5 Signs of Trouble in the Stock Market, And How To Survive Them (Podcast 305)


In one way or another, all of us were affected by the last recession. The economic downturn of 2007-08 managed to not only devalue homes but also decimate investment accounts, impact jobs, and force lenders to tighten their hold on lines of credit.

After years of dealing with the after-effects, our economy is finally in a good place. Home prices are on the rise again, interest rates are healthy, and we’ve enjoyed a number of years of easy borrowing against our credit. But many experts are wary, saying that another market crash is on the horizon.

Whether or not they are right, the fact of the matter is that stock market backslides are expected over time. And while it’s impossible to predict exactly when the market will crash, there are a few signs that can often precede the plummet.

Here is a look at five signs that can signal impending trouble in the stock market.

1. The Market is Volatile

Whether you’re a seasoned investor or new to the stock market, you probably know that volatility is bad. In fact, an increasingly volatile market–tracked by the Cboe Volatility Index (VIX)–is one of the biggest signs of trouble.

Market volatility is best identified by significant swings in the Dow Jones Industrial Average, which can easily drop or rise by hundreds of points in a single day. Back in February 2018, we saw the largest ever single-day drop in points in Dow Jones history: a whopping 1,600 points. So, what does that say about this year and the near-future of the stock market?

Well, it’s hard to tell. Some experts believe that the perceived volatility of the market today is simply due to the fact that our stock market is bigger than it’s ever been. As a result, a 1% drop today would equate to significantly more falling points than a 1% drop a few decades ago. In their opinions, it’s not necessarily that our market is swinging more wildly than it should… it’s just a bigger pendulum these days.

Even still, we do see a trend in market volatility this year. While it hasn’t really led anywhere just yet–leaving some feeling like this is simply a case of the boy who cried wolf–that doesn’t mean that we couldn’t still be on the cusp of trouble.

And when you combine that data with, say, an overvalued market, it makes the volatility seem a bit more significant.

2. The Market is Overvalued

When it comes to stocks, you want to buy low and sell high, right? But where is the limit to that “sell high” goal? While stock prices that climb and climb may seem like a good thing (especially if you hold shares in your portfolio), it’s actually concerning in the long run, leading to a market that’s priced far above its true value.

And an overvalued stock market can be a very dark cloud on the economic horizon.

We all saw what happened in 2007, when most of the country’s largest home markets were overvalued–many of them by a long shot. The home-price balloon inflated and stretched and inflated some more until it simply popped, leaving both homeowners and lenders to clean up the suddenly-devalued mess.

When this happens to stock prices, the effects can be equally devastating. After all, a grossly overvalued market has no choice but to eventually pop.

There are many experts who believe that we are currently sitting in an overvalued market, while others believe that we aren’t quite overvalued yet. To gauge where our market actually stands, there are a few key valuation metrics that can be utilized. They are the:

  • Price-Earnings Ratio (or Trailing P/E Ratio): This metric takes the average share price of S&P 500 firms and divides those by those companies’ average earnings per share from the last 12 months.  The historic mean for the trailing P/E ratio is 17; we currently sit at 25, indicating an overvalued market.
  • Forward P/E: Similar to the trailing P/E ratio above, this metric also gauges stock prices against earnings. Except, that it uses the expected earnings for the next 12 months rather than actual earnings from the past 12 months. The historic average for the forward P/E is 17.2; we currently sit at 17.9, which points to a somewhat overvalued market.
  • Buffet Valuation Indicator: This calculation finds the ratio of the S&P 500 total market cap to the country’s GDP. As one would expect, this is one of the favorite valuation metrics for Warren Buffet. This ratio currently sits at 142.1, which is the second-highest it’s been since 1950. It has only been topped by a 151.3 ratio in 2000… right before the dot-com bubble burst.
  • Price-Peak Earnings: This valuation metric compares current stock prices with the historic peak prices of the past 12 months, and is another variation of the P/E ratio above. Our P/E ratio is currently 24, which is significantly higher than usual. In fact, we’ve only seen this number go higher than 19 four other times since the 1920s.

It’s impossible to predict the future of the stock market, even with valuation tools and market calculations. However, when multiple tools start smelling like smoke, it’s smart to at least wonder if there’s a fire somewhere.

3. Lenders Start Tightening the Reins

Lenders are some of the first to spook if there are signs of stock market trouble on the horizon. This is especially true for lenders who traditionally extend lines of credit to borrowers with average or below-average credit. If they sense trouble ahead, even if it’s not immediately impending, they will begin to pull back on lending in small, but calculated, ways.

In some cases, this might simply mean tightening up the requirements for lending. Borrowers might have more trouble getting through the underwriting process, or may be denied for loans and credit products that they would have been approved for a few years ago.

New cardholders may be offered only modest opening lines of credit on their new credit cards, even if they don’t have bad credit. Existing cardholders could see their credit limits reduced–whether they still have a balance or not–and may even find dormant accounts closed without warning.

We are already seeing this happening. Over the last two years, in fact. Discover and Capital One are closing underused credit card accounts, lowering lines of credit (even “chasing the balance”), and offering lower-than-normal limits to users who would otherwise qualify for more. Discover has managed to free up $30 billion in credit through these efforts, which offers them significantly more security if and when the market does crash again.

4. Market Prices “Melt Up”

Sometimes, things are too good to be true. In terms of the stock market, this could be seen in a share price “melt up,” which is really just a facade of good news.

In a stock market melt up, investments in a particular asset class will suddenly, drastically, and often unexpectedly, find themselves driven upward. While asset class improvements are typically indicative of economic performance–and as such, are great news–this isn’t the case with a melt up. Quite the contrary, in fact: with a melt up, this improvement is temporary and only due to investors looking to quickly “get a piece of the pie.”

We saw an example of this with Bitcoin last winter, when stock prices climbed exponentially in a very short period of time. The cryptocurrency enjoyed a bit of fan mania, with folks who had never invested before looking to jump on the bandwagon. Prices soared and those who were invested before the craze hit, loved the upward ride.

Of course, that bubble was short-lived. While Bitcoin is still priced higher than it was before its melt up, shares are valued nowhere near where they were at the peak.

A melt up of one individual stock isn’t cause for alarm in terms of the entire market. However, when we begin to see entire asset classes quickly climbing upward and onward, without a foundational cause for their growth, it could signal trouble ahead.

5. Investors Stop Looking Toward the Future

If you have faith in the stock market–or really, anything–you begin to look toward the future. This comes into play in relationships, jobs, and, of course, the economy. But when investors start focusing more on the short-term than the long-term, it can be a sign of dark times to come.

We see this demonstrated with what’s called the yield curve. Economists will compare the yields for both long-term bonds and short-term bonds. When the yield for long-term bonds drops below that of the short-term bonds, this is called an inverted yield curve.

What does it mean? Well, it indicates that investors are not looking favorably upon the economy (and even inflation) in the few years to come, and can be a good sign that there’s trouble brewing in the market.

Right now, we are not sitting in an inverted yield curve, which is the good news. The bad news? We are the closest we’ve been to an inverted curve since just before the Great Recession, and an inverted yield curve has preceded every single recession of the past six decades. The existence of a curve doesn’t give us any idea of timing, unfortunately, but I would say it is still a pretty reliable indicator of things to come.

Bottom Line

The best tool to have when predicting trouble in the stock market would be a crystal ball, or perhaps a time machine. (I would go back and invest $200 in the 1800s, enjoying the multi-millions it would have grown to today.) Since neither of those are available to us yet, though, we are forced to use the metrics at-hand.

No one knows exactly when the stock market will crash again, or how bad it will be. These five signs typically precede a bubble burst, though, so it’s smart to keep an eye out for them. Depending on where you are in your investment journey, their presence might be reason enough to think about rebalancing your portfolio to something a bit more conservative.

Topics: InvestingPodcast
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