Is the Stock Market Crashing?

With the consumer price index (CPI) jumping to 8.6% in May 2022 — above the 8.3% reading in April and higher than analysts’ consensus forecast — Wall Street lost all pretense of sparking another robust rally. Instead, many investors ran to the relative safety of the U.S. dollar, fearful of a stock market crash and thus the start of a recession.

Logically, rising costs are anathema to equity valuations as they reduce real earnings because of a drought to consumer spending. While the backdrop may be ominous, it’s also important to approach these choppy waters with hard data, not wayward emotions.

Is the Stock Market Crashing?

Let’s get right into the question that’s on every investor’s mind: is the stock market crashing? In a word, yes. From the start of January to the closing bell of June 16, 2022, the benchmark S&P 500 index dropped almost 24% of value. With analysts unofficially regarding a 20% peak-to-trough decline as confirmation of a bear market cycle, it would be disingenuous not to consider the recent erosion as a market crash.

Nevertheless, this basic conclusion is not the equivalent of a green light to hoard rice, beans and ammunition. Rather, investors must understand that the free market never operates in a perfectly linear fashion. Indeed, supply and demand in the stock market is essentially the culmination of human emotions whittled down to a binary output: buy or sell.

However, the real calculus begins when attempting to decipher at which price point the binary setup mentioned above begins skewing beyond the 50/50 equilibrium; that is, what is the trigger that inspires investors sitting on the fence to commit to one of two actions?

Here, University of International Business and Economics’ Jiangze Bian, Chicago Booth’s Zhiguo He, Yale’s Kelly Shue and Tsinghua University’s Hao Zhou noted that economists long theorized that “leveraged-induced fire sales” lit the fuse for the U.S. stock market crash of 1929. But without empirical evidence, the proposal was a barstool missing a leg.

However, through studying the equity account risk profile of investors engaged in China’s stock market, the researchers discovered that “retail investors rapidly unload holdings as leverage limits are approached or exceeded.” In other words, when the implied risk of holding onto publicly traded securities is greater than the potential reward, investors take the rational approach and run to cash (i.e., sell stocks).

While it’s impossible to cover the full spectrum of human motivations, the evolution of a stock market crash can be roughly categorized into two main catalysts: kinetic and fundamental. Under the former category, investors might react viscerally to sharp swings in valuation, thus panicking out of their holdings. In the latter category, investors strategically or deliberately respond to core data — such as looming threats of a recession — as their north star.

In a somewhat pejorative sense, Wall Street analysts often refer to the “smart money” and the “dumb money.” Dumb money is reactive, chasing the whims of the moment. The smart money is decisive, having conducted ample research beforehand to engender the confidence necessary to move pieces on the board under a rationally concocted framework.

Ultimately, the question isn’t so much about whether or not the stock market is crashing. Frankly, markets rise, markets fall. The critical arbiter that often determines success or failure is the preparation to respond effectively.

What is the CBOE Volatility Index?

Colloquially referenced as the fear index or fear gauge, the CBOE Volatility Index is a popular benchmark to determine the implied volatility of the stock market. Calculated and disseminated on a real-time basis by the Chicago Board Options Exchange, this barometer — which is perhaps best known by its ticker symbol VIX — incorporates pricing dynamics within S&P 500 index options.

Specifically, the VIX represents the equity sector’s expectations for volatility (downside price movements) over the next 30 days. Mainly, investors analyze the VIX to determine the magnitude of risk or fear in the stock market. Although the fear index may be an applicable tool for short-term swing traders, analysts and patient buy-and-hold investors often pull up historical VIX readings to determine probabilities of game-changing events such as a recession.

Peruse mainstream media reports about a potential stock market crash, and you’ll often see exhortations to watch whether the VIX reaches a certain milestone, with the implication that certain threshold breaches imply troubled waters ahead. But just how much emphasis should investors place on the CBOE Volatility Index?

Likely, the best answer is to never use any one barometer as your exclusive guiding compass. Though the VIX certainly presents interesting data, its utility as a predictive tool is debatable. At the most elemental assessment, if the VIX was even modestly prescient — meaning a better than a coin toss odds of predicting future events — all traders would eventually use the metric to pick up easy profits.

As well, the VIX is the output of a mathematical formula, forcing an interpretive profile. Benzinga contributor Bob Lang hit the nail on the head when he stated, “For most long-term investors, it's not as much to hit the exits when volatility rises, rather it's an understanding of what is actually happening - panic and hysteria.  Big moves in the VIX are often temporary and only last for a period of days, and then it falls.”

In short, the VIX is useful, but don’t put all your eggs in this basket.

Are We in a Recession?

The next question that everyone is wondering about is, are we in a recession? Technically, the answer is no, but the substance of this response involves complexities. According to a recent article by The Wall Street Journal, no precise definition of a recession exists. In fact, the National Bureau of Economic Research (NBER) has the unenviable task of being the bearer of bad news.

Per the agency’s definition, a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” However, even the NBER is not consistent with its framework. Glaringly, it declared the downturn immediately following the COVID-19 disruption as a recession even though it only lasted a quarter, based on information provided by the U.S. Bureau of Economic Analysis.

While investors are inherently curious about whether the current downturn qualifies as a recession, it’s vital to keep in mind that an official declaration of such has almost no value to those seeking profitable trades in the capital markets. Once the public realizes that an economic downturn is in the books, the equities sector has already priced in this reality.

For instance, last year’s incident involving the collision of the USS Connecticut with an uncharted seamount (underwater mountain) could have been avoided had the commanding officer of the submarine turned on its sonar. But doing so would alert surrounding warships to the Connecticut’s presence, thus rendering the whole concept of “silent service” moot.

It’s the exact same principle when discussing a recession as it relates to a possible stock market crash. You need to make a move before an event happens to truly capitalize on it — and this necessarily involves taking a shot in the dark.

Market Indicators to Watch for

At its root, any investment that you make involves risk. Bluntly speaking, if a future market outcome was guaranteed, all rational actors would place their orders accordingly. At the same time, not knowing how circumstances will transpire represents the basis of profitability. Usually, the greater the risk (or the magnitude of the underlying ambiguity), the greater the reward.

But this dynamic doesn’t necessarily mean that you must fly blind. In contrast, you can deploy certain market indicators to better determine the possibility of a stock market crash and an incoming recession.

• Moving averages: Analysts will often refer to the “death cross” where the 50-day moving average of the S&P 500 index dips below its 200 DMA. While this demarcation is interesting, investors should also note how the price action responds as it approaches these commonly watched averages. Following a death cross signal, should the S&P 500’s 50 DMA act as a resistance barrier to upside momentum, this may be a clue that the bears have control of the market.
• Unusual options activity: Everyday, traders pour into the derivatives market and place bullish or bearish orders on options contracts, which are financial instruments that give owners the right but not the obligation to purchase the underlying asset. But in certain cases, the ratio between the volume and open interest of specific options exceeds normal boundaries. Investors can reference these unusual dynamics as a real-time gauge regarding what other traders are doing.
• Velocity of money stock: An economic indicator as opposed to a market indicator, the velocity of money stock (specifically, the M2 money stock) is one of the most important yet underappreciated warning signs about a possible recession. Essentially, this metric represents the rate at which each unit of currency circulates throughout the economy. Given that the reading is near all-time lows, the Federal Reserve’s hawkish monetary policy absolutely risks sending the economy into recession as a low money velocity is necessarily deflationary.

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