There are 4 basic conditions that align and lead to a stock market meltdown or correction:
1. A deeply oversold condition
2. The market down on successively higher volume
3. Inability to rally much
4. Complacency among investors
As I have stated many times, the stock market doesn’t crash from the high, it crashes after it has already declined and looks very “oversold.” Most technicians that use overbought/oversold indicators are licking their chops when such a condition exists. But experienced market operators know the risks that come along with such a condition. A market that refuses to rally from a deeply oversold condition is a dangerous market. In 1987, the NASDAQ fell about 10%, achieving a deeply oversold condition (very similar to the condition and readings we face today).
When a market comes under distribution – down on increasingly heavy volume – it’s a sign that institutions are selling big blocks of stock. If this appears after the general market has had an extended advance, the amount of supply can overwhelm the indexes as money managers flee stocks and lock in profits. In 1987, the market ran up unabated for years (similar to what we face today.) When the market finally broke, few believed it was less than another opportunity to buy the dip, as they had seen the market come roaring back time and time again. Does this sound familiar?
The NASDAQ is currently off about 10% from its high, almost the identical amount of the first leg down prior to the 1987 crash. The oversold reading is also very similar. Volume has been picking up and the index closed right on the low for the day (this also occurred in 1987). Based on one measure, the last time the Dow was this oversold was in Aug 2011 when the Dow was off 11% from the high and then fell an additional 6.5%.
I always say, if you know when the train is supposed to pull into the station, then you will know when something is wrong. When the market gets deeply oversold, this condition should produce a sharp snap back rally, or “bounce.” When that doesn’t occur, it’s a sign of weakness; the train is not coming in on schedule.
Friday put volume spiked to levels that have historically coincided with or near market bottoms. For any years, my friend John Bollinger followed the CBOE equity put volume vs. its own 10 day average. When the reading rises to 2.0 or greater (daily put volume 2x the 10 day), it’s an indication of extreme fear. That number hit 2.05 on Friday. This suggest a trading low is near in time, but how near in price is the big question.
The fact that the market is selling off on increasing volume and the indexes are deeply oversold but refuse to rally, is enough to warrant caution. But the level of complacency is the real red flag. NO ONE SEEMS TO BE TOO WORRIED. I watched CNBC all day on Friday (something I rarely do) to try and get an idea of how people were feeling during this relatively severe decline. I could barely find anyone that said much more than “buy the dip”, “it’s a great buying opportunity”, or “buy for the long term.” It is certainly possible that this is a great buying opportunity. With a more transparent Fed, the market could be discounting a rate hike. If that’s the case, this correction is right in line with historical norms.
S&P 500 CORRECTIONS FROM FIRST RATE HIKE
-2% in 1972
-12% in 1999
6 of 9 down 7.6% or greater
The 3 under 7.6% averaged down 2.7%
AVERAGE down 7% — 7.4 weeks
AVERAGE MINUS 3 UNDER down 9.2% — 9.3 weeks
On the flip side, with all the life support the Fed has pumped into this economy over the years through its QE operations, does the lack of growth indicate that the Fed has lost control and we are headed for a recession? Is the Fed is out of ammunition? If that’s the case, then we could indeed be entering a bull bear market. Don’t think that the Fed doesn’t have more stupid things they can do to prop up the economy short term – long term implications, YES!. The Fed will fight a U.S. recession with everything they’ve got, tooth and nail to avoid mud on their face. If a recession should occur, it would undermine everything the Fed has done and prove their theory completely wrong.
When you have a big scary decline and the market is acting very weak, but no one is scared, you should be scared. Is a stock market crash like 1987 or a flash crash meltdown probable? No. Is it possible? Yes! One thing you can count on for sure is volatility. Risk is indeed high. If you like swings, then you’re going to love what’s in store over the coming days and weeks ahead.
I think we are at an important crossroad here. If the market can stabilize soon, the correction may be close to the end and in line with the historical norms of a response to a first rate hike, only this time discounting that hike. However,should we have another day or two like Friday, the long term trend and the bull market is likely in jeopardy.
Receive News & Ratings Via Email - Enter your email address below to receive a concise daily summary of the latest news and analysts' ratings with MarketBeat.com's FREE daily email newsletter.