Market Crash: Avalanche Approaching?
Every year, there are a number of pundits that come out of the woodwork and announce that a market crash is imminent. If these pundits continue to make a prediction at the beginning of every year, then eventually they will be correct in their assessment. I am not here to make any bold predictions that the stock market will crash in 2017. Instead, I will highlight some of the developments that may be pointing to a possible market correction. Whether or not this correction snowballs into something more sinister like a market crash is something that remains to be seen.
Interest rates are on the rise, and history has shown us that when the Fed begins to tighten, markets have a higher tendency to correct. An interest hike is now on the table for March 15, 2017, and this development was sparked after Donald Trump made his first address to Congress. The following day, the equity markets soared and government bonds sold off, pushing yields higher. This sell-off in government bonds raised the likelihood that an interest rate hike was going to occur. Prior to the address to Congress, the likelihood of an interest rate hike in March stood close to 50%, and afterwards it jumped north of 90%. Janet Yellen didn’t waste any time responding to the indications from the bond market and quickly announced that a rate hike was on the table.
Advertisement
This interest rate hike comes at a time where key select indices are testing extremely important levels of resistance after running a great deal in a short amount of time. The markets are overbought and this increases the odds that a correction can ensue.
The following Nasdaq price chart illustrates an important level of resistance, as well as an indicator that has successfully warned of an imminent correction.
The Nasdaq index is currently bumping up against an ever important level of resistance. This level of resistance is highlighted on the chart above as an upwards-sloping trend line. This trend line was created by connecting the peaks on the price chart. This level of resistance has contained price since price began bumping up against it in 2004. 13 years later and price is still trading below this level. The NASDAQ index has tested this level on a number of occasions and a correction has ensued shortly afterwards.
Chart courtesy of StockCharts.com
This correction has been confirmed by the relative strength indicator (RSI) in the top panel. The RSI is a momentum oscillator that is used to measure overbought and oversold conditions. When the oscillator is above 70, it suggests that the index is overbought. When it is below 30, it suggests that the index is oversold. For this example, the signal that confirms that a correction is set to ensue is when the RSI oscillator falls back below 70.
In late 2007, the RSI breached the 70 level, indicating that the market was overbought, and it broke back below 70, indicating that a correction was set to ensue. This correction snowballed into the financial crisis, where great losses were suffered as a result of the crash that followed.
In 2013, the RSI breached the 70 level, once again indicating that the index was overbought. It wasn’t until the middle of 2015 that resistance was finally met, and then the oscillator proceeded to fall below 70, before a sell-off finally ensued. This sell-off set off a round of choppy sideways trading, and from peak to trough, a substantial sell-off did occur.
Currently the Nasdaq is bumping up and against resistance once again, and the RSI has just breached the 70 level. I would be on the lookout for the RSI to fall back below 70, indicating that another sell-off was set to ensue. Whether or not this correction will snowball into something more sinister like a market crash will have to be seen.
The following IWM stock chart illustrates that the small-cap stocks have formed a bearish price pattern that could be suggesting that a correction is imminent.
Chart courtesy of StockCharts.com
The bearish pattern that is illustrated above is referred to as a “megaphone top.” This pattern contains two diverging trend lines, where the upper trend line acts as resistance and the lower trend line acts as support. This pattern is difficult to trade because it is consistent with higher highs and lower lows, which give it the megaphone look.
Each and every time price has met a level of resistance or support, it has caused the trend to reverse. This new trend continues until the next level of resistance or support is met. If I apply this logic to the chart above, I can only assume that if a correction does ensue, support lies just north of $85.00. From current levels, this would suggest that a market crash was going to ensue based on the 36% losses that it projects.
Bottom Line
The market has gone on an epic run on the outcome of the presidential election, and there is little doubt that the equity indices are overbought as important levels of resistance are being tested. This event, combined with the headwinds that are created in an increasing-interest-rate environment, increases the odds that a correction is set to ensue. A correction that can snowball into something more sinister like a market crash can never be ruled out.
