Stock market crash: what are the warning signs?

With the rise of “stonks” and meme shares, on top of over a decade of low interest rates, there seems to be increasing talk of a stock market crash. However, at the same time, governments are keen to keep rates low, so it’s hard to know when any bubble would burst. Some will likely even disagree that we’re in a bubble given the market fall as a result of the Covid-19 pandemic.

For the purposes of this article we’ll say that a stock market crash indicates a fall of 20% in a stock market over a short period of time. Falls of 5% or 10% are relatively common, and are more commonly known as a correction, which all investors will have to face up to and deal with as part of the ‘cost of business’.

With a crash we’re looking at something that can be more damaging, especially if an investor panics. These stock market crashes below highlight how crashes are often roughly a once in a decade event that all investors need to be wary of. A crash often follows a bout of speculation as you’ll see from previous stock market crashes.

Examples of stock market crashes

1987: Black Monday – the exact cause is unknown but it followed a long bull-run in equity markets.

2001/2: Dotcom crash – overexuberance in the US technology market and faddish investment led to extreme overvaluations which eventual burst.

2008: Global banking crisis ‘credit crunch’ – cheap credit and lax lending standards fuelled a housing bubble that once burst left financial institutions were left holding trillions of dollars worth of near-worthless investments in subprime mortgages.

2020: Covid-19 pandemic crash – this is a more unusual one that most people reading this will have invested through. The realisation of the impact the virus would have on the global economy led to a prolonged period of selling off in the early part of 2020.

Advice form Jim Slater’s The Zulu Principle on signs of the top of the bull market

Some of this is worded differently from how Jim Slater phrases it, but I’m sharing his ideas on the red flags that indicate the top of a bull market, or could do.

  • Cash is Trash – when there’s a view amongst money managers that cash isn’t important then it’s a sign that risk has become potentially excessive.
  • Value is hard to find – average P/E ratios for shares will be at or near historic highs
  • Investment advisors are bullish – similar to the first one, when professionals are very bullish it could be seen as a sign of groupthink and a lack of focus on fundamentals
  • New issues – an abundance of rights issues and new listings, with quality suffering
  • Insider Trading – the ratio of selling to buying is often at a high level
  • Party talk – at the peak of the market, everyone is talking about shares, even those who’ve never previously expressed an interest.

There are some other signs he discusses, and not all can be seen in the current market. Some, however, clearly do exist.

Signs we may now be in a bubble

From the list from Jim Slater above, there are definite examples of new issues, insider trading and party talk, at the current time.

There has been a glut of new listings recently, notably Dr Martens, Moonpig and The Hut Group. The London Stock Exchange is also said to support relaxing the 25% minimum free float requirement, as well as allowing dual-class structures for premium market listings. These rule changes may attract more founder-led businesses as well as tech businesses to the London market – but could also feed a bubble as investors clamour for the latest exciting company. Transferwise, Deliveroo and DarkTrace could all be perfect examples of these kinds of ‘sexy’ companies listing.

The UK will be following behind Wall Street where there has already been significant IPO activity, even last year. There the technology boom has meant Airbnb (NASDAQ:ABNB) and DoorDash (NYSE:DASH) took advantage of the chance to become publicly listed.

Beyond Slater’s list, there are other reasons to think we’re in a bubble. The FT reported just this week that investors put $58bn into stock funds last week while slashing cash holdings. Something the journalists went on to describe as “the latest sign of the fervour that has swept across global financial markets.

Overall I think there are plenty of indicators for bears to grab hold of. I doubt talk of another market crash will ever be too far away, even if the economy does recover through 2021 and companies report stronger earnings as a result.

What I’ll do now

If we accept we’re in a bubble, then the question really becomes: what to do about it? And also, when will it burst? The latter one is easy to answer. No one will know until it happens. People will retrospectively say they knew, in reality, that’s nonsense and is a form of psychological bias or just plain BS.

The problem with trying to anticipate a bubble bursting is you may miss out on the strong bull run that often precedes the crash. Timing the market is incredibly difficult, as any experienced investor will know.

That’s why my plan is simple. I’m going to keep some of my portfolio as cash within my ISA, have other money saved in the bank, never bet the farm on a single or a small number of shares and I’ll spread my investments around different industries, countries and even investment styles. What I won’t do is stop investing in equities just because there’s some risk. I accept that one day there will be another stock market crash. It’s just par for the course.

I’ll also look to invest in shares with reasonable valuations and that actually produce something that customers are prepared to pay for, preferably in growing numbers. So for growth stocks a high year-on-year increase in revenue is essential. For value shares, you want to see signs a turnaround is bearing fruit before investing, in my opinion.

I’ll mostly ignore noise around the economy and definitely anything from gurus saying when the market will crash. Instead, I’ll stick to my strategy and try to buy good companies at a fair price. It works for me, so I’ll keep doing it.

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