The 5 Red Flags of a Market Crash
These days, risk mitigation is more imperative than ever. But the investment road from here requires vigilance, not undue fear. To prevent getting blindsided, you need to pinpoint the trouble signs ahead of time. Below, I examine five of those potential signs.
In the meantime, U.S. stocks closed sharply higher Wednesday as second-quarter 2022 earnings continued to exceed expectations and the Federal Reserve offered no nasty surprises. In pre-market futures trading Thursday, the major U.S. indices were taking a breather from their relief rally.
Your Early-Warning Checklist
When the stock market crested in 1987, 2000, 2008, and 2020, were you caught up in the euphoria…and did you eventually get burned?
Let’s look at five key indicators that typically tell us whether a market is doomed or not and see how we score. Any one factor, or combination thereof, can spell trouble.
1) Economic growth sputters.
Global economic growth is recovering from COVID-caused damage, but that rate of growth is slowing. According to the latest projections from the International Monetary Fund, the global economy is projected to grow at a year-over-year pace of 3.6% in 2022. The U.S. economy is projected to grow by 3.7% this year (see chart).
However, the Russia-Ukraine war and Federal Reserve tightening are weighing on projections, which have been downgraded lately.
2) Valuations soar off the charts.
Index forward price-to-earnings ratios (FPER) and other valuation measures aren’t high enough to cause investor nosebleeds. Recent sell-offs have put many quality stocks back on the bargain shelf.
The FPER of the S&P 500 currently hovers at 18.1, below the five-year average of 18.6.
3) The New York Stock Exchange Advance/Decline Line (NYAD) falls.
It’s a bad sign if the NYAD has peaked and is declining, even though the S&P 500 and Dow continue higher. This dynamic indicates that even though the selective market indices are rising, the much broader market is foundering, a phenomenon known as “bad breadth.” It tells us that overall market performance is being driven by a minority of companies.
When major indices are declining, a falling advance/decline line confirms the downtrend. As of this writing, the cumulative advance/decline lines for the All Exchange, NYSE and NASDAQ remain negative.
4) Market leadership changes.
Another red flag is when market leaders become laggards. Bull runs often are propelled by a relatively small number of strong stocks that are market leaders. When these stocks begin to falter, it could mean that the rest of the troops will follow.
The Big Tech stocks that have driven the broader rally for the past two years have taken a back seat to value. Indeed, the tech-heavy NASDAQ is officially in a bear market (decline of more than 20%).
5) The central bank gets aggressively hawkish.
Another warning sign is when the Federal Reserve gets stingy. When the Fed increases interest rates and squeezes credit, it causes money supply growth to plummet, an unmistakable sign that the stock market will soon stall. Historically, money supply growth has exhibited a close correlation with stock price movements. An increasing money supply boosts stocks; decreasing money supply puts the brakes on stocks.
On Wednesday, the Fed raised its key interest rate target by 50 basis points (0.5%) as expected.
The verdict: the stock market fails four of the five above tests.
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John Persinos is the editorial director of Investing Daily.