Can You Predict the Next Market Crash?
Stock markets (and their movements) are often a mystery to the average investor, and that mystery can often create fear. After all, in roughly 30 years, we’ve experienced three major stock market crashes, and they are all surprisingly similar.
The Black Monday market crash of 1987, the bursted tech-bubble and devastation of 2000, and the real estate bust and recession in 2008 all came after similar signs of impending decline. And now, there are indications that the market is in store for a substantial fall off in the not-too-distant future.
While a crash or steep economic decline could be years away, it’s always better to understand what factors can cause a steep market decline, and what similarities exist between crashes. In this article, we take a look at the patterns that persisted before crashes of years’ passed. But more importantly, we also outline important steps you should take to limit the impact of any market downturn.
Do You Know What Information is Worth Assessing and Which is Noise?
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Market Trends: Growth, Dispersion and Omens
There is no crash without a period of growth. Markets tend to sustain long rallies before its growth becomes unsustainable and leads to a crash. And markets have held strong in recent years. But several indicators point to an impending economic decline.
HSBC, Citigroup, and Morgan Stanley have all presented evidence suggesting global stock and credit markets are in the last stage of their rallies, with a potential downturn in the business cycle looming in 2018. Some of those analysts have cited investors’ disregard for key valuation fundamentals and data. And there are several market signals that are born out of that data.
The major sign of decline typically starts when equity environments and the major indices push toward new highs, but market behaviors are indicative of shifting investor preferences – away from growth speculation and toward risk-aversion. Generally speaking, these market indicators depict much greater disparity between the best- and worst-performing stocks.
Dispersion of stock market returns, a reflection of how widely market returns are distributed, is an important measure that assess the conflicting forces that drive broader economic movement. When the number of stocks setting new 52-week lows is greater than the number of stocks setting new 52-week highs – in spite of overall market growth – it often highlights the deterioration of positive market trends.
The Hindenburg Omen
Beyond the simple majority presence of declining stocks, the Hindenburg Omen is a sell signal that depicts a market environment in which an abnormally-large number of securities reach new 52-week highs, while a similarly overwhelming number of securities fall to new 52-week lows. The rationale is that in a healthy market under "normal conditions," a substantial number of stocks may set either new annual highs or new lows, but not both at the same time.
The simultaneous presence of many new highs and lows may signal trouble.
The Hindenburg Omen specifically states that when 2.2% of an exchange’s securities reach new highs and 2.2% of an exchange’s securities dip below their annual lows, a market decline is soon to come.
The Titanic Syndrome
Another related sell signal is the Titanic Syndrome, a term coined by Bill Ohama in 1965 that typically indicated a 10% decline in the Dow Jones Industrial Average. The Titanic Syndrome is a phenomenon in which the NYSE reaches an all-time high in equities, but within a week, the number of stocks falling to 52-week lows outnumbers those that reach 52-week highs.
The Big Versus Small
Many stock market strategists closely follow the performance of small public companies as indicators of economic boom or bust. The reasoning is that small stocks tend to be the first securities to surge in a new market rally, and the first to fall before a downturn.
The disparity between the performance of big and small stocks is even more indicative of a looming bear market, however. Five of the past six market downturns were preceded by a period in which the growth of small companies trailed large business by 10% or more.
The Collective Indicators
While any singular market indicator is never enough evidence of a downturn, a combination of several corresponding signals can be greater cause for concern. John Hussman – former University of Michigan economics professor and president of Hussman Investment Trust – cautions that simultaneous occurrence of dispersion, the Hindenburg Omen and the Titanic Syndrome have signaled an impending market fall.
In fact, these indicators presented themselves simultaneously both in 1999 before the dot-com crash and in 2007 when the financial crisis was getting underway. And in November 2017, markets hit a record high, stocks setting 52-week lows outpaced those setting 52-week highs, and more than 3% of NYSE companies formed both new highs and lows.
Additionally, shares of small companies have produced average returns around 10%, while the biggest businesses on the Dow Jones Industrial Average have made average gains of 22%, eclipsing the noted 10% threshold.
Taking Precautionary Measures
There’s a lot of noise surrounding the investing world, and that includes a news cycle that’s inherently geared toward entertainment. Before reacting to any potential media hype that predicts a crash, you need to be able to truly assess the current financial environment. But most investors don’t have the inherent knowledge, experience, or time to wade through information and understand how it may impact their portfolio.
A seasoned financial advisor has experienced many market falls, however. They have the necessary context to assess what data and indicators are relevant to your goals. And they certainly should understand how to build your portfolio to weather any financial downturn over the long term.
Unfortunately, some investors succumb to the emotions and pressures that come with a swirling media cycle that includes many predictions of a downturn. And they may make decisions based on recommendations from a “guru” who knows nothing about their individual portfolio. It’s those decisions that can put your long-term goals at risk.
Your investment advisor is there to help educate you on what your investments are doing and make sure you’re on track to achieve your long-term goals. The exact timing of a crash – or even the actuality of a crash – may not be predictable, but if you take the proper measures to solidify your portfolio and steer clear of emotion-based mistakes, you will be far more secure in the long run.
How do you know what information is worth assessing and which is noise?
Click below to download your copy of our investor awareness guide.
About Greg Hammond, CFP®, CPA
Greg Hammond is the chief executive officer of Hammond Iles Wealth Advisors, and co-founder of Planned Giving Strategies®. Greg leads a team of professional financial advisors providing customized wealth management and investment solutions for high-net-worth individuals, families, companies, and charitable organizations across the U.S.