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What are the top six signs that a stock market crash is coming?

There is increasing concern among investors and analysts that the incredible bull run enjoyed by Wall Street may soon be brought to its knees. This is precisely the kind of sentiment that is enough to rattle the nerves of market participants the world over. So how will you know that the bubble is set to burst?

We are at a critical juncture: the Chinese economy is faltering with deep contractions in imports, exports and manufacturing, with a domino effect on emerging market economies like Brazil, Russia, India and South Africa. This in turn impacts on the multinational corporations that have invested in those countries.

Already the energy and mining sectors in global bourses are performing poorly, and this is dragging down major indices like the S&P 500 and the Nasdaq 100. It is disingenuous to imply that what happens in China or emerging market economies is unlikely to affect Wall Street. On the contrary, we are part of a synergistic economic system where each part influences every other.

This week we are likely to see a sharp contraction in the performance of the S&P 500 given that energy companies will be reporting their quarterly results. But a full-on crash is much harder to predict.

How do you know when a bubble is forming?

As its name suggests, a bubble is a rapidly inflating overvaluation of a particular stock or sector. If the fundamentals of a stock are sound and they warrant such growth, this is not a bubble. However, in the six years since the global economic meltdown in 2008/9 we have seen stock prices skyrocket. Of paramount importance is the fact that people are losing confidence in equities.

Current market conditions give us pause for thought:

  • A Fed rate hike is likely to come on 16 December or in early 2016 and it will lead to subdued declines in equities. A dramatic sell-off is however unlikely given that the market always factors these issues into the pricing before the announcement is made.
  • When equities markets rally for any prolonged period of time, speculators often fear a reversal. When this sentiment gains momentum it can lead to massive sell-offs, thereby causing the purported ‘bubble’ to burst.
  • Past performance is a barometer of future performance when it comes to predicting stock market crashes. If the market is overheating – growing too rapidly – a sudden slowdown could cause a crash.

The six warning signs

  1. Any rapid rise in the value of a stock or financial asset is a warning sign that a sharp contraction is a real possibility. We have seen numerous bubbles including the real estate bubble and the tech bubble. Right now, China is undergoing a real estate bubble and this is causing a sharp contraction in the Chinese equities markets. The problem with bubbles is that they give rise to panic-selling. The consequences of such behaviour are obvious.
  2. When major multinational companies like Apple, Google, Facebook and others issue debts for the purposes of major share buybacks, this could be a potential trigger of a stock market crash. This reduces company revenues especially if the market turns south.
  3. When investors take on a high degree of margin debt this means that stocks are being purchased with a tremendous amount of borrowed money. This is a dangerous situation to be in since high levels of margin debt have often coincided with stock market crashes. This is precisely the reason why Chinese equities tanked in August 2015. Much the same is true for the US stock market this year. The problem comes with profit-taking as markets start to reverse direction and everybody tries to exit rapidly.
  4. A surge in the number of IPOs in any given cycle may indicate a bubble. When the volume of companies wanting to go public increases, it is clear that the stock market is enjoying a bull run.
  5. The VIX, or Volatility Index, measures the volatility of the top options on the S&P 500. Known for obvious reasons as ‘the fear index’, a drop in the VIX may be a sign of investor overconfidence, while a rapid rise in the VIX could be one of the first indications that a crash is taking place, triggering investors to exit positions en masse.
  6. We’ve seen a glut of mergers and acquisitions, especially in the healthcare sector, recently. When there is access to cheap debt at low interest rates, many companies start buying up competitors and unrelated companies. Often they attempt to swallow up too much too soon, and fail dismally. It takes time to generate revenues, and often divestitures result from failed mergers and acquisitions.

Brett Chatz

Published: 3 November 2015

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.

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