7 Ways to Identify an Imminent Market Crash

MIAMI (MarketWatch) — For years, people have been warning of an impending stock-market crash. Those who listened buried their money in short-term bonds or cash and missed out on one of the greatest comebacks in market history.

The purpose of this article is to help traders and investors understand the clues and psychological characteristics that often precede a market crash. No one can predict the day or time, but if you pay attention, you can recognize the signals.

Clue no. 1: Leading stocks fall

This comes from “How To Make Money In Stocks” by Investor’s Business Daily founder and Chairman William J. O’Neil. If leading stocks such as Priceline.com Inc., Amazon.com Inc. and Apple Inc. start to break down and fall, this signals that the market is weakening and that the market’s dynamics are changing for the worse.

In addition, after the recent two-year bull market, expect choppy conditions moving forward, which increases the risk there could be a correction or crash. Bottom line: Pay attention to leading stocks.

Clue no. 2: September-October curse

Historically, most crashes occur in September and October. If you’re in the stock market, you must be acutely aware of these two months and be prepared for potential crashes. Because traders with trigger fingers know about the September-October curse, fear often increases during these two volatile months.

Clue no. 3: Speculation is rampant

Who can forget the crazy days of 1999 when Internet stocks like Qualcomm Inc. went up by 100 or more points in a day? My favorite example is the 17th-century tulip mania, when thousands of Dutch people paid more than $200,000 (using today’s exchange rate) for a single tulip bulb.

Although the current market environment is not that speculative, there are clues that some stocks are flying into the stratosphere. “You could make the case that the current valuations of Twitter, Facebook, LinkedIn, Pandora and Zillow are extreme,” says Timothy Sykes, professional trader and short-seller. “These companies have amazing business models and people think their businesses will never stop growing, but that is just bull. The odds are that Facebook’s valuation will see $60 billion valuation (currently $80 billion) before it sees $120 billion.”

Clue no. 4: Media doom and gloom

When the media begin to report that the market has been falling for a record number of days (i.e. “down for fifth straight session”), it makes people anxious. “It causes people to want to exit en masse,” says Sykes, “like a run on the bank. They are being influenced by fear.”

Although the media don’t create news, the cumulative effect of the negative news creates anxiety and fear. It might not take much for millions of investors to throw in the towel and sell. Read my interview with Timothy Sykes on the characteristics and clues that precede market crashes.

In addition to the above clues, it’s also important to study crash characteristics.

Characteristic No. 1: The catalyst

There is usually a big event that takes a weakened market lower. This can be the catalyst that causes the crash.

“Crashes don’t usually happen out of the blue,” according to Sykes. “Sometimes they do, but most crashes occur when the market is already downtrending.” He says that people are already selling into a downtrending market when they “suddenly puke it up one day. The momentum that causes a crash is built up over days, weeks or months.”

The most dangerous market is a long and gradual downtrend where there are no bounces. This can lead to a severe crash.

Note: The current market remains in a two-year uptrend, although it has been struggling lately.

Characteristic No. 2: The big bounce

As you probably know, the two big motivators in the stock market are fear and greed. Although greed can go on indefinitely, most people don’t remain in a perpetual state of fear for long. That is why after a big crash, there is often a big bounce. “Every crash throughout history has been followed by a bounce, no matter how fleeting,” says Sykes. “It might not be huge or long, but if you can sit in cash while everyone else is panicking, you have an opportunity.”

Flash crashes, although rare, can create the biggest bounce, he added.

Characteristic No. 3: Crashes rarely happen at tops

Most people think the market hits some magical number, like the Dow Jones Industrial Average at 13,000, and then crashes. This myth has caused people to miss out on many financial opportunities. “People love calling the top,” says Sykes, “because they think there will be a crash from the top. The market might fail to break out to new highs, but crashes usually don’t happen at the top.”

A more likely scenario, he remarked, is there’s a drop before the crash. “This scares the momentum buyers away, which can then lead to a crash.”

For example, it took 17 months for the blue-chip index to fall from 14,164 in October 2007 to 6,469 in March 2009. The most severe damage to the market lasted only five months beginning on Oct. 1, 2008, when the Dow already had fallen to 10,850.

Understanding the characteristics and clues of market crashes is essential for traders and investors. It’s also important to have a plan before the next crash occurs, which will be the subject of my next article.

Michael Sincere is the author of Start Day Trading Now (Adams Media, 2011), All About Market Indicators (McGraw-Hill, 2010), and Understanding Stocks (McGraw-Hill, 2003).