This is an opinion column. The thoughts expressed are those of the author.
The Coming Stock Melt Down: Part 3
Sam Pearson 5/19/2021 5:33 AM
In part 1 of this series I spoke of the coming Melt Down of stocks. I discussed that that it is the change from exuberance that causes a meltup and then it is fear that causes the meltdown as stock owners sell their stocks not wishing to weather the loss of stock values. Part 2 was a discussion of previous melt downs in US stocks and some of the causes.
In Part 3, I am going to discuss some of the ways one can predict a coming melt down based on statistical analysis. The first method is using the volatility index. The image below is the estimated and observed VIX, 2007-10. VIX is the volatility index computed from S&P 500 options by the Chicago Board Options Exchange, converted to a percentage. VIX^ is the filtered out-of-sample estimate based on two-factor SVJ2 (2 Level Factorial Designs) parameter estimates over 1926–2006 and on subsequent S&P 500 excess returns. The lower panel shows the difference between the two. 95% confidence intervals are shown for the difference between observed and estimated VIX based upon parameter uncertainty (dark grey), combined parameter and Vt uncertainty (medium grey), and combined parameter and (Vt,θt) uncertainty (light grey).
As one can see above, as investors became concerned about the valuation of stocks prices the VIX began to rise rapidly even as stock prices continued to melt up. When the VIX peaked, stocks melted down very rapidly. Historically if one chose an arbitrary number (Percentage) and said that my exit plan was when the VIX reaches 30%.
Of Course, for everyone using the VIX charts to make selling and buying decisions there are 10 investors who use the 50/200 day simple moving average crossover strategy as it is one of the most commonly used trading methods for both professional as well as those of us who are part time traders. Seems like every financial news channels “professional trader” refer to the 50 day and 200 day moving averages. Trading with the 50 day and 200 day moving average is really quite simple, buying and selling on the moving average crossover. This trading system is applied only to the daily charts such that day traders will find it too slow and inconvenient as it often takes weeks or sometimes even months to get a good read on the market.
The 50 and 200-day simple moving average (SMA) allows traders to apply our own rules. As an example, I prefer to use the 50- and 200-day simple moving average as a trend following set up, but this means that I have to hold the trades for long periods of time. Others that I know will use the 50 – 200 day moving average and simply trade the markets using the trends themselves to anticipate the future.
When one uses the 50 and 200-day (SMA), they need to look for two occurrences. The first is commonly referred to as the “Death cross”. This refers to when the 50-day moving average cuts the 200 day moving average from above. It signals that the trend is shifting and not in a good way. The second occurrence is the “Golden cross” it is the opposite of death cross and refers to when the 50 day moving average cuts the 200 day moving average from below. It signals that the trend is shifting in a positive fashion.
As one studies the history of bear markets the death cross indicator has proven to be a reliable predictor of some of the most severe stock meltdowns of the past century: in 1929, 1938, 1974, and 2008. Investors who got out of the stock market at the start of these bear markets avoided large losses that were as high as 90% in the 1930s. Because a death cross is a long-term indicator it carries more weight for those of us who wish to lock in gains before a new bear market gets underway. One will also notice that an increase in volume will often accompany the appearance of the death cross.
The golden cross is the opposite of the death cross, this occurs when the short-term moving average of a stock or index moves above the long-term moving average. Those of us looking to buy back into the market or to increase our holdings view this pattern as a bullish indicator and opportunity. One will note that the golden cross will normally occur after a prolonged downtrend has run out of momentum or as commonly referred to as the “Bears” getting tired.
As a word of caution, one should confirm the trend reversal after several days or weeks of price movement in the new direction. Never forget that investing is a competitive market with each investor trying to beat the masses in self-fulfilling behavior, because as financial news stories about a particular stock or the movement of an index occur trading volumes increase. In the case of meltdowns the volumes increase geometrically.
Deciphering the liquidity and credit crunch 2007–2008
Journal of Economic Perspectives, 23 (2009), pp. 77-100
 Golden cross vs. death cross: What's the difference? (2019). . New York: Newstex. Retrieved from https://search-proquest-com.ezproxy2016.trident.edu/blogs-podcasts-websites/golden-cross-vs-death-whats-difference/docview/2251474314/se-2?accountid=28844
Sam Pearson is a retired Army Colonel with a variety of experience in both government and private sectors. As arguably one of the World's foremost military logisticians, he has been responsible for the on time delivery of supplies and services worth billions of dollars. After service in Southwest Asia, he was hand picked to support logistics operations in support of earthquake relief operations in Haiti. Pearson now serves as a consultant and volunteer mentor for students seeking their doctorates in advance statistical analysis.
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