Indicators that Spot a Crash

Is the stock market ready to crash? This is a near constant concern for some investors. But, it probably shouldn’t be. Crashes are rare, having occurred just a few times in market history.

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  • There are many ways to define a crash but the most significant stock market crash in history might have come in 1929. Near the end of that year, stocks sold off sharply. The selloff occurred as the economy was entering the Great Depression, an economic downturn that lasted throughout most of the 1930s.

    The Dow Jones Industrial Average collapsed after the 1929 crash, losing almost 90% of its value. We have never seen another crash like that although the Nasdaq 100 index, an index that tracks tech stocks, did lose a similar amount after the Internet bubble burst in 2000.

    There have been other crashes, like the single day decline of nearly 20% in the Dow in October 1987. There have been large losses on other days, but the stock market has always recovered from these events relatively quickly.

    In hindsight, the large one day crashes have been buying opportunities. While they can be frightening at the time, history has shown the best thing to do in a sudden market decline is to sit tight or even to buy more if cash is available.

    But, history tells us that it could be best to avoid the worst of a market decline like the ones that occurred in 1929, 1999 2008 and in several other instances. These were deep bear markets that destroyed wealth quickly. Recovery from these bear markets took years.

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  • Rapid destruction of wealth and a slow recovery could force an investor to change their plans. For example, they could be forced to retire later than desired. Fortunately, those bear markets all showed some warning signs.

    Momentum Leads Price

    Technical analysts have developed a large number of indicators to track the behavior of prices. One area of intense study in the field has been momentum.

    Momentum measures how fast price is moving. The idea behind momentum is that prices face some undefined natural speed limit. While the actual value of the speed limit is unknown, momentum indicators seek to find times when the price is simply moving too fast.

    For example, if a stock gains 100% in a week, it is unlikely it can continue moving at that pace indefinitely. Eventually, it must slow down or even reverse. Momentum indicators are looking for signs that the price went too far in too short of a time frame.

    In studying momentum, many technical analysts have concluded that changes in momentum lead price. For example, if we measure the percentage change in price, that is called the rate of change, or ROC, indicator. If ROC moves to 100% in one week, we expect it slow the next week.

    It is possible the price will continue moving higher as the ROC slows. That is what technicians mean when they say that momentum leads prices.

    ROC in 1929 and Now

    At the bottom of the chart below is the 26 week ROC indicator. It is shown as the thick line and a thin line is drawn two standard deviations above and below the ROC.  These lines are the technical indicator known as Bollinger Bands.

    Bollinger Bands shows when the price action is unusual compared to the recent past. They expand and contract in line with the recent market action and in this way they adapt to the current market environment. Although they are usually applied to prices, Bollinger Bands can be added to any indicator.

    Notice that in 1929, the ROC topped the upper Band. This is a sign that markets are moving too fast. This warning sign came well before the ultimate top and market crash.

    The next chart shows the current market. Notice that ROC is at the upper Band but has not moved above it.

    The current market could pull back or decline by more than 10% but the decline is likely to be orderly according to the ROC indicator.

    MACD in 1929 and Now

    In the next chart is the simple and widely followed MACD indicator. Weekly MACD signals are among the most reliable market signals. This indicator works well on weekly and monthly charts but is prone to whipsaws on the more commonly used daily charts.

    This is the MACD histogram which makes buy and sell signals easy to spot. A sell signal occurs when the indicator turns negative. That is shown with the long blue arrow in the price section of the chart above. The sell signal came three weeks before the market crash.

    But, you may notice in the chart that the MACD indicator was declining in the weeks before the sell signal. In other words, momentum was leading the price action and warning of a potential downturn in the index.

    The next chart shows the Dow with MACD in the current market.

    For now, MACD is still on a buy signal which means the histogram is above zero and shown as green in the chart. It is no longer rising and that is an indicator that will be important to follow in the coming weeks.

    A sell signal in the MACD indicator, on the weekly or monthly chart, would indicate that the stock market could be set for a decline. It could also indicate that momentum is slow as we saw in early 2017 when the histogram turned negative as the price advance slowed.

    For now, risk in the stock market appears to be high. However, there is no sign that a runaway bear market or significant market crash is ahead. For individual investors, that means that a pullback should be considered a buying opportunity.

    This bull market will eventually end, but if history is a guide, the end of the bear market will include a significant divergence in MACD and other momentum indicators. ROC will likely accelerate into the ultimate top and breadth indicators will break down as that occurs.

    Those are the warning signs to watch for.

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