What early warning signs of a stock market crash might we see?

The next stock market crash will inevitably come…

There could be no warning. On May 6th, 2010, the “crash of 2:45”, as it has been called, started at 2:32pm and lasted for approximately 36 minutes in which time the Dow Jones fell some 9%, most of this within minutes. Fortunately, values largely recovered almost as quickly.

The stock market does not have to crash, but could enter what is call a period of correction. If the correction extends and the market retraces 20% from its peak over a few months it becomes known as a bear market.

This is what happened during the great financial crisis. The U.S. markets peaked on October 9th, 2007.  By mid-2008 the bear market was declared and this was all before the sub-prime crisis began to unfold.

On September 29th, 2008, the Dow Jones fell some 7% in a day. Eventually the bear market reversed course on March 9th, 2009, having shed 54% of its value from the 2007 highs.

However, if the stock market decline is not so obvious and protracted, there are some useful potential early warning indicators to keep an eye on – we plan to update these daily on the ETF Centre website in our market warning box.

  • Retracement from recent market high (% decline) and duration
    This is a metric frequently used to describe the condition of the market and can signal the start of a bear market. A first note of caution typically arises when we reach a 4% decline from a recent high, while a correction is official at the 10% mark.
  • Market correlations
    In 2008, all risky assets, primarily the equity asset class, became highly correlated and moved together. We monitor all asset class correlations daily.
  • Equity / fixed income correlations
    Academic research has identified that weakening equity to fixed income correlations are associated with a weak and volatile equity market
  • The Japanese Yen
    The Yen is viewed as a “safe-haven” asset and was one of the first to signal concern in 2007. The Yen strengthened against the U.S. Dollar well before the market peaked in October 2007.
  • The price of gold
    The movement in the price of gold, while not perhaps predictive, can certainly be expected to rise, particularly at a time of increasing geopolitical tension.
  • The yield curve
    The yield curve is one of the most reliable indicators and one that savvy market traders always keep on their radar. Most economic forecasts are based on backward looking data. A better forecast is generated from looking at what investors are doing with their money. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield inversions have preceded each of the last seven recessions, including becoming inverted in August 2006, a bit more than a year before the recession started in December 2007. The inversion occurs because of investors buying long dated bonds as protection, driving down long dated yields.
  • Social media
    It has been suggested that searches on Google and other search engines for “market crash” or similar terms are indicative of investor concern. Google Trends provides a record of our Google searches, scored between 100 (peak interest) and 0 over any period. A score of 40 or more might be worth watching.

There are a number of precursors that signal an impending economic recession.

  • A downturn in the growth of average earnings per share (EPS)
  • A downturn in world trade or exports
  • The end of a series of central bank interest rate hikes, suggesting the central bank is concerned about future growth prospects.
    A slowdown in employment increases or even a rise in unemployment

Definitions

  • crash – when the major stock indices fall 10% or more within a day or two
  • correction – when the major stock indices decline 10% over a week or more
  • bear market:     When the major stock indices fall 20% over two months or more

More on stock market crashes

This is part 2 of a 4 part series on stock market crashes.