Stock market crashed! What’s next (hint, don’t panic)
*Written as of Wednesday, October 10’s close.
As you probably know, the U.S. stock market crashed today.
As I said in last week’s market outlook, the U.S. stock market would probably experience some more short term downside. But I’ll admit: this “some more short term weakness” is a little more than I expected (and I didn’t expect it to fall this much in 1 day).
*I also wrote in September why the stock market’s volatility would spike in October (here and here)
With that being said, breathe and relax. When the market crashes:
Stay calm and unemotional
Focus on facts and data
Focus on risk:reward
Know your trading plan/model, and stick to it.
Here’s what the U.S. stock market will probably do next, and what I plan on doing.
The size of today’s stock market “crash” is not exceptional. The S&P fell more than 3.2%. From 1950 – present, this happened 103 times (1 – 2 times a year).
However, what’s notable is the “relative size” of this crash. In other words, the volatility.
For starters, the S&P fell more than -3.8 standard deviations below its 20 day moving average (i.e. a massive crash relative to recent volatility). How extreme is this?
It only happened twice from 1950-present. One case was after the 1987 crash. So keep that in mind when people tell you “another crash is incoming!”
Similarly, the NASDAQ is -3.3 standard deviations below its 20 daily moving average
As you can see:
The short term usually results in more choppiness (or short term weakness). These sort of 1 day crashes don’t resolve themselves in 1 day
The long term (1 year forward) outlook is excellent. These kind of high volatility crashes after a period of low volatility don’t happen right before bear markets.
Remember what I’ve been saying throughout 2018:
During the final 1-2 years of a bull market, volatility (VIX) and the S&P tend to trend higher together. This is because the market gets increasingly choppy towards the end of a bull, before the bull finally ends.
That is what we are seeing right now. Volatility is expanding, while the stock market is still in an uptrend.
Right now, I’m mentally kicking myself in the butt. 2 weeks ago I was working on a VIX trading model. The model at the time said “VIX has a >56% chance of spiking in the next 1 month” (On any random day there’s a 17% chance of VIX spiking within the next month). I didn’t share the model because it wasn’t completely done.
VIX spiked today. Sorry for not sharing it with you guys. Opportunity missed.
With that being said, VIX’s current spike is very intense. VIX is now more than 3.7 standard deviations above its 20 dma.
This was a very common “time to short VIX” signal that we used back when I was still working with my family’s hedge fund.
When VIX spikes as it does now:
VIX might go up another day or two, BUT…
VIX’s short term risk:reward is heavily bearish.
But here’s the more interesting point. These kind of crazy VIX spikes don’t happen during an equity bear market or just before a bear market! Why?
Because before a bear market, VIX (volatility) is already extremely elevated.
So in conclusion, these kind of “flash crashes” happen every now and then. They’re typical of the final year before a bull market top.
As you can see, the U.S. stock market was very choppy before the 2000 and 2007 tops.
Long Term Outlook
As you probably know, we have been predicting a bull market top sometime in 2019. Here’s 1 more piece of evidence.
As of today, the S&P is down 5 days in a row, fell more than -2% today, and is still above its 200 dma.
In other words, a very sharp downwards reversal. This has only happened 3 other times in history.
As you can see, this tends to happen 8-12 months before a bull market top.
Signal in February 2007. Bull market topped in October 2007.
Signal in April 1999. Bull market topped in March 2000.
Signal in November 1986. Crash started in August 1987.
Other signs of more short term weakness
The NASDAQ has now closed below its 200 daily moving average for the first time in 2 years (since June 2016).
Other times when the NASDAQ ended such a long uptrend, some more short term weakness over the next week usually ensued.
However, this generally did not mean that the bull market was over. Long uptrends don’t usually result in a bull market top. Long uptrends usually result in a much choppier rally before bull markets top.
Meanwhile, the S&P 500 is rather oversold. It is now more oversold than this February 2018.
When the 14 day RSI becomes as oversold as it is right now, the U.S. stock market tends to experience more choppiness (or short term weakness) over the next 1-2 weeks.
The 5 day RSI is also extremely oversold. Likewise, the stock market usually experiences more short term choppiness.
Click here to see how much more the stock market can fall
My trading plan
I am currently 67% long SSO (S&P 500’s 2x leveraged ETF), down from 100% long SSO earlier in the year. In hindsight, this was the right thing to do. Having more cash allows you to:
Not panic when the market goes down
Average in if the market crashes unexpectedly, and then close your position at no loss when the market does bounce (because no bear market goes down in a straight line).
I currently do not plan on using my cash to buy more $SSO. If the stock market falls even more, then I will buy. (I’ll let you guys know when that happens).
Today’s crash also proves why I focus on the medium-long term. The short term is extremely unpredictable. As crazy as today’s crash seems to be, the U.S. stock market is right back to where it was 4 months ago in June.
So for all the people who told you that “the stock market is going to crash”, just because that the stock market did crash today doesn’t mean that they are right. If they turned bearish in June 2018, then they are no better off than someone who buys and holds.
Early = late = wrong. (And it’s much easier to turn bearish too early than bearish too late).
The Medium-Long Term Model ignores the stock market’s short term movements. It remains long term bullish, but as I said, will probably turn long term bearish in Q2 2019.
What should you do?
The answer depends on what kind of trader you are, and what your position $ is. I can’t tell you what to do, but here’s what I would do if I were in your shoes.
If I was short
Take my profits. Could the market crash even more tomorrow? Yes. But risk:reward does not favor those who are heavily short. Accept this as a gift from God, and take my profits.
If I was a short term trader sitting on the sidelines
I would wait a little more before going long. Let the dust settle. These sort of min-crashes usually don’t sort themselves out in 1 day.