Is A Stock Market Crash Around The Corner?

Is a Stock Market Crash Around The Corner? Every experienced investor knows that the stock market goes through ups and downs. Portfolio diversification helps offset losses by investing in a broad range of assets. Even if one industry crashes, the others should protect you from significant loss.

However, a stock market crash makes it harder for diversification to protect your investments because falling values happen across a wide swath of the sectors. For example, the Dow Jones Industrial Average fell 24.8 percent over a few days before the Great Depression. The crash ruined investor confidence, which encouraged people to pull more money from other markets.

A stock market correction doesn’t usually rise to the level of a crash, but it can still have a dramatic influence on investors.

Is there a stock market crash around the corner? No one can predict precisely how the market will behave. Some traits, however, suggest that a stock market correction could happen soon.

SKEW Is Elevated

SKEW helps define an option’s implied volatility – specifically the differential between in-the-money, at-the-money and out-of-the-money options.

Some share price volatility is good because it gives you entry and exit points for short-term trading. Too much volatility, however, worries investors because they do not know how to plan for a stock’s future movement.

The historic median SKEW figure is 118.48. Typically, investors don’t worry much until the level exceeds 140. It has done so several times over the last year.

Fortunately, the overall SKEW figure is under 140. It’s high enough to raise concern, but probably not so high that investors will begin dumping their stocks to avoid losing money during a stock market crash.

Buffett Indicator at All-Time High

The Buffett Indicator uses a market capitalization-to-GDP (gross domestic product) ratio to determine when the stock market has exceeded a reasonable valuation. Warren Buffett has tweaked his formula a few times over the last couple of decades.

The overall point remains the same, though. When a market’s value exceeds GDP, a premium exists In the stock market above the total production of goods and services. After all, the value of investments cannot have a value higher than the GDP—at least not logically, although markets don’t always behave logically.

The Buffett Indicator shows that the stock market’s peaks and valleys seem to use GDP as a centerline.

Think of the composite stock market as a wave undulating above and below and centerline. When the composite market value stays near the GDP, you have a fairly stable system.

Between 1950 and 1970, the difference between the composite market value and GDP never reached 50 percent. Still, the market entered a correction that kept market values under GDP for nearly 25 years.

During the late 1990s and early 2000s, the stock market experienced a sudden surge that only lasted a few years before it came back to the GDP. During the Great Recession, the market stayed below the GDP for a few years.

Looking at graphs of these numbers, it becomes apparent that cycles of boom and bust are happening more frequently.

In February 2021, the Buffett Indicator reached an all-time high: 228 percent ratio of market value to GDP. If the stock market responds as it has over the last 70s years, investors can expect a sudden drop that could fall well below GDP.

VIX at Very Low Levels

VIX is a measurement of volatility from the Chicago Board Options Exchange. Recently, the VIX has been at very low levels. Low volatility might sound like a good thing to some investors. After all, who wants high volatility that adds uncertainty to the market?

An extremely high VIX level certainly indicates struggles within the market. Very low levels should also raise concern, though, because they might show complacency among investors.

If investors become too complacent, they might buy with abandon, use all their cash, and trade on leverage. When buyers are exhausted only sellers remain and so complacency often is correlated with market peaks.

Too much caution can do nearly as much harm as recklessness. Without risk, the market does not grow. Without growth, the fundamental concept that supports market-based capitalism falls apart.

Financhill Buy/Sell Index Above February 2020 Levels

Financhill’s proprietary indicator shows the percentage of stocks on buy versus sell signals and heightened bullishness. You might wonder why heightened bullishness matters since increased trading and speculation tend to push stock prices up.

While that’s true, bullishness cannot always increase. At some point, the market will correct itself. A stock with a fair value of $150 will eventually reach a price near that amount. If thousands of bullish investors purchase shares for $500 each, they stand to lose a lot of money during a stock market correction.

Stock market corrections happen often. Financhill’s Buy/Sell Index, however, shows levels now that rival those of February 2020. Few believe that the market is trading at a discount to fair value now, indicating the existence of a potential bubble. At some point, a pin prick could pop the elevated share price levels and cause a correction.

The question is whether the stock market corrections will unsettle investors enough that they pull their money from companies with fair valuations. If investors overreact to corrections, they could trigger a stock market crash that hurts the entire market.

Interest Rates Rising

Treasury yields have been low for quite some time. Regardless, some investors worry that rising interest rates would lead to a stock market crash.

It’s important to keep in mind that terms like “low” and “rising” only apply to the present. Between December 2020 and April 2021, Treasury yields doubled. Still, the yield is only 1.7 percent, which makes it historically low.

Why are some investors concerned?

Low interest rates from Federal Reserve make it easy for people and organizations to borrow money. When the rates are low enough, it becomes reasonable to borrow money and invest it at higher rates of return.

Conversely, low interest rates hurt pensioners and savers who rely on fixed income to finance their golden years.

At this point, the interest rate might not need to increase much to scare investors. They have gotten used to extremely low rates that make it easy for them to gamble on stocks.

Returning to a historically “typical” yield rate would make them think harder about whether they want to make these gambles.

Suddenly, the bullishness caused by low interest rates clashes with the realization that higher rates will make future investments more difficult. In an odd way, the low rates that were intended to grow the economy could contribute to a stock market crash that ultimately hurts everyone.

Is A Stock Market Crash Coming?

Investors use a lot of tools to predict how the market will behave. None of them guarantee anything, though. You can only make an educated guess about what will happen.

Few retail investors a market correction to trigger a stock market crash, but some signs suggest that it will happen. Historically, though, the market always recovers long term and continues to accumulate value for those who buy the fear.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.