Blow-Off Pattern Recognition

As noted in Part 1, historically, blow-patterns in stock markets share many characteristics. One of them is a shifting monetary backdrop, which becomes more hostile just as prices begin to rise at an accelerated pace, the other is the psychological backdrop to the move, which entails growing pressure on the remaining skeptics and helps investors to rationalize their exposure to overvalued markets. In addition to this, the chart patterns of stock indexes before and after blow-off moves are displaying noteworthy similarities as well.

“On Margin” – a late 1929 cartoon illustrating the widespread obsession with the stock market at the time. There was just a 10% margin requirement, i.e., investors could leverage their capital at a ratio of 10:1. The demand for margin credit was so strong, that it pushed call money lending rates in New York up quite noticeably. This in turn made it increasingly difficult to maintain extremely leveraged positions.

Why do we assume the current move is a speculative blow-off and not just another “normal” up-leg? The main reasons are the speed and size of the move, the fact that it happens at the tail end of a very sizable advance that has already lasted a full eight years, the chart pattern, and above all, valuations.

The chart below was recently posted by John Hussman – it shows the evolution of five different valuation parameters over the entire post WW2 era. As an aside to this: he estimates that another 12% advance would push SPX valuations to the extremes recorded in 2000. We already seem to have passed the 1929 threshold recently, so this is the only record that remains to be aimed for (that does not mean one should expect it to be reached).

Five different stock market valuation parameters since 1947, via John Hussman. He quotes Benjamin Graham in this context:  “Speculators often prosper through ignorance; it is a cliche that in a roaring bull market, knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”

As you might expect, we can neither predict when the blow-off move will end, nor how far it will go. A rule of thumb worth keeping in mind regarding the pattern is that blow-off moves tend to survive at least one correction. For example, the Nasdaq had an A-B-C shaped correction in January of 2000, approximately in the middle of the blow-off rally.

The 1999 – 2000 blow-off pattern in the Nasdaq: in early 2000 the rally was interrupted by an a-b-c type correction. At the time there were fears about the “Y2K computer bug”, which turned out to be completely unfounded – but they gave the Fed an excuse to open the liquidity spigot in late 1999 in spite of the fact that a mild tightening cycle was underway. The surfeit of short term liquidity provided an extra boost to the blow-off rally.

The Shanghai Composite had a similar shaped correction in May-June 2007, which took place at a slightly earlier point in the overall move – the final leg of the rally went further and lasted a bit longer than in the Nasdaq. Other than that, the advance looks almost like a spitting image of the Nasdaq blow-off eight years earlier:

Generally the SSEC tends to produce patterns that are slightly different from those observed in other, much longer established stock markets. This is probably due to the much stronger and more direct influence China’s government exerts on the Shanghai stock market (this influence has begun to wane though, as the difficulties the government experienced in trying to get control of the 2015 decline illustrated. Ultimately, markets cannot be “controlled”). Once the desired trend has been set into motion though and speculators begin to herd, pattern self-similarity reasserts itself.

Note that the shape of the correction interrupting a blow-off move is not always exactly the same. For example, the Nikkei had only two small down months in June and August of 1989, interrupted by a strong advance in July. In principle this was also an A-B-C shaped correction, but if had an upward skew, it was a “running correction” that almost doesn’t feel like a corrective pattern while it plays out.

The DJIA in the 1920s exhibited a few peculiarities as well. There was a strong, but volatile rally in the DJIA during the Gilded Age between 1861 and 1906. Then the market started to go sideways, fluctuating in a wide range between roughly 55 and 100 points for 20 years. When the 100 level was finally decisively breached in 1925, an accelerating rally began.