
This issue is at the heart of something that Cramer said every investor must understand: the idea of stocks as paper risk, meaning all the non-fundamental factors that can take a share price lower. Like the fear sown by short sellers, for instance. Ever since the uptick rule was repealed in 2007, these traders have hammered down stocks with impunity.
It’s a shame because the uptick rule, which required a stock to tick up in price before it could be sold short, was put into place after some hard lessons learned during the Great Depression. And it worked beautifully for all those years, but former Securities and Exchange Commission Chairman Christopher Cox got rid of it, giving short sellers free rein during the financial crisis. Cramer said these shorts were instrumental in the fall of Lehman Brothers, among other market catastrophes during that time.
Then there are the double- and triple-leveraged short ETFs. The point of these funds is to give buyers better bang for their buck, but that’s only true for day traders. Why? Because they rebalance everyday, making them useless for long- and medium-term investors. Take the UltraShort Financials ProShares ETF, which lets you short the financial-sector stocks with 100% leverage. Instead of being up during 2008, one of the worst years in bank-stock history, the SKF was actually down for the year – because it only tracks day-to-day changes, rebalancing at the end of each trading session.
Cramer said these ETFs are more of a play on volatility than any of the sectors they allow you to short or own. What’s more, he thinks they exist mainly “to allow the shorts to get around the margin rules [and] manipulate the market with massive selling firepower.”
“This gets at a larger problem of an SEC that no longer seems interested in protecting you, regular investors,” Cramer said.
(Written by Tom Brennan; Edited by Drew Sandholm)
Call Cramer: 1-800-743-CNBC
Questions for Cramer? firstname.lastname@example.org
Questions, comments, suggestions for the Mad Money website? email@example.com