How to Know if a Market Crash is Coming

Miles of flat dry terrain cover the landscape from east to west and north to south; the grassy plain extends for miles and it is all that the naked eye can see. With keen hearing and close attention to detail, one discerns the muted swishing of the wind as it meanders through the tall vegetation. The scene appears lifeless. Suddenly, a slight movement of the earth is felt; a tiny shake as though a distant rock has fallen or perhaps a tree (but there are no trees). A small cloud appears on the horizon.

The vibration is growing; now it is a low rumble. What began as a tiny quiver is getting stronger by the second until the force of its movement is so strong it resembles an earthquake. The small cloud of dust expands rapidly and covers the sky; the thundering noise of hooves grows to a deafening level. Tiny particles of dry earth fill the air.

Somehow and for some reason a herd of buffalo is stampeding across the Great Plains. Perhaps one lone buffalo was spooked by a snake or a small animal; and then again, perhaps not. Maybe there was some other cause. The precise reason for the massive movement is unknown, but individual members of the herd are acting as though they have lost their unique identities and have merged into one huge, destructive mass. In unison, the enormous animals are charging forward, unable to consider the rationale behind their rampage. Their hooves hammer the land; one-by-one they follow those before them. Some of the enormous beasts die painful deaths as they are trampled by others. A few, as if blind, charge headlong over distant cliffs and die suddenly as they crash against the earth below.

It doesn't take long for the phenomenon to pass. Within a short time the thunderous roar lessens and the sun reappears. Calm returns to the landscape and the. surviving buffalo fade into the distance. The herd was strong and healthy; even those now dead. Had they not joined the stampede, they could have easily avoided the dangers of the plains and saved themselves. Sadly, they moved with the masses and were destroyed.

Investors are a lot like the buffalo of the Great Plains. They like to move with the crowd and seek "safety" in numbers. Sometimes that is a good thing. When the market is orderly, the keen trader can correctly identify a trend and successfully join it.

The purpose of this chapter is to alert you of potential dangers and assist you in designing a plan to avoid being caught off-guard in the stampede.

What is a Crash or a Panic?

One can define a market crash or panic in a number of ways. However, for this chapter, a panic is a market reversal in which major indexes like the Dow Jones and the S&P lose a significant amount of their value.

In '87, stocks on the Dow lost just shy over a trillion dollars of value in a day. On Black Monday, the Dow fell by more than 20%. However, the markets recovered relatively quickly. In 1929, the percentage of daily decline was actually less, but the long-term loss was far greater and the effects far more long lasting. Our nation did not fully recover for decades.

It is difficult and perhaps impossible to precisely define the terms "crash" and "panic." Everyone knows that they both involve a dramatic economic downturn accompanied by widespread financial loss. We further know that a panic is by definition irrational and unrestrained. Intuitively, we sense what it means to experience a market crash. But, how great must the loss be before we have a true "crash?" There were actually some market analysts who called Black Monday of 1987 a mere "correction".

How to Gauge if a Market Crash is Coming

No one knows for sure when a crash is going to hit, but history has repeatedly given us signs as to when this may occur.

A Bull Market That Has Overstayed Its Welcome

In September 2005, the bull market had been ongoing for thirty-five months. The average length of a rally is thirty-two months and our last low had occurred in October 2002. The longer the rally continued, the greater the chance that a rapid meltdown would occur. In fact, the longer the rally, the more severe the meltdown will likely be.

A 10% Drop in Stock Prices During Any Eight-Week Period

If stock prices drop ten percent during any eight-week period, beware. It does not mean that there will necessarily be a crash, but it certainly means that you need to exit equities or at least be certain that you have firm stop-loss orders in place that will take you out of your positions if the deterioration continues. Unquestionably such a drop in price should raise your antenna and force you to start taking a very close look at the landscape because a situation is developing that might be extremely hazardous.

This rule applies, of course, to any eight-week period with a 10% or greater drop in price. When prices fall that far that fast, it creates structural problems for the market. This is especially true with leveraged instruments like futures and leveraged equities. Also, remember that if prices fall that far that fast there will be an emotional response; the mass of investors will not be relying on rational analysis but panic. Many will quickly join the herd and be ready to stampede.

The Technology / Education Gap

The market is packed with day traders and other investors who trade on-line. It is very easy to open an account, get a trading platform, and start clicking a mouse. However, a huge number of these individuals are not properly trained and do not understand the world they are entering. Most of them have no respect for the risk they are assuming. They just click and "buy" and then click and "sell." The vast majority does not really have a plan. There is a tremendous educational gap, the likes of which we have never seen before. For many, trading is not much more than a video game. It is exciting, thrilling, and has the potential for making money. However, unlike the pinball machine, a sinking account will not just tilt and go to zero.

When a crash comes, millions will be literally hung out to dry. They will not be prepared; they will not have a clue. We liken these dabbling and clueless traders to a fleet of irresponsible and uninformed fighter pilots with a cargo of nuclear bombs. The pilots are carrying the most destructive weapons the world has ever known but they do not appreciate the power of their cargo. They act as recklessly as a child transporting caps in his pockets for his toy pistol.

After the crash, these poor souls will be broke. That means that the brokerage firms holding their margined accounts will be in trouble, their creditors who have financed their homes, their cars, and everything else will be in trouble, and our economy will be in tremendous distress.

Increasing Interest Rates that Trap Indebted Consumers

A commercial on television depicts a man who calmly explains that he has a beautiful home, new cars, membership in the Country Club and debt up to his ears. Unfortunately, millions of Americans are in that situation and it is no joking matter. Interest rates were enticingly low. The allure is too much for many people. Millions of our citizens are in far more debt from consumer goods and housing than they have ever been. Many lower income families charge necessities like gas and groceries; they also overspend for clothing, cars, and other consumables. Nationally, outstanding credit card balances are nearing eight-hundred billion dollars. At the same time that personal debt has been increasing, savings have been decreasing. That means that there is no safety-net for many. As rates inch up, these consumers are squeezed; the bottom line is that millions of Americans are extremely vulnerable. Such extensive indebtedness is not desirable, but what is the solution?

Growing Trade Deficit

For nearly four decades the United States has been burdened with a negative balance of trade. We have been consistently importing far more goods than we have been exporting. This imbalance has been increasing year-by-year and is ballooning. Mexico, Canada, China, Japan, the oil-rich Mid-East, and other nations — all seem to be making and exporting goods and the United States seems to be buying them.

A negative trade balance is problematic for a couple of reasons. First, we are no longer a nation of manufacturers or producers; we have become a nation of importers. In the long-term our nation may pay a hefty price for this shift. Second, just like other purchases, the price of the imports must be paid. It is paid with money borrowed from other nations. Consequently, if there is a serious decline in the dollar it could result in a global recession.

If the negative balance of trade continues to swell, Americans are simply more vulnerable to international factors and the trade deficit may be one of the ingredients that adds to a host of others and starts the economy moving downward, especially with a serious decline of the dollar.

Escalating Oil Prices and Scarcity

Though oil prices have been low over the past year, this is an area to keep an eye on. Though prices have been hovering around $50 a barrel, efforts are underway to cut back on global production and drive up the cost of crude. In fact, many global economies from Russia to Venezuela are highly dependent on oil process back at $100 a barrel. And as long as the American economy is highly dependent upon a steady and large energy supply of cheap oil that can all too easily become disrupted, oil and gas shortages may also be one of the straws on the proverbial camel's weakening back.

Soaring National Debt

In 2000, the United States government had a surplus of more than 200 billion dollars. Remember when news stations aired reports about the surplus and discussed how it would be spent? In 2015, that situation has dramatically changed. The surplus is gone and we are now close to $20 trillion in national debt.

If a household is heavily in debt, that debt has to be paid. Well the United States government is no different. The debt of the United States is borrowed money that must also be repaid. That means that as a nation, we are spending our future revenues at an unprecedented rate. A large portion of the GDP from future years will not be available for consumer spending because it will be used to repay debt' The national debt is increasing by well over a billion dollars a day!

War and Political Uncertainty

The markets hate uncertainty. Unfortunately, uncertainty is an integral part of the world in which we live. Any number of major political events may send our economy into a tailspin. September 11th made us all acutely aware of dangers that have become a part of everyday life. Realistically, we must face the fact that another attack could occur. When it does, the markets will obviously respond. The degree of the response will depend on the nature and seriousness of the attack. If a vital organ of our infrastructure or economy is hit, there will be a major response that may be long-lasting.

Also, we are a nation at war. Your personal feelings about the war are irrelevant. The fact is that waging a war costs money. Those costs are increasing our nation's debt. The war also adds another element of uncertainty to both our political and economic landscape. An unexpected and serious set-back abroad could also have a negative impact on Wall Street.

Housing Speculation

The housing boom that has been taking place in the United States and in a number of other industrialized nations is reaching frightening proportions. Low interest rates have lured many investors out of stocks and into real estate. Some investors who lost money with high-techs in the 1990's aggressively bailed out of the markets and placed their money in the housing sector. According to a study conducted by the National Association of Realtors, 20% of the houses bought in 2012-2013, were purchased for investment purposes.

Some geographical areas have experienced a far greater boom than other areas. Prices on the west coast have been rising for years. In the southern Gulf Coast area, property near the water has become golden. Condominiums on the sandy white beaches sell like hotcakes. In fact, they sell before they are built and it is not uncommon for long lines to form when projects are announced; the perceived scarcity means that buyers are often selected by lottery. In some cases, speculation seems to have reached irrational proportions. Across the United States, the average price of housing has nearly risen to its peak in 2006.

Many buyers have no intention of holding their investments for long and they never intend to inhabit the homes. They plan to flip them and make a large, fast profit. The next buyer, they assume, will be willing to pay thousands more than they paid. Therefore, they use riskier and often creative forms of financing that require little to no money down. Interest only loans and loans requiring no down-payment, or lines of credit are all popular financing tools. That works well as long as prices keep rising, but obviously, they cannot keep spiraling upward indefinitely. A day of reckoning will come. Widespread unemployment, increased interest rates, more attractive investments in bonds or stocks, any number of factors may deflate the bubble – just like in 2008.

Sentiment

Panic, by its definition is irrational; it is emotional and lacks logic. Therefore, once it is perceived by the public that a crash is imminent or ongoing, the markets will lose all rationality and investors will stampede. During those periods back in the early 70’s and 80’s we had gas shortages long lines of people waiting at the pumps. Were those panic stricken people causing the shortage? According to some sources, there was not a shortage of fuel, there was only a perceived shortage and that was enough to send panic stricken consumers to the pumps in droves. Often the reality of a situation is not what matters; it is the perceived reality that really counts. Therefore, if Americans sense that a crash is coming, and their feelings are supported by some event like a significant drop in stock prices, or an increase in interest rates, a smoldering ember may be ignited into an unstoppable inferno.

Signs of an Impending Crash

So how will you know that a crash is in progress? First, stock prices will drop significantly. Based upon history and current valuations, you may see a drop of 30 -50% before markets stabilize. Such a decrease would not be unexpected. That is the reason that we believe a drop of 10% may be a red flag that requires a thoughtful and strategic response.

The big idea is that in a crash the liquidity will be sucked from the market. Look for the interplay of factors that work to exacerbate an already weak financial condition. For example, is the dollar falling? What about interest rates? Is the price of gold rapidly rising? If the dollar is sharply declining, long-term interest rates are rising, and bond prices falling, the combination will eventually drain money out of the equity markets. Likewise, if gold prices are quickly increasing, there is evidence that confidence in paper money is declining and faith in central banking is evaporating. Again, liquidity will be shifted from equities to gold and commodities deemed to be safer and more marketable.

Or, perhaps a major segment of the economy will experience such great distress that the negative effects will fan out into other economic areas. For example, if the real estate market becomes very soft and bearish, it could quickly lead us into a recessionary climate. As noted above, with the prolonged bubble in real estate and low interest rates, many Americans have become accustomed to using the equity in their homes like an ATM. They have transformed long-term debt into short-term assets. For years, real estate has been a readily accessible source of liquidity. If asset prices reverse, this sector will remove liquidity from the market rather than adding to it. A major softening of this sector will have a recessionary effect on our economy.

Another obvious market to watch is oil. Disruption in supply or distribution will cause a sharp rise in prices. This will take money out of the pockets of consumers. Both the equity markets and the consumer markets will suffer. Another problem with escalating oil prices is that they may throw consumers off the edge and into a panic mode that is unstoppable.

A natural disaster can also exacerbate things. When Hurricane Katrina hit the United States, the Gulf Coast had been severely damaged. The infrastructure of numerous communities in Alabama, Mississippi, and Louisiana was destroyed. The Federal Government spent huge amounts of money to help Hurricane Katrina survivors and rebuild these communities. That means that a nation that was already struggling with a huge national debt was significantly increasing that debt. Time will tell how effectively our nation and economy can deal with another domestic problem of that size.

Conclusion

In summary, there is no single factor or market that can definitively tell you that a crash is in progress. You must look at the total landscape and watch the interplay of several factors. Just remember that once stock prices drop 10% during any 8-week period - history tells us that a crash may be imminent.

We do not have a crystal ball and we do not know when disaster will hit, but we feel certain that at this stage of the cycle there is a significant risk. Therefore, you need to prepare. If this chapter has alerted you to the dangers are ahead and helped you get prepared, it has done its job. Now you can take the steps you need to safeguard your assets. Gain as much knowledge as you can about the economy and the markets and position your assets as best you can to preserve them. When the dust settles, you want to have most of your assets intact.

A crashing market looks a lot like a herd of buffalo stampeding across the Great Plains. If you stay with the herd you will be in grave danger. You may senselessly leap over a financial cliff. Therefore, to avoid such a disaster, we recommend that you review your current portfolio and realistically plan for the future so that when a crash situation develops you are positioned to take full advantage of it. With care, your assets can remain intact and you can emerge a market winner.

On a brighter note . . . all markets are cyclical; the storm will lead to a period of calm and recovery. After down markets, stocks tend to snap back by 100% and sometimes more. We anticipate identifying the inflection point of the upcoming down market and shifting our strategy at the appropriate moment as the bulls regain dominance. There are profit-making opportunities in all markets, both bullish and bearish.

We look forward to helping you find those opportunities now and in the future.

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ABOUT THE AUTHOR

Tom Busby

Author: Tom Busby, Founder
Company: Diversified Trading Institute
Website: DTItrader.com
Services Offered: Trading Education, Software, Trade Alerts Markets Covered: Stocks, Options, Futures, Forex

Tom Busby’s trading career dates back to the late 1970’s. Quoted and published in Futures magazine and Active Trader Magazine, he actively trades and invests in futures, stocks, options and currencies.