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A Predictor of Stock Market Crashes

A Predictor of Stock Market Crashes

September 26, 2019

I was looking at a chart of the S&P 500, and decided to add a few “Moving Averages” to it.

Some Definitions To Start:

N-Day Simple Moving Average (SMA): A Simple Moving Average for a stock or index is an indicator that simply averages the prices over the past N days. Eg: The 10 Day SMA averages the prices for the last 10 days. The 10 Month SMA averages the prices for the last 10 months.
N-Day Exponential Moving Average (EMA): The exponential moving average is similar to the SMA, expect it gives greater weight to more recent prices.

Below is the monthly price chart of the S&P500, with 3 EMAs on it:

The yellow line is the 9 month EMA
The teal line is the a 20 month EMA
The purple line is the 200 month EMA

Do you notice anything interesting in the chart? Hint: Zoom in a bit…

Zooming Into The S&P500

Notice one thing that has happened before both stock market crashes: The yellow 9 month EMA crossed from above the teal 20 month EMA to below it. More importantly, it did this several months before major drops in the market!

Over the last 20 years, this happened both times before a major stock market crash!

Notice how this crossover happened in Feb 2001 and June 2008. If you had gotten out of the market when the crossover happened, you could have avoided an eventual loss of approximately 40% and 50%, respectively!

Not only that, there have been no false positive signals throughout this 20 year period!

Ok, What About Other Indices?

That is even more interesting. Not only did the above signal occur on the S&P 500 (SPX), it also occurred on both of the other 2 most followed stock market indices, namely the Nasdaq (QQQ) which is heavily weighted towards information technology companies, and the Dow Jones Average (DIA), an index that measures the stock performance of 30 large US listed companies.

Look at the massive drawdowns that could have been avoided, if you simply exited the market when the crossover happened. You could have exited the market many months in advance!

Below are the charts

QQQ

QQQ Zoomed In

DIA

DIA Zoomed In

So, What’s The Conclusion?

The above isn’t statistically significant, so be careful in thinking that this signal is predictive. But clearly, this is an interesting indicator to keep an eye on.

Zero false positives (at least in the examples above) seems very powerful. In cases when there were large market crashes, if you sold at the crossover points, despite locking in some losses, significant additional losses would have been avoided.

That said, this indicator does not spare you if there are smaller market drops. For example, the 20%+ drop in prices in Q4 2018 would not have been avoided.

Nonetheless, I’ll surely be keeping an eye on this one...

A Question For You

Do you have access to older stock market data? If so, please share with! I’d love to see how the above signal performed in the past!

What’s Next?

Next, I’m thinking to do a company deep dive, or perhaps a discussion about whether one should buy insurance for your stocks.

Let me know if you have a preference, or feel free to suggest other topic suggestions.