It’s October. Is it time for a stock market crash?

October 4, 2010, 8:56 PM UTC

There are some big macroeconomic signs that a U.S. stock market crash could be coming, but it’s important to keep an eye on how October surprises play out around the globe.

By Keith R. McCullough, contributor

Lately there seems to have been an almost perfect storm of economic and political warning signs — both domestic and global — that point me towards one conclusion: the stock market is due for a crash. However, before we look at these big warning signs, let’s take a step back. There’s a growing group of signals in the global macro risk-management model that we use at my research firm, Hedgeye, which indicate that an abrupt 1-3 day U.S. stock market crash in October is probable. To be clear, I’m not saying it’s likely, but I am saying it’s probable. There is a difference.

Probable means predictable. Likely means there’s a better than 50% chance. What I see here is a 33% chance that a crash could happen. For the sake of accountability, let me explain what it would take for a
Heavier Crash
to occur instead. We would need to see:

  • the S&P 500 get squeezed one more time in the next few weeks to a price north of 1164;
  • volatility (VIX) get oversold toward 20; and
  • the world’s “reserve currency” (The U.S. Dollar) lose its credibility.

The bad news is that all three of these factors are already in motion, big time. Since late August the SP500 is up 10%, the VIX is down over 20%, and the U.S. Dollar has been crushed to lower-intermediate-term lows. If all three trends continue, we could have a serious short-term problem in the U.S. stock market.

Measuring time and space is a critical aspect of my profession. As a chaos theorist, I don’t expect to be taken seriously by those gurus who advocate buying stocks with cheap P/E ratios, nor do I want to be. If those kinds of investors didn’t see the events of 2008 coming, I don’t see why they’d see this coming now. Evolving the risk-management process is a dynamic exercise. Hedgeye changes as the market’s ecosystem does.

What Would a Heavier Crash Look and Feel Like?

The most probable scenario is a 1-3 day correction on the order of -5.4% to -6.9%. The least probable scenario in my model is an “October 1987”-type day (down -23%), but again, I still consider that improbable, at least for now.

“Now,” you might object, “Wouldn’t the smaller drop be called a correction rather than a crash?” Normally, yes, but, the market is of course based not just on prices, but on expectations of future prices. And expectations are running hot. Last week’s Bullish to Bearish Survey from Institutional Investor shows a +2400 basis point swing to the bullish side since the week U.S. stocks closed at their late August lows. Because the market is turning bullish right before a possible crash, this could feel like a
Heavier Crash
than it might be considered in strictly nominal terms.

A global set of problems

Looking at some broader domestic trends, we note that the U.S. consumer confidence index is sinking again, going down to 48.5 for September versus 53.2 for August.  The possibility of a “Republican House” also recently found its way onto the cover of Barron’s, stoking investors’ hopes for a favorable political environment. And of course, M&A rumors haven’t been this frothy since September of 2007. We’ve counted 67 alleged “takeouts” that haven’t occurred.

In terms of the U.S. Dollar Index — it’s down now for the 15th of the last 18 weeks, and yet Washington doesn’t seem to care or perhaps is out bullets. And U.S. Treasury Yields are in what technical investors call a “bearish formation,” another bad signal for U.S. economic growth.

Looking to Asia, Chinese stocks have closed down for several stretches of days over the last weeks, and Japanese stocks continue to be down in recent days, down 10% for 2010 to-date. Japanese exports (August) have been hammered sequentially down to +15.3% y/y August vs. +23.5% y/y in July. Furthermore, Japan’s bureaucrats are calling for another $4.6 trillion Yen stimulus package and proposing to pay for it by raising taxes this time. (My colleague Darius Dale recently explained Japan’s long term problems for Fortune.)

In Europe, credit default swap spreads continues to get wider (meaning investors are fearing increased risk of defaults), on the heels of Greek equities being down -13% since the first week of September. The Russian deficit risk of default is also on the rise since Medvedev fired the longtime mayor of Moscow, and Romania’s Interior Minister just resigned in the face of that country’s austerity program.

Finally, looking to the near east, Sri Lanka is now issuing $6 billion of sovereign debt, and markets there are inexplicably cheering it on. Somehow, even poor old Dubai seems to be saying to the markets, “We are back.” All in all it’s not just U.S. factors but a host of problems abroad, that make this crash a probable event.

Here, I need to acknowledge that there are plenty of bullish data points on the other side of this (there better be, with the SP500 up +9.6% in a straight line from its August 26th low until today), but I can still only count only about a dozen indicators that really matter—not nearly enough for me to hold off warning investors and our clients to buckle up.

It’s now October. The S&P 500 hasn’t touched 1164 yet, and it’s slightly down today, so, I’m not short it just yet. As I wrote at the top of this article, there’s only a 33% chance, in my mind, that the worst will come to pass. Keeping an eye on all of these indicators and how they change over the next weeks will be very important in figuring out whether October will really hold a surprise in the stock market.

— Keith R. McCullough is CEO of Hedgeye, a research firm based in New Haven, Conn.

More from Fortune: