Will the Stock Market Crash in the Fall of 2017? Part 1

will stock market crash in fall of 22017

In my most recent article, I wrote about the recent development of multiple confirmed Hindenburg Omens in the equity markets. Today, I want to delve into some other signals that I use to gauge whether a stock market crash is imminent.

History has proven that it is wiser to be a long-term bull and to trade the trend the vast majority of the time. But an investor must always keep an eye out for potential reversals; both as a measure of caution for one’s portfolio and for the opportunity of outsized gains.

And no bigger percentage trades exist than when a bull market turns over. If a trader can nail the timing of a crash (caveat: while risking only a tiny portion of his account) with either deep out-of-the-money put options or leveraged ETFs, the returns can be astronomical. {For a detailed explanation of this tactic, pick up a copy of Alexander Elder’s book, Welcome to My Trading Room.}

The Dystopia USA Crash Index

Let me start by listing the various indicators and anecdotal evidence that I have used in my trading past to predict a potential major decline in the markets. I will then explain each one and how the markets are poised today relative to these standards. I will also show you how to check the data for yourself, with links when appropriate.

This is in no particular order nor is it a weighted, scientific index. They are instead a list of historically important red flags.

  1. The Hindenburg Omen.
  2. Large sales of stock by company insiders.
  3. Investor sentiment indicators.
  4. Bubbles and manias.
  5. Chart patterns.
  6. MACD Histogram divergences.
  7. Business and market cycle theories and where we are in time relation.
  8. Political factors.
  9. Price to Earnings (P/E) ratios.
  10. Margin levels.
  11. IPOs.
  12. Yield Curve.
  13. Potential catalytic economic events or “black swans”.
  14. Put/Call ratio.
  15. Volatility Index (VIX).
  16. Market Cap to GDP ratio.

As the number of flags increases, I treat it as a corresponding rise in risk. Using any one indicator by itself as justification for taking a position is foolhardy. False signals happen all the time with even the best ones. We’re looking for preponderance. Think of a hitter with a great batting eye; he will only swing at a pitch if it’s in or near his sweet spot. Looking at all the available information dispassionately and winnowing out the noise aids us in finding our trading belt-high fastball.

. The Hindenburg Omen

This is my favorite crash indicator. Since only one major market sell-off has occurred in the past 30+ years without a confirmed Omen, being long the general indices is a fairly safe bet in the absence of one. But when the HO is flashing, it is alerting us to consider standing aside.

Read my previous article about the Hindenburg Omen here. Then also visit the link in that article to Robert McHugh’s exhaustive research on this important signal.

Where this factor of the Crash Index stands on 7/14/17: On the clock and ticking. Red Flag 1

2. Insider Selling

When high-ranking executives begin to sell their company’s stock in bulk after a protracted run-up in the price, this is a great signal that the hogs realize the trough is emptying and it won’t be refilled for a while.

Company officers are privy to inside information as to the health of their going concerns. No one is better poised to see when there is a slowdown in earnings that might affect the value of their 401ks and stock options. To get to the top of the corporate ladder requires a level of financial cunning and experience that Joe Investor usually lacks; therefore they know best to get out while the getting is good and they will gladly dump their shares to any bagholder who will buy at the top of the mania or cycle.

In Wall Street parlance, this is known as smart money selling to dumb money. This rule applies doubly to hot, high-flying sectors. At the peak of the housing bubble, insiders like Angelo Mozillo of Toll Brothers were shoving away shares like they were hand grenades. All the while, those execs would go to the adoring financial press and tell you that there’s never been a better time to buy the stock they are so eager to sell. On the other hand, just before the market bottomed in 2009, insiders scooped up shares at unprecedented levels.

All shares by key officers must be declared by rule to the public on SEC Form 4. You can find insider share transactions for any given company on the Security and Exchange Commission’s EDGAR database. For a broader gauge of insider selling, Insider Rank breaks it down by industry.

Verdict on 7/14/17: Insider sales are very high, although off of the extremes of February as reported by Vickers Weekly Insider. Good enough for Red Flag

3. Sentiment Indicators

Investor sentiment (via Bull/Bear Ratios) is often a useful contrarian indicator for pegging both approaching market tops and bottoms. If too many investors are of the same mind – all bulls or all bears after an extended trend – then everyone who has wanted to buy has already bought or who has wanted to sell has already sold. In poker parlance, the whole table is all-in. During manias, investors and money managers are chasing the rising price at all costs until they have exhausted their cash.

Call it Fear of Missing Out Syndrome, or what it more correctly, is: greed. Without fresh money flows, there is no impetus to drive prices higher. When the bubble expands and thins out – either because the market runs out of momentum and stalls (buyer’s remorse) or a catalytic event occurs –  the market enters a free-fall because there is no cash on the sidelines to alleviate the selling pressure.

The AAII Investor Sentiment Survey and the Investor’s Intelligence Bulls and Bears Ratio (requires subscription, but Ed Yardeni puts out a good report that shows it) tracks sentiment for retail investors and money managers, respectively. The NAAIM Exposure Index is a way to check how fully invested Wall Street is at the moment.

The AAII small investor sentiment indicator is used for predicting tops under the old adage that, “when your cab driver starts giving you stock tips, the move is over.” It is well known on Wall Street that small investors pile in at market tops and at the late-stages of bubbles. They become the bagholders for the more nimble professionals.

What you are looking for here are extremes. The historical Bull/Bear ratio for the AAII is around 1.3. Extremes are around 2 to 1 for the AAII and 3 to 1 for the Investor’s Intelligence.

Where this factor of the Crash Index stands on 7/14/17: Mixed. Half a red flag. The professionals are getting frothy at about 2.7 to 1. But smaller investors are nearly evenly divided and have been for some time. There is a solid theory that, since the middle class is almost extinct, small investor sentiment hardly matters to the markets anymore because the Wall Street casino is almost entirely big money these days. I believe there is something to it.

4. Bubbles and Manias

This won’t require much explanation to our astute readers. You know it when you see it: tulips in the 17th Century, the South Sea Company in the 18th, margin-a-go-go in 1929, right up to our modern Nasdaq and housing bubbles.

The hallmarks are always the same.

  • You will see prices go parabolic in very compressed time frames.
  • Breathy headlines will read, “it’s different this time”, or “this is a paradigm shift”. No. No, it’s not. It is never different.
  • Lots of Insta-millionaires will be minted by doing nothing but following a trend.

Verdict for today: Mixed. Half a red flag. We stand at 3 flags out of 4 indicators so far. There’s very little that jumps out and screams, “THIS IS A BUBBLE” like these other events. However, there are many investment classes that have climbed steadily, unabatedly, for years (like the bond market) without a parabolic spike. In essence, what we have is just pure, across-the-board asset inflation. So perhaps everything is a bubble. Thank you very much, oh dear leaders of the Federal Reserve, for our Franken-economy.

5. Chart Patterns:

I’m not a fan of chart patterns in general. They bust way too frequently for my liking. But a few patterns have historically been present before major selloffs and crashes; most notably the head and shoulders, the double or triple top, and the rising bearish wedge.

7/14/17: A quick check of the $SPX symbol on StockCharts, there is a rising wedge, but nothing else of significance. Sometimes a rising bearish wedge will terminate in an initial selloff that will form go on to form the left shoulder and neckline of a head and shoulders pattern. If the H&S does develop, it would mean the indices will have another high to make before any possible larger selloff, which could coincide with the right shoulder forming in the late summer/early fall crash season. No red flags as of yet, but bears monitoring.

6. MACD Histogram Divergences:

This is my second favorite indicator for finding potential tops. When the peaks in the MACD Histogram indicator slope downwards while prices rise higher, the market is screaming that there is trouble ahead. The longer the time-frame of the chart, the bigger the trend change one can expect. For instance, if there is divergence on the hourly or daily chart, a minor move may be coming. If the divergence is on the weekly or monthly charts, then it is possible that a major trend change could develop, perhaps even the end of an economic cycle.

An investor who utilized MACD Histogram wisely would have caught both the 2007 market top and the early 2009 bottom.

How are we doing today? There is a very significant bearish MACD divergence in the weekly chart of the S&P 500. The monthly chart looks OK. Half a Red Flag. (Crash Index stands at 3.5 out of 6 thus far).


See Part 2 of this series on the Crash Index here.

Please note:

This Crash Index merely is an informational and educational guide that may serve you well if you take it for what it is: a warning that several important indicators are stating that risk of being long in the stock market is increased at this snapshot in time. Although I did formerly work on Wall Street, I am not now, nor have I ever been, a financial advisor. A good trader collects information and uses it to inform his own decisions.


{As a gentle reminder, Dystopia USA is a new website, and as such links and social media shares are as vital to our survival as blood is to a vampire! Also, please consider subscribing if you feel the articles are bringing you some value. Thanks as always for reading.}

 

 

 

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