Stan Weinstein On The ’87 Stock Market Crash

October 19th was the 24th anniversary of the 1987 stock market crash, and interestingly enough the Nightly Business Report interviewed Stan Weinstein that day to get his thoughts on the crash.  This interview piqued my interest due to the fact that Stage Analysis is one of the methods I like to use to analyze the market.  The interview with Weinstein starts at about 4 minutes into the clip.  Below, I’d like to discuss some of the important statements he made in the interview:

“What I learned long ago, when you’re in a crash sequence, you don’t try and guess a bottom.”

If you read the book Secrets For Profiting In Bull And Bear Markets, the number one rule Weinstein says in the book is don’t buy and hold anything in a Stage 4 chart pattern.  This means don’t buy and hold anything declining below a declining 30-week moving average (see the graphic above).  The basic reason is you have no idea when the bottom will come.  A small loss could turn into a huge loss if you stick with something in a Stage 4.  When the majority of the stock market transitions into a Stage 4 pattern, it’s called a bear market.

“This didn’t come out of the blue.”

Weinstein states in the interview that internal indicators he was monitoring were breaking down before the crash.  There was also a Dow Theory sell signal, and the week before the crash the Dow Jones Industrial Average crossed below the 30-week moving average in a big way, with heavy volume.  The chart below is a weekly chart of the ’87 crash:

One thing to note here.  One week isn’t usually the amount of time it takes for the market to transition into a Stage 4, usually there is some type of topping period or Stage 3 in between, and that topping pattern can take weeks to months to form.  But nevertheless there was enough technical damage during the week before the ’87 crash to recognize that something was seriously wrong with the market going into the following week.

“When the market broke below 2450 you turn negative, and this is a negative phase that we’re in, and the market is now panicking.”

Here, by saying “negative” twice and “panicking”, he’s emphasizing that the market was in a negative mood.  Robert Prechter likes to talk a lot about the “social mood” of society and how it affects the market, and how shifts towards negativity in the world lead to the biggest market collapses.  A Stage 4 is essentially a shift towards pervasive negativity for the market, which in many ways reflects what is going on in the economy and the world, and that’s what Weinstein was trying to get across in that statement.  Think about all the negativity in the world today with the Eurozone crisis, Occupy Wall Street, signs of a new worldwide recession, etc.  Combine that with the fact that most of the market is transitioning into another Stage 4 trend and you can start to see how the pieces are falling together.

“There’s going to be a lot of base building since there was a lot of technical damage done.  I’ve learned to never guess the bottom.”

Again, don’t try and guess the end of a Stage 4 trend.  Instead, wait for the base building, or Stage 1 phase to begin.  You don’t even want to buy the Stage 1 either, if you read his book the goal is to buy only after a Stage 1 breaks out into a Stage 2.  The reason is if you buy something in a Stage 1, it can sit there for an unknown period of time going nowhere and essentially wasting your time.  The two most important assets an investor has is time and money, so wasting your precious time and buying in a Stage 1 is not what you want to do.  The bottom line is you want to see all of this in the rear view mirror, the end of the Stage 4 trend and the end of the Stage 1 base building afterwards.  Once you can clearly see all of that is over with, then it’s a much more constructive time to be participating in the market.

“I have to wait and see the action, I don’t want to look ahead of the action.”

The interviewer asks Weinstein what he’s going to buy when all this is over, is he going to buy back into the blue chip stocks?  Weinstein responds by saying he doesn’t know, and wants to see the action in the market first.  If you understand his trading method then you know that what he’s really saying is he’s going to wait to see what sets up in a Stage 1 base, and then breaks out on high volume into a Stage 2 uptrend.  He has no idea what is going to do that ahead of time, so there’s no point in trying to guess.  This is an essential point of trend following, or being reactive to the market versus being proactive and trying to outsmart the market.  Trend followers let the market tell them what to do, and the Stage Analysis trading method is essentially a trend following method.

Bulls Hanging By A Thread

The bears suffered a face-ripper rally over the last couple weeks during the biggest short term rally the market has seen all year.  When looking at why this rally occurred, it was evident by many indicators that pessimism was still at high levels as the market attempted to breakdown on October 4th.  With pessimism too high on a market that hadn’t really worked off its’ oversold condition, the market was able to reverse sharply and fake out the bears on the downside.

First, check out the percentage of stocks in the S&P 500 that were above the 50 day moving average leading into the action on October 4th.  The percentage was only at approximately 10% as the market attempted to breakdown out of the trading range.  This is still an extremely oversold level and made it difficult for the bears to get the next downleg they were looking for.

Looking back at the bear market in 2008, each of the major bear downlegs occurred with the percentage of stocks in the S&P 500 above the 50 day moving average at a level of at least 60%, and usually closer to 80%.  This helps explain why the market was unable to break to new lows on October 4th.   It still hadn’t really worked off its oversold condition yet from the fall in August.

The put/call ratio and the volatility index, two widely used sentiment indicators, were also at extremely bearish levels going into action on October 4th.  The 10-day moving average of the put/call ratio is shown in the next chart, and as can be seen it was at a level that was more consistent with market bottoms then tops.

Looking at the Volatility Index (VXO), the latest failed bear downleg attempted to start with a VXO reading over 30.

In 2008 however most of the major bear downlegs occurred with a VXO reading closer to 20.  The last bear downleg occured with the VXO over 40 but this was after the heart of the meldown that pushed the index over 40 for multiple months.

The bulls still have a lot of work to do however to turn this market around.  Most world stock indices, individual market sectors, and commodities are in a Stage 4 trend now.  This means they are declining on a weekly chart below their 30-week moving average.  A Stage 4 trend is the buy and holder’s nightmare, and when a large percentage of the market has transitioned into a Stage 4 it means the market is not healthy.

The last sector of the market to remain in a Stage 2 trend has been select large cap tech stocks, and most notably the triforce of AAPL, IBM, and AMZN.  Back in August I alluded to the fact that these powerhouses would be key to a rebound in the market.  I stated:

“So if you take the optimistic side of the trade and think that we go up and retest 1260 from here, then the market is going to need leaders to follow on the way back up.  Fortunately some of the market leaders since 2009, stocks such as AAPL, IBM, and AMZN, haven’t taken as much technical damage as the rest of the market.  If the market was to regain enough footing for a sustainable bounce those stocks would be expected to re-emerge as market leaders.”

All three stocks have rallied nicely off of that October 4th low, which has helped the bullish case since then.  One thing that doesn’t look good for these leaders though is the lackluster volume that has accompanied their move higher this year.  The next few charts show that the On Balance Volume (OBV) in each of these stocks has failed to confirm their trend higher.  This divergence can sometimes indicate a weakening trend as buying pressure isn’t being sustained.

The same lack of buying pressure can be seen in the Nasdaq 100 as represented by QQQ.  The OBV has actually declined all year in QQQ.

The bulls at a minimum are going to need more stocks to repair their damaged chart patterns to sustain this rally higher.  Looking further down the totem pole, former leaders with light damage such as PCLN, CRM, and BIDU could embolden the bulls case if they were to move back to the upside.  The bulls could also use a breakout of GOOG and INTC out of their multi-month trading ranges.  If you check out the volume patterns in each of those stocks though you’ll see that they are suffering from a similar lack of buying pressure as the other leading tech stocks.

Chances are the short term war between bears and bulls is going to continue for the immediate future, as there are still a fair number of stocks that are mean-reverting back to the upside as they work off some of the recent technical damage they have sustained.  The put/call ratio and VXO shown above are also working off of their overly pessimistic short term levels.  But looking longer term, as long as the majority of the market remains in a structural Stage 4 downtrend, the bear market will remain intact.  The bulls need their three leaders to remain in Stage 2 uptrends, and they also need to broaden their leadership for the market to transition back into a bull market.