Two days ago the S&P had the biggest up day of the whole year on news that the Federal Reserve was worried about the strength of the US dollar and the global economic slowdown. We rocketed up 45 S&P 500 handles and closed at the highs of the day. The bulls were confident that the selling was over, and the bear was dead.

But yesterday, a mere 24 hours since investors were chasing stocks higher with wild abandon, the stock market experience its biggest down day of the year as various Fed officials threw cold water on the idea that they were going to panic.

Yesterday Fed Vice Chairman Stanley Fischer said that “considerable time” could mean anything from two months to one year – not the reassuring sweet nothings the market was hoping for. Then St. Louis Fed President James Bullard spelled it out in black and white for the market:

“In my mind the markets are making a mistake.”

That was all the market needed to hear. The entire short covering rally following the release of the Fed minutes evaporated as markets were forced to re-price the Fed’s willingness to ease up on their tightening expectations.

This sort of volatility is ominous. The market is confused by the mixed messages that the Fed is sending. When you combine that with a market that has been propped up by five years of Quantitative Easing programs that are coming to an end, you have the ingredients for a big accident.

Yesterday by mid morning as I realized that the volatility was picking up, I headed to the sidelines for a lot of my trades. I came to the conclusion that it is time to hunker down and play defence. There are definitely opportunities, but you need to decrease your position size dramatically. The market is extremely emotional and the swings are wild. If you are trading expecting the markets to resume the nice trending nature of the past six months, you are going to get crushed.

Don’t be a hero and try to call the bottom. We very well might bounce from here. Who knows? This morning might be the panic lows. But we aren’t screaming to new highs any time soon. The best we could probably hope for is that things settle down and we grind back up to 2,000 for the rest of the year.

But the other side of the coin is quite scary. Although you will hear all sorts of Larry Kudlow arguments that you should buy stocks because the P/E ratio is quite reasonable at 16 times forward earnings (or whatever level he dreams up because forward earnings are a moving target), don’t forget this chart:

Corporate profits as a percentage of GDP are at all time highs. Many of the bulls will tell you why this is trend is sustainable, but I am not convinced of their arguments. This rally has been driven by corporate buy backs financed through an increasingly leveraged corporate balance sheet.

As the Fed winds down their QE programs, many of these tailwinds disappear.

When you combine that with a global economy that is slowing alarmingly quickly, you have the necessary conditions for a re-pricing of risky assets.

Let’s take Kudlow’s 16 times forward P/E argument. The index is roughly 1920, so he is assuming $120 of earnings. Given their stretched nature, I don’t think earnings can rise. In fact given the US dollar’s rise, the fact that labour is poised to start sharing in the benefits of a growing US economy and that many of the gains earned by corporations refinancing at lower rates have already occurred, I suspect that earnings might actually fall. So imagine we get a 5% decrease in earnings to 114. Then given the lower growth and the lack of the Fed pushing investors out the risk curve through QE, let’s say the market moves down to a cheaper multiple of something like 14. Suddenly the S&P 500 is trading at 1596. It doesn’t take much of a re-pricing in risk assets to get a 300 point decline in the S&P 500.

Everything needs to go right for you to continue to make money on the long side. Very little has to go wrong for you to lose big time. Investors have forgotten that stocks go up and down. They are currently in the midst of being reminded, and it is not the time to assume they will learn the lesson quickly.

Given the stupid pricing of all financial assets, I am not even sure there is anywhere to hide except cash. I have long held the belief that we will get to a point where stocks and bonds will both go down together. At that point, it will get really scary.

I came across this great chart that outlined the drawdowns of a portfolio composed of 50% stocks and 50% bonds for both the US and the UK.

It has been a while since we have had a big drawdown in a balance portfolio as the secular bond bull market of the last 33 years has provided a cushion for all financial assets. And although I know we are in the midst of a deflationary mini-scare that will likely make bonds rise, I think that in the long run we have sowed the seeds for a 35%–45% type correction in a balanced portfolio.

I am mixing time frames and wandering all over the place this morning, so let me get back on track.

My main message is not to be a hero and to be extremely careful in here. The market went up on the QE induced push out the risk curve. Investors have taken way more risk than they would have absent the QE policies. It is human nature to adapt to new conditions as if they are the normal, but the current environment is anything but normal. Investors have forgotten what risk looks like. As they are reminded of that fact, we have the possibility that if they all head for the exit at the same time, it is not going to be nearly big enough.