Is a Crash Coming in 2017? Part 3 of 3

Today I am going to run through the final four crash indicators that I use to check the temperature of the markets. Many of the market signals I touched upon earlier in this series are blaring that a significant pullback could be straight ahead in the next 3-4 months. Or worse. Now I will try to answer the pertinent question: Is a crash coming in stocks later this year?

Read the first two parts of this series here:

Crash Indicators (1-6)

Crash Indicators (7-12)

Let’s get straight to business.

13. Black Swans

If you haven’t already read Nassim Taleb’s seminal work, The Black Swan, I suggest you do so. It truly is one of the most important books of our era. When most everyone else was oblivious to the systemic dangers posed by the housing bubble in the last decade, Taleb’s Black Swan Theory helped anyone who listened to him prepare for the dangers to come.

Unexpected, outlier events will always be dismissed by the governing class of technocrats because they truly believe, in their genius, that they have prepared for every contingency. These bureaucrats never admitted in the mid 2000s that housing was in a bubble, but they knew it and lied to the public. Too much was at stake to tell the truth. But arrogance being what it is, they really thought that no systemic ills could come of it.

By not admitting what they don’t know, they make idiots of themselves time and again.

Potential Systemic Events

So what are the outlying factors that could dupe the policymakers this time and act as a catalyst for the next crisis?

  • The Federal Reserve being found out as the emperor with no clothes. A Fed that is out of both credibility and ammunition could be powerless to halt even a moderate-sized hiccup in the markets.
  • A hard reversal in the bond markets from bull to bear.
  • Spillover effects from a debt or pension crisis like we have just seen in Puerto Rico and Illinois into the broader U.S. economy.
  • Mass student and auto loan defaults.
  • Robotics displacing too many workers (this one is further down the road, however).
  • Nationalism defeating globalism en masse and upsetting the economic status quo.
  • Derivatives market failure and subsequent contagion.
  • An organic, flash social movement such as minimalism or people dropping out of modernity that catches the TPTB off their guard.

Verdict: There are catalysts and accelerants everywhere. We’re in a woodshed with a floor covered in sawdust and gas cans in the corner. One match flung in the wrong spot and it will all blow.

To use a different analogy: when the world is so insanely interconnected it resembles a million dominoes laid out. There are inevitably a few key tiles out there that all the experts have forgotten about or assumed safely placed where they couldn’t start a chain reaction. The hive mind will be proven wrong once again.

This is red flag 7.5 of 13.

14. The Put/Call Ratio

The 20-day moving average of the CBOE Put/Call Ratio has historically been an excellent contrarian signal presaging corrections and crashes. It has caught most of the big corrections and crashes over the years.

When the P/C ratio has fallen below around .80, markets usually tumble. The trading public gets overly euphoric and often cease buying protective put options.

Where is the 20DMA of the P/C today? .92, right in line with its long-term averages. But I’ll be monitoring it, as it can change quickly.

No red flag here. We’re holding at seven and one-half out of fourteen.

15. Volatility Index (VIX)

The Volatility Index, or VIX, is a gauge used to measure fear amongst market participants.

The lower the VIX, the more complacent the investing public and the lower the premiums charged on options contracts. On the other hand, when the VIX increases, more fear is creeping into the psyches of traders.

A bull market on its last legs will exhibit VIX readings at extreme, protracted, lows. That is the first condition we need for this part of our Crash Index.  It has been met. This indicator recently broke below a 10-handle.

The second condition we need is a rise in the Volatility Index after these abnormal lows.

Professional options writers are a crafty bunch of insiders, privy to all kinds of important data that the layman doesn’t get as quickly. Since they have major liability problems if they do not price their premiums correctly, a writer will jack them up if they sense that a shock to the system is imminent.

vix seismograph for market quakes

The VIX and “Earthquake Weather”

Think of the Volatility Index as the way your pet behaves right before an earthquake. They will know before you do when a tremor is coming.

Sharply rising options premiums after long periods of complacency is the market equivalent of your dog whimpering and hiding shortly before the big one hits.

The VIX is also similar to a seismograph; when all is fine and dandy, the needle will move slowly, if at all. A daily trading range for the VIX might be in the 10-11 intraday range. But eventually the lines get bigger and more erratic in the precursor phase. It may fluctuate from between, say, 10 and 14 on a single trading day. The next few days or weeks will be similar, but nudging upwards to around 20. The market as a whole may not drop at this time, but the trading range will increase as well. Then all might quiet down for a few weeks; the lull before the big event.

For our purposes, we are looking for the first whimper from the options dogs – or those first few precursors and shaking needle.

Verdict: We are not there yet. It will happen suddenly if/when it does, so this should be monitored daily.

But the persistently low volatility being our first condition, it means this is worth half of a red flag.

8 out of 15 red flags is our latest Index tally.

16. Market Cap to GDP Ratio

The Wilshire 5000 Index contains the broadest collection of stocks of any of the major indices. It is therefore the best representation of the total stock market capitalization in the U.S. For the uninitiated, market capitalization is the price of a stock multiplied by the number of shares (or float).

Warren Buffett, possibly the greatest investor of all time, uses the Wilshire 5000 to Gross Domestic Product ratio to determine whether stocks are expensive or cheap. Whenever the W5000 has been at over 100% of GDP, stocks have declined shortly thereafter. It hit 137% at the height of the Dotcom mania, 105% during the housing/subprime bubble, and close to 130% around the time of the waterfall selloff in August 2015.

Where does the Buffett Indicator stand today? Very near the all-time high.

Verdict: Red flag 9 out of 16.

Conclusion

Our Dystopia USA Crash Index for late July, 2017 registers at a hefty 9 bells tolling out of 16 possible.

To summarize:

Signals warning of a downturn (7):

  • Hindenburg Omen
  • Insider selling
  • Cycle theories
  • Price/Earnings ratios
  • Margin debt
  • The number of potential Black Swans
  • Market Cap to GDP ratio

Signals that have NOT set off alarms as of yet (5):

  • Chart patterns
  • Political factors
  • IPOs
  • Yield curve
  • Put/Call ratio

Neutral, partial, or mixed signals (4, worth a half a point):

  • Sentiment indicators
  • Bubbles/manias/parabolic price action
  • MACD Histogram divergences
  • VIX

This is warning us that there is a significantly higher than normal chance that the markets will either enter into a major correction or worse. There is a decent chance this could mark the end of the bull market that started in 2009.

Is a Crash Coming This Year?

If you put a gun to my head and forced me to make a prediction, I tend to think there will be a selloff in the range of 8-12%, commencing in the August to October period. Probably towards the latter part of that time span; it will take time for a head and shoulders pattern to form and for volatility to ratchet upwards.

What is keeping me from forecasting a full trend reversal is that the Crash Index, though in a clear danger zone, was higher than today leading up to both the 2000 and the 2007-08 declines and even before the quasi-flash crash in August-September 2015.

The factor holding me back the most in my prediction is that 2017 is lacking the extreme ebullience of retail investors that we saw in almost every prior crash. Now it may be that retail will never be a part of this bull market since the Fed’s insane policies have helped destroy the middle class. However, if we go into a full-on mania phase in stocks, what is left of the retail class of traders will pile in late and cause a true parabolic spike that we are lacking.

My best guess for how the bull market will end is this:
  • A sizable correction in the fall of 2017, similar to what we saw in August 2015. Fast and sharp but fleeting.
  • Bears get trapped by being too early.
  • Recovery and consolidation until December.
  • A top in early to mid 2018 caused by short covering (max pain inflicted on bears) and retail piling in.
  • Crash in fall of 2018.

2017 could resemble 2007; a weakening economy, a precursor selloff, a bear trap, and a new high in the indices the next year with larger divergences. When the reality of a recession slaps delusion late bulls in the face, then the main event hits; a sharp selloff, followed by a bull trap, and finally the crash.

But it is just a guess. I have no crystal ball. All a good trader ever does is make educated guesses based on odds, risk factors and history.

 


*As a reminder, I am no longer in the securities industry. Although I was formerly Series licensed, I was never a financial advisor. Please do not construe this article as a recommendation on my part to take any positions. It is for educational and informational purposes only. Do your own due diligence.


P.S. – If you have enjoyed this series of articles or found it valuable, please consider helping us out by sharing the link to your social media or website. As a new blog, we can use all the links we can get. Thank you as ever for your readership.

 

 

 

 

 

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