When it comes to stock market crashes, it isn’t a matter of if they will happen but when. Some of the more notable market crashes include the stock market crash of 1929 and the dot-com bust of 2000. Luckily, if you know what to look for, you can actually thrive during these tough economic times so now let me share with you 5 signs that a market crash is on the way!
So before we get into what signs to watch out for, let’s go over what constitutes a stock market crash. A stock market crash is said to occur when there is a rapid and unanticipated decline in the market index in a day or within a few days. A stock market crash occurs when a stock market index like the Dow Jones Industrial Index or the S&P 500 drops dramatically. This usually leads to panic as investors turn into sellers which further brings down the value of the stock market.
In essence, the stock market crashes as a result of a bubble being formed. A bubble is a rapid increase in the value of an asset usually above the real value of the asset driven by speculations from investors. When investors believe that an asset will perform well they will pour large sums of money into it. This triggers the increase in value of said asset and very soon, more people begin to notice and invest. Eventually, the value reaches a certain peak and then performance begins to decline. Panic sets in and investors begin to sell their stocks in droves. This phenomenon sends the price of the asset into a free fall and eventually, a crash ensues.
Many of you may remember the dot-com bubble in the late 1990s which ultimately led to the stock market crash in the year 2000. Several internet startups began operating in the 1990s and investors believed that they would be their ticket to great returns. Many people bought into the hype, often times at inflated prices, with the hope to sell at even higher prices. Unfortunately, most of these startups did not see the success that their investors anticipated and many investors lost their money. If only these investors knew the following five signs that the stock market will crash!
Sign #1: Rapid rise in stock valuations
One of the signs that a stock market crash is imminent is a rapid rise in the value of stocks. Stocks generally rise in value as more people become aware of their existence and pour their money into them. While this is great for the company, this can cause the stocks to become overvalued and when there is a market correction, prices will fall and the stock market can crash.
This happened before the stock market crash of 1929 which left many people unemployed and homeless. Let me briefly share the history of this crash so you can understand how a rapid rise in stock valuations can cause this economic depression.
About a decade before the crash, at the beginning of the 1920s, all was well and the economy was flourishing. New industries such as the automobile industry and radio were booming and people became very optimistic. Unemployment levels were low and people moved to the city in search of better jobs. Because of this, that decade was called the roaring twenties.
The stock market was also performing exceedingly well as the value of stocks increased steadily. The Dow Jones Industrial Average rose from 63 points to 381 points within that period which is over 600% growth in the stock market. Although there were speculations that the stock market price had reached its peak, people were confident that the market would only continue to rise. However, this increase was based on a bubble and it was unsustainable and would soon come to an end.
It began on October 25, 1929, with about 12.9 million shares traded in a single day. The panic continued on October 28 also known as “Black Monday” as more investors sold their shares. The Dow Jones Average Index dropped by 13% that same day. The next Tuesday, more investors sold their shares, and the market index dropped further by another 12% making a total decline 25% within just two days. By the middle of November of that same year, the stock market had lost more than 50% and this downward spiral continued until 1932 when it dropped a total of 89%, leaving a ton of investors decimated.
Sign #2: Major share buybacks
A buyback is when a company repurchases its shares, and major share buybacks are one of the signs that a stock market crash is looming. Companies can boost the value of their stock and improve their financial statements by buying back their shares from the marketplace. Buying back their shares from the marketplace reduces the number of shares in circulation thereby creating artificial scarcity and inflating the value of the stock.
Share buybacks can be good if a company is doing it because it is sure that its shares are undervalued. It can help the company boost the value of its shares. However, if a company has the ability to use their funds to expand its operation but decides to buy back its stock instead, it could be a sign that the shares are not overly valuable and that the company is buying back shares to inflate their value. This inflation of value is not sustainable which is why it contributes to the bubble already existent in the market.
More specifically, major share buybacks can increase share value by boosting the earnings per share. That is, there would be fewer shares available to the public and the earnings would be distributed among the few remaining shareholders. This increase in value can lead to a bubble which would attract more people to invest in the company and as you have already learned, the stock market crashes when a bubble is formed.
Additionally, many share buybacks are financed with debt and this is a bad management practice, given that the debt could have been used to finance investments that can generate more revenue. A company could be using these funds to invest in their employees or technology, both of which can contribute to the organization’s growth. However, instead of the company benefiting from strategic investments, these stock buybacks only benefit the organizations major stakeholders.
As you probably guessed, when there is an economic downturn, companies who have recently undertaken large buybacks find it difficult to cope because they lack the cash they need to ride out tough economic times. When this is the case, operations slow, employees can become disengaged and many of them go out of business.
Sign #3: When investors are using debt to buy stock
Another sign that the stock market will crash is when investors are using debt to buy stocks. When investors use debt to buy stocks, it’s called buying on margin. Investors who do not have money to invest with or those who simply want to invest more can put some money down and rely on leverage from a broker. This is similar to a mortgage loan where you are relying on someone else’s money to fund your investment.
This exact situation took place in the early 1920s when people who hoped they could make money from the stock market did everything possible to have a share of it. Many of them bought stocks on margin by taking advantage of loans from banks which was very accessible at the time. Investors were confident that the stock market would continue to increase hence, they paid less attention to the risk that they were assuming.
Of course, this strategy makes sense when times are prosperous. The benefit of investing in stocks using debt is that investors can buy more than they typically could with just their own money but if the market collapses, like it did, their losses would be amplified, making it almost impossible to repay their creditors.
Sign #4: When a lot of companies are going public
One of the ways that new companies raise capital is by going public. This refers to the initial public offering (IPO) of a new company that allows the general public to buy its shares. When lots of companies are going public, it is usually a sign that the stock market will crash. A good example of this is the dot-com bubble that led to the early 2000 stock market crash. Several technology companies went public within that period in order to raise money and take advantage of the market bubble. People were willing to invest because they believed that the internet was untouchable and that any company associated with it could continue to rise in value. The estimated number of startups that launched during the bubble was about 7,000 to 10,000 and by mid-2003, more than half of them were out of the market.
In short, when several new companies are going public within a short period, it may be as a result of a bubble. Most of the technology companies that went public during the dot-com bubble raised a lot of money within a short time. Most of them were new and they had no record of profit or a plan to generate the profits that would support their share price. Sadly, most investors didn’t care about this and faced severe financial consequences as a result.
Sign #5: The yield curve is inverted
An inverted yield curve is when the interest rate of a short-term investment is higher than the interest rate of a long-term investment. The normal pattern is that long-term investments should have a higher yield while short-term investments should have a lower yield. Why this curve is important is because it has always been observed before any recession and it may be a sign that the stock market will crash.
The inverted yield curve starts when the interest rate on short-term and long-term investments are almost the same. This curve is called a flat yield curve and it is followed by the inverted yield curve. What this means is that investors have little confidence in the short-term economy and they think the long-term economy will perform better. They would rather make a long-term investment with a lower yield because they believe that it is more secure. Now that you have seen some of the reasons why the stock market will crash, the next question you may have is “how can I handle a stock market crash?” Well, if you want to experience minimal impact from a stock market crash, you must be prepared before it ever happens. Start by diversifying your portfolio. Don’t invest all of your money in one single industry. During a market crash, some industries get hit harder than others therefore, diversifying your portfolio is a strategy you can use to reduce the impact of the crash.
You should also build up your emergency savings to avoid the temptation of selling off your stock during a market crash. The only way you lose money during a crash is by selling your stock when the value is low. Historically, the value of the stock market has always increased again after a market crash. In fact, you should keep some extra cash on hand that you can use to buy more stocks when their prices are low. This will allow you to buy stocks at bargain prices and reap the benefits of your wise investments when the market rebounds.
Finally, while these signs can indicate an upcoming stock market crash, no one can predict the exact time it will happen however knowing the five signs I just went over will give you the best chance of riding out a tough economic wave!