Just a Little Avalanche or an Implosion?

A few years ago, we briefly discussed the dynamics of sand piles in these pages, which are a special field of study in mathematics and physics (mathematically inclined readers can take a look at two papers on the subject here: ”Driving Sandpiles to Criticality and Beyond “ (PDF) and  ‘Games on Line Graphs and Sand Piles “(PDF) – unfortunately two other studies that used to be available have in the meantime disappeared from the inter-tubes).

Waiting to crumble: a giant sand dune in the Namib desert.

What makes sand piles interesting is the usually seamless transition from seeming stability to sudden collapse. Grains can be added to a sand pile one at a time for quite some time without disturbing its stability – it simply keeps growing. However, eventually a point is reached when one grain too many is added and an avalanche or even a complete collapse of the sand pile will ensue.

Despite their lack of purposive behavior, sand piles serve as a good metaphor for how asset bubbles usually end. Seemingly out of the blue, and with no clearly definable trigger event. All one can say with certainty is that instability within the pile (or bubble market) has increased over time, and that in the end, all it took was a superficially insignificant event or decision to trigger the reversal of the low-volatility growth everybody was becoming accustomed to.

In financial markets, this is usually preceded by a period of liquidity slowly but surely drying up as the monetary backdrop tightens and becomes more hostile. The worse the state of the economy’s pool of real funding is when this happens, the more profound the effects on financial markets and eventually the economy should be expected to be.

What concerns us here is the question of whether we have just seen a little “run-of-the-mill avalanche”, or if something more sinister lurks underneath the still well-entrenched complacency in the stock market.

Below is a chart comparing the DJIA, NDX and the NYA (roughly the “middling”, “strongest” and “weakest” performers). We have annotated a number of recent daily candles on the DJIA chart. With a hat tip to Robert Prechter of EWI, certain patterns and sequences of daily candles have been historically observed dead ahead of major panic selling episodes, and just such a sequence actually recurred before the beginning of this week.

Given the recovery over the past three trading days, the probability of a true panic sell-off has receded markedly, but it may not be completely off the table just yet. This is inter alia indicated by the continuing strong divergence between the broader market and “leading benchmarks” such as DJIA, SPX and NDX. Obviously, the more prominent averages and indexes are also the psychologically more important ones, so the focus should be on their performance.

Interestingly, the DJIA is currently in the technically strongest condition relative to the “pre-panic” pattern of daily candles, while NDX and NYA continue to look very vulnerable. Even the SPX looks not all that convincing, while the Russell 2000 Index (RUT) is an ongoing disaster area – albeit one that has received a strong boost over the past few days. The latter is usually a positive signal for the overall market, as RUT has been a leading indicator for both downside and upside moves for several years.