Stock Market Crashes – Are We About To Experience One? What History Can Tell Us

Stock Market Collapse
If you’re reading this post, you’re probably aware that from time to time, stock markets undergo a pretty nasty crashes.

We’re not talking about “corrections” (technically defined as a 10% drop), but the really scary stuff – typically a 50% to 80% fall across entire markets.

These kind of events are truly the stuff of nightmares for investors – entire life savings can be decimated in a mere matter of months.

For those with investments, being able to identify times of high market risk and withdraw from the market before the panic sets in, is an exercise that can potentially save you thousands and thousands of dollars.

Not only that, but it leaves you with a large supply of “dry powder” (cash), ready to purchase extremely over-sold assets at the height of despair, ready for the recovery that ensues.




With all the market volatility of late, it’s a great to to take a step back and look at how these kind of events played out in the past, to obtain clues as to whether or not the current prolonged bout of volatility could be the beginnings of the next catastrophic market collapse.

But firstly, lets take a quick look at what I mean when I’m talking about a market top:

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1. What is a Market Top?

The term is as simple as it sounds – by it’s very definition, it refers to the point in time when a market (or markets) stop moving higher. In other words, it’s the point at which a “bull” market ends and “bear” market begins.

There’s really nothing more too it. Now, common thinking is that markets eventually end up recovering and moving on to new highs, therefore a “market top” is a temporary thing thing, not an absolute, “all time” top. However, despite this common belief, many major global indices have never fully recovered from major crashes (more on this in the next section).

Example Market Top

So, now that I’ve described what I mean by a “market top”, lets dive in and take a look some of most spectacular and well studied market crashes over the past couple of decades.

2. A Quick Look at Historical Stock Market Crashes

Firstly, lets take a look at the most recent major market crash – the Global Financial Crisis (GFC) induced stock market crash of 2007/08.

The Global Financial Crisis

The “GFC” as it’s commonly known was caused by the collapse of the U.S. house bubble that inflated throughout early to mid 2000’s. Without going into too much detail, the collapse was largely triggered by the collapse of “sub-prime” mortgages and the inability of the people who took out these loans to repay them.

US Housing

Chart showing the 25% to 30% collapse in housing prices prior to the GFC.

When it finally became clear that the bucket load of securitized financial products linked to these dodgy mortgages were essentially garbage, the worlds financial markets ground to a complete halt.

This triggered the failure of some of the worlds biggest and longest serving financial institutions such as Lehman Brothers and Bear Sterns and resulted in world governments bailing out a number of huge multi-national corporations who experienced extreme financial stress as a result of the evaporation of liquidity in the worlds credit markets.

The result for the stock markets the world over – utter pandemonium.

The Dow Jones Industrial Average (what I consider to be the best indicator of the “real” U.S. economy) peaked in late 2007, before entering “correction” territory in early 2008.

At the start of the decline, media vehemently played down the possibility of a recession and a much deeper decline – this was just another normal “correction”. After all, the U.S. economy was still blazing on all cylinders.

However a “correction” this was not, and over the following 18 months, the Dow (and the other major U.S. indexes) went on to shed well over 50%. The chart below shows how it all played out:

Dow Jones Crash

Chart showing the crash in the Dow Jones Industrial average during the GFC.

You’ll notice two or three clear “dead cat” bounces, also known as “bear market rallies”. I’ve found from studying a number of market crashes that these kind of rallies tend to typify trading behavior during the “topping” phase, where the bulls still have a lot of enthusiasm and “buy the dip” is still well and truly the mantra.

Eight years later, the Dow is back above pre-GFC highs, but not by much and is essentially at a similar level if you adjust for inflation.

The NASDAQ Tech Boom (& Bust)

The US based NASDAQ index absolutely boomed throughout the 90’s as the internet became a mainstream piece of technology and companies clamored to get on board a whole new (online) economy.

This really was a time when the “new normal” paradigm we touted left and right – the internet was going to change the world as we know it and many thought the new generation of online businesses (and their investors) we’re going to become very, very wealthy.

Nowadays it’s hard to imagine a world pre-internet, so change the world it certainly did, but things on the tech heavy NASDAQ got way out of control. At it’s peak, valuations climbed over 1000% in less than 8 years!

The NASDAQ Composite index peaked at around 5,000 at the beginning of the year 2000. During the subsequent “tech wreck”, it proceeded to lose a staggering 80% over the next 20 months, as shown in the chart below.

Chart showing the epic rise in the NASDAQ through the 90's, culminating in the crash around the turn of the millennium.

Chart showing the epic rise in the NASDAQ through the 90’s, culminating in the crash around the turn of the millennium.

Today, over 15 years later, the NASDAQ is still trading below it’s 2000 peak. This means if you’d gone long the index at it’s peak (and hadn’t bought anything since), you’d still be underwater today.

Taking inflation into account (as you should always do), you’d be significantly down.

The Nikkei Index & Japans “Lost Decades”

The market top (and subsequent bust) that I personally find the most fascinating occurred in Japan at the end of the 80’s/early 90’s. Japans economy was absolutely booming, and I’m told that many people world over thought Japan was on track to surpass the U.S. as the worlds biggest economy (and dominant super-power).

Valuations of just about every Japanese asset class went through the roof. Things got so crazy that at one point the property value of the Japanese Imperial Palace in Tokyo was worth more than the entire land value of the state of California!

It wasn’t just property valuations that were booming – the Japanese stock market went absolutely parabolic during the late 70’s and 80’s, rising over 20,000% in the 20 years from 1970 to 1990.

And no, that’s not a typo (20,000%!)… Check out the figure below to see what that kind of a rise looks like on a chart.

Chart showing the monumental rise in Japanese stock valuations, followed by the dramatic bust that has occurred in the following 25 years.

Chart showing the monumental rise in Japanese stock valuations, followed by the dramatic bust that has occurred in the following 25 years.

Now, it doesn’t take a rocket scientist to realize that that kind of a rise isn’t sustainable in the long term, and sustainable it was not. Following the peak in March 2000, the Nikkei underwent a prolonged and relentless crash from almost 40,000 to a low of 8,000 (a decline of nearly 80%) 12 years later.

Today, the Nikkei is trading around 17,000, still well over 55% lower than it’s 1990 peak. Yup thats right, one of the worlds most important stock market indexes (Japan remains the worlds 3rd largest economy after all) is still down 55% from it’s peak over 25 years ago.

The Recent Gold (and silver) Crash

Whilst not technically a “stock market” crash, the last market top I’m going to cover is the recent top in precious metals, namely gold and silver. The price of both these two precious metals boomed following the GFC as investors fled to the perceived safety these metals offer.

The main reason for buying precious metals – fear that the unprecedented monetary stimulus from central banks the world over would stoke massive inflation (possibly even hyper inflation) and erode the value of the worlds most important currencies, especially the U.S. Dollar.

This resulted in prices for the metals rising over 500% (gold) and 800% (silver) during the 10 years from the early 2000’s, culminating in a peak in 2011.

Once it became clear that hyper rampant inflation wasn’t occurring, at least not in every day prices (assets are a different story…) and that deflation rather than inflation was the primary foe facing central banks, precious metals lost their appeal, at least for the time being.

A chart showing the rise in valuations of precious metals, namely gold and silver during the 2000's, and the subsequent bust in prices since 2011.

A chart showing the rise in valuations of precious metals, namely gold and silver during the 2000’s, and the subsequent bust in prices since 2011.

Today, gold and silver are down around 40% to 70% from their peaks respectively and have been in a down trend for the better part of 4 years.

3. Examining the Key Characteristics of Market Tops

So we’ve had a quick look at a number of major stock market crashes in the recent past. Taking a closer look at there, are there similarities in the trading behavior during these topping phases? Is there typical market top “characteristics” we can look out for to warn us that a fall in a given market is imminent?

I would argue that answer to that is a resounding “yes”. In this next section I’m going to outline some observations that I’ve found from studying market tops, and a few key signs that seem to occur around every market top I’ve looked at.

So, what “market characteristics” have I found that tend to occur around market tops?

A Series of “Lower Highs”, Followed by the Break of a Long Term Trend Line

It may sound overly simplistic, but the failure of price to break higher by putting in a series of “lower highs”, followed by the break of a long term trend line has more often than not signaled an imminent and dramatic decline isn’t far off.

The best example of this was the GFC induced bust of the Dow Jones Industrial Average. The Dow had held above a linear, long term up-trend line for the better part of 5 years.

There were a number of short term highs and sideways trending periods through that 5 years, but the up-trend remained in place.

However rumors of trouble in the housing and mortgage markets began to surface around 2007, and markets began to get the jitters and the Dow reached a (then) all time high of 14,198 in October 2007.

The index then proceeded to put in a series of “lower highs” throughout the end of 2007 and start of 2008 – the first key characteristic that hints a market top is possibly in the making.

The point I must emphasize here is the “lower highs” – i.e. each short term peak in price occurs lower than the previous peak. This is highly important, as short term peaks lower than the all time high, but higher than the previous peak often typify the trading activity of short term corrections, rather than longer term market tops.

During late 2007 and early 2008, we saw two distinct “lower highs”, or “dead cat” bounces. This was followed by an eventual break of the five year up trend in January of 2008.

Following the break of the down trend the bulls “buying the dip”pushed for one last “dead cat bounce” as price rallied back above the long term trend line, before capitulating and the down trend proper set in.

We’ve already examined what happened next, with Dow then fall well over 50% over the next 18 month (albeit with one last dead cat bounce and a false bottom along the way).

Annotated chart of the GFC induced collapse of the Dow Jones Industrial Average.

Annotated chart of the GFC induced collapse of the Dow Jones Industrial Average.

Lofty Valuation Metrics & Economic Data Diverging From Price Action

There are countless ways to value whether or not an individual company or the broader stock market is over valued or undervalued, and each has their own merit.

However, one thing that seems to be common during market peaks is that most of them are above the long term average.

The most commonly spouted valuation is the Price to Earnings Ratio (P/E in short).  Over the long run, markets tend to average a P/E of around 15, with a “normal” range of between 13 and 17.

Currently, most U.S. indicies (i.e. the Dow, NASDAQ and S&P 500) have P/E ratios above 20 – still not in “crazy” land, but certainly well above the long run average.

Chart showing historical P/E Ratio

Chart showing historical P/E10 ratio’s. Note the peak of 44.2 correlating with the tech bubble. We are currently sitting around pre-GFC levels, above the long term average. Source: advisorperspectives.com

Now, slightly lofty valuations wouldn’t be an overly strong cause for concern on it’s own, particularly if economic data backed up the valuations. More specifically, investors are willing to pay more for stock during strong economic conditions when business profit growth is consistent and strong.

However, when economic indicators are signalling things aren’t so rosy, all the while stock valuations continue to rise, something has to give. Historically, this has meant company valuations take a bashing in the form of a stock market crash.

Here’s a look at one such financial metric reported by the U.S. Federal Reserve, essentially a measure of “real” corporate profits:

A chart showing corporate profit growth by year. Note decreasing corporate profits has been a leading indicator of the last 3 major recessions.

A chart showing corporate profit growth by year. Note decreasing corporate profits has been a leading indicator of the last 3 major recessions.

The chart speaks for itself, so I’m not going to say much other that this metric has been declining steadily for five years, and recently crossed into negative territory.

As a side note, what should be clear is that declining corporate profit was a clear leading indicator of a looming recession preceding the past two major stock market crashes. We’re currently seeing a very similar pattern playing out as we speak (more on that in a second).

Euphoria, “Paradigm shift” & “New Normal” Rhetoric

One thing that’s usually prevalent around market tops, is extremely bullish sentiment and talk of a “paradigm shift” in the world economy.new normal

I’m told that back in the 80’s, economic consensus was that Japan was on it’s way to being the worlds biggest economy, that during the 90’s the internet was going to revolutionize productivity and super-charge corporate profits, and the mid 2000’s had ushered in a new era of central bank induced (see Alan Greenspan) financial stability.

Of course, hindsight has shown all of the above to have been short sighted and just, well, straight out wrong…but at the time, those trains of thought were largely seen as rational.

Extremely high levels of investor and general economic confidence is one of the key conditions used by contrarian investors to identify good times to get out of the market, and something that those trying to identify market tops should be looking out for.

4. So Where Are We Now & Are We About To Experience The Next Stock Market Crash?

Before I get started, I just want to make it clear that the following opinion is just that – my opinion and my opinion only. I’m definitely not a trained economist and the last thing I want to purvey is that I have some kind of “inside knowledge” as to the real state of the global economy.

I’m just your average punter and these are simply my observations based on what I’ve studied from past market crashes, so take everything I say in context – I’m likely to be completely wrong!

But anyway, lets get to make take on the current “state of play” and look to see if global markets are showing  typical “market top” characteristics.

The Technicals – We’ve Seen “Lower Highs” & the Break of Long Term Trend Lines

As I mentioned above, one key characteristic of a market top is that as investor buying enthusiasm wanes, prices start to put in “lower highs” which eventually culminating the breaking of the long term bull trend.

This is exactly what we saw in the lead up to the GFC and it is exactly what we are seeing today.

Cue the following chart comparing the trading action on the Dow leading up to and including the GFC crash with the following 6 years up to the present day:

Two charts comparing the trading action on the Dow Jones Industrial Average leading up to and during the 2008 GFC crash, and the behavior we are seeing today.

Two charts comparing the trading action on the Dow Jones Industrial Average leading up to and during the 2008 GFC crash, and the behavior we are seeing today (click to expand).

As you can see, the Dow is currently:

  1. Putting in a “lower high” following it’s all time high way back in May last year,
  2. Clearly breaking the long term bull trend that was in place for the better part of 6 years and
  3. Showing bearish divergence with regards to price and momentum indicators like Money Flow.

I don’t know about you, but there looks to me to be an uncanny similarity between the patterns we saw as the Dow was peaking back in 07/08 and today. All of the above are about as bearish as they come as far as mid-to-long term technical indicators are concerned.

I don’t have a lot of time for perma-bears like Harry Dent and Peter Schiff (a broken clock is right twice a day, after all), but these guys have long been calling a “broadening megaphone” pattern for years now.

If these guys happen to be right and history is in the process of repeating (GFC style), it wouldn’t be out of the question to see sub 6,000 in the next year or so (as crazy as that sounds).

Chart showing the possibility of the "broadening megaphone" pattern playing out, which would see the Dow down as low as 6,000 in the next year or so.

Chart showing the possibility of the “broadening megaphone” pattern playing out, which would see the Dow down as low as 6,000 in the next year or so.

I’m not quite so sure we’re going to get there, but at the very least, the technicals are literally screaming caution right now.

Lofty Metrics & Poor Economic Data

It’s hard to argue that stocks are “cheap” right now, given almost all the standard valuation metrics are well above average across almost all the major indexes right now.

If we go back to the graph I posted earlier, stocks are well above their long term average price to earnings ratios and are well and truly in that “danger zone” which is historically associated with major market crashes:

Chart showing historical P/E Ratio

So how does the economic data look? Are things rosy enough to suggest the lofty valuations are justified?

There’s no easy answer to that, and I’m not even going to pretend I have a grasp on the intricacies of the global macro economic picture. In a previous post, I suggested the whilst the economic picture appeared (to me at least) to be mixed, there were enough things to be positive about.

Nothing much has changed since then, although we have since seen that technical break of the long term bull trend, which worries me a lot.

There are also a number of highly worrying signs, such as:

  1. The decrease in corporate profits of late (as shown in the graph earlier in the post)
  2. The Baltic Dry Index which measures the cost of seaborne shipping (i.e. a proxy for global trade) is at all time lows, down a staggering 95% from it’s pre-GFC highs. Part of the dramatic decline is the huge drop in the price of oil, the single biggest cost input, but there’s gotta be a serial lack of demand for the index to have got this low.

    Chart showing the dramatic collapse of the Baltic Dry Index.

    Chart showing the dramatic collapse of the Baltic Dry Index.

  3. Chinese GDP growth, or lack thereof. China has been almost single highhandedly responsible for the growth in global economic output over the past decade or two. The fact it’s growth in GDP is dropping like a rock is worrisome indeed – it’s clear the world is going to need someone else to pick up the growth baton…and soon. China GDP growth
  4. The fact that central banks have been stuck holding interest rates at or around 0% for over 6 years. Some countries (i.e. Japan and Switzerland) have even resorted to negative interest rates – that means you literally have to pay money to keep your money in the bank…
  5. The rout in the price of almost every major commodity. I’ve written a number of times about the current “state of play” in the commodity sector. whilst commodity prices aren’t an “economic indicator” unto themselves, the “armchair economist” in me can’t help but feel that if the worlds economy was firing on all cylinders, we wouldn’t have seen the price of almost every major commodity on the planet absolutely tank over the past five to eight years. Sure there’s some over supply issues, but there’s gotta be anemic demand – the opposite of what you’d expect in strong economic conditions.

    Chart showing the bust of the Dow Jones Metals and Mining Index over the past eight years.

    Chart showing the bust of the Dow Jones Metals and Mining Index over the past eight years, which tracks the performance of major metals and mining companies.

  6. Gold, probably the most important “flight to safety” asset (along with U.S. government bonds) has recently broken out of a 3 year bear trend. Just as the the break of a long term bull trend is extremely bearish, a break of long term bear trend is usually extremely bullish. 
    Monthly candlestick chart showing the recent break of gold above the long term bear trend.

    Monthly candlestick chart showing the recent break of gold above the long term bear trend.

    The fact that this is occurring at exactly the same time as global stock markets look to be topping out suggest smart money is starting to flow back into “risk off” assets like gold. In fact I think gold is worth watching extremely closely as a prolonged break above this down trend will be a significant sign that the current weakness in global stock market has legs.

Now, don’t get me wrong, there is a lot of positive news out there as well, which makes it all the more difficult to form an accurate opinion, however I can’t shake the feeling that we’ve never quite recovered from the last crash, and there hasn’t been much, if any effort to fix the systemic problems that have caused all of the major financial crises of recent times (something that could be a post topic unto itself!).

Euphoria & Extremely Bullish Sentiment (Or Lack Thereof)

The lack of this probably the one thing that makes me really question if we really have seen a market top – the last six years of bullish market behavior has been a constant climb up a wall of worry.

Maybe it’s just the fact I’ve read the commentary of too many perma-bears, but I can’t recall anything that even resembles “ultra-bullish” sentiment from just about anyone.

We’ve had six years of “recovery”, without ever really reaching that economic “escape velocity” the Fed has often talked about.

There’s been a constant flow worries about the Eurozone, Greece, world banks, China, Japan, commodities, derivatives, debt, employment levels, consumer spending etc. etc.

It just seems like the stock market has risen in stark contrast to the economic reality the world has been enduring, and this hasn’t been a secret to anyone.

I’m still trying to decide whether I think the lack of bullish sentiment is actually a positive sign, or whether this time the prolonged bearish sentiment is actually a sign that things are really going to hit the fan.

The jury is still out on this one, but it’s the one piece of the “market top” theory that hasn’t quite played to script.

5. To Sum Things Up

So, to sum it all up, my view of the global macro situation has probably moved from neutral the last time I posted on the matter, to moderately bearish as we speak.

I think the fact that a lot of key world indexes (especially the Dow) have broken multi year bull trends to the downside and failed to bounce back is highly significant.

The prolonged decline of many of the worlds key economic “bellwethers” such as the Baltic Dry Index and commodity prices in general, suggests that at the very least, demand is weak (even if most commodities are over supplied at present), hardly a sign of a strong global economy.

I’m cautious enough about the current economic climate and market sentiment, that I’ve sold the majority of my risky, highly volatile small cap stocks (with the odd exception), and purchased a number of precious metals exposed companies as “insurance”.

I think the best we’re likely to get in the near term (i.e. the next 6 months) is a sideways consolidation in many of the worlds major stock markets. However, my gut instinct based on my analysis of past market declines tells me we’re in for more tough times.

I’ll be watching for a continuation of the “lower highs” we’ve seen – the formation of “higher lows” or “higher highs” would be a cause for optimism.

I’m also watching how both precious metals and U.S. government bonds perform – continued strength in these would strengthen my bearish bias.

There’s no way I can possibly tell if we’re in for the cataclysmic declines the perma-bears are calling for (i.e. Dow 6,000), but I know I’m worried enough to be taking a very cautious approach to the markets right now.

Time will tell whether that caution was warranted. In the mean time, the near term is going to be a very interesting period indeed for the arm-chair economists out there.

Very interesting indeed…

I’d love to hear your thoughts regarding the current state of play and whether we are in the throws of the next major bear market. Comment below and let me know what you think!

 

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