High Likelihood of a Market Crash

Includes: DIA, QQQ, SPY
by: ContraHour

This past week, the Royal Bank of Scotland credit strategist Bob Janjuah warned of a full-fledged crash in global stock and credit markets.  He anticipates a 300 point drop within the next three months.  Janjuah has a lot of credibility because his warnings of credit troubles last year came to fruition this year. 

The whole setup reminds me a bit of Elaine Garzarelli in 1987.  Garzarelli was a relatively unknown quant analyst and money manager at Shearson Lehman in 1987.  In the weeks before October 19th, she made brief appear on FNN, the precursor to CNBC, saying there was a high likelihood that the market could crash.  That sealed her place in history. 

A lot of other warning signs indicate that the Bank of Scotland isn't that crazy in predicting the unpredictable. 

First, the past month generated an Hindenburg Omen.  The Omen is a measure of internal divergences in the market and is signaled on June 6th.  While the Omen doesn't necessarily mean the market will crash, no crash has ever occurred without a signal in the prior 40 days.  For instance, an Hindenburg Omen signal occurred on September 19th, 1987 about one month before the market collapsed. 

click to enlarge images


The market is suffering extreme internal divergences, similar to the NASDAQ and Dow in 2000.  During the final run higher, basically the only stocks going higher were technology and Internet related.  Similarly, right now, the only stocks hitting new highs are commodity and agriculture related.  The banks and financials in particular are showing an unsustainable downside divergence.  The financial stocks have, in fact, already crashed.  While the financials typically move in line with the broader market, they have been leading it lower in the past twelve months.

The market has worked off its oversold conditions from March and January and has built up energy to move lower.  The stochastics have just started rolling over, as have the internal breadth indicators.  Neither is yet at an oversold extreme.  In addition, the Summation Index never made it past the 500 level on the rebound from January and March lows - that indicates the rebound lacked breadth and depth. 

Bernanke In PainFinally, the Fed and politicians always have some hand in causing market panics.  In 1987, Greenhorn Central Banker Alan Greenspan caused problems when he indicated that the dollar's decline would come to an end because the fundamentals were improving.  Shortly after taking leadership post, Greenspan hiked rates partially to stem the greenback's decline.

Of course, the trade deficit continued to increase and the dollar plunged anew.  That caused a crisis of confidence in the market and contributed to the crash in 1987.  Combined with reckless comments from Secretary of State James Baker, the market was nudged over a cliff.  Similar comments from Ben Bernanke's two weeks ago about raising interest rates to stem the decline in the dollar could cause a similar panic if he follows through with his threats.

So while it's difficult to predict a crash (crashes are by definition 4 standard deviation events and are therefore unpredictable), I think all the elements are in place for one to occur.