Oversold Market Panic or All-Out "Flash Crash?" How Can You Tell the Difference?

by Guest Editorial Technical Analysis Technical Analysis

Oversold Market Panic or All-Out "Flash Crash?" How Can You Tell the Difference?

by Clif Droke, Guest Editorial, Clifdroke.com

Wednesday, May 26, 2010

Much has been written about the so-called "flash crash" that occurred on Thursday, May 6, which saw the Dow Jones Industrial Average lose nearly 1,000 points intraday. But did this sell-off fall under the category of a crash or a panic? The difference between the two events is significant and will usually determine whether the stock market bounces back or continues to free fall.

Before we can analyze what happened on May 6, we must discuss the terminology, which is of utmost importance. You'll hear the words "crash" and "panic" being used interchangeably in the financial press in describing what happened, yet there is a clear distinction between these two terms...

The Definition of a Market Crash

My definition of a crash is a financial event catalyzed by a monetary or financial event that results in a sustained cascading of stock prices, usually over a period of several months. The conventional definition of a bear market as being a decline of 20% or more would apply to a crash, i.e. a crash will carry prices lower by at least 20% if not greater.

Crashes are more than just ephemeral phenomena...

  • The damage inflicted by crashes tends to be long-term and systemic rather than temporary and localized (as is true of panics).
  • It usually takes several months or even years -- sometimes decades -- for stock prices to completely recover their losses following crashes.
  • Examples of crashes in recent years would include the NASDAQ crash of 2000-2002 and of course the debt crisis crash of 2008-2009.

The reason for the long recovery times following a crash is due to the overwhelming amount of supply that overhangs the market following the cataclysm. A panic is more akin to short-term "buyer's remorse" in that no sooner do investors dump their shares onto the market that they (or another interested party) scoops those shares back up in short order, thereby eliminating the long-term supply overhang.

Crashes are usually set up months in advance of the actual event. A period of churning prices or distribution normally precedes a major crash. Sometimes the distribution period can last for up to a year, as happened in 2007, before the crash occurs. Crashes rarely, if ever, come out of nowhere. There is usually sufficient evidence to indicate the onset of a bear market well in advance, be it in the form of tightening monetary policy, declining internal momentum (as measured by the new highs-new lows and advance-decline line) and other technical and fundamental measures of stock market strength/weakness. Crashes are nearly always catalyzed, at least to some extent, by tight money policies. They also tend to be a product of an excessively large supply of shares relative to investment demand (as was true prior to the 2000 tech stock crash).

Market Panic... Caused By The Herd Mentality

By contrast, financial panics are strictly short-term affairs that can seem to come out of "nowhere," though there is usually a technical justification for the panic selling. By the very nature of panics, they can best be described as manifestations of sudden and widespread fear which grips investors, which in turn catalyzes a mass exodus from the stock market. The "herd mentality" is instrumental in bringing about a panic. Moreover, it's usually found that a negative news event is behind the widespread fear that leads to the panic.

A panic, in contrast to a crash, is strictly a short range affair. The recovery and retracement process that follows a panic is usually quite swift and it's not uncommon for a panic to be retraced completely within a period of only a few weeks. The reason for the faster recovery times of a panic vis-à-vis a crash is that panics are not fundamentally caused by significant distribution on the part of insiders or moneyed interests, as are crashes. Panics are also not typically the result of any of the negative factors that contribute to a crash, viz. negative long-term internal momentum, unsustainable corporate fundamentals, tight money or an excessive supply of shares. Panics are for the most part news driven events and as such are as ephemeral as the news headlines themselves.

All of this is by way of introduction. It's important that we get our terminology straight so that we can properly address what happened on May 6, 2010. It's my view that the event was a panic, as defined above. Despite the talk about "robo-trading" and other mechanical causes, the main catalyst in the days leading up to the panic was the excessive fear over the European debt crisis. The technical backdrop for the panic sell-off was provided by the short-term reversal of NYSE internal momentum as well as the violation of some important technical benchmark levels (including the 90-day moving average in the New York Composite Index). I would even add to this the observation that the percentage of bulls as measured by AAII was persistently higher than the bears over the last 3-4 weeks for really no reason at all other than excessive optimism. The market, in other words, needed to be corrected.

Now whether it "should" have been corrected to the extent that it was on May 6 is debatable. Then again, that's what makes a panic unique: the market doesn't care whether the market is fundamentally or technically strong enough to prevent a major correction from taking place. Panics are irrational and emotionally driven by nature and as such tend to ignore all technical and fundamental considerations in the obsessive drive to sell at any price. As the well known market technician Bert Dohmen used to say, in a panic "support levels can be broken like a hot knife through butter."

This definitely applied to the May 6 panic. Quite a few short-term and interim support levels and trend lines were violated by the sell-off, both on an intraday and on a closing basis. This will definitely require a period of digestion and recovery and will probably take several weeks to completely effect. I don't believe the May 6 panic was the start of a new bear market, however, for reasons we'll discuss here.

All Points Lead to a Classic Market Panic...

The May 6 sell-off had all the earmarks of a classic panic instead of a crash. To evaluate this panic we'll start by putting it into historical context by looking at prior recent panics. The panics that have occurred in my career as a financial analyst date back to 1997, and I can still vividly recall the panic of October '97, which in many ways was similar to what took place recently on Wall Street. The '97 panic wasn't catalyzed by any of the major weekly or yearly cycles, nor was it fundamentally based. It was essentially an emotional reaction to the "Asian contagion," or currency crisis that was raging through the Pacific Rim economies at that time.

Yet there were definite preliminary warning signs that the stock market was vulnerable to a serious correction heading into late October of 1997. Between August and September, the S&P 500 Index violated its 60-day moving average three times and the MACD indicator was diverging badly to the downside against the higher highs in the SPX index (see chart below). The panic came suddenly and (to most investors) without warning. Yet the recovery was equally rapid and in no time at all the market was back on track in its march to new all-time highs.

An unexpected oversold market panic

I must point out, however, that in contrast to the late 1990s, the long-term Kress Cycle configuration is less supportive of such rapid bounce-backs. The reason why the stock market could recover from panic sell-offs so quickly in the late '90s was because the 30-year cycle was peaking into late 1999. This time around only the 6-year cycle is up: the other components of the Kress 60-year cycle are all down, including the important 30-year cycle. This makes it far less likely that recoveries will happen in a matter of days, as we saw happen in the '90s.

Yet recovery can -- and probably will -- still occur. (We'll also address the problem of the 4-year cycle being down right now in our analysis of the market's recovery prospects). The recovery process will likely takes a few weeks, as discussed previously. Indeed, we already can see that unlike the October '97 panic, the SPX still hasn't established support the day following the panic. In the October '97 panic the recovery began the very next day.

The Advent of the Stock Market's "Mini-Panic"

Another market sell-off akin to a panic occurred in May 2006. Prior to the panic collapse, the SPX had been steadily making higher highs before investors suddenly began dumping shares onto the market in relentless fashion over a period of three weeks. This particular episode wasn't a classic panic, but neither was it a true crash as previously defined; we'll call it a "mini-panic." It did have certain panic type characteristics and was similar to a true panic in that the selling wasn't based on any significant fundamental event or monetary policy consideration. It was based on fear, plain and simple.

May 2006 Market Mini-Panic

The mini-panic of May-June 2006 was somewhat similar to the one we're now experiencing in that it occurred at almost exactly the same time of the year and the 4-year cycle was scheduled to bottom later that year, just as it is later this year. However, as the sell-off that occurred in spring 2006 cleared the air of the technical and psychological excesses that had built up in that market, there was no need for the SPX to decline into the late September/early October time frame where the 4-year cycle last bottomed. Instead, the SPX soared onward and upward, seemingly ignoring the 4-year cycle bottom. In actuality, the corrective potential of the 4-year cycle had already been satisfied earlier that spring, hence there was no reason for another correction. There is a possibility that once the SPX recovers from its present panic-related weakness, the recovery will take the SPX higher before the effects of the 4-year cycle are felt later this fall.

The previous true panic occurred in late February 2007. Former Fed Chairman Greenspan was the catalyst for the '07 panic as he made a high-profile comment about the U.S. real estate outlook. This statement, coming as it did from such a respected source and reported widely in the financial press, spooked the markets and resulted in the sharp decline in the SPX, which on an intraday basis declined by almost 60 points. The bottoming process that followed this panic took place over a couple of weeks but once it was completed the market had resumed its upward trajectory and ended up making a new high six weeks later.

Panic decline on the SPX

The latest panic decline in the SPX took the index down closer to 100 points on an intraday basis and was obviously more severe than the one occurring previously in February 2007. It will be important that we watch for positive internal divergences as the market seeks to establish a bottom in the next few days. Already there are already some divergences showing up in some of the technical indicators.

Major "Crisis" Events Descending Towards the Financial Markets

There are a couple of bromides that apply whenever a major "crisis" type event descends upon the grand stage of the financial markets. One is the old saying, "For every crisis there is opportunity." Another is the admittedly conspiratorial concept expressed by FDR: "If it happens, you can bet it was planned that way." Whether or not financial crises are the products of fore planning on the part of unseen "powers that be" can't always be proven and is open for speculation. One thing that can't be denied, though, is the fact that each time crisis rears its ugly head, those inside the "system" always seems to benefit from it at the expense of the outsiders.

This certainly held true in the credit crisis in 2008 as the federal government managed to expand its powers on a scale that many would have deemed unimaginable. Banks and other affected private industries also were able to use the credit crisis to consolidate their interests and grew to oligopolistic levels (in some cases bordering on monopolistic). No sooner did the "flash crash" descend that we already see the usual attempt on the part of federal regulators at expanding their powers, using the latest "crisis" as a pretext for another power play.

TDAmeritrade's managing director of order-routing strategy, Chris Nagy, told Barron's last week that the time has come to merge the Commodity Futures Trading Commission and the Securities Exchange Commission. His reasoning for this opinion is that "individual investors are losing faith in the U.S. markets" according to Barron's. Nagy stated further, "We need better regulation, because the markets are too big on their own." Here again we see the knee-jerk reactionary spirit that comes up each and every time the market experiences a major setback, namely the fallacy that more government regulation is somehow better for the market.

If anything, since the government started usurping a greater role in the market following each crash or panic since 1987, the expansion of government regulation has resulted in even more volatility, not less. And despite the many assurances that more regulation would somehow decrease the likelihood of market crises, we've seen more than a fair share of panics and crashes in the years since the government has expanded its regulatory purview.

As any serious student of the financial market knows, volatility is the product of the crossing currents between internal momentum (as defined by the new highs-new lows) and the interplay among the weekly and yearly cycles. As long as there is even a semblance of a "free market," the cycles will continue to exert a discernable impact on stock prices and no amount of regulation can prevent this. The only way to prevent an outbreak of hyper-volatility like we saw two weeks ago is to eliminate the stock exchanges altogether. One thing is certain, more regulation isn't the answer.

The Best Book on Stock Market Cycles

Over the years I’ve been asked by many readers what I consider to be the best books on stock market cycles that I can recommend. While there are many excellent works out there on the subject of technical and fundamental analysis, chart reading, etc., precious few have addressed the subject of market cycles. Of the relatively few books on cycles that are available, most don’t even merit mentioning. I’ve read only one book in the genre that I can recommend – The K Wave by David Knox Barker – but even that one doesn’t deal directly with stock market cycles but instead with the economic long wave. I’m pleased to announce, however, that after nearly 10 years of research and one year of writing, I’ve completed a book on the subject that I believe will meet the critical demands of most cycle students. It’s entitled, The Stock Market Cycles, and is available for sale here.

Clif Droke

Syndicated at Stockhouse.com. Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy.

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