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Aug. 1, 2011, 12:00 a.m. EDT
By Michael Sincere
MIAMI (MarketWatch) "” For more than two years, people have been warning of an impending stock-market crash. Those who listened buried their money in short-term bonds or cash and missed out on one of the greatest comebacks in market history.
Even with all the problems in the world, the resilient market continues to go higher. Nevertheless, based on recent market action and interviews I've conducted with traders, I believe there's an increased chance the market will drop 10% or 15% before it rises 10% or 15%.
Even as the debt-limit crisis dominates U.S. attention, next week's calendar is packed with major corporate earnings and key economic indicators. Sara Sjolin breaks down the outlook with Markets Hub host Paul Vigna.
The purpose of this article is to help traders and investors understand the clues and psychological characteristics that often precede a market crash. No one can predict the day or time, but if you pay attention, you can recognize the signals.
This comes from "How To Make Money In Stocks" by Investor's Business Daily founder and Chairman William J. O'Neil. If leading stocks such as Priceline.com Inc. /quotes/zigman/90481/quotes/nls/pcln PCLN -1.17% , Amazon.com Inc. /quotes/zigman/63011/quotes/nls/amzn AMZN -1.82% and Apple Inc. /quotes/zigman/68270/quotes/nls/aapl AAPL +0.78% start to break down and fall, this signals that the market is weakening and that the market's dynamics are changing for the worse.
In addition, after the recent two-year bull market, expect choppy conditions moving forward, which increases the risk there could be a correction or crash. Bottom line: Pay attention to leading stocks.
Historically, most crashes occur in September and October. If you're in the stock market, you must be acutely aware of these two months and be prepared for potential crashes. Because traders with trigger fingers know about the September-October curse, fear often increases during these two volatile months.
Who can forget the crazy days of 1999 when Internet stocks like Qualcomm Inc. /quotes/zigman/77257/quotes/nls/qcom QCOM -2.01% went up by 100 or more points in a day? My favorite example is the 17th-century tulip mania, when thousands of Dutch people paid more than $200,000 (using today's exchange rate) for a single tulip bulb.
Although the current market environment is not that speculative, there are clues that some stocks are flying into the stratosphere. "You could make the case that the current valuations of Twitter, Facebook, LinkedIn /quotes/zigman/5131883/quotes/nls/lnkd LNKD +1.20% , Pandora /quotes/zigman/5419837/quotes/nls/p P -4.57% and Zillow /quotes/zigman/5930210/quotes/nls/z Z -5.21% are extreme," says Timothy Sykes, professional trader and short-seller. "These companies have amazing business models and people think their businesses will never stop growing, but that is just bull. The odds are that Facebook's valuation will see $60 billion valuation (currently $80 billion) before it sees $120 billion."
When the media begin to report that the market has been falling for a record number of days (i.e. "down for fifth straight session"), it makes people anxious. "It causes people to want to exit en masse," says Sykes, "like a run on the bank. They are being influenced by fear."
Although the media don't create news, the cumulative effect of the negative news creates anxiety and fear. It might not take much for millions of investors to throw in the towel and sell. Read my interview with Timothy Sykes on the characteristics and clues that precede market crashes.
In addition to the above clues, it's also important to study crash characteristics.
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