As regular readers will remember, we have a mathematical model of 'periods of financial distress' called CrashTrak. We bring it out in market moments in which we have had a long ramp up to a decided market peak, and then a decline that achieves at least 10 percent. We gave an initial nod to the developing crash scenario which we are now in back in January of this year.
Crash: the Rally that Fails as a Hallmark of Major Market Dislocations
Market 'crashes' are low probability events that are notoriously difficult to predict accurately. CrashTrak did predict the tech crash of 2000-2. Unfortunately we were not able to forecast the great stock market reflation of 2003-2007 which the Fed had engineered until it was well underway.
This points out the weakness of using technical analysis in forecasting markets priced in fiat currencies that can be used to mask the actual market dynamics of real values, especially if the deflators and actual rates of inflation have also been rendered opaque. Simple models that worked in the past may not work in this environment of economic obfuscation.
Nevertheless, it can be used successfully if one couples technical analysis with fundamental analysis. The movements on a stock chart are an abstraction that represents an underlying marketplace of individual transactions. There are other ways to assess these transactions to obtain enough data to forecast a 'crash,' again reminding the reader that forecasting a low probability event is notoriously difficult. The flow of money in the market is one of these tools which we use, and is listed on a number of the charts which we provide almost every day.
We will be publishing updates of CrashTrak now that we have reached a second threshold of probability with the dip of the major indices below the -20% decline from the top level again.
The underlying mechanics of crashes is interesting and informative. Here is one of the best descriptions of how a crash happens that we have found, quoted in a paper by Barkely Rosser. For those of you who are students of market dislocations, Charles Kindleberger is a 'must read.'
Falling from the Period of Financial Distress into the Panic and Crash
In 1972, Hyman Minsky described the "period of financial distress," in a paper in a journal that no longer exists (Reappraisal of the Federal Reserve Discount Mechanism, vol. 3, pp. 97-136), "Financial Instability: The Economics of Disaster."
Charles P. Kindleberger picked up on this and followed Minsky's analysis in his famous book, Manias, Panics, and Crashes: A History of Financial Crises... The period of financial distress is a gradual decline after the peak of a speculative bubble that precedes the final and massive panic and crash, driven by the insiders having exited but the sucker outsiders hanging on hoping for a revivial, but finally giving up in the final collapse.
According to Appendix B of Kindleberger's 2000 edition, 37 of the 47 great historical speculative bubbles exhibited such a period before the final crash...
