Here is a Possible Crash Scenario for the sp500

Here at BestOnlineTrades we like to consider a realm of possibilities for the market at any one time.  Sometimes they are bullish, sometimes they are bearish, and sometimes there exists a very remote possibility of a stock market crash.

So, after reviewing a few charts of the sp500 in the current time frame and the 1987 time frame and then also the XLF financials ETF, we see that there is a possible window for a crash to develop. 

These types of setups can occur a few times every few years and 99% of the time they fail and do not lead to the massive volatility of a stock market crash.  Still, I like to display and consider possibilities, but am well aware that bearish expectation must be kept under control and ‘tempered’ significantly depending on price action developments.

In some cases a posting like this can be a strong contrary signal!  (in other words meaning that we may have hit bottom).

However at this time I do not see much expectation for a big drop in the market.  In fact when we get a reactionary rally back up to the old 52 week highs, it tends to really discourage the bears and short sellers and squeezes them out, sometimes leading to a new decline that becomes very persistent because of their lack of participation and short covering.

I think it important to recognize that the Japanese Nikkei or EWJ already DID crash a few weeks ago between March 7 and March 15, 2011.  So we are in a time frame now where we have already seen one crash.  Of course in America we feel that we area immune to everything and can weather any storm, most of the time anyway.

The Nikkei plunge also shows that crashes do not always have to occur in September or October.  In fact they are likely to catch people more off guard if they occur in a seemingly innocent month like April or May.

The chart above shows the sp500, the XLF and the sp500 1987 time frame.  The structure of a crash is typically a first bearish decline on HEAVY volume that marks the first low, THEN, a ‘disbelief’ rally, usually in the form of a rising wedge on low volume that kills all the bears and shorts.. and then after that a slow initial drift down, with limited short covering that accelerates into a vertical drop, or crash.

The similarities are there right now.  RSI hit 60 on this reaction rally. On the XLF we rallied in rising wedge form to the Fibonacci 61.8% retracement similar to what occurred in 1987.  The sp500 however retraced almost to a new 52 week high, but did not quite make it.

The rising wedge sometimes serves as an overbought catapult for the new vertical decline down.

I do not expect this scenario to play out simply because of the typical low probability of such an event occurring.  But I will at least keep it in my back of my mind in case we start to see more pattern similarity confirm the chart above.

The crash of 1987 was unique in that the crash portion occurred very rapidly within 10 trading days with only 1 up day in between.

The only way I can see this happening again is if it follows that similar ‘shock and awe’ type pattern with maybe only 1 or 2 up days on a persistent vertical decline.

Note: every time in the past when I have done crash similarity analysis, it has never actually led to a real crash.  Although I would say that I was long the TZA before and during the May 6, 2010 flash crash.