chart of the day

Quit Worrying about a 1987 Style Crash

More and more I am hearing and reading about the coming of a 1987 style crash. There are interviews airing about how we have to prepare for it. Articles are published telling us that this year’s percentage gains rival those of 1987 with the clear implication being that another crash is coming.

Fear sells and it is always a hot topic as a result. As you know, I am no fan of the methods that the central bankers have taken to force asset prices higher despite a plethora of continuing issues, but that’s a subject for another day. These hotbed topics can be argued from here till yonder and personally I don’t care to engage in such a time sink. My interest is in making money, not bickering about Uncle Ben and Abe. I care about finding ways to profit in the equity markets without taking significant risks. That’s what I get paid to do.

With this idea in mind, if there is a possibility of a 1987 style crash how does one truly prepare? Well, in my humble opinion, you don’t do it by worrying excessively before it’s time. You also don’t accomplish anything by liquidating your holdings or worse, getting short in anticipation of the crash before there is any real evidence that a crash possibility is near.

So how do you know it’s time or at least potentially time? To answer that let’s review the way the charts set up in 1987 using neoclassical analysis. I apologize for the less than stellar charts below. It turns out that it really isn’t very simple to find charts that far back in time so these are some quick and dirty charts I put together to simply prove a point - the common neoclassical concepts I preach today clearly indicated that a fast break lower had a high probability of occurring that fateful October of 1987 just as it did in in November of 2012.

Starting with a daily chart that spans from about 3 months prior to the October crash, notice how price moves up to all-time highs back in August of 1987 and then struggled the remainder of the month.

Eventually price fell then rose again into the first week of October which resulted in the formation of two swing point lows. Those two swing points are located right along the $300 price range.  As we know in neoclassical literature, a break of multiple swing points can lead to a fast move in the direction of the break.

What we also know in neoclassical technical analysis is that a break of multiple swing points that spans multiple time frames can lead to an even larger and emotional move in the direction of the breakout which was, in this case, lower. If we look at the weekly chart back in October of 1987 we find that this is exactly the pattern that had set-up. Here’s that chart.

Thus, the potential for a fast move in the direction of the break was telegraphed to all market participants on October 14th. At that price point, about a 9% decline had already occurred but that was nothing compared to what was about to happen. Even if a trader had done nothing with their portfolio until that fateful break of multiple swing points on multiple time frames they would have still saved themselves the pain of an additional 23% drop in price over the next few days. There were other less obvious signs like the completion of a bullish ABCD upside target on the weekly chart and the fact that not only were there two swing points on the daily chart but actually five swing point lows all lined up within a few percent of each other. If you find two or three swing points within close proximity the odds are that many stops will gather just below that price area - but five is clearly asking for trouble.

The point is, from a neoclassical perspective the potential for a fast and deep drop in price was possible in 1987 and you could see it coming. If you can see it coming then you need not blindly live in fear of it happening. A far better approach is to remain cognizant of the possibilities but continue to hold exposure until the possibilities have turned to reasonable probabilities. It’s not as if a crash swoops in out of the blue without so much as a whisper or a warning. The facts simply do not corroborate such erratic market behavior. In fact, market crashes are typically preceded by noticeable supply and demand behaviors that a neoclassical read will necessarily pick up on.

So if I look at today’s market, how does it look? Is there the potential for a crash? Here’s a weekly chart of the S&P 500 (^SPX).

Weekly SPX

When I look at this chart I cannot find any worrisome set-ups. There are no glaring similarities between now and 1987. That doesn’t mean it can’t develop, but right now it just isn’t there technically. This market would need to move down about 8% to get to even begin to reach a point where a crash situation would have any real possibility. Although down 8% is really not that much given that the market has moved 18% higher so far this year, but still, at this juncture the market has no sellers of size. Until we see evidence of more deliberate selling/dumping, we can’t just assume a crash will appear out of thin air like the Fed’s magical money.

Daily SPX

If I shorten my time frames though and examine the daily chart, there is some evidence there of an inability to get higher. There still are no sellers of consequence even on this time frame though so, once again, it’s premature to get bearish. What is evident right now is a lack of interest by both buyers and sellers. If, for whatever reason, selling does occur and the two swing points on this time frame (which reside about 15 points lower) are broken, then one would definitely need to raise their eyebrows a bit. That would be the first potential sign of real trouble.

It is my professional opinion that this market is beginning to show signs of wear and tear once more just as it did in June. We have some sector divergences, a failed breakout on the listed issues and the need for retest and regenerate sequences playing out in the NASDAQ and NDX. It is for this reason that once more I have begun to flatten out my portfolio and am employing short term timed index hedges against my long term bullish stock portfolio. If the problems listed above begin to reverse, then I’ll do the same with the hedges. If not, I’ll look to increase the hedges to cushion the retrace and use the opportunity to get longer again when it completes. For now though, talk of a “crash” is quite premature. In fact, it borders on ludicrous. There’s a lot more work left to do technically for a “crash possibility” to have any chance of playing out and that will take time. For now, trade what is front of you, not what the ghost writers have hidden behind the trees.

This article was originally published on MarketWatch on Aug. 13, 2013, 6:01 a.m. EDT