Market Crashes

Scientific Prediction Is Not Market Timing: Separating Crashes From Corrections

The buy-and-hold doctrine insists that since no one can predict the future, it is futile to try to time the market. Investors recite this mantra to justify their fear of missing gains during hypothetical recoveries, but using established historical patterns as a basis for planning is not an attempt at market timing. It is a prudent risk-management technique that has the potential to shield investments through corrections and crashes.

Moving Averages: Separating Crashes From Corrections

The ability to tell a crash from a correction is among the most critical skills a money manager can possess. When investors mistake crashes for corrections, they run the risk of buying in at what they think is going to be the bottom, when the bottom is actually a long way off. Moving average indicators provide the historical context required to determine whether a downturn is a correction or a crash.

The Oil Crash: A Lesson on Buying Signals

At the beginning of 2015, many investors began buying oil. A steep crash that began toward the end of 2014 had sent the price of oil plummeting from the low $90s to the low $50s, but at the start of 2015, it appeared that recovery was on the horizon.

The price had stopped falling at around $53. It began ticking upwards towards $60. Then past $60. Then to $64. Investors felt that the worst was over.

The worst was not over. Those who got in at $64 got crushed. Oil prices tanked. By the end of January, 2016, oil was trading at less than $27 a barrel—a 13-year low.

Managers who understood moving average indicators had warned their clients not to buy at $64—and if they did, to be prepared to dump far more money in at the actual bottom, which they knew was a long way off. Those who analyzed moving averages had seen a glaring red flag that was based in factual numbers, not feelings, thoughts or assumptions.

The Death Cross

The short-term moving average (50 days) mirrors any data set (in this case, the price of oil) much more closely than the long-term moving average (200 days). When the short-term moving average and the data set dip below the long-term moving average, this indicates that a correction has been triggered.

Dramatically referred to by the media as the "death cross," this downturn could be a correction (any loss under 19.8 percent), or it could be the start of a major crash (any loss greater than 19.8 percent).

A death cross appeared in the end of 2013, but the short-term moving average quickly took its rightful place above the long-term moving average, and oil fell only from $88 to $82 — a mild correction with a drop of less than 10 percent.

So what made the ensuing oil crash so devastating, and what signal was missed by those who got in at $64? Moving average analysis reveals that the 50-day average hadn't yet re-intersected with the 200-day moving average. That intersection was the buy signal that never happened. The buyers entered on a head fake and lost nearly half their money based on a feeling that wasn't backed by a buy signal.

Take a look at the oil chart:

Sources: Bloomberg, Squire Asset Management

If they had bought and held when oil was near $140, they would have lost more than 90 percent.

There have been 70 death crosses between 1896 and 2010, or one every two years. But the clarity of this useful indicator is lost in the clutter of financial industry misinformation. Many financial advisers, in fact, don't even include moving averages anywhere in their charts because their only concern is mutual funds. Moving averages, however, reveal the buy signals—or the lack of buy signals—that take the guesswork out of identifying corrections and avoiding crashes.

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