Stock Market Panic in October?

By Anthony M. Cherniawski and Janice Dorn  OCT 04, 2012 2:55 PM

There are stock market patterns that warn of the probability of a reversal in trend and possible panic or crash.

 


MINYANVILLE ORIGINAL The panic of the Hong Kong stock market in October 1997 -- similar to the 1987 stock market crash, and with remarkable parallels to the October 1929 crash -- raises questions.  What is different about the month of October?  Is October the month where market excesses are purged?  If so, how can we tell if another panic may be imminent?

First, a little background about October stock market panics: They are worldwide. We have identified at least three one-day market panics of 10% or more in the Dow Jones Industrials (INDEXDJX:.DJI), the Hang Seng Index (INDEXHANGSENG:HSI), the Nikkei Index (INDEXNIKKEI:NI225), and the DAX (INDEXDB;DAX).  Of the sixteen panics exceeding 10%, twelve of them occurred in October.  Here is a Table of Panics in declining order of magnitude:
 


Even though it was less than 10%, the October 10, 2008 panic in the DJIA has been added to show the remarkable similarities in the dates of the panics in the Nikkei and the DAX.  The flash crash on May 6, 2010 missed the cutoff for this table with only a 9.19% decline.   
There were other occasions in the 19th century, most notably in 1857, which is when similar panics occurred simultaneously in Britain and the United States, even though there was no instant communication between the two countries. (Travel time in those days was nine to 10 days by ship across the Atlantic.)

Panics Vs. Crashes

Wikipedia defines a crash as follows: “A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles.” A simple definition of a crash is a 20% or greater stock market decline.

Panics may be defined as sudden and “irrational” market declines within a one to three day period that are far larger than the normal range of deviations in price. Panics may be stand-alone, as in the 1987 panic, or occur within a larger crash setting, as in 1929. Warnings

There are stock market patterns that warn of the probability of a reversal in trend and possible panic or crash.  A classic pattern mentioned in Technical Analysis of Stock Trends by Robert D. Edwards and John Magee is the Broadening Formation.  They comment, "[T]he Broadening Formation may be said to suggest a market lacking intelligent sponsorship and out of control – a situation usually in which the ‘public’ is excitedly committed and which is being whipped around by wild rumors…  Nevertheless, the very fact that chart pictures of this type make their appearance as a rule only at the end or in the final phases of a long bull market lends credence to our characteristics of them.”


                                                                 Daily Chart of $SPX

Edwards and Magee go on to say, “[W]hile further advance in price is not ruled out, the situation nevertheless is approaching a dangerous stage. New commitments should not be made in a stock which produces a chart of this type and any previous commitments should be switched at once, or cashed in at the first good opportunity.”

Edwards and Magee describe two types of  Broadening Formations. The first is "the Orthodox Broadening Top, which has three peaks at successively higher levels and, between them, two bottoms with the second bottom lower than the first. The assumption has been that it is completed and in effect as an important reversal indication just as soon as the reaction from the third peak carries below the level of the second bottom.”  In the daily chart of the $SPX,  the Orthodox Broadening Top becomes complete as it crosses below the bottom trendline at 1395.00.

The second Broadening Formation is the Broadening Wedge.  It has slightly less bearish implications, but nonetheless signals an end of the trend once the bottom trendline is broken. The Broadening Wedge shows three rising peaks above two bottoms rising to a lesser degree. The daily $SPX chart shows both formations, with one nested within the other. By all appearances, the first Broadening Formation may trigger the second. This has yet more bearish implications, since the target is somewhat lower. 

An even more bearish omen is that, while there is some doubt that the first target may be met, the second formation in the daily chart raises the odds considerably of this pattern having a successful outcome.


                                                                   Weekly Chart Of $SPX

This leads us to the weekly $SPX chart shown above, showing a larger Broadening Formation (with even more dire consequences) encapsulating the two smaller formations. Its trigger point is above the average targets of both smaller Broadening Formations. It is not necessary for the third peak in a Broadening Formation to reach the upper trendline drawn in these charts. It simply must terminate at a higher point than the second peak, as did the Broadening Top formation in 2007 that warned of an imminent decline.



The CRB Index does not appear exempt from a probable panic.  An interesting observation is that the lower trendline of the Broadening Top may also double as a Head & Shoulders Neckline with a probable target near 162.00 in the CRB.



European stocks offer no safe haven, either. Note that the Broadening Top in 2007 gave ample warning of the ensuing crash in 2008.  The current Broadening Formation in 2012 is clearly not a top, but has similarly ominous implications.



An unexpected finding is that both the long bond and the 10-year Treasury note have Broadening Formations. Those prescient enough to own these instruments during the 2008 decline may not be so fortunate this time around. Should the long bond decline through the lower boundary of the formation, currently near 125.00, its price projects to 100!
 
The charts above are warning signals. History does not favor the complacent, nor does the market reward the crowd -- especially at market tops. There may be comfort in the crowd, but the real rewards come to those diligent enough to see the signs of the times and have courage to take action accordingly.

See more from Anthony M. Cherniawski at The Practical Investor, and more from Janice Dorn, M.D., Ph.D. at Trading With Art and Science.
No positions in stocks mentioned.