Market crash signals

Before the tech crash of 2000, some keenly attuned investors spotted something unusual. Although the major US indices – the Dow and the S&P 500 – continued to climb, the gains were made by a declining number of stocks, mainly Internet stocks. A shift in investor behaviour was clearly in the making as stock movements had fundamentally altered. Those who were successful in spotting the signals were either out of the market, or had shorted stocks for the possibility of making money as the market fell. Others, who weren’t so lucky, saw the value of their investments plummet overnight.

Over the years researchers have carefully studied the months, days and even hours leading up to a market crash for any signs that could assist in more accurately forecasting such calamitous events. Some theorists have put pen to paper and have come up with elaborate names for their revelations, such as the Hindenburg Omen, a rare technical signal, that purports to have appeared before all major stockmarket corrections over the past 21 or so years.

In the US on Friday, the 20-year anniversary of the 1987 stockmarket crash, the Dow Jones, the index representing America’s largest 30 companies, tumbled by 2.64 per cent and the S&P 500 index by 2.56 per cent. The US media highlighted record high oil prices, continuing concerns for the plight of US housing and lacklustre company earnings as reasons for the selloff. Less attention was given to the apparent jumpiness of the US share investor.

Market crashes occur due to investor nervousness and rising pessimism, otherwise known as fear. When fear sets in the mere whiff of bad news can send investors packing as opposed to bull markets where investors are continuously on the hunt for more stocks to buy. Market crashes occur when investors all hit the sell button at the same time.

If you think of shares like any ‘good’ for purchase – such as a buying a business – you can get a feel for the underlying reasons for why, all of a sudden, buyers can head for the exits.

The reasons why investors can stop adding to their batch of stocks may include:

1. Running out of money (unemployment, interest rate or inflation spikes cause investors to reduce spending);
2. Viewing stocks as expensive and the likelihood of making a profit low (stocks are overvalued);
3. Regarding an alternative good as better value (investors switching from stocks to bonds);
4. Buyers feel that the risk levels don’t warrant the return (risk/return tradeoff);
5. Nervousness, causing the buyer to protect the funds by stashing the funds in cash, such as a bank account instead.

How does the Australian sharemarket stack up in light of these points?

Well, unemployment is at record lows in Australia, and interest rates are currently sitting at 6.5 per cent, which – although higher than rates in the US, Europe and the UK – are still relatively low historically. Inflation is still contained at 2.7 per cent (before the 1987 stockmarket crash, inflation sat at 8.5 per cent). Although record oil prices certainly don’t aid inflation, the inflation genie isn’t out of the bottle just yet. (Traders should be closely watching the upcoming inflation figures due out on Wednesday.)

Most agree that the Australian sharemarket is reasonably valued too, and there are still bargains to be had. Sharemarket punters are still fairly upbeat on the returns to be made in the Australian sharemarket, especially resources and companies that service the mining sector.

Are investors encouraged to switch out of stocks and into bonds?

Well, at the peak of the bull market in September 1987, prior to Black Monday, the ten-year bond yields sat at 12.5 per cent. Today, the ten-year bond yield is just 6.2 per cent; clearly the attraction of switching out of stocks and into bonds is much less tempting for investors in current conditions.

So based on these fundamentals, a market crash is hardly likely. Neither factors of unemployment, interest rates, inflation, bond yields or valuations should be the catalyst to cause a large-scale sell off.

However, as we move down our list to the final two points, we enter dicier areas.

Once investors feel that the risk levels of investing in the sharemarket are too high – that the safety of their precious savings is at risk – they start to pare back exposure. Wild swings in share prices make investors nervous. It can be the catalyst for a shift in behaviour.

Since early this year, global sharemarkets have experienced numerous harsh and sudden sell-offs. In February, a 9 per cent fall on the Shanghai knocked 6 per cent off the value of the Australian sharemarket over ensuing days. On the first day of August the S&P/ASX 200 index suffered the biggest one-day fall since trading resumed after the September 2001 attacks, following hot on the heels of a 2 per cent stumble on the Friday before.

As market gyrations send portfolio balances into freefall, investors suffer sleepless nights. And in compensation for the trauma experienced, investors require a bigger return from their sharemarket investment. Should the return not be forthcoming, the investor is more likely to pull their money out.

Market volatility, as occurred last Friday on the US bourse, isn’t good on any accounts. Although analysts might point to strong fundamentals as the reason for why a crash isn’t on the cards, investor sentiment is a fickle thing.

Fundamentals alone can’t explain why the tech boom lasted for so long, for instance. As early as 1998, company analysts were critical of the high price/earnings ratios (P/Es) attained by many tech stocks – whose share prices continued to surge for a further two years. As company analysts continued to grapple with the valuations of stock prices seeming to defy gravity, the floor came from under the market.

Investor sentiment is clearly the wild card when it comes to predicting large-scale events such as a market crash. Having some understanding of how investors are behaving is therefore important for investors and traders wanting some means to predict a market crash.

A popular measure to gauge investor behaviour is the market breadth. This is the measure referred to earlier that was used to pinpoint the market tremors leading up to the tech wreck in 2000.

The market breadth measures the bullishness of a market by comparing the number of stocks that advance on a particular trading day to the number of stocks that retreat. An increase in bearish sentiment is noticeable when the number of declining stocks grows, compared to those advancing up the charts.

Indeed, using the overall market index (such as the S&P/ASX 200) as a guide for bullishness or bearishness of the underlying market can be flawed; a few rapidly rising stocks can make up for a vast number of declining stocks. The market breadth is a much more accurate measure.

Next week we’ll further investigate theories around market breadth, plus explain how investors can calculate the market breadth of the Australian sharemarket as a guide to underlying investor behaviour. The market breadth is also the cornerstone of the infamous Hindenburg omen, but more on this next week.