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Indicators That Can Be Used To Avoid a Stock Market Crash


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Why it is Important To Avoid a Stock Market Crash

Stock Market CrashIt is important to invest in the stock market with conviction; however, it is equally important to monitor indicators to avoid a stock market crash and protect an investment portfolio from excessive losses.  Avoiding a stock market crash also allows an investor to buy stocks and related assets, such as mutual funds and exchange traded funds (ETFs), when they are inexpensive, as a crash reaches a bottom.  While stock market crashes are relatively rare, they have occurred occasionally and will likely occur again in the future.

A stock market crash is when stock market indexes decline sharply, by 50% or more, within a matter of months or sometimes over a few years.  The most recent stock market crash occurred during the 2008-2009 financial crisis, when the S&P 500 index lost over 55% of its value.  The technology heavy NASDAQ Composite index fared even worse during the post-dot.com bubble stock market crash that lasted from 2000 to 2002.  From a peak of over 5,000 during the year 2000, the NASDAQ Composite index lost over 75% over of its value by the time it bottomed near the 1,200 level in 2002.

Investors obviously have a strong incentive to protect their investment capital from occasional stock market crashes by identifying the warnings signs and taking defensive measures ahead of a potential crash.  Investors need to be aware of the numerous stock market valuation indicators that are available that provide guidance regarding the risk of an imminent stock market crash and assess whether defensive investment measures are warranted.  Many of the valuation indicators discussed below were flashing overvaluation warning signs before the crashes that occurred in 2000-2002 and 2008-2009, and therefore are worth tracking for signs that the risk of another crash is elevated.

How To Use Valuation Indicators To Avoid a Stock Market Crash

Attempting to sell stocks and related assets at the peak of bull market is not the purpose of tracking stock market valuation indicators that can be used to avoid a stock market crash.  It is futile to try to determine the exact top of the bull market phase of a stock market.  Instead, the indicators should be used to develop a broad understanding regarding stock market valuation levels to identify when stocks are grossly overvalued on a historical basis and susceptible to a crash, so defensive investment measures can be taken in case a stock market crash materializes.  These stock market valuation indicators can also be used to identify times when the stock market is grossly undervalued, and provide investor guidance regarding when to reenter stock positions for future gains.

Some of the Indicators That Can Be Used To Avoid a Stock Market Crash

DJIA 1929 CrashThe S&P 500 Price-to-Earnings Ratio (P/E Ratio) is the average price of all the stocks in the S&P 500 index divided by their reported earnings for the prior year.  The average S&P 500 P/E Ratio can vary considerably over time from under 10 to over 30.  The long-term average, going back nearly 150 years is approximately 15, which is a good level to gauge whether the stock market is currently undervalued or overvalued based on the S&P 500 P/E Ratio.  When the average S&P 500 P/E Ratio is well under 15, the chances of a stock market crash are very low, and most likely the stock market is at a level that presents a good buying opportunity.  When the S&P 500 P/E Ratio is above 15, it is a good idea to pay close attention to other indictors for indications that the chances of a stock market crash are elevated.  When the S&P 500 P/E Ratio trades above 18, the chance of a stock market crash is high, and defensive measures should be considered, especially if other indicators are also indicating an elevated risk of a stock market crash.

Investor Sentiment is a reading of how many investors think the stock market will increase in price and are bullish compared to how many investors think the stock market will decline and are bearish.  While it may seem counterintuitive, excessive bullishness is actually an indicator that a stock market top may be near and indicates the risk of a stock market crash is elevated.  Excessive bearishness is an indicator that a stock market bottom is either occurring or will likely occur in the near-term, and has proven historically to coincide with good entry points for stock investments.

The Ratio of Stock Market’s Total Market Cap (TMCRelative to the United States Gross Domestic Product (GDP) is a broad stock market valuation indicator that many analysts think is one of the best indictors to assess the current valuation of the stock market.  To determine the reading for this indicator, divide the total market capitalization of the entire stock market and by the most current reported total GDP for the United States.

For example, in late September 2013, the total market capitalization of the stock market was $18.3 trillion, which equals an approximate ratio of 114.6% based on the last reported GDP, which puts the stock market at the high end of the modestly overvalued range of 90% < Ratio < 115% (see chart below).  For updates regarding the current Total Market Cap to Gross Domestic Product (TMC:GDP) Ratio, see: Where Are We With Market Valuations?
TMC GDP Ratio
iM’s Weekly Business Cycle (BCI) Index is recession prediction gauge that has a track record of providing an eleven week average warning time before a recession occurs in the United States.  It has an impressive record of providing no false recession predictions since it was created in the late 1960s.  Since economic recessions are often what causes the stock market to turn into a bear market (20% or great decline) or a crash (50% or more decline) as corporate earnings decrease, the iM’s Weekly Business Cycle (BCI) Index is worth following for advanced warnings of oncoming recessions, so defensive measures can be taken in regards to stock investments.

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One Response to “Indicators That Can Be Used To Avoid a Stock Market Crash”

  1. chitra says:

    The things you can do if your scared of stock market crash are:
    1)You can buy bonds, though the risks of rising interest rates still seem to outweigh the hope of lower interest rates
    2)You can sell call options to increase income or hope your shares get called away at higher prices
    3) You can lighten up on how much stock you own and slide into cash for a while.

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