How to spot a market crash?

Emotionality within the financial markets is a crucial element in investment decisions, both short and long term. A lot of news, sometimes sensational, could push operators to be afraid, to feel emotions that strongly affect the “market sentiment and therefore many decisions are taken in non-optimal conditions, ie in the grip of emotion.

With regard to trading and investments, this is a absolutely not recommended approach as it completely dismantles all the work concerning the planning of an investment or a specific trade.

It follows that an essential element to avoid emotion is the analysis of certain news and the contextualisation of the same within our investment/trading plan.

We speak of emotion because, given the recent events, with the markets in the throes of news regarding some bankrupt banks (see the SVB or Credit Suisse case) we have seen reversals in the face of many analysts who, previously were bullish, then they turned bearish, all in the grip of the emotions that market news arouses in traders.

In this context of fear and uncertainty, it is necessary to do some analysis on the graphs and actually see how long it takes for a market to collapse, i.e. to make movements that lead the market to unload buyers with important consequences in long period.

Investments, trading and emotions

Let’s start right away by specifying what emotion involves in trading. We have already said that emotion inevitably leads to making decisions that are not absolutely rational by definition, therefore the probability of making mistakes and then repenting is very high.

This is due to a "herd effect" according to which the emotions we feel, if they are felt by others, give us an unconscious sense of security, they give us peace of mind. In practice, our analyzes are influenced by the emotions we feel at that moment and consequently when we see a group of people feeling what we are feeling too, we calm down and we are led to overturn what we have done up to that moment in order to feel calm and avoid a state of anxiety that could be detrimental in the long run. In essence, this emotion is the result of an analysis conducted in an approximate and unclear way, the same lack of clarity that we then find in the decision-making process regarding investments and trading. A good analysis estimates all the dangers, "black swans" included, and it is precisely this lack of clarity that brings out all the emotion that is unleashed in the excited moments of the market.

To take a recent example, many panicked over the SVB bankruptcy and Credit Suisse crisis, thus fueling new rumors about a new 2008 imminent. In these cases, all the assessments made previously are questioned only by those who have not considered the fact that some banks, or the banking system itself, could be in danger due to high interest rates, something known for a year already. Those in the markets who have planned events of this type (not specifically, let it be clear), face these moments in a more relaxed way and without major problems.

In these contexts, the operators with a higher degree of preparation have the upper hand, i.e. the more technical ones who structure investment portfolios based on risk and the return opportunities commensurate with possible losses, whether they are in the short term that in the long run. In this regard, given the pessimism that is hovering over the markets at the moment, we must resort to technical analysis and actually see if conditions similar to the current ones have occurred in the past before a market crash, in this case similar to a collapse like that of 2008. In this analysis we will look at only and exclusively the prices, without taking into consideration the macroeconomic factors, other fundamental factors to conduct an analysis accurately.

The case of the Dax and the dynamics of descent (example)

The first thing to do in these cases, when we have to examine market movements that have continued over time, is to choose a long timeframe (i.e. a temporal reference). In this case, as we see in the image, we have taken the trend of the Dax on candlestick chart with 1 month timeframe, i.e. each candlestick we see represents 1 month of trading.

The first step is to identify market crashes, i.e. those conditions on the graph that are represented by strong downward movements, movements which in this case are highlighted by the blue arrows.

The second step consists in seeing how the market moved as soon as the dynamics of the collapse began.

The third step is to highlight how the market moved before the movement started.

Monthly DAX

The blue arrows point to a market crash while the red areas show prices before the crash.

Looking at the graph we can see that the market, before starting a crash, achieved several months below the monthly highs before starting a downward movement. Looking closely we see that the movement that saw a "faster preparation" lasted at least 3 months. We are talking about the second red area that we see in the graph from the left. The other areas see at least 4 candles in preparation for the move, while the last area even sees 6 candles before seeing a consistent descent.

At the moment therefore, given the current dynamics of the Dax, we can say that we are not yet in the presence of a significant bearish movement. But beware of the fact that it is clear that there is currently a decline but, with a certain probability. Having observed what happened previously, it is very likely that now is not the time to see significant declines. This does not mean that there won’t be a downturn, on the contrary, we may be seeing a movement in preparation for the downturn, but at the moment, at a time level, we are not seeing anything concrete compared to what we see on the graph .

It follows that, in a moment of fear like this, where we shout about the "new 2008", an investor knows that the current dynamic does not coincide with what we saw previously and consequently the collapses we see now could be only moments of preparation for a collapse. The operator in question will not be willing to liquidate assets in the portfolio or to take clearly bearish positions if he trades when, in terms of time (therefore technical evaluation) we do not have the ideal conditions to see a "collapse" event in the ’imminent.

Original article published on Money.it Italy 2023-04-25 17:22:00. Original title: Come individuare un crollo di mercato?