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Sniffing Out a Stock Market Crash: Charting Tips for Bears

February 15, 2012
Sniffing Out a Stock Market Crash: Charting Tips for Bears

You can’t predict a market collapse, but there are tools you can use to help you see if there might be rough roads ahead.

What’s a black swan?1

It’s a random, high-impact event that surprises a lot of people. The bursting of the dot-com bubble, when trillions of dollars were made and lost in a few short years, was a black swan. The 2008 credit crisis, and its ensuing collateral damage, was another.  

In the eight years that separated these two events, the US experienced two steep downturns in the stock market that left many investors exposed to greater risk than they bargained for. The reality is black swans just happen. So, if black swan events are, by definition, unpredictable, then are there ways investors can take precautions to soften the impact of one? Perhaps.

  1. FIRST, IDENTIFY THE ENVIRONMENTS in which black-swan events tend to arise. Even the most basic-level charting allows investors to lay out the inter-market relationships that can offer important warning signs. Still, the whole black swan concept is about how commonly used indicators, like charts, missed foreseeing the event.

  2. SECOND, DIVERSIFY. Keep in mind here that diversification will soften the blow if a particular stock, industry, or sector gets hit, but it will not protect against a broad market downturn.

  3. THIRD, CONSIDER TRYING TO PROTECT PORTFOLIOS with stop losses. (Predetermined orders to sell a security at a set price in order to attempt to limit potential losses.)

Identify the Environment

Black swans don’t happen overnight. While you can’t predict them, keep in mind that equity and bond markets may tend to discount the future health of the economy several months in advance, based on today’s data. There are typically some warning signs that things may be going awry. For example, the credit crisis in the fall of 2008, was preceded by significant deterioration in stock prices well ahead of Lehman Brothers’ bankruptcy.

Black swans may tend to occur after the equity market has begun to fade. To catch a whiff of stock weakness, consider looking first at the action in the bond markets, and watching for US dollar breakouts. Bond prices and the dollar tend to move inversely to stocks. The US bond market, second in size only to the global currency market, may lead the equity market by two to nine months. For example, the 10-year Treasury yield peaked June 13, 2007; the equity markets then peaked October 11, 2007. In 2011, 10-year yields peaked February 8, and equities peaked May 2. (Source: Thomson Reuters)


FIGURE 1 S&P 500 vs. 10-year Treasury. Market data: Thomson Reuters. For illustrative purposes only.

Once 10-year rates have peaked, consider watching for breakouts in the US dollar. In August of 2008, the US dollar broke out of its downtrend, and the equity market then went into freefall one month later. By October 2008, the equity markets were down more than 35% from their highs. Investors that followed the bond market and the US dollar could have prepared their portfolios a little differently.


FIGURE 2 When stocks broke down in May 2011, the U.S. dollar found its bottom. Market data: Thomson Reuters. For illustrative purposes only.

Spikes in short-term emergency lending by the Federal Reserve or European Central Bank, major bank, or hedge-fund bankruptcies, stock-sector rotation, and contractions in money supply can also be leading signals. Sharp upward moves in the CBOE Volatility Index (VIX), the volatility index for the S&P 500, may be a a coincident indicator of black-swan events. The VIX is a “fear” gauge that measures how much “institutions are taking positions in the options market to protect their portfolios. Fast declines in commodity prices can be another blip worth some attention. Copper prices, in particular, can offer important economic clues because of the metal’s diverse industrial use.

Protect the Portfolio

Because black swans are unpredictable, diversifying across asset classes, time, and geography can be helpful in reducing risk exposure.

There are tactical portfolio moves that can potentially provide even more risk management. Placing stop losses below defined support levels may be a way to potentially help hold ontoprofits, or decrease losses, in down markets. Stock prices can react to support levels by bouncing several times after reaching the area.  

Breaks of support levels are important because those breaks can imply that institutions are net sellers of stocks. Institutions will be net sellers of stock if they believe their investments will do better elsewhere. Support breaks may often lead to follow-through selling. For instance, prices broke support at 1370 on the S&P 500 index in January of 2008. Prices then fell 51% to 667 by March of 2009. To limit losses, you can consider stop losses (most investors using this tactic will decide on a range, for example 1-3%) below major support areas. By doing so, you might avoid riding the market to the bottom.

Remember, black-swan events frequently may occur during existing equity-market weakness, the bond market may often leads the equity market, and equity breakouts/breakdowns are often seen by traders to be more reliable if the US dollar confirms the move. To help protect your portfolio in volatile times, consider diversification, and consider placing stop losses below defined support. Breakdowns through support may also tend to be more reliable when bond rates have peaked and the US dollar has broken out.

1 Mathematician and trader Nassim Nicholas Taleb wrote bestselling The Black Swan in 2007 followed by updated editions.

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