ANATOMY OF A CRASH

By David Schwartz 10:17 28- Oct -2009

Some investors worry about a stock market crash. If history is any guide, it will not happen in the very near future.

The eightieth anniversary of the Crash of ’29 just passed.  Right on cue, the media ran stories about this historic event. Some investors even began to speculate on the likelihood of another crash in the near future.

For those who are concerned that a new Crash might on our doorstep, rest easy. Past records provide useful clues on the stock market’s behaviour in the run-up to a crash. The current market profile does not match any of the necessary pre-conditions.

Given the strong price advance in recent months, we are probably overdue for a correction. But a full-fledged crash? Not likely. A stroll down memory lane helps to explain why.

Recall that the Crash of ’87 was preceded by a six-year advance. Our graph shows what happened once prices peaked in mid-July of 1987 after almost quadrupling. 

Notice that the initial sell-off was minor. Prices fell 11 per cent in the next five weeks. A fresh rally then kicked in but soon faltered without reaching July’s high.

Shares began to drift down a second time. The decline continued for several weeks. Prices eventually slipped below the previous month’s low. Soon after, nervous investors suddenly pulled the plug and began to run for the exit on a day that we now call Black Monday.

A similar pattern occurred in the run-up to the Crash of 1929.  Wall Street rose almost six-fold during an eight year run, with no significant correction along the way.  It is not common knowledge but shares peaked on September 3, 1929, almost two months before October’s crash.

The events that followed will sound quite familiar. A sudden sell-off dragged prices down by 15 per cent. Once again, a bounce-back rally quickly ran out of steam, well below the previous high.  A fresh down-wave then began. Prices dipped for several weeks before a massive selling panic suddenly occurred - what is now referred to as the Crash of ’29.

We all know that definitive statistical studies need more than two data points. Even so, these trends are quite similar. A Crash is typically preceded by a powerful multi-year rally. Peaks are followed by sell-offs and weak rebounds that fail to recapture former highs. A second down-wave then begins. It runs for several weeks before a headline-grabbing crash finally occurs.

As far as this year is concerned, none of these important pre-conditions have occurred. There has been no powerful multi-year rally. Although we have enjoyed a healthy rally since March, gains in the multi-hundred per cent arena are not in sight.

Also keep in mind that we probably need an initial sell-off plus a failed re-test of the former peak. If anyone wishes to wager with you that a new crash will occur in the next few days, history advises you to take the bet. A possible claw-back of some profits from the recent rally? Of course, this is possible.  But a fresh Crash of 1929 magnitude? Not likely.