My Comments: I wish I knew what will happen between now and this crash people keep talking about. The warning signs are meaningless unless they actually result in a crash, which may or may not happen for many months.
Yes, we are more or less in unchartered territory, but then every tomorrow is unchartered territory, much less what happens, say between now and the end of the year.
Nevertheless, if any of this helps you from losing your shirt whenever it happens, that’s a good thing. Just don’t hold your breath until after you read the rest of the 14 warning signs, which I plan to share with you next Tuesday. I decided to split it up as this one alone is a lot to read.
by Joshua Rodriguez \ June 29, 2021 \ https://tinyurl.com/yjn7o739
The longest bull market in history ran from 2009 to 2020, until COVID-19 began to sweep the world and sent stock prices diving. While economic conditions dwindled for some time, the bear market only lasted a few months, then the bulls took control once again. Were it not for the coronavirus, the markets could theoretically be still enjoying the longest bull market in history.
That’s exciting — and scary. History tells us that the market is a cyclical beast, but when its ebbs or flows are off balance, serious corrections happen.
With share prices reaching record highs, even in the face of economic hardship and increasing debt loads, and key valuation metrics telling investors to turn and run, a big question arises. Is a stock market crash just around the corner?
Warning Signs That a Stock Market Crash Is Coming
To determine whether you’re headed into a downturn, it’s important to pay attention to the warning signs that the market practically yells to euphoric investors who often fail to listen. In fact, it’s the euphoria of dramatic gains that often leads investors down the wrong path, resulting in the market crashes that follow.
But what exactly are those warning signs? And do they reliably say a crash is imminent?
1. Prolonged Dovish Monetary Policy
The United States Federal Reserve Bank, also called the Fed, is the central bank of the U.S., meaning the bank is charged with determining monetary policy for the U.S..
Considering the stock market, at its core, is nothing but a system that allows for the movement and balance of cash and value, the Fed plays a big role in market activity.
When the Fed comes to the conclusion that the U.S. economy is in trouble, it moves forward with one of two key policy adjustments, or a combination of them:
Fed Funds Rate
The fed funds rate is the interest rate charged between banks to lend excess funds overnight. When this rate is lower, interest rates on loans like mortgages, auto loans, credit cards, and more become lower, spurring a wave of lending.
Of course, when consumers are able to borrow more money relatively cheaply, they tend to do so, creating tons of liquidity in the U.S. economy. As a result, spending ensues, leading to higher revenues and profitability for corporations, and ultimately a bull market.
However, prolonged low rates can be a very bad sign because they can’t last forever. At some point, debt will have to slow and rates will have to increase, resulting in a tightening of consumer spending and, if the contraction is significant, a stock market crash.
Bond Buying Programs
Another way the Fed works to stimulate growth in the economy is to buy bonds. By purchasing massive numbers of bonds, the Fed exchanges liquid cash today for bonds with future maturity dates. This floods the market with spendable money and leads to the same loose spending that low rates often encourage.
Like with low rates, the party doesn’t last forever. At some point the bonds purchased will mature, but even before that, the Fed will likely slow its bond-buying activities. As this happens, many businesses expect reduced revenues because consumers tend to spend less, which has the potential to result in a market crash.
Pro tip: David and Tom Gardener are two of the best stock pickers. Their Motley Fool Stock Advisor recommendations have increased 563% compared to just 131.1% for the S&P 500. If you would have invested in Netflix when they first recommended the company, your investment would be up more than 21,000%. Learn more about Motley Fool Stock Advisor.
2. A Bubble In Market Valuations
Bubbles appear in the stock market all the time. Some of the most memorable in recent history include the dot-com bubble in the late 1990s and the real estate bubble in the 2000s:
The Dot-Com Bubble
During the late 90s, excitement around the widespread adoption of the Internet ran high. Stocks that represented virtually any online company rocketed, leading to outlandishly high valuations in the sector.
With investors earning such massive returns, nobody seemed to be paying attention to the excessively high prices they were paying to own slivers of companies that, in many cases, weren’t making a dime. When the bubble popped, the entire market took a hit.
The Real Estate Bubble
Following the dot-com bubble burst, excessive monetary stimulus mixed with poor lending practices led to a flood of demand for real estate, sending property prices skyrocketing. When the real estate bubble popped in 2007, a massive sell-off began and the Great Recession set in.
After the Great Recession, the stock market enjoyed the longest bull run in history, climbing for more than 10 years before COVID-19 took its toll. By mid-2021, the market had largely made a full recovery, with many stocks trading at record highs — hundreds or even thousands of basis points above pre-pandemic highs, suggesting to some analysts that bubbles are taking place once again.
3. An Extended Bull Market
The market is thought to be a balanced system, but the reality is that it’s anything but balanced. From day to day, month to month, and even year to year, the stock market struggles to keep valuations in check as the bears and bulls argue their points.
Any time the bulls take control for too long, the prices investors pay to own stock goes through the roof, generally creating excessive overvaluations. On the other side of the coin, too much control by bears sends stock prices tumbling, resulting in extreme undervaluations.
In fact, active traders make it their life’s work to take advantage of the inconsistent balance in the market.
Look at the amount of time the trend in the market has been upward. According to Forbes, the average bull market lasts about two years and seven months. An uninterrupted run of the bulls that lasts considerably longer could be a sign that we’re due for a reversal.
4. Corporate Profits Turn Flat
One of the key drivers in the stock market is profit, and for good reason; nobody wants to invest in a company that’s losing money with no sign of profitability ahead. When profits are growing, investors are happy and willing to pile more money into the stock.
Value investors use the price-to-earnings (P/E) ratio — which could also be called the price-to-profits ratio — as a key ratio to determine whether a stock is under- or overvalued. In other words, a company’s profits help to determine the fair price of its stock.
A clear sign that a market crash is coming is when profits begin to go flat.
Investors are only happy when the companies they invest in are seeing growing profitability. If profits stop growing, it raises questions about the company’s ability to continue growth ahead, leading many investors to abandon ship and driving stock prices down.
During times of economic uncertainty, when consumer confidence is lacking the most, consumer spending often dries up, leading to plateaus in profitability for many businesses and widespread stock sell-offs.
As of June 2021, corporate profits remain on the rise. A mix of relaxed federal monetary policy and stimulus provided by way of cash payments has led to increased spending, and corporations and investors are reaping the rewards.
There’s no question that federal policy is beneficial to the market at the moment, but many are beginning to question what will happen when stimulus-related spending stops and profitability declines.
Pro tip: Before you add any stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
5. A High Cyclically Adjusted Price-to-Earnings (CAPE) Ratio
Staying on the topic of profitability, another clear cut warning sign that a market crash could be on the horizon is a high cyclically adjusted price-to-earnings (CAPE) ratio. The ratio is a 10-year moving average of the traditional price-to-earnings ratio, which measures a company’s profitability in relation to its share price.
Developed by Robert Schiller in 1996, the metric has been used by stock market experts and economists alike for more than two decades. Also called the Shiller P/E, the CAPE ratio averages price-to-earnings ratios over the past 10 years, which largely washes out short-term peaks and valleys and volatility to show whether the market is truly under- or overvalued.
A healthy CAPE is in the 15 or 16 range. Anything over 20 is cause for concern, and when the figure nears 30, it’s a clear warning sign that something big is on the horizon. If you measure the CAPE of the S&P 500 index just before the Great Depression, you’ll see that it climbed as high as 33.1.
As of June 2021, the CAPE ratio appears to be sounding the alarms, with the S&P 500 index reading at 37 for the month, according to YCharts.
6. Rising Inflation
Some inflation is natural. As the economy progresses, a slow and steady increase in prices for consumer goods, services, and any other category is normal. It’s why your great-grandparents could buy an entire lunch for a dime, and today it’s hard to find a stick of bubble gum for that price.
Inflation becomes a problem when it happens too fast. The U.S. Federal Reserve has a target of stabilized inflation at 2%, which it feels is the healthy rate at which prices should increase.
Leading up to market crashes, rapid inflation tends to take place. This creates a major problem.
As prices rise, consumers become more fiscally conscious, often leading to an increase in saving activities and a decrease in overall spending. From there, reduced corporate profitability is on the horizon, which has the potential to lead to a stock market crash.
As of May 2021, inflation was exceptionally high in the U.S. According to The Wall Street Journal, prices increased 5% year over year in the month, which was strikingly similar to the 5.4% year-over-year growth that took place the month before the Great Recession set in.
7. The Buffett Indicator
The Buffett Indicator is a fundamental measure of whether the stock market is under- or overvalued as a whole. It was first proposed in 2001 by the iconic investor Warren Buffett. Since then, the indicator has been used by economists and Wall Street experts almost religiously.
The indicator compares the total value of the U.S. stock market to the U.S. gross domestic product, or GDP.
According to Buffett himself, the market is valued fairly when the indicator is somewhere between 75% and 90%. Once the indicator climbs to between 90% and 115%, the market is modestly overvalued. Finally, any time the indicator is over 115%, the market is highly overvalued and poised for significant declines.
So, what does that say about the market in 2021?
As of June 4, 2021, the indicator sat at more than 207% according to Advisor Perspectives, suggesting that the market is overvalued to an extreme, and dramatic declines are likely ahead.