Beware, there is danger ahead. What are some of the most common signs to look out for when a market which has been in the bull for a period is about to crash? Investors invariably acknowledge the market crash and the untoward effects on the price value of shares and stocks in the market. This article highlights the top five details that could be major indicators of a market crash.
1. Irrational Exuberance.
Former Fed Chair Allan Greenspan popularized the term irrational exuberance, and just as the term suggests, investors become overly optimistic. Therefore prices are driven as a result of enthusiasm. With irrational exuberance, prices may appear to be rising for valid reasons, and economic optimism may create the assumption that the rise in prices predicts the future. With this assumption, investors lose sight of the underlying value of stocks and assets, leading to the widespread bubble of enthusiasm bursting. Now it is important to note that while irrational exuberance can occur and deservedly so during the later expansion phase of the business cycle when the economy is running at full capacity, it is very dangerous and not at all a positive indicator of a market that will continue to run at such capacity. Excessive enthusiasm usually results in a recession; that is when investors panic after prices of an asset return to their real-world values forcing them to sell even at prices below real value. The resultant collapse causes an economic contraction which leads to recession. In 2014, U.S oil companies in the shale-oil industry laid-off workers after West Texas crude oil prices kept plummeting from $100.14 to $38.42 in August 2015. Low prices affected the economy and investors.
2. Excessive Margin Debt.
When investors borrow more money to buy stocks, it is referred to as margin debt—for example, buying $200 worth of stocks with $100 capital necessitating an additional $100. Despite benefits such as increased buying power which allows an investor to make more and higher purchases, higher potential returns, and diversification, the risk associated with margin debt cannot be overemphasized. The combination of rising margin debt and slipping stock prices augments the risk to the market. When the stock market falls too far below, investors will receive margin calls that could force excessive selling, dragging the market prices below. As a trader, you may incur higher risks if you use margin to buy stocks that later fall in price. More money would have been lost than if you didn’t use margin debt. Interest charges may also accrue, and investors will have to account for the cost of borrowing money. For poor-performing investments, these charges increase losses.
3. Excessive Valuation.
A stock may become overvalued if there is a surge in demand due to investor perception or if its market price remains constant after a decline in revenues, earnings, growth projections. Stocks with higher market value than their intrinsic value are considered overvalued stocks. The rise and fall in demand for shares, market fluctuations, etc., contribute to excessive valuation. Investors must determine whether the stock market is specific and the economy would witness any major cyclical fluctuations that could affect prizes tremendously. Warren Buffet, in 2001, proposed the buffet indicator as a fundamental measure of whether or not the stock market in whole is overvalued or undervalued, and American economists and Wall Street experts use this to compare the total value of the U.S stock market to the U.S gross domestic product.
4. Widespread Complacency.
Another very common sign of an impending market crash is widespread complacency. Widespread complacency has to do with market sentiment wherein a positive sentiment is indicative of a rising market, and negative sentiment is a falling or bear market. This seems to prevail as a result primarily of Central Bank marketing. Political developments, geographical location and conditions, and significant economic indicators affect the sentiment associated with widespread complacency. When the real-time index of an expected level of price fluctuation in the S&P 500 index over the next year is calculated, a higher market sentiment projects market instability and more uncertainty. A high low index compares the number of stocks reaching 52-week highs versus 52-week lows. An index rating below 30 indicates bearish sentiment, while above 70 indicates a bullish sentiment. In general, however, widespread complacency proceeds the bear market and is, therefore, a major sign one should prepare for and note in an upcoming market crash.
5. Domestic and Geopolitical Uncertainty.
There cannot be a booming bull market or bearish stock market without the interplay of politics and geographical location. Legislations across several countries in the world may prove either favorably or unfavorably with legislation and legislative changes. Political expectations and anticipation of major changes, especially on taxes imposed on the stock market, can go a long way in determining whether or not a market is about to crash. On the international stage, many investors claim that underlying concern for market crashes and domestic uncertainty could weigh heavily on the market as investors and traders do not trust the security of their stocks and projection for higher returns. And undoubtedly, investors know not to invest in a stock market that heavily relies on fluctuating policies.
Take note to heed and prepare for the signs above if you want to avoid as much risk as you can as an investor. We have other more information on the stock market, and you can check them out as well. Don’t forget to ask in the comments section below if you have any questions.