Warnings of an impending stock market crash
Pattern matching can be useful if the results are evaluated in the proper context. Usually, visual pattern matching is misleading; the human eye is not very good at calculating the actual correlations.
Charts have recently emerged in blogs and financial social media which, according to their editors, shows a high degree of similarity between the price action in the S&P 500 Futures (SPX) this year from the all-time high on January 3 and the price action on October 19, 2009, both spanning 147 trading days. I reproduced the table below.
The black line represents the closing price of the S&P 500 through August 3, 2022. The orange line represents the index’s closing prices from the high on October 9, 2007 and spanning the same number of days, 147 in total.
Visually, the two price sets look very similar. However, the 21-day average correlation with a 0 lag of daily returns is +0.04, i.e. the two series are uncorrelated.
Those who argue that the chart reflects a great similarity in price action between 2007 and this year ignore the correlation, or even calculate it, and focus on visual trends. According to them, the two models are similar. Beliefs are hard to refute.
Below is the chart of the S&P 500 with more details on price action since the 2007 high.
The market top occurred on October 10, 2007, based on the closing price. The index reached an intermediate low on March 10, 2008 and after 147 days, on May 8, 2008, it had gained 11.4%. The current gain after the June 17, 2022 low is 13.3%.
In 2008, the market rebound continued until May 19, for a gain of 14.04%, and thereafter a crash began which took the index to new lows.
Based on the May 19, 2008 high, the pattern corresponding to the current chart indicates about 7 more days to a high and then the start of another correction to new lows. This, at least, is the main argument for the pattern-matching of the price action of 2007 and 2022, as presented in blogs and social media posts.
Pattern matching is not enough
The fundamentals of 2008 were different from the fundamentals of this year. In 2008 there was a financial crisis that culminated in September with the bankruptcy of Lehman Brothers. This year, there is no financial crisis, but there are inflation and supply problems. However, in July 2008, the CRB index was much higher than it is now and inflation was at a respectable 5.5%. Additionally, the price of WTI Crude Oil was around $144 from just under $90 on August 4, 2022. CRB, WTI and CPI levels are shown in the chart below.
In other words, the fundamental conditions in 2008 were much worse than what we have now. If conditions worsen, a reversal to new lows in stocks is possible. But with improving commodity prices, inflation and falling bond yields, it is likely that the pattern matching from 2008 will be partial.
Price action alone is insufficient to predict future price trends. Fundamentals are also important, and in 2008 economic conditions were much worse than they are now. If economic conditions deteriorate, a stock market reversal to new lows may occur, but at this point consolidation is the most likely path.