In most years, the stock market goes up. And then, when you least expect it, it plunges. Unfortunately, stock market investors can’t totally predict or avoid periodic dips, corrections, and outright crashes, but looking back at history’s biggest stock market crashes can help guide your investments going forward, and it could give you an inkling of when a market dip may be in the cards.
- It's impossible to perfectly predict when the stock market will crash, but there are a few factors that typically signal the possibility.
- These three signs are: an over-valued market, some type of financial engineering, and an external catalyst.
- It's wise to always be prepared for a crash by diversifying investments and keeping some funds in cash.
Does Anyone Know What Causes a Stock Market Crash?
There’s been some research into the commonalities of stock market crashes. Scott Nations, author of The History of the United States in Five Crashes, says that the major stock market drops and modern-day crashes included:
- An over-valued market
- A type of financial engineering or “contraption”
- An external catalyst, frequently unrelated to the stock market
So, with these three things in mind, here's what to look for before a stock market crash.
Understanding an Overvalued Market
In general, the best indicator of how the market is being valued can be found in its price-to-earnings ratio, or P/E (which is also used to value individual stocks). By dividing the aggregate price of the stock market by all of the companies' earnings, you arrive at the price that investors will pay for $1 of earnings or profit. The lower the P/E ratio, the cheaper (more undervalued) the stock market.
By examining the market’s historical P/E ratio, and comparing it to its current ratio, you get an idea of the stock market's relative value. For example, as of March 13, 2020, the mean P/E ratio of the S&P 500 was 15.78 and the current P/E ratio of the S&P 500 was 20.38. The difference between the two shows that it was 29% overvalued.
In the words of world-renowned economist John Maynard Keynes, “The market can stay irrational longer than you can stay solvent.”
Basically, the stock market can stay overvalued for a long time before it corrects itself. So, that alone isn’t enough to predict when a crash will occur.
What Is Financial Engineering or Contraption?
Hindsight is 20/20, and pinpointing the prior financial contraptions is easier than predicting the future culprits. The dotcom crash was facilitated, in part, by investors’ irrational enthusiasm for all technology-related stocks. The more recent stock market crash of 2008 was partially due to the mispricing of mortgage derivative securities, which are complicated financially engineered products.
Nations posits that algorithmic trading or extremely illiquid ETFs could pressure the markets in the future. Along with the overvalued market and an external catalyst, these investment products could complete the stock market crash equation.
The Catalyst for a Stock Market Crash Could Be Anything
Markets closed for six days following the 9/11 attacks in 2001, in an attempt to forestall a market crash. Despite that effort, on the first trading day after the attacks, the Dow Jones Industrial Average fell 684.81 points, or 7.1%, for the largest one-day loss in the history of the stock market at the time.
Other crashes can similarly be linked to disasters. The 1907 stock market crash was set off by the catastrophic San Francisco earthquake of 1906, and the 1987 Black Monday crash was partially impacted by the Iran War.
Of course, it’s not always easy to see when a big event will trigger a market crash. That doesn’t stop skittish investors from over-reacting to a potential market-moving event, though.
How to Prepare Yourself for the Next Market Crash
We have an overvalued market now. There are sufficient financially engineered investment products in our marketplace. Yet, no one knows what the catalyst will be for the next stock market crash. But in a sense, it doesn’t matter, because you can’t totally prepare yourself for the next stock market crash without completely exiting the investment market. However, you can cushion the blow when the inevitable market crash occurs. Your best bet is diversification: Don’t keep all your money in one place like the stock market. Especially as you get older, consider owning other investments like bonds and real estate funds, and then keeping some money in cash. That could help you have assets that won't fail if the market collapses.
And when markets are overvalued, consider trimming back your stock holdings. Just be aware that you might also lose some upside potential in the meantime.
As Keynes succinctly implied, markets can remain irrational and overvalued longer than you can remain solvent. Recent history is a testament to that fact. Ultimately, when liquidity is compromised with more sellers than buyers, the markets will drop in value, but when the inevitable market crash will occur is a mystery.