Updated: Aug 6, 2019
Recognise the chart in Figure 1? The axes should give you a clue.
That’s right, it’s the roaring 20s! And what a decade it was for swing band members, aviation enthusiasts, movie stars, gangsters and, well, pretty much everybody. It was a time when Wall Street traders in dark, pinstripe suits and fedoras could make a killing by picking stocks with such whimsically arbitrary strategies as favouring companies whose executives had the longest beards. Then they could spend the rest of the day complimenting each other’s stupendously profitable, and intelligent, stock selection techniques until 5 o’clock, at which point they could high-five their way to the local speakeasy to Charleston the night away. The ticker tape never had any bad news. Everybody who was buying stocks was making money, and everybody was buying stocks. In the 8 years leading up to August 1929, the Dow, shown in figure 1, had rallied over 500%. By 1929, investors were twice as wealthy as they were only 18 months earlier! Life was good. It was very good. It was too good to last.
October 29th, 1929, dubbed “Black Tuesday”, shocked America and the world. Investors sold stocks hysterically as panic gripped the banks. The Dow plunged 12% on that day. It was only the beginning. What followed was the most devastating stock market disaster in history.
Figure 2 shows the immediate aftermath. Stock prices fell like a fat skydiver without a parachute. It took just over two years to erase the entire decade’s worth of gains. The onslaught of relentless selling subsided in 1932, but not before wiping 89% of the Dow’s market value. Goodbye Roaring 20s, hello depressing 30s. It’s difficult to comprehend an almost 90% fall in stock prices today. Even the financial crisis of 2008 saw the Dow fall by only 54%, a meagre hiccup by the 1929 investor’s standards.
The crash came as a huge shock, but could it have been predicted? Did the chart leave clues as to what was about to happen? Analysis of this chart using only data that was available at the time reveals some valuable lessons. This article examines only the Dow Jones.
By May of 1929, 5 months before the final high, analysts who were charting the market would have been looking at something very similar to figure 3. They could have identified that support for this rally is tracing a parabolic curve, also shown in figure 3. Of course, parabolic moves have limited life spans and a tendency to terminate rather abruptly. Crucially, the way to think about the curve is that up to this point, price has been able to keep above the curve. As the curve’s gradient approaches infinity, at some point the price will fail to keep up and fall through support.
Figure 4 shows the same chart 5 months later, when price breaks through the curve with the most recent strong black candle pointed to by the red arrow. When the market breaks through a parabolic support that has sustained a rally of this scale for a decade, that is a hint that things could be about to turn ugly.
Now, the market didn’t just break support. It powered through it with the most bearish month of the entire decade. In fact, the real body of this candle is the joint largest of the entire rally, rivalled only by that strong bullish candle indicated to by the green arrow. Breaking through support with one of the strongest candles of the entire rally is a flashing red light to those who choose to acknowledge it. This single candle is telling you to brace yourself because this rally just ended.
Look at the Relative Strength Index for this chart in figure 5.
The downward sloping red line on the RSI shows a divergence. The vertical dotted line marks where the new high is created in price. At the same time, the RSI is unable to break above into a new high. When oscillators stop tracking price action, i.e there is a new price extreme in price action which doesn’t occur on oscillators, the trend is probably running out of steam.
Between the support break on the mammoth bearish Marubozu candle and the RSI divergence, the market left clues that the rally was over early enough to get out relatively unscathed. As figure 6 shows, these clues all appeared at the market high. Banking your profits here would have saved you from financial ruin had you been trading at the time. You should not have needed more confirmation, but if you did, the next candle was a monster and sent shockwaves through economies around the world.
Analysis of this chart is particularly interesting when one considers that the very same data was available to 1920s analysts. Of course, their inability to foresee the crash can be attributed to the lack of technology and technical research. Charting wasn't popular because it had to be done by hand. All oscillator indicators would have been very difficult and time consuming to calculate and plot. Very few traders understood technical analysis which was in its infancy as a science, barely extending beyond Dow Theory.
Today I can view decades of historic data with hundreds of complex indicators in minutes on a computer, and read a reasonably sized library's worth of books exploring analysis techniques. What excuse have today’s analysts for being blindsided by crashes which develop for years right under their noses?
Learn from history that even the greatest rallies do not last forever. Market conditions can metamorphosise from intensely bullish to intensely bearish very quickly, usually undetected by the masses. Consider Newton’s 3rd Law of Motion which states that for every action, there is an equal and opposite reaction. The greater the action, the greater the reaction; the greater the boom, the greater the bust.
Perhaps the greatest forewarning of the Wall Street Crash came from neither technical nor fundamental analysis. The clearest and most worrisome indication that trouble lay ahead may have been mass complacency. When those traders in dark pinstripe suits and fedoras having a blast down at the speakeasy became so euphoric with their profits that they forgot entirely that markets can move downwards too, it became an inevitability. Should you ever find yourself in the unfortunate situation where a line of financial advisors is giddily telling you that stocks are going to the moon mid-conga, think of the Wall Street Crash. Excessive exuberance is a dangerous sentiment for markets. A little cynicism will serve you well.