When the stock market crashes, it gives warning signs.  Red flags start to go up as much as six months in advance.  Furthermore, market crashes usually take around a year-and-a-half to complete, from top-to-bottom, so it’s not as if the market falls 40-50% in value overnight.  Naturally, everyone wants to avoid these terrible, yet inevitable recessions.  The good news is, it’s possible to avoid a nice portion of the negative returns.  You just have to know what to look for, and of course, you have to be paying attention. 

When the stock market crashes, it does so in an inconspicuous, but orderly fashion.  In fact, the market is a lot like the human body.  Pretend the market is an individual going in for a doctor’s visit.  They seem completely fine.  No pain, skin looks good, nothing to report in terms of illness.  Even heartrate, blood pressure, and vitals all seem okay.  Then, all of a sudden, bloodwork comes back from the lab and something is wrong.  When more tests are done, it’s determined that the individual has a serious disease.

How could this be?  They felt completely fine that morning when they got out of bed.  Here’s how it happened…

Step 1:

When the stock market crashes, small companies start to crash first, falling -10%, then -15%.  Big institutions and mutual funds (who are forced to stay in the market all the time, regardless of market crashes) know this process, so they start to sell their smaller positions once this weakness is observed, which puts additional downside pressure on these small companies, sending them down -20%, -25%, etc.  They then take the proceeds and buy mid and large-sized companies, fleeing to quality where they can try and capture more growth.  This pushes prices up on the larger companies in the market, temporarily.

Step 2:

Now mid-sized companies are starting to crash, first correcting, then falling -15%, just like the small-caps.  The same story plays out here… again, big institutions sell these mid-caps at the first sign of serious weakness, pushing prices down even further, and the climb the wall of quality higher to the large, blue-chip, dividend paying companies.

— Time Out —

Now here’s where things get interesting.  Just like the individual who didn’t know they had serious medical conditions under the surface of their skin, you cannot recognize the terminal nature of the stock market’s issues until you implement a proper examination…and it has to go much deeper than looking at what the S&P 500 or the Dow are doing.

You see, the Dow doesn’t include any small companies at all, so how would you know if the foundation of the market was collapsing beneath it if you aren’t even looking at the foundation to begin with?

Further, the S&P 500 is a cap-weighted index.  This means that the largest companies are given the vast majority of the weight of the index when it’s priced throughout each day.  Said another way, small and mid-sized companies could be crashing and because they’re so small, relative to the large and mega-cap companies, you wouldn’t really notice much of an effect.

Alright, back to our story…

Step 3:

As money flows out of small and mid-cap stocks, prices are pushed down further, but the large companies continue to rise as these big institutions buy more shares, pushing prices up further and further.

— Time Out —

Do you see what’s happening here?  All this big money is pushing prices up further on the large-caps, which is what most individuals look at each day when “watching the market.”  So to the average viewer, the S&P 500, the Dow, and thus, “the stock market” still look completely fine.  Meanwhile, a disease is eating away at the market from the inside-out…

Step 4:

At this point, the institutions have gobbled up as many of the large-cap shares they can and when they’re done buying, the upside pressure previously put on price stops… and this is when the battle really begins.  Smart money starts to see the large caps waver and they’ve already gotten out of the small and mid-caps at this point.  As the teeter-totter leans from an uptrend to a downtrend, the smart money starts to sell and at least for the time being, there are enough buyers on the sidelines present to buy the shares they’re selling.

Step 5:

Eventually, the vast majority of the buyers in the market have dried up.  There’s no one left to buy the shares you’re selling, and the market goes into free-fall.  Once your portfolio hits terminal velocity, all the bad habits and emotions kick in…

“I’ll just wait till it comes back, then I’ll sell.”

Now, the market doesn’t go down in a straight line, just like it doesn’t go straight up.  There are plenty of times when the market looks horrible from the inside-out, but the volatility and occasional counter-trend bounces cause investors to think “it’s over now… I can sit tight,” when the truth is, it’s far from over.

“Bummer, I’m down -35%, but it can’t go any lower than this.”

  “Ahhh, I’ve lost almost half my money… how long is it going to take before I make up for all these losses?”

So that’s how it works.  Believe it or not, there’s a rhyme and reason for how the market progresses from bull market to bear market.  But how healthy is the stock market today?

As you can see below, the opposite of what I just explained above is happening.  While the larger companies have been taking a breather, making it look as if the market is getting ready to crash, a higher number of stocks (lower pane) are actually climbing higher, under the “skin” of the market.

So to keep the analogy going here, the market has a mild cough and a runny nose, but it’s being quite the hypochondriac and spending too much time worrying (CNBC) about such a silly, non-threatening illness!

It’s extremely difficult to have a market crash when small and mid-size companies are rising in price.  I wrote in our April 6th Market Commentary (click here to read it) that I felt the market might do something like this:

Here’s where we are today…

So, not much has changed in the last couple weeks other than some expected oscillation between the confines of this descending triangle pattern.

However, while the weight of the evidence (small and mid-caps rising underneath the surface of the S&P 500 and other indices) still points to new highs in the future, there’s always a chance things don’t go our way.  As such, we always need to have a B-Plan.  An exit strategy.

The highlighted level between 2,500 and 2,570 is going to be crucial in the coming weeks.  If the market breaks below the horizontal black line (support) and stays there for much longer than a week, we could see selling accelerate across the board, including small and mid-cap stocks, which could drive the market down below the highlighted box, below which we would want to dramatically lighten up on stock exposure.

However, with positive momentum on our side and a high number of small and mid-caps printing new highs already, as long as the market breaks down below that floor, but stays in that highlighted area without falling below it, we should be in good shape for a rise to new highs on the S&P 500, Dow, and NASDAQ from that point forward.

Let me know if you have any questions at all.  In the meantime, I hope you have a wonderful weekend!

Till next time…

Adam

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* Adam Koos, CFP® is a CERTIFIED FINANCIAL PLANNERTM  Professional, as well as president and portfolio manager at Libertas Wealth Management Group, Inc., a Fee-Only Registered Investment Advisory (RIA) firm, located in Columbus, Ohio.

The opinions mentioned in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial adviser and strongly consider interviewing a fee-only financial advisory firm, prior to investing. Past performance is not guarantee of future results. Economic forecasts set forth may not develop as predicted. The views and opinions expressed in this commentary are those of Adam D. Koos, CFP® and do not represent the views of TD Ameritrade Institutional and its affiliates. Investing involves risk including loss of principal.