Through my career, Iâ€™ve experienced several major crashes and corrections. I can tell you, the first few were scary! But as I began to realize how to manage my positions, and then how to identify the telltale signs of a stock market crash, my investment performance started to accelerate.
In this article, Iâ€™m going to show you the 3 telltale signs that warn you a stock market crash is just around the corner. This article could be the most valuable you read all year!
To understand the 3 telltale signs Iâ€™m going to discuss, you must first have an understanding of what a crash and correction are. There is a distinct difference between the two.
A stock market correction is a â€œrealignmentâ€ back to the median or average. It typically occurs when prices have become too overbought (inflated against their fundamental valuation).
Whereas a stock market crash is where prices fall quickly, typically without warning, and are driven by panic.
But there are a few key facts that you may not be aware of, that will change how you emotionally manage yourself at times of uncertainty:
- A stock market crash rarely occurs at absolute peaks of the market
- Whilst a crash might occur without warning, there is always reason
- Market sentiment causes a crash. The movement is purely emotional reaction from investors
- A Correction can turn into a Crash, if it has reason and investor sentiment follows.
These key points pave the way for our 3 telltale signs a stock market crash is just around the corner.
Telltale sign #1
Take a look at a chart for any leading index where there has been a stock market crash. Did it occur at the peak of the market?
The answer is no.
Panic occurs as a last resort. Investors wear the pain of a falling market for only so long, and when that pain threshold has been exceeded, they sell. Like sheep, they all follow each other.
All the big market crashes have occurred after the markets have declined for some period of time. Normally a Correction realigns prices, and investors accumulate stock at â€œbetter pricesâ€. The uptrend is still intact, and thereâ€™s no reason to exit.
But institutions are savvy. They donâ€™t sell as markets are falling. They create the fall! Once they have decided to reduce exposure, either in individual stocks, or in portfolio totality, they are unable to quickly offload stocks. Otherwise, they would create a panic.
Institutions will sell stock into an uprising market when they find reason to reduce exposure. They are the market makers. They create the environment that we are dealing with. But we will never be privy to the fact that they are changing their stance to broader economic/fundamental shifts.
Our best tool to identify this change is the Primary Trend of the broader market.
If you have a change in Primary Trend for the market you are trading (say the S&P500 index for the US markets), then the next step for you is to be on watch for Telltale Sign #2.
A change from a Primary Upwards trend, particularly to a Downwards trend as opposed to a sideways trading range, means there is an increased potential of an underlying shift occurring with market participants. And because the institutions are the biggest influencers in the markets, you will be unable to â€˜predictâ€™ a change in trend as the institutions do not benefit by showing you their hand before a fundamental shift has changed.
Telltale sign #2
When Joe Kennedy, father of President John F Kennedy, was quoted as saying â€œYou know its time to sell when the shoeshine boys give you stock tipsâ€, he highlighted the underlying fact that the markets have a natural order.
And although the stock markets are an opportunity for any person from any walk of life, the fact is that the stock market represents the gathering, dissemination, interpretation, and execution of data and information. It is why those who have connections and who have trained/practiced in their profession for many years, will typically make better decisions than those who â€œhave a puntâ€ at stocks.
By their very nature, a stock market crash is something that seems to come out of nowhere without warning.
My opinion is, that in the modern information age, we are far more aware of what causes market crashes and how to read the information to provide warnings.
Every market crash, from the GFC 2008, Tech Crunch 2000, the Greek Financial Crisis 2009, and even Black Friday 1987 and the Great Depression of 1929, have all had fundamental reasons for why they have occurred.
Some of those reasons were very obvious early on. Greed led to â€˜moms and dadsâ€™ holding onto investments through the crash, while savvy investors manage their portfolios. And for other scenarios where markets crashed or reverted to a Bear market, the reasons needed to be explained after the event occurred.
The American economist Hyman Minsky explained that a crisis (or crash) had to start with a â€œdisplacementâ€. Something that would trigger the event to â€œshockâ€ the macroeconomic environment.
So telltale sign #2 is that, as part of your daily/weekly study of the environment you are trading, you are finding continuous news pointing to data that can have a major impact on the economic environment, especially if this has followed Telltale #1 with a Primary change in trend of a leading index, then you have an environment that has the right conditions for telltale #3.
If the markets were controlled by fundamental and economic data only, then we would have no volatility; no movements in prices; just a flat line of stock prices that shift only when data changes.
Investor emotions create price fluctuations. Supply and Demand are influenced by fear and greed. The more investors see others making money, the more they want to participate, and the more Fear Of Missing Out (FOMO) causes them to buy at any price.
Greed and Fear will also cause investors to keep holding positions even when the data tells them not to. Until such time as they can tolerate the pain no more, and they panic sell. Typically at huge losses. Then Fear will inhibit their ability to see value again, restricting their re-entry into the markets, until FOMO returns â€“ at which time, again, it is too late.
Reading investor sentiment, on top of fundamental and economic analysis, is your greatest tool to identifying if a stock market crash is just around the corner.
Before the computer age took over, investor sentiment was something that was privy only to the floor traders, or those wealthy investors who had a direct line to an industry professional. Even your broker was a valuable tool.
But with very few live trading floors existing, and all trading activity occurring electronically, reading investor sentiment is now solely left to the chartist. Using price analysis techniques and technical analysis is not only a mathematical methodology to define either a momentum or a trend alert, there is an art to using price analysis to understand investor sentiment.
Master the art of reading charts and understanding investor sentiment, along with defining a change in trend and doing your â€˜homeworkâ€™ and identifying a key displacement to trigger a stock market crash, and you will never fear a fall in the markets again.
Embrace the inevitable
Big stock market crashes are far and few between. So knowing the telltales that lead to a crash will save you when it does eventually occur.
What your course of action will be to the signals that a bear market, or potential crash, are just around the corner all depend on a number of factors. Such as: are you in retirement; long-term strategy versus short-term strategies; diversification management; your tolerance to volatility; your Beta exposure (alignment with the broader market).
And it is prudent to note some key numbers about Bull and Bear markets. The following data shows the percent decline in the market and how frequently they have occurred since 1945 to present;
- A 30-60% decline in the US markets has occurred 5 times (on average once every 14.6 years)
- A 20 to 30% decline has occurred 5 times (on average once every 14.6 years)
- A 10 to 20% decline 13 times (on average once every 5.6 years)
- A 5 to 10% decline 39 times (on average once every 1.8 years)
Crashes will occur. Maybe not so frequently, but when they do, it hurts!
By setting in place a plan to identify when they are likely to occur, you can avoid the pain and heartache. And be right and ready to benefit from the recovery that follows.