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February 10, 2006

How Basch Turns A Crash Into Cash
by Dan Basch

Introduction

Have you ever sat in the front car on a rollercoaster? When it reaches the crest after slowly ratcheting up creating an ever more heightened sense of anticipation, the first car begins to decline but not quickly at first. The bulk of the cars behind it have to cross a tipping point before the momentum is sufficient to create the intense rush of the near vertical drop.

Today's stock market is showing it may be on the verge of a severe decline spearheaded by a handful of tech stocks which may act like that first car on the rollercoaster. In January, the market saw several bellwether tech companies such as Yahoo!, Google, Intel and Amazon.com show double-digit gaps down after they reported earnings, crushed by not meeting Wall Street's expectations.

These bellwether tech stock implosions may be early warning signs that the stock market may crash in the coming period, not just domestically but internationally as well. This is dreadful for those who have stuffed their portfolios with frothy stocks, but excellent news for those who may be able to take advantage of such a possibility. This essay is written not to be alarmist, but rather to serve as a summary from an amateur technician's standpoint of why the stock market is likely about to crash. Better yet, it provides information of how one can protect capital should such a scenario come to bear (pardon the pun) and perhaps even profit from such an event.

Controlled Burn or Raging Wildfire?

The general public looks upon stock market crashes with fear and dread as worst-case scenarios, as though one could happen at any time. The reality is that upon further examination, some crashes can be foreseen with clarity provided by technical analysis. Here's an insight you may not have considered before: Crashes are necessary for the healthy functioning of free markets. Allow me to explain.

A stock market crash acts like an intense, raging wildfire does after the ground fills with several seasons worth of ecological debris and the summer months make kindling out of dry brush and dead foliage. It's the market's natural way of clearing out bad money while serving to strengthen those companies healthy enough to survive such an inferno and make way for the new corporate seedlings to gain access to capital that had previously been improperly allocated. They remove excessive capital from undeserving companies by the same efficient mechanism as Mother Nature: they incinerate it.

To follow the forest fire analogy a bit more, it was once the official policy of the U.S. Forest Service (USFS) to suppress all forest fires with the belief that they were universally bad. It wasn't until the 1960's that this policy came into question because people began to realize that no new Sequoia trees were growing in the redwood forests of California. It took this discovery to spark the epiphany that rather than being universally bad, fire was in fact part of the tree's life cycle which functioned by heating their pine cones until they opened, thus releasing their seeds.

So the USFS modified their policy to stage controlled burns which not only helped the trees survive, but also served to manage the undergrowth while reducing the risk of future high intensity, vast covering blazes. This can be likened to the curbs and "circuit breakers" placed on the markets by the SEC after the crash of 1987, so as to make an orderly decline of what otherwise would be an unsettling crash. This means that were a crash to happen now, the market would still decline to its original target, it would just take more time in getting there.

As forest fires were once considered bad under any circumstance, but later found to be essential to the proper functioning of the ecosystem, contrary to popular belief, market crashes are perfectly healthy and totally normal in the market ecosystem. They should not be dreaded, but sought out and anticipated, and when one sees signs that a crash appears imminent, market participants would be wise to take cover while those who have the experience, chutzpah and luck to make a profit from such a situation may do so at will.

Today's Market Indices Parallel Pre-Crash 1987

Many market old timers remember the crash of 1987. I was a teenager then, and my father who was a university professor came home with a remarkable story: He had just finished his lecture when a student approached him and asked, "Mr. Basch, do you own any stocks?" My father said he didn't, and the student said, "Good, because the Dow just dropped 500 points today." It was one of those rare events in life where you can remember exactly where you were at the time you first heard the news. That same evening, I visited a friend's house where they were still laughing about a darkly humorous weather report on the local TV news, "Tonight there's going to be a 20% chance of rain and a 50% chance of stockbrokers!"

Today's market may be in a similarly precarious situation in comparison to that fateful time period. Pictures serve better than words at this point, so please closely examine the following charts and their respective commentary, and we'll see whether this weatherman has gotten the forecast right.

First, the 1987 NASDAQ Chart: Note first how the Pivot Line served as support first, then as resistance. Next, observe the declining money flow (CMF) and negative divergence on the MACD leading up to the crash.

Second, today's NASDAQ 100 Chart: Note the similar Pivot Line, and how the gap from 2/3 was filled today, 2/9, with a Bearish Engulfing Candlestick.

Lastly, today's S&P 500 Chart: Note the perfect retest of its Pivot Line.

All three of the above charts show declining money flow and a negative divergence, however the most telling is the second and third charts which show increased distribution since the blow-off top in early January, which is most visible on the NASDAQ 100. Interestingly, this wasn't nearly as apparent on the 1987 chart.

Today, the NDX filled the gap left from February 3 rd, while the SPX made a perfect retest of the pivot line. The primary difference between today and 1987's stock chart action is whether there will be a second retest? The answer lies yet ahead.

Global Markets Peaking

When the "new economy" tech stocks of the late nineties crashed and burned, they were subject to the whim of domestic markets which did their job by being unmerciful. Not so with international markets, whose governments can intercede in order to stem the hemorrhaging of capital should they decline precipitously when market participants rush the fire exits. Apparently the world needs to relearn the hard lesson of the international market crisis of 1998. In a follow-up to my essay published last December, "DJ World Stock Index Emulates Pre-Crash Nikkei", in which I made the case that the DJW is closely mimicking the Nikkei from 1997-2000, this example has continued to show topping behavior and now appears to be turning at the same resistance level as in early 2000:

When comparing domestic to international markets, one can see the results of speculative excess, likely caused by ever increasing injections of liquidity from the central banks of industrialized countries (particularly the U.S. Federal Reserve), almost everywhere in the world. Today, India's Bombay Stock Exchange 30 epitomizes the quintessential boom country which, after a nearly 250% gain since April 2003, now has the highest P/E ratio in the world and is well into bubble territory.

The man on the street would think this should be something to celebrate, however as any good market bear would tell you, it's a case of having gone too far, too fast. As George Soros said at this year's meeting of world business leaders in Davos, Switzerland, it's like we're dancing on the deck of the Titanic, having a cheerful time. Something's gotta give, and that something is foreign inflows of speculative capital that has made these markets primed for an immense decline. Massive amounts of cash into emerging markets have created an unsustainable situation, as we in the U.S. experienced just over half a decade ago which inspires another analogy: hot money has made international markets today's dot coms.

I would expect the subsequent result to be similar in severity as they initiate their inevitable revertion to the mean.

Conclusion

In comparison with the chart setup preceding the decline of 1987, domestic markets appear poised on the precipice overlooking a yawning crevasse, as do international markets which are awash in speculative hot money. Bears are licking their chops, relishing an impending decline on both domestic and international indices, and why shouldn't they? Most have been proven wrong all the way up. But every dog has its day.

I fully intend to use my own capital to see whether or not I can turn a buck from what I anticipate to be a genuine market calamity. To do this, I am using leveraged mutual funds and keeping a daily monitor of market trends and my own brand of technical analysis at my free public website, Black Magic Charts. Please stop by and if you feel like it, throw in a vote, and please do not take any information either in this essay or at that site as actual trading advice as it is presented for entertainment purposes only.

Sometimes the markets are pretty boring, but this is one setup that is not. And as at an amusement park, you must be as tall as the cartoon pelican to ride. I'm gonna put my hands up through the Big Dipper's drop while everyone else screams like sissys.

Dan Basch

Copyright © 2005-2009 Dan Basch

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