Financial Collapse: How Low Can We Go If the Market Bubble Pops?

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I think anyone remotely familiar with the markets can acknowledge that we are in a massive bubble—meaning valuations are extremely rich and not supported by the underlying fundamentals. Valuations have been greatly inflated thanks to the Fed—via low interest rates (now at near zero) and quantitative easing (debt monetization). This begs the question: How low can we go if the bubble pops?

This is an important question for those who consider themselves preppers. First, it provides a framework to analyze how bad the broader economy and society could get if the financial markets enter a bear market. Second, many preppers still have capital in the markets—either in personal investment portfolios or through 401Ks and/or some form of pension plan. Third, prepping—done properly—is a holistic approach. This means it involves preparedness in all aspects of life—water, food, shelter, defense, … and finances.

In this article, we are going to analyze the current market and attempt to answer that question—both from a technical and fundamental perspective. It is critical to note that this analysis is merely an attempt to define parameters and probabilities—not time or absolutes.

We believe we are in a bear market and the V-shaped “financial” recovery was just a very strong (but typical) bear rally. The first rally in a bear market is always the strongest—it sucks in more bulls (the “buy the dip,” “the trend is your friend,” and FOMO group—led by retail investors). This one was especially powerful thanks to the rapid and unprecedented response by the Fed. However, it is still just that—a bear market rally.

The technical rules for a trending market are valid (viz., buy the dip). However, one must be able to recognize when that trend and the market milieu change—either a reversal or consolidation. In this case, the signs of a reversal are present in number and agreement.

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However, trend changes can take time to develop—especially when it involves a broader topping process. In other words, we can predict a longer-term change in direction BUT we cannot precisely predict when it will take effect. The current bullish trend (or bear rally) can continue for a while. However, the technical and fundamentals all point to the fact that it IS coming to an end.

This represents the danger zone—a point when the elevator down could commence at any moment but not necessarily the next moment. It is a period where great loss can be experienced—either by hanging on too long or jumping ship too quickly. It is a time to avoid greed and rash judgement.

Again, our purpose is to illuminate how bad things could get (i.e., how low we can go) when the reversal kicks into full gear. Let’s dig and see what the technicals and fundamentals can tell us about how low the markets could go…

(Spoiler Alert: They could go pretty low… but let’s see why and low!)

Technical Analysis for the Market: How Low Can We Go?

As we noted, there are two approaches to analyzing the financial markets: technical and fundamental. First, let’s explore the technical side of things. We’ll look at short-term signals (aka stick patterns) and longer-term signals (broader patterns).

Broad Picture of the Markets: A View from 30-Thousand Feet

We find that the markets peaked in mid-February and then sold-off as fears grew about the pandemic and the economic ramifications it posed. Nearly one month later, they put in their first bottom—a culmination to the fastest and greatest drop in the history of the markets.

Technical Analysis: Initial Market Top

Since then, the markets have been in a rising wedge pattern. This pattern typically plays out as a continuation pattern—meaning the bearish trend will continue. In essence, this pattern represents a large and extended bear flag—setting up an A-B-C pattern (or even larger Elliot wave series).

We recently put in a second peak. There are several important technical characteristics (patterns) present in this secondary peak.

Short-Run Technical Patterns—Trend Change Imminent

First, it represents a potential double-top in the markets—slightly higher for the Nasdaq (a likely momentum fueled overshoot) and slightly lower for the S&P 500.

Technical Analysis | Rising Wedge and Double Top

Second, it was marked by an island top in both. This means we had a gap up that was followed by a reversing gap down—forming an isolated (island) trading range at the peak. This can be viewed as a rejection of this pricing level by the aggregate markets and, therefore, a firm top—from which the prevailing trend reverses.

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We saw this with the Nasdaq at the initial peak—marking the trend change and (initial?) leg down:

Technical Market Analysis | Island Reversal Pattern in the Nasdaq (QQQ)

It is worth noting that both the Nasdaq and the S&P 500 have mirrored this island reversal pattern at their second peaks (in the case of the Nasdaq, it could also be viewed as a shooting star or evening star):

Technical Analysis | Island Top in the S&P 500 (SPY) as well--with strong rejections in both the Nasdaq & S&P

Third, we have a failure of the rising wedge in the Nasdaq. This means the Nasdaq broke the wedge’s support trend line. The S&P 500 is riding the lower support line, trading below it but managing to close on or just above it on a daily time frame (known as a stick save).

Technical Analysis | Break of Support in the Rising Wedge

The Nasdaq demonstrated a strong break, with a subsequent failed retest of the support line.

Now, the Nasdaq’s break of support could be a false breakout… or it could be confirmed by an S&P 500 breakdown shortly. Again, there is still space and time remaining in the wedge—meaning the indices could bounce back in the short run and maintain the wedge (even pushing slightly higher).

However, the time element (which is as important—if not more important—in technical analysis) is running out. Time and price are both important—but time typically takes control. In this case, both variables point to the fact that a trend change is imminent.

Longer-Run Technical Patterns—Trend Change Underway (Bear Market Rally)

As we noted above, from a longer timescale perspective, we have a rising wedge pattern in the markets. This pattern is typically a continuation pattern—meaning, the trend that existed prior to the wedge is likely to resume. In this case, that means a continuation of bearish action. It is characterized by furthering deepening divergent highs (i.e., higher prices on lower momentum).

A wedge typically represents the midpoint of an A-B-C pattern (also referred to as an A-B-C-D pattern, depending on how you label the points), or it can lead to a larger Elliot wave pattern (also referred to as three-drive patterns), where you have three waves (or moves)—the second of which is usually the largest/strongest.

Technical Analysis | The ABC (or ABCD) Pattern & Elliot Wave (or Drive) Theory

These larger (macro) patterns are referred to as harmonic patterns, and they can get quite complex and detailed. The primary harmonic patterns are 5-point (Gartley, Butterfly, Crab, Bat, Shark and Cypher) patterns. These patterns have embedded ABC/ABCD patterns. All the price swings between these points are interrelated and have harmonic ratios based on Fibonacci.

If you are interested in learning more about harmonic patterns, we recommend reading Trade What You See: How to Profit from Pattern Recognition by Larry Pesavento and Leslie Jouflas.

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Suffice for our analysis, the markets are in a rising wedge pattern (with evidence of a potential breakdown) that is more than likely to play out to the downside.

Technical Analysis of the Financial Markets | Rising Wedge Pattern

Again, this does NOT mean this breakdown will immediately trigger a significant selloff—there is still a little time left and price could bounce and push higher one last time.

Technical Analysis | Time and Price--Still Have Room to Move

However, (1) an imminent trend change is inevitable and (2) the market would have to break the level of the two gaps that created the islands in order to reach a new high—which is clearly a very strong point of resistance. Even if it did this, it just increases the likelihood of a massive trend change (further supported by a fundamental analysis—as we will see in the next section).

So, when (not if) the markets reverse, how far is that downside risk?

Support & Target Levels—Where Could the Market (We) Be Headed?

To determine the downside risk (or final target) for the markets, we must consult two additional technical tools: resistance and Fibonacci levels.

First, we need to identify key resistance levels. Based on both short- and long-term price history, we position these levels at: 285.97, 274.75, 261.64, 244.94, and 226.19 for the S&P 500 (SPY):

Technical Analysis | S&P 500 (SPY) Support and Resistance Levels

Second, we utilize Fibonacci levels as confirmation ranges—we like to use and overlay of both the first leg and the second leg (the rising wedge) of the potential ABC pattern:

Technical Market Analysis | S&P 500 (SPY) Fibonacci Levels

This gives us a combined picture that looks like this:

Technical Analysis | Primary Price Targets for the S&P 500 (SPY)

The Fibonacci levels confirm our mid-tier resistance levels—adding weight to them.

Finally, we need to get a much broader perspective in order to identify the most likely worst-case scenario—meaning we re-test the March lows… or go lower:

Technical Analysis | Broader View & Worst-Case Targets

This gives us a worst-case lower range of between 212 and 199 on the SPY. Obviously, we could always go lower in a SHTF scenario (or momentum fueled overshoot). However, this range provides us with enough information to (a) determine the short-run impact on our portfolios and (b) help prepare us mentally for the possible market future.

The Really Big Technical Picture: Skewed Head & Shoulders Topping Pattern?

Finally, it is worth stepping back and looking at the long-duration trend picture—meaning the broader 11-year bull market trend.

When we do, we can see a potential topping pattern developing—a skewed head and shoulders pattern. Interestingly, this supports strongly supports (1) our “island reversal” assertion (with surprising accuracy), (2) our bear market rally assertion regarding the rising wedge, and (3) our broad conclusion regarding where the markets may be going—namely, down (way down).

Technical Analysis | The Broader (Long-Duration) Bull Market Trend Reveals the Formation of a Potential Head and Shoulders Topping Pattern (Skewed)

Now, we need to take a look at fundamental analysis to see if it confirms our technical forecast.

Fundamental Analysis for the Market: How Low Can We Go?

With fundamental analysis, we are evaluating the underlying fundamentals of the market rather than price action. In this case, we are going to examine valuations as a function of GDP and corporate profits.

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The market is ultimately driven by earnings (corporate profits)—which should reflect a dependent relationship with our gross domestic product. Remember, in the short run, the market is a voting machine (price action); however, in the long run, it is a weighing machine—meaning, it reflects value.

A useful measure of under(over) valuation of the market is the Shiller PE Ratio. We are currently sitting at 28.52. However, our double-tops recorded levels in excess of those recorded at the start of the Wall Street Crash of 1929 (aka the Great Market Crash) and only exceeded once in all history—the Dot-Com bubble of 1999.

Furthermore, the mean and median fall in a range of 15.8 to 16.7—meaning, the market is currently at historically high valuation and primed for a massive correction. This is the result of both falling earning and the flow of massive capital into the markets—the result of (1) historically low interest rates, (2) quantitative easing, and (3) investor FOMO.

Fundamental Analysis | Shiller PE (Valuation) Ratio for the S&P 500

In order to forecast where the markets may correct (crash?) to, we will look at historical GDP, corporate earnings, and the broad market (Wilshire 5000)—from a relative perspective (i.e., based on percentage gains and losses).

This is useful because history demonstrates a clear relationship between market valuations and GDP. Whenever the market gets ahead of its skis (i.e., gets ahead of GDP), it naturally corrects. As the following chart demonstrates, we have become massively uncoupled from our actual economic output—meaning, the market is in “nosebleed” territory when it comes to valuations and is primed for a massive correction to bring us back to a sustainable equilibrium:

Fundamental Analysis | GDP vs Wilshire 5000 Performance

The question becomes: How big will that correction be?

To answer this, we need to look at the relative spread between the broad market, GDP and corporate earnings:

Fundamental Market Analysis | Relative Performance of the Wilshire 5000, GDP, and Corporate Profits (Earnings): Targets for the S&P 500 (SPY)

This analysis indicates that—with an expected 40% contraction of GDP in Q2 (could be worse)—we should expect the markets to contract between 34 and 39 percent. For the SPY (S&P 500), this would correspond to a level of between $222 (best case) and $206 (worst case).

This range corresponds very well to our technical analysis—increasing our confidence in this market target.

S&P 500 (SPY) Price Targets: Technical vs Fundamental Analysis (How Low Can We Go?)

For more fundamental analysis regarding the financial markets, make sure you read our powerful article Priced for Perfection: Mother of All Financial Bubbles… Or Market Has It Right?

Conclusion

How low can we go? The analysis indicates the financial markets are headed for a massive correction. Our price target for the SPY is somewhere in the range of $199 to $222.

However, this does not mean we can’t exceed this range on a short-run basis due to a momentum-fueled overshoot (e.g., due to extreme capitulation). However, we would expect the market to stabilize somewhere within this range.

One really BIG caveat: This is predicated on a 40% contraction in GDP for Q2, followed by slow (but steady) improvement over the next 2-3 years. IF the economic situation continues to deteriorate, then we will go lower. A collapse in our socio-economic system would obviously trigger a financial collapse—one reflected in the markets.

Thus, things could get much worse than even these projections. Again, these projections require that we maintain (hold) what we have. If the pandemic, social, or geo-political environment should get worse—further impacting the economy, then all bets are off!

We continue to maintain our judgment that the broader market trend reversed in March—meaning, we are in a bear market and the recent rally (i.e., the rising wedge) was nothing more than a very strong bear market rally—a perfect bull trap that sucked in a tremendous amount of “dumb” money (i.e., retail investor capital).

We take a holistic approach to prepping—one that reinforces the need to achieve preparedness in all areas of life. That includes your personal finances.

Be prepared for a massive correction in the markets—one that could expand into an outright collapse if things don’t go perfectly in our economy and society (not to mention the global economy and geo-political environment).

Be very cautious. Diversify (especially into tangible, real assets). Think very long term (or don’t invest). And if you are trading, I would suggest transitioning to a “sell the rip” approach from a “buy the dip” mentality.

Finally, be very careful with timing. We may know where the market “wants” to go. However, it is much harder to pin down the “when.” There is still time remaining on the clock. We know the elevator ride down is coming… but it can sometimes take longer for it to arrive than we think.

It has wisely been noted that the market can remain wrong far longer than you can remain solvent!

If you’re interested in learning more about long-term investing, we highly encourage you to visit my investing website Wicked Capital (Wicked.Capital).

Wicked Capital

Sources:

WILSHIRE 5000 PRICE INDEX (WILL5000PR)

Wilshire Associates, Wilshire 5000 Price Index [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR, June 12, 2020.

GROSS DOMESTIC PRODUCT (GDP)

U.S. Bureau of Economic Analysis, Gross Domestic Product [GDP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDP, June 12, 2020.

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