Last week, U.S. equities dropped 2% to 3%, depending on what index you monitor. That had the financial columns full of crash warnings about the coming plunge. Now to be fair, we have seen these headlines for a while now, so it's not like they just suddenly began to appear, but the fact that there actually was some selling added a little credence to the crash worries. Sure there were a few voices of reason, but for the most part, the coming declines were all but set in stone as far as most commentators were concerned. But is that really the case? Is it finally time for a crash?
A year ago, almost to the day, I penned a piece here on MarketWatch that outlined the technical structure that precedes a crash. You can read that original column here and the follow-up column as well. Back then, the crash chorus was rising as well. The most important points of the columns were:
- Market crashes have a technical structure that forms prior to the crash
- Significant market declines (not crashes) also have the same exact structure
- The technical structure is a necessary but not a sufficient condition
That last point is a salient one. What it says is that given historical data, large declines and crashes have a structure we can identify, but just because the structure is present does not necessarily mean those declines will be realized.
What is the structure? It is the break of multiple swing points on multiple timeframes across the major indexes and, in case you are wondering, we don’t have that yet . In fact, we haven't seen that since that piece was penned a year ago. We came close a couple of times — once late last year and again earlier this year, but so far, nothing yet. Remember, even when we do get the breaks and the trend transitions that they imply, it still doesn't follow that we will necessarily get a large decline or crash — it just raises the possibility and the resultant odds.
So what would it take to get a larger decline at this juncture? If you take the weakest index, the Russell 2000, it would need to decline another 3.7%, which is equal to another decline of equal size to last week's push lower. that would bring it to the brink.
The same is true of the S&P 500 as a decline of another 3.5% from Monday's closing levels would also bring it to breakdown levels.
Although we can always postulate what may or may not happen, as has been said in this column many times in the past, if you stay on the right side of the market in the short- to intermediate-term timeframes, you don't have to worry about the long term as you will be where you need to be when you get there. There are far too many variables that affect the long term. There are literally thousands of factors that could come into play between now and then, so quit worrying about it. Just focus on what is in front of you, reduce risk when appropriate (when larger declines have a higher probability of happening) and stay with the trend as long as the trend stays with you.
To even set up the possibility of a larger decline (bear market and/or crash possibility), the markets would need to suffer another loss equal in size to what has been suffered so far. For traders and investors who are more inclined to protect than to risk, the current bounce that began Monday should yield important clues as early as today about whether further declines are likely because many indexes and sectors are in the midst of bearish retest and regenerate sequences on their daily timeframes as seen here on the S&P 500.
If equities cannot trade over and hold above the 1943 area on the S&P 500 for a couple f bars, then either removing some risk or hedging off some of the risk would make sense as that would leave more options on the table should the intermediate term swing points lows are threatened in the coming days.
