How to tell if a stock market dip is turning into a crash

[mahatmakanejeeves]

Last edited Wed Dec 1, 2021, 08:39 AM - Edit history (1)

How to tell if a stock market dip is turning into a crash

Larry Light
Tue, November 30, 2021, 8:00 PM

Bull markets, like the human investors that compose them, are mortal—and sometimes they die in a spectacular and bloody fashion. Trouble is, you never know for sure when a few days of big losses represent a mere dip (or to some, a buying opportunity) and what is the start of bigger decline. But there are at least four signs that appear when equities are approaching the abyss.

Crashes hit with the scary impact of a Category 4 hurricane, ripping apart portfolios that people depend on to fund retirements and college educations. Often, they are precursors to a recession. In 1929, the Dow Jones Industrial Average lost half its value. Amid the early-2020 pandemic, the Dow fell by more than a third. Today, with the market at a heady level, prophets of market doom are everywhere. Example: Michael Burry, the Big Short hedge fund manager who predicted the 2007-08 housing bust and the resulting market rout, sees hazardous amounts of speculation that he says will bring “the mother of all crashes.”

When these four warning signs occur together, be alert that wicked circumstances may ensue:

High market multiples. An overvalued market is tempting fate. The most common means of tracking stocks’ affordability—the price/earnings ratio, or P/E—has been at a high level for some time: for the S&P 500 lately, it’s 26. That’s far above the historical average of about 15. The market tends to revert to the mean. That is, after getting too lofty, it drops to a more sustainable level, a painful experience.

Since stock prices are largely a reflection of corporate earnings, the P/E measures what you are getting for your money. In the third quarter, earnings were burgeoning, and FactSet projects they’ll be up 45% for all of 2021. Next year, though, prospects aren’t as rosy: The research firm expects a dramatic downshift to 8.5%. And if an economic slowdown comes along, those earnings will evaporate.

Another and even more fright-inducing metric is Nobel laureate economist Robert Shiller’s cyclically adjusted price/earnings ration (CAPE), which smooths out earnings gyrations over the preceding 10 years, giving investors a longer view of valuations. The Shiller P/E, as it’s known, is around 40 lately. The last time the CAPE was this high was during the dot com bubble, and a fearsome market descent followed.

{snip}

[Tomconroy]

1. Are you trying to tell us something?

I always figure things aren't going well when I see brokers jumping out of windows.

[KPN]

2. Good article. I'm not sure P/E ratios aren't permanently higher as a

result of huge cash infusions into the market over the relatively recent past as far more people today invest than ever before. People aren’t going to just stop investing because of P/E ratios when that is their retirement package. I’d like to see a rigorous analysis of this if anyone knows of one.

[Warpy]

3. A rare post, sorry if it's in Ragtime, can't see well enough to edit

but I'd add fifth and sixth signs.

Five: debt bombs. There are outstanding student loans that will never be paid back and dwarfing those is the debt load a lot of corporations took on during the Covid crisis last year when credit was at its cheapest, debt that financed mostly stock buy backs, very little of it going to corporate infrastructure. Stocks slide a bit, they'll have to dump that stock in order to service the debt they took on. These are two of the debt bombs that are set to blow up in our faces. Sadly there are more that will join them.

Six: the "everyman" factor. When I heard fellow nurses giving each other hot tips on IPOs in 2000, I told them to get out fast, that the gravy train would last only a few more weeks, at most, and I was right. Oh, I didn't tell them I told them so when the NSDAQ had all the hot air let out of it, but I did get a lot of funny looks. The same thing went on in the mid 2000s, everyman jumping into the real estate market with liar loans because the sky was the limit, they're not making more land, ya know. I'm overhearing stock market and mutual fund tips now, so I would caution people of modest means not to bet the rent/mortgage money that it will continue much longer.

Only a fool would predict the day and hour of the next crash, but one is coming and it will likely be a bad one. Only a grifter would try to tell people in advance all the right things to do to protect themselves and their money, nobody knows that one until it's all over.

Just be aware that the markets reallt are a casino, at least to a small extent: things can go "poof" and they can do so quite rapidly, especially after a prolonged hot streak. Unlike the casino bets, going "poof" rarely leaves an investor at zero; wise investors take the opportunity to evaluate those suddenly low priced stocks for their earnings potential or lack thereof. In both cases, it must be remembered that the odds lie with the house.

If this is legible, great. If not, oh well. Best I can do is refer you to the cover of "The Hitchhiker's Guide to the Galaxy." It's good advice.