Crash? Correction? Or Change in Primary Trend?

With the recent stock market decline I wanted to take this opportunity to reiterate to all clients, both old and new, how we attempt to differentiate between a stock market crash, price correction, and potential change in primary trend using the BLUE LINE INVESTING® (BLI) process. In doing so, I will attempt to do my best to limit my use of technical terms to help relay these concepts in a manner that may be easier to comprehend.

First, let’s define these three terms as follows:

Stock Market Crash – A rapid and often unanticipated decline in stock prices. Two historical examples could include October 1929 and October 1987. In 1929 the stock market declined by approximately 33% from the high to the low, and in 1987 the stock market declined by approximately 31% from the high to the low.

Stock Market Correction – A decline in the market price after extensive price increases. This can occur even when there is no evidence that the increasing price trend should end. A price change of 10% or more from the peak high is common.

Change in Primary Trend – A transition that tends to occur over the course of a few months where prices that have been in a long-term rising trend invert and begin a short-to-intermediate declining trend (or vice versa). One of the better examples of a change in primary trend from positive to negative began back in October 2000 and ended in March of 2003. Over that 30-month period the stock market declined by approximately 49% from beginning to end.

It is somewhat concerning that as I am writing this article it becomes apparent that the examples above all began in the month of October. But moving along, what can be observed right now?

First, using the S&P 500 Index (S&P)¹ as our reference point, the price decline has so far been almost exactly 10% from the recent high earlier this month. So, according to the definitions above it does not fall under the definition of a crash but definitely a correction. So with that said, what would have to happen from here to redefine this recent price decline as a change in primary trend?

Please click here to review the BLI sell process rules and refer to page 7 of the Case Study on the S&P. First, with this month’s price decline, the primary trend can no longer be categorized as positive since the S&P has declined below its Blue Line by over 3%. The primary trend must now be changed to neutral.

Second, as can be seen by our sell process rules, created from historical patterns observed from the S&P dating back to 1926, if the S&P declines by at least 5% below the Blue Line it would trigger a Phase 1: WARNING of a possible change in trend. Since that has not happened yet I will leave off explaining Phase 2 and Phase 3 further. But to visualize what this tends to look like visually, please refer to the following chart of EWI, an exchange-traded fund owning stocks from the country Italy, courtesy of StockCharts.com.

From the recent high, EWI declined by over 7% to the Blue Line. Through today, price has declined an additional 18% since completing Phase 2 and Phase 3. In total, the price decline over the past six months has been approximately 25%. For additional examples of stocks that have experienced these three phases in recent years and their resulting outcomes, check out General Electric and Kraft Heinz Co.

So far the S&P has not triggered a Phase 1:WARNING – yet. But if it does in the days or weeks to come, I believe it will be important to follow the BLI sell process to attempt to limit significant losses that could be on the horizon. Until then, we patiently wait and observe the patterns.

For comparison of what the S&P looks like right now in light of EWI above, please see the chart below.

As I conclude this article, allow me to make one additional comment. On occasion, the BLI process attempts to implement partial protective hedges using inverse exchange-traded funds (ETFs) either preceding or during price corrections. Sometimes they are successful and sometimes they are unsuccessful. But it is only upon a Phase 3: CONFIRMATION event that our process may attempt to profit from a broad-based, stock market downturn, buy using inverse ETFs exclusively. We must have complete belief and conviction that the primary trend has in fact changed from neutral to negative, something that is not remotely close at the present time.

Jeff Link

Founder of the BLUE LINE INVESTING® process

Disclaimers:

Blue Line Investing (BLI) is an alternative to traditional wealth management. BLI uses a disciplined, rules-based investment process to seek investment opportunities, regardless of whether financial markets are rising or falling. Based on technical analysis research, the process applies trend-following using specific Exponential Moving Averages (EMAs) of the market along with other technical indicators. A moving average is a widely used indicator in technical analysis that helps smooth out past price action by filtering out the “noise” from random price fluctuations. EMA’s can be calculated for any time period. Some examples include the 5 day EMA; 50 day EMA; and 150 day EMA. We have attempted to simplify this by calling the various EMAs we use in our process the “Blue”, “Purple” and “Green” lines.

¹ The S&P 500 Index is one of the most commonly followed equity indices, and many consider it one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy. It is comprised of 500 large companies having common stock listed on the NYSE or NASDAQ. The volatility (beta) of the account may be greater or less than the index. It is not possible to invest directly in this index.

 Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volumes. Technical analysis attempts to predict a future stock price or direction based on market trends. The assumption is that the market follows discernible patterns and if these patterns can be identified then a prediction can be made. The risk is that markets may not always follow patterns. There are certain limitations to technical analysis research, such as the calculation results being impacted by changes in security price during periods of market volatility. Technical analysis is one of many indicators that may be used to analyze market data for investing purposes and should not be considered a guaranteed prediction of market activity. The opinions expressed are those of Blue Line Investing. The opinions referenced are as of the date of publication and are subject to change without notice. Blue Line Investing reserves the right to modify its current investment strategies based on changing market dynamics or client needs.

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. This information is intended for educational purposes only and should not be considered financial advice. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. Forward looking statements cannot be guaranteed. 

Advisory services offered through Gordon Asset Management, LLC (GAM). GAM is an SEC-registered investment adviser. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (866) 216-1920. The principle office of Gordon Asset Management, LLC is located at 1007 Slater Road, Suite 200, Durham, North Carolina, 27703.