Time For A Crash In The Stock Market?

I received this question recently from one of our subscribers:

Hi Alessio,

As most crashes happen every 7 to 8 years, are we in line with one happening now do you think?  Some commentators are saying the crash will be worse than 2008.

Thanks!
Omair

This is an interesting question.  Another crash seems to be something many folks are thinking about right now.

Even though it’s been 8 years since the previous market crash, we need at least 3 things to happen before we can see another crash in the stock market.

The first thing you need for a market crash is extreme optimism.

This is when the “dumb money” investors become extremely bullish and greedy about the stock market.  Fear of risk goes out the window and instead you see ridiculous valuations for stocks.

Take a look at this chart from Jason Goepfert’s Sentimentrader:

Sentiment on stock market

As you will see from the above chart, it is far more likely for a market crash to immediately follow an extreme in optimistic sentiment for the stock market.

This is exactly what happened in the crash of 2008.  We had an extreme in bullish sentiment in 2007 before we started the major crash in the following year (see above chart).

At the moment, sentiment is not yet extremely bullish.  In fact, quite the opposite.  There are still many bears in the stock market.

A bull market does not usually end until all the remaining bears have given up and turned bullish.

The second most important ingredient for a market crash are breaks in market structure.

This is when key support levels – or “floors” – in the stock market are broken by sharp declines.  Take a look:

As you will see, in 2008, the S&P 500 broke key support levels at the time.

This started a wave of panic as “sell programs” started to sell more – leading to larger panic selling and eventually margin calls.  As a result, investors began to run for the hills.

So we need to see the “floor” in the main stock market index – the S&P 500 – broken.   Price needs to close below 1800 and 1790 before we can be confident of further selling and a potential market crash.

And finally, we need to see a sudden and large rise in volatility.

As you’ll see from the above chart, the Volatility Index (or “VIX) spiked massively higher in 2008.  Notice how the stock market fell in line with the rise volatility.  

Currently the volatility is very low.  Investors are complacent and not at all worried about a potential market crash.  

A low VIX tends to be a contrarian signal – but we need to first see the VIX start to go above 20 before we can be confident of a further rise in volatility.

Will the next market crash be worse than 2008?  That is a question that nobody can know the answer to.  It’s possible, but I personally doubt it.

I think the more likely scenario is that we could see a serious and significant correction in stocks – in the realm of 20 to 35%.

But we need to see the 3 factors I’ve mentioned above come together first, before we can be confident of a crash or correction in stocks.

Hope it helps and good investing!

Alessio Rastani is a stock market trader at www.leadingtrader.com

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