The 5 Warning Signs Of A Looming Stock Market Crash
It’s hard for someone to accurately predict when a stock market crash is likely to happen. However, there are some experts who have been able to accurately tell this. If you are an investor, there are various things you should know that have happened during previous market crashes. If you notice these things happening, it could be an indication of a stock market crash. This includes if there is a high level of margin debt, lots of mergers and acquisitions taking place and an overheated IPO market. Other technical considerations include a lower than normal VIX reading for a prolonged period of time.
Stock Market Crashes Timeline
There are a number of stock market crashes that have taken place over the years such as the stock market crash of 1929. The most recent is the one that took place in 2008. In most instances, market crashes are usually followed by a recession. During recessions, economic growth slows down a lot.
After every crash, a new set of financial regulations are usually put in place in order to minimize the chances of another crash happening. However, even with these new regulations, it’s generally hard to predict how the market would go. This is because there is a constant risk, which can be hard to completely avoid. In most cases, when you invest in the stock market, chances are that your investment will go up with time. However, you should always be aware that there’s a possibility of a crash happening. That’s why all your investments should not be in stock
What Causes a Stock Market Crash?
Many studies have been done to understand what causes stock market crashes.
In his book “The History of the United States in Five Crashes,” Scott Nations delved into the world of stock market crashes and he came to the following conclusions about modern-day crashes:
They are caused by an over-valued market
There’s usually some kind of financial contraption/engineering
A third factor that’s usually not directly related to the stock market
Understanding an Overvalued Market
If you want to know how the market is fairing, you just have to look at the PE (Price to Earnings ratio). To arrive at the PE, you divide the total price of the stock market with the total number of earnings of the companies listed. This will give you an indication of how much investors would be willing to pay in order to get $1 worth of the company’s earnings. The lower the PE ratio, the more undervalued the stock market is.
If you want to know the real value of the stock market, take a look at the history of its PE. Compare this PE to the current PE. On average, a PE ratio is 15.66. The current PE ratio of S&P 500 is 24.71. This shows that it has been overvalued by up to 58%. As John Maynard Keynes, one of the world’s leading economists says, “The market can stay irrational longer than you can stay solvent.”
That’s to say that a market can be overvalued for a long period of time before natural correction happens. This, therefore, is not an indication of a stock market crash.
Understanding Financial Contraption And Engineering
It’s usually much easier to see financial contraption in hindsight than it is to predict the future. The dot-com market crash was largely as a result of investors being over-enthusiastic about technology-related stocks. The 2008-2009 crash happened partially as a result of not pricing mortgage derivative securities right.
Illiquid EFTs and algorithmic trading could put the market under pressure in the future, according to Scott Nations. Therefore, these 3rd party factors, together with an overvalued market and financial engineering could all work together to bring about a market crash.
The Catalyst for a Stock Market Crash Could Be Anything
In 2001, markets had to be closed for 6 days after the 9/11 attacks. This was done in a bid to prevent the markets from crashing. Even after this had been done, the market still fell by 684 points the first day it opened for trading. This was one of the largest loses in a single day of trading in history
The San Francisco earthquake of 1906 led to a market crash in 1907. The Iran war partially led to the 1987 Black Monday Crash.
However, it’s not always easy to tell what major event could have an effect on the stock market. Most investors, who are panicky, usually feel nervous about any events that they think could affect the market in any way.
Will The Stock Market Crash Soon
Currently, the market is overvalued. There are also a number of financially engineered products in the market. However, no one knows what will catalyze the next market crash. But this shouldn’t matter since you cannot completely protect yourself from the next market crash unless you sell all your stocks and leave the market.
However, you can take certain steps in order to cushion yourself from suffering a total loss. One of the things you can do is to diversify your investments. Avoid putting all your investments in the stock market. This is especially true as you grow older. Invest in other areas as well. This includes real estate, bonds, and cash.
This way, in case the market collapses, you will have at least some backup investments to rely on.
Also, when the markets are overvalued, as is the case now, think about reducing your investments. There’s also a chance that you could lose out on some upside potential.
As Keynes said, the market could remain overvalued for a long time and it could also stay irrational for longer than you could stay solvent. You can tell this from recent historical happenings. When there are more sellers than buyers, then liquidity gets compromised and this leads to a drop in the markets. However, it’s not possible to tell when a crash would happen.
What Not to Do During a Crash
During a crash, all the stock prices would be at rock bottom. That’s why it’s not a good time for you to sell your stock; otherwise, you will incur huge losses.
Also, it’s not a good idea to sell at this time, since the market usually corrects itself very soon. It can take up to three months for this to happen. In any case, once you sell and the market experiences a Bull Run, you are likely going to be scared into buy again. This means that you will have locked down your losses. When a crash happens, the best thing would be for you to sit tight and wait to see what happens. The crash could be over in a day or two.
The best thing to do would be to sell before the crash happens. However, it can be quite difficult to tell when a crash is about to happen. Most people panic and buy because they feel that if they don’t get in now they will miss out. Therefore, a lot of people don’t even make rational decisions when it comes to their financial matters. They are more driven by their emotions. However, a lot of investors end up buying when the market has peaked.
The key would be to diversify your investments and not have only stocks, but also bonds, commodities. Keep making changes to your portfolio as the market changes.
If properly handled, then you will most likely be able to sell your stocks when prices have gone up. In case a recession happens, you can balance your portfolio by buying stocks when the prices are really low. When the prices go up again, as they are usually bound to, you can profit by selling them. Continuously rebalancing your portfolio is the best way to protect yourself against a market crash. Even the most advanced investors have a hard time predicting when a market crash will happen.
As most financial planners would tell you, buying gold might not be the best way to protect yourself or buying any other single asset. What will protect you is having a diversified portfolio. The assets that you buy should help support you towards meeting your goals. But even with a diversified portfolio, gold shouldn’t take up more than 10% of your total assets.
Top Signs of a Stock Market Crash
Here are some of the signs that show that a market crash is coming:
Bubbles and Crashes
Bubbles usually happen when there’s a fast increase in the stock price, followed by a fast fall in the price of the commodities. As evidenced by the Dutch tulip bubble, bubbles have been around for a long time. Bubbles can be caused by changes in how business is done or it might be caused by a big shift in perspective. This is what happened during the dot-com bubble that took place in the early 2000s.
Human feelings and weaknesses are some of the main factors that could lead to bubbles. What happens is that at the height of the bubble, most investors believe that they are right and that the price cannot drop. Most people end up following other investors in order to not miss out. Then something happens to the financial system and a weakness is revealed. This causes people to panic and they begin to sell, causing the price of the stock to drop. This further leads to other investors to panic and also try selling, thereby getting into a vicious cycle, causing a huge drop in the market. Only in hindsight will it be possible to see how the bubble formed.
High Margin Debt
High margin debts were first noticed during the 2000 and 2007 stock market crash. High margin debt occurs when investors are allowed to use borrowed money to buy and sell. High margin debt could be an indication of an excitement in the market, where investors are trying to stock up, so they can make quick money. The market goes up since investors are buying lots of stock using borrowed money. Then stock prices start to fall after some time. When this happens, most investors decide to sell before prices fall any further. This causes panic in the market, causing more people to sell and leave the market all at the same time.
IPO Market Activity
Having a lot of IPOs all taking place at about the same time could indicate that a crash is about to happen. Most companies want to take advantage of a strong market to get investors on board. Before the market crash of October 1987, there were 500 IPOs that raised $22.5 billion. In 2000 during the dot-com bubble, there were 406 IPOs. In 2015, there were 50 IPOs that raised $5.1 billion. Whether this indicates a market crash is coming remains to be seen.
Mergers and Acquisitions
A high level of Mergers and Acquisitions (M&A) could be an indication that a crash is about to happen. Before the 2000 dot-com bubble and the 2008 crash, there were a lot of M&As taking place. M&As happen when companies try to increase their profits by buying out their competitors or purchasing other non-related companies. There have been lots of M&As in 2014 and 2015. This could be an indication that the Bull Run has come to an end.
There are experts who take a technical approach to predict when a crash is going to happen. In 1987, Tudor Jones predicted the crash was going to happen and that’s how he made 200% of his hedge funds that year. He made this prediction by comparing the factors that led to the 1929 crash to what was happening in 1987.
Some of the technical factors that experts can look at to predict a crash include looking at the bearish chart indicator. You can also look at the VIX level or the fear index. Crashes usually happen when the VIX level rises too fast.