Business

How can you determine whether a stock market dip is about to evolve into a crash?

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Bull markets, like the people investors who make them up, are mortal, and they can die spectacularly and bloodily. The problem is that it’s impossible to tell if a few days of large losses are only a dip (or, to some, a buying opportunity) or the beginnings of a larger slide. However, there are at least four warning indications that equities are on the verge of collapsing.

Crashes struck with the terrifying force of a Category 4 hurricane, ripping apart portfolios that people rely on to support their retirements and college educations. They are frequently signs of impending recession. The Dow Jones Industrial Average lost half of its value in 1929. The Dow dropped by more than a third during the early-2020 epidemic. Today, with the market at an all-time high, market doomsayers abound. Example: Michael Burry, the Big Short hedge fund manager who foresaw the housing meltdown and subsequent market panic in 2007-08, sees dangerous levels of speculation that will lead to “the mother of all crashes,” according to him.

When all four of these warning signals appear at the same time, be aware that bad things are about to happen:

Market multiples are high. A market that is overpriced is tempting fate. The most frequent metric for determining stock affordability—the price/earnings ratio, or P/E—has been at an all-time high for some time: the S&P 500’s P/E is currently at 26. This is significantly higher than the historical average of roughly 15. The market has a tendency to return to its mean. That is, it dips to a more manageable level after becoming excessively lofty, which is a terrible sensation.

The P/E ratio evaluates what you get for your money because stock prices are largely a reflection of business earnings. Earnings soared in the third quarter, and FactSet predicts a 45 percent increase for the entire year of 2021. However, the outlook for next year is less rosy: the research group predicts a sharp drop to 8.5 percent. And if there is a downturn in the economy, those earnings will be lost.

Nobel laureate economist Robert Shiller’s cyclically adjusted price/earnings ration (CAPE) smooths out earnings gyrations over the last ten years, providing investors a longer picture of prices. The Shiller P/E, as it’s known, has recently hovered around 40. The last time the CAPE was this high was during the dot-com bubble, which was followed by a terrifying market decline.

The actions of the Federal Reserve. One of the most common causes of market crashes, and consequently recessions, is the Federal Reserve raising interest rates too high for investors to bear. Higher rates make borrowing less appealing and have a negative impact on company earnings. The Fed has hinted that short rates will be raised beginning late next year after remaining at zero for so long. However, during his hearing on Tuesday, Fed Chairman Jerome Powell stated that persistent inflation (which was alarmingly high at 6.2 percent in October) may prompt the central bank to act sooner and more forcefully. Economist Jeremy Siegel, a professor at the University of Pennsylvania’s Wharton School, believes the Fed will act in the next month or two, causing stocks to fall.

The yield curve has been inverted. This occurs when the yield on a two-year Treasury bond is higher than the yield on a 10-year bond. Of fact, the 10-year yields much more than the two-year since investors must be compensated for the risk of owning a longer-dated bond with a higher interest rate. When economic storm clouds gather, however, investors flock to the 10-year, viewing it as a safer haven. As a result, the bond’s price rises, and its yield falls (price and yield move in opposite directions).

In the last 50 years, the yield curve has inverted before every recession, with only one false positive. The difference between two-year and 10-year bonds has shrunk recently, while it remains around one percentage point.

Swans in black. These are the kinds of events that send the stock market and the economy into a tailspin. The entrance of these monsters can be unpredictable, as in the case of the terrorist acts on Sept. 11, 2001, which sank stock markets. Other dangers are hiding in plain sight, as hedge fund guru Burry can attest, such as rising subprime mortgage defaults in 2007. Starting in September 2008, these events resulted in the global financial crisis and the market’s dramatic swoon. (Unlike white swans, black swans are said to be rare.)

Identifying a black swan isn’t an exact science, to be sure. When official wisdom dismisses an evident and growing mega-problem, it’s a major indication. The official stance in 2007 was that the mortgage crisis could be “controlled.” The White House and the Federal Reserve claim that supply-chain constraints caused by COVID-19-related labour shortages are “temporary” in 2021. But what if they’re not?

The market’s astronomical P/E and officialdom’s supply-chain optimism are currently the only possible indicators that disaster is brewing. Keep an eye out for the others if they crawl into view.

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About the author

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Kathy Lewis

Kathy Lewis is an all-around geek who loves learning new stuff every day. With a background in computer science and a passion for writing, she loves writing for almost all the sections of Editorials99.

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