(This is an excerpt from Friday's blog for Decision Point subscribers.)
READER QUESTION: Hi Carl: I would like to tell you that I really enjoy your service and kudos because yours is one of the most accurate out there. I just wanted to make sure I was correctly interpreting your 3/18/2011 big bang message: are you suggesting we can crash here? Because that's what I got out of it . . . so, I am just checking to make sure that was what you intended to convey.
ANSWER: As a practical matter there is always the potential for a market crash, but the causes and magnitude will be different. For example, the Flash Crash and the 1987 Crash, were, in my opinion, caused primarily by structural weaknesses in the exchange trading systems. The 1929 Crash was only a decline of about -14.5%, but it was part of an already in progress bear market that eventually reduced the Dow by about –90%. The 1929-1932 Bear Market was caused by problems in the economy, as is the case with most bear markets, the most recent being 2000-2002 and 2007-2009 Bear Markets. There were “crash-type” events in those bear markets, but they occurred well after the bear markets had begun, which was why I said in my 3/18/11 article that we would probably have ample technical warning to avoid most of the downside.
However, sometimes there will be unexpected external events which will provide no warning of a technical nature, that could trigger a market crash. A recent example is, of course, the major earthquake and tsunami in Japan, which caused a crash in Japan's stock market.
As for future natural disasters that could affect the U.S. stock market, we are guaranteed to have a major earthquake in the Los Angeles basin sometime within the next 15 seconds to 1,500 years. In the extreme, the Yellowstone Caldera is roughly due for a major eruption any day within the next 40,000 years, and, naturally, there are some scientists who think it is immanent. These are bad things that could happen, but they are completely out of our control to predict or plan for in a financial context.
In my opinion, the global debt crisis is going to result in another major bear market in stocks. It is not a matter of “if”, but “when.” Just like the stock bubble and real estate bubble, the debt bubble will eventually collapse. The question is whether it will begin gradually deflating, thus creating technical evidence upon which we can act, or will there be a sudden major failure of confidence caused something like an important sovereign default, or banking system failure? A sudden loss of confidence would surely cause a crash.
My observation of how markets normally move leads me to believe that the next bear market will begin with a gradual deterioration of prices, sufficient to give us the technical warning to exit before a crash. A crash-type event will probably follow to let one and all know that the bear is back in town. This is my best case scenario, because the debt problem is too big to solve easily. Worst-case, the potential for a sudden collapse without warning is greater than I can remember, but I am not predicting a crash.
From a strictly technical point of view, the current correction has pulled moving averages down to where they are fairly close to making the bearish crossovers, which will be the advance warning I referred to above. Of the 27 market and sector indexes we track, five have switched from buy to neutral. The broader indexes are still fairly healthy in this regard (see the EMAs in the thumbnail chart above), but we'll have to watch things closely if there is a retest of this month's lows.
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Technical analysis is a windsock, not a crystal ball.
