What are the warning signs that a stock market crash is coming?
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.
Currently, the Fed Funds Rate sits at 0.25%, a very dovish sign, and it has been there for years. As recently as early 2020, the Federal Reserve expected this rate to be at incredible lows for at least a few more years. However, more recently, the Fed announced that it is aiming to increase the Fed Funds rate in late 2022. As we get closer to the increase, there’s a strong chance that investors will become increasingly bearish, which could result in a 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. Some members of the Federal Reserve suggest that these activities could be slowed by the end of 2021. As this happens, many businesses expect reduced revenues because consumers tend to spend less, which has the potential to result in a market crash.
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 go 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 September 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.
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 September 2021, the CAPE ratio appears to be sounding the alarms, with the S&P 500 index reading at just over 38 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 September 2021, inflation was exceptionally high in the U.S. According to The U.S. Bureau of Labor Statistics, prices increased 5.3% year over year in August, 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 September 29, 2021, the indicator sat at more than 239% according to Current Market Valuation, suggesting that the market is overvalued to an extreme, and dramatic declines are likely ahead.
8. Excessively High Market Sentiment
Emotion is a key driver of movement in the stock market. When fear hits hard, market prices decline as investors sell their holdings, and market prices rise as investors buy shares when euphoria and greed set in.
In some cases, emotions can run extremely high, leading investors to throw all fundamental analysis out the window and make emotionally-driven decisions that either drive prices to extreme undervaluations or overvaluations.
When the market gets too euphoric and overvaluations are rampant, it’s a sign that a crash is imminent. One of the best ways to guage this is by using the Fear & Greed index. Developed by CNN Money, the index was designed to gauge whether investors are too bullish or too bearish based on the two primary emotions that drive the market.
As of September, the index came in at 34, suggesting that the overall feeling toward the market is fearful. With the market turning fearful after a long-term greedy run, and sentiment weighed down, declines could be ahead.
9. Domestic and Geopolitical Uncertainty
Politics will always play a major role in stock market activity. Legislative changes have the potential to pick up or completely destroy large sections of the economy, whether those political changes happen here at home or around the world.
Political uncertainty is a common concern prior to market crashes. After all, when investors don’t know what to expect, they’re not willing to risk their money, leading to less investor interest and declines in market values.
In the U.S., political uncertainty was high during the 2020 election season and has remained a concern since. Expectations that President Joe Biden will raise corporate tax rates from 21% to 28% have led to concerns that the political environment may not be best for investors.
Since the initial expectations of tax increases, a few other concepts have hit the table. Biden has talked about raising the minimum corporate tax rate to 15% and, more recently, lawmakers are considering increasing the corporate tax rate to 26.5%
Although nobody knows where the rate will end up, an increase in corporate taxes is all but imminent, which could cut into profitability and lead to declines in the market.
On the international stage, many argue that geopolitical uncertainty will continue for some time to come as China, Russia, and Iran vie for power and many western countries face internal political turmoil.
Continued uncertainty or major political events could weigh heavily on the market.
10. An Inverted Yield Curve
An inverted yield curve takes place when long-term coupon rates on fixed-income securities fall below short-term rates. The term inverted is used to describe this action because long-term fixed-income investments usually pay a higher return than their short-term counterparts.
When the curve is inverted, it suggests that investors believe economic struggles are ahead and that rates will fall in the long run. Historically, this has been a compelling signal of coming crashes. In fact, over the past 50 years, an inverted curve took place just before each recession, with only one inverted curve happening but not being followed by a recession.
So far in 2021, the yield curve has been on a fast paced move upward. However, in recent months, the growth in the curve began to slow and a flattening trend may be on the horizon.
11. Weakening Economic Indicators
Economists use various indicators to determine the state of the U.S. economy at any given time, which is important when determining whether a crash is coming. Investors tend to pull out of equities when economic conditions are poor.
Many investors look to the Conference Board Leading Economic Index, or LEI, which takes the following indicators into account:
- Manufacturing. When more manufacturing takes place, it’s a sign that economic conditions are positive. The LEI tracks both average weekly manufacturing hours and new orders for manufactured consumer goods, materials, and nondefense capital goods excluding aircraft orders.
- Unemployment Claims. When economic conditions are booming, there tend to be fewer unemployment claims; the opposite is true when economic conditions are a cause for concern.
- Housing Market. If economic conditions are positive, consumers are more likely to jump into the purchase of a new home. So, if there’s slowing in the housing market — including home sales, building permits, and new private housing units — there’s likely a slowing in the overall economy.
- Stock Prices. The U.S. stock market and the state of the economy are heavily correlated. The LEI factors in the prices of stocks on the S&P 500 index to determine if the market is reacting to economic uncertainties.
- Credit Index. Consumers are more likely to take out new loans when they feel economic conditions will make paying those loans back relatively easy, and they are less likely to borrow when economic conditions are concerning. The U.S. credit index measures the performance of taxable corporate, fixed rate, and government income securities, helping to determine the state of the economy based on returns in the fixed-income sector.
- Treasury Bond Yields. Finally, the LEI compares 10-year Treasury bond yields minus the fed funds rate. The difference is the premium investors are willing to pay for mid-term Treasury bonds, further pointing to the state of investor sentiment surrounding the U.S. economy.
As of August’s reading, the LEI climbed to 116, which is a record high, suggesting that economic conditions have completely rebounded from COVID-19 pandemic-related lows. On the other hand, many argue that these figures are skewed by stimulus, prolonged low rates, and bond buying.
12. Declining Vehicle Sales
Vehicle sales are a great gauge of what’s happening with the U.S. economy. Therefore, they can be a great signal for a coming stock market crash.
The purchase of a new vehicle is a big decision that comes with a significant price tag. Most people take advantage of loans when buying vehicles because they simply can’t afford to buy them comfortably with cash.
As a result, vehicle sales tend to be positive when consumers believe positive economic conditions are ahead and seem to hit a brick wall when the overall sentiment turns negative.
By looking at growth in vehicle sales, you’ll get a gauge of how consumers feel about economic conditions and their confidence in making big-ticket purchases. This is important because consumer feelings toward the state of the economy often dictate their spending and saving habits, which boil down to either revenue growth or declines for many businesses.
According to Forbes, vehicle sales were down more than 13% year over year in August. While some say this points to a market crash ahead, others note a recent chip shortage had caused automakers to reduce production of new vehicles, which is a factor in the declines.
13. Declining Home Sales
The reason to track home sales falls along similar lines; consumers aren’t as cavalier about buying a home if they don’t feel comfortable with the state of the economy.
At the moment, existing home sales are on the rise, with a 2% increase in July according to the National Association of Realtors. Should sales continue to increase, they will represent a strong sign that consumers are confident about economic growth ahead.
14. A Black Swan Event
In a black swan event, none of the above matters. These rare, unforeseen events happen completely out of the blue, leading to dramatic market declines. Some examples of black swan events in recent history include:
- COVID-19. The most recent black swan event took place in early 2020, when COVID-19 swept the world. The virus came out of nowhere, leading to lockdowns and driving the market down tremendously in a short period of time.
- Terrorist Attacks. On September 11, 2001, a terrorist attack on New York City and the Pentagon shook the United States. The resulting fear of further attacks and geopolitical fallout led to significant declines in the market.
- Soviet Union Dissolution. The collapse of the Soviet Union took place in 1991. The geopolitical uncertainty that followed led markets to tremendous lows.
By their nature, black swan events are rare and unpredictable. There’s no way to tell if a black swan event will happen tomorrow or 10 years from now, but when they do, they tend to lead to major market crashes.
Any time there’s a bull market, fearful investors wonder when the bears will take hold and the market will crash. It’s no surprise that as prices hit record highs, many are wondering when the next crash will come.
As of this writing in September 2021, there are clear signs that a crash could be on the horizon. While not all signs point to a crash, much of the positive economic data has been spurred by monetary stimulus led by low rates and bond buying, which simply can’t last forever.
The good news is that declines don’t last forever either, and even in the face of a market crash, wise investment decisions can lead to profits, which is why it’s so important to do your research before making investments.