Recipe for a Stock Market Crash

By: Clif_Droke

Over the past few days I've received quite a few nervous inquiries from investors who worry about the potential for the stock market to crash sometimes between now and year end.  Part of this fear is founded on what is known as the Year Seven Phenomenon, which says that the seventh year of the decade usually sees a substantial stock market decline or even a crash, a ‘la 1987 and 1997. 

The combined influence of the mythology surrounding the Year Seven Phenomenon is often used by perma-bear newsletter writers into scaring their readers away from the stock market during the seventh year of any given decade.  A reflection of this latent fear, which all investors have had at one time or other, is found in the following e-mail I received recently: “I am still scared about that history of all years ending in 6 & 7 suffering one 20% correction since 1856.” 

The so-called Year Seven Phenomenon is discussed at length in the classic book, “Tides in the Affairs of Men,” by Edgar Lawrence Smith.  Edson Gould, Yale Hirsch and Larry Williams have also written extensively on this subject and have helped to promote the Year Seven phobia.

Yet not every seventh year of the decade was bearish for stocks and a few were actually quite bullish.  The year 1927 was one notable example.  A survey of stock market trading patterns for every seventh year of the decade, spanning from 1857 until 1997, shows that when the market had a particularly bad year during a Year Seven, the market usually started off on a sour note.  In other words, bearish Year Sevens saw the market start declining almost from the get-go and continue its slide into the year end.  If the market started off the year in a bull market there was a good chance the Year Seven would end with gains in the major stock averages.

There were, however, a few notable instances in the most notable declines that occurred in the past 140-years of our survey of the Year Seven Phenomenon.  For instance, there were mid-to-late-year selling panics that occurred in 1957, 1987 and 1997.  What accounted for these sudden appearances of weakness during the seventh year of each of these three decades?  While the factors contributing to each separate decline were unique in their own right, all three instances had similar characteristics in that investor sentiment became euphoric, in varying degrees, at the market ops of each of these years.  The common element in the 1957 and 1987 experiences was the 6-year cycle, which peaked in both of those years.  Six-year cycle peaks tend to produce sharp declines in the stock market, especially when investor sentiment is high.  That was most certainly the case heading into the 1987 stock market crash.

In our present case the last 6-year cycle peak occurred in October 2005, which produced the September-October market correction.  The 6-year cycle peak not being a factor this year, what other cycle of major magnitude could act as a catalyst to a stock market crash?  Answer:  none of any importance.  The 10-year cycle is up until 2009 and that's the most prominent longer-term cycle in any given decade.  Therefore cycle considerations are beyond the scope of this discussion for now.

Now that we've seen that fears founded upon seasonal concerns for the year 2007 are largely unfounded, what other influences could bring about the widely feared stock market crash this year?  Probably single most important consideration when analyzing the securities market for crash potential is investor psychology.  Investor sentiment isn't the most important *cause* of crashes, but it frequently serves as the trigger for them.  Crashes are *caused* by, among other things, overvaluation of the asset class under consideration.  Let's discuss both of these factors for a minute.

My formal response to questions I've been asked this year pertaining to the Year Seven Phenomenon and the risk it poses for a stock market crash is that there are two considerations in that respect:  1.) It's possible the market has already taken its obligatory Year Seven hit for the year with that late February decline.  That bout of panic selling came out of nowhere, catalyzed by bearish comments by former Fed Chairman Greenspan and the Chinese authority.  The late February selling panic pushed the investor sentiment figures to their lowest numbers we've seen in years.  In fact, one such survey of put/call ratios fell to its highest level of puts versus calls in its history!  This shows investor sentiment in the U.S. is currently very bearish by historical standards, and that's actually quite bullish for stocks in the intermediate-to-longer term.  2.)  If we are to take another hit later this year, I can't imagine it being in the vicinity of 20%.  That's because valuation is still very low (stocks are 28% undervalued according to the IBES model and the S&P 500 forward earnings yield is still well above the T-bond yield). 

To get a 1987-type crash you really have to have a combination of things going on.  You have to have a cycle peak.  You also have to have investor sentiment beyond the boundaries of normal (i.e., WAY too bullish based on the standard measures).  Clearly it's too early in the game for a stock market crash to happen anytime soon. 

There also needs to be a reversal in internal momentum (as defined by the rate of change in the number of stocks making new highs against new lows).  Once again we see that it's too early in the decadal cycle for a crash to occur since internal momentum is actually very strong and has been since the major market low in June-July 2006.  Even the 200-day momentum indicator of net new highs for the NYSE is still in a strong rising trend.  It will take a long time for this kind of momentum to reverse and create dangerous undercurrents for the stock market.

Finally, for a major stock market crash to happen there has to be a fundamental over-valuation of stocks as reflected in the IBES valuation model and/or by the spread between earnings yields and Treasury yields.  For instance, in 1987 and 1997 the IBES model spiked well into “overvalued” territory just prior to the crashes in those two years – somewhere in the vicinity of 40% overvalued in ‘87 and around 25% overvalued preceding the mini-crash of ‘97.  Today it's the exact opposite with the model showing stocks to be 28% *undervalued.*  I just don't see a crash happening this year with this kind of massive undervaluation.  Note the IBES valuation chart from Haysadvisory.com.

Also, keep in mind we have record liquidity today, a Fed committed to pushing up money supply with abandon, shrinking supply of stocks, and the fundamental strength just mentioned.  Throw in investor psychology being quite bearish compared to 1987 and 1997 and it's hard to see how this bull market will end before the crowd joins in a massive capitulation of euphoric frenzy -- just like in the late 1990s before the tech stock crash. 

Another e-mail I received is worth mentioning because it gets to the heart and soul of the issue as to why stocks should continue to offer value despite the nay-saying of the super-bears.  He writes:  “Corporations have been retiring billions of dollars worth of shares each month for the last 3 plus years.  Additionally an enormous amount of U.S. shares have been removed over the same period through M&A activity and private equity transactions for a total net share loss worth a few trillion dollars.  Furthermore, to the point of your bearish individual investor, they have been directing 90+% of their equity investment funds into foreign equity funds over the last 2-3 years -- chasing performance.  When the Dow passes 15 or 16 thousand, perhaps a few will take notice and begin to ignore the folly which has been continuously written about old news items like ‘sub-prime': all of which has no doubt been priced into the ‘Wall of Worry.'  The stubborn holdouts will focus on tomorrow's old news items and miss until perhaps the DOW hits 19 or 20 thousand and they panic and dive in with all they've got.  The top will likely coincide when the Private equity players attempt to cash in their chips and offer a flurry of old company IPO.  Maybe it tops in 2010 to 2011 -- who knows?  Not me.”

The fear of a stock market crash has never been stronger than it is today.  One reason for that is that we've all been conditioned by at least one or more major stock market crash in our lifetimes and a few mini-crashes and selling panics to boot.  These market reversals and the damage they inflict tend to leave deep-seeded memories and emotional scars that are not easily healed with the passage of time.  These emotionally-charged memories have bubbled to the surface in recent years as the corporate scandals earlier this decade along with massive pension losses have left millions with an uneasy feeling about the future of the U.S. financial system. 

A survey of history shows that aggregate psychology at any given time is reacting to the problems and fears of at least 3-4 years ago.  In other words, mass psychology is *always* behind the reality of the here-and-now.  These deep-seated fears that were seeded earlier this decade are at the forefront of the mass investor psyche but they will soon be replaced by gradual acceptance of the bull market, then outright embracement.  This transition will probably take place over the next 1-2 years.  Until the shift in investor psychology goes from firmly bearish (today) to decisively bearish, the downside risks to the stock market will continue to be limited and a crash of major proportions such as the super-bears are currently preaching is most unlikely. 

The “recipe” for a stock crash as outlined in the above paragraphs is nowhere to be found in the equity market kitchen today.  When the ingredients begin showing up (in the form of diminishing liquidity, overvaluation of stocks and bullish investor sentiment) we'll know a top of major proportions is near with a possible risk of a market crash.  Until then, fear will continue to be just another tool used by the mainstream press to keep the public from participating in this bull market.

By Clif Droke
www.clifdroke.com

Clif Droke is editor of the daily Durban Deep/XAU Report which covers South African, U.S. and Canadian gold and silver mining equities and forecasts PM trends, short- and intermediate-term, using unique proprietary analytical methods and internal momentum analysis.  He is also the author of numerous books, including "Stock Trading with Moving Averages."  For more information visit www.clifdroke.com

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