You’re nearing the end of the longest bull market in U.S. history. The probability of a stock market crash in 2020 is about 80%. I’ve built a big list of bear market indicators. And this year, most of them are flashing warning signals. Mark my words… a market collapse is coming.
Six of my favorite market indicators are below and more importantly, what does this mean for you? The downturn will hurt the economy and destroy jobs… but it will also reveal great opportunities. I’ll show you how I’m preparing my portfolio.
Hint: I take a move right out of Warren Buffett’s playbook.
Six Stock Market Crash Indicators
Standalone, most of the indicators below are not a great predictor of a market crash. But together, they change the story. One underlying theme is the expansion of credit. Cheap debt has fueled the economy since the last crash.
History doesn’t always repeat itself… but it rhymes. These indicators are some of the better predictive measures we have. Let’s dive in…
1. Yield Curve Inversion
When investors are uncertain about the future, they pile money into safe assets. And government bonds are the safest they get – thanks to the power of taxation.
Investors have flocked to 10-year treasuries and have avoided short-term bills. Investors have lower confidence in the near-term economy. This has pushed the 10-year yield below short-term rates. This occurrence is called a yield curve inversion. It has been a strong predictor of past stock market crashes.
The chart below shows the 10-year minus the 3-month treasuries.
Every time it drops below zero, a recession follows within about a year and a half. The past recessions are shaded in gray. Last month it dropped into the negative territory. This is a strong indicator that we might be headed for a stock market crash in 2020.
2. Stock Market to GDP
This warning signal is one of Warren Buffett’s favorites. It shows total stock market cap to U.S. GDP. And after the long bull market, stocks to GDP are at an all-time high.
The Warren Buffett indicator has climbed from 93% in 2009 to 154% this year. That’s above the two previous highs and it’s not sustainable. Investors have pushed up company valuations. They’re at historically high levels and have outpaced economic growth.
3. Price-to-Earnings Ratio
The price-to-earnings ratio is a sign of stock market valuations. And over the long haul, it’s even more useful after adjusting for market cycles and inflation. This improved ratio is called cyclically adjusted price to earnings (CAPE).
For the S&P 500, it comes in at 30 and is over 45% higher than the long-term average. Although, it could still continue to climb. It’s well below the peak of the dot-com bubble. Either way, the ratio tends to revert to the mean as the stock market ebbs and flows.
It’s not a great predictor of a collapse but it can show excessive optimism in the markets. Instead, the PE ratio is a better predictor of future stock market returns.
I put together custom research on the PE ratio and subsequent 10-year returns. In the post you’ll see the negative correlation between the PE ratio and stock market returns.
4. Corporate Debt Levels
The Fed has pushed interest rates to historically low levels. This helped fuel the recovery from the last crash. Although, continuing to cut rates is not sustainable.
Companies have had a heyday leveraging up. Some have over borrowed and defaults will increase. This will send waves throughout the market. The chart below shows interest rates vs. total corporate debt…
Corporate debt continues to grow each decade but the borrowing will likely slow down if rates reverse. This will put pressure on the economy.
5. Housing Market
Cheap debt has also fueled home sales. Many homebuyers have borrowed above their means. This demand has pushed home prices back above pre-crisis highs.
It’s not as toxic as the last run up but it’s still a concern. Lending standards and the CDO market are more controlled this time around. Although, the housing market is still overextended due to the Fed’s manipulation of interest rates.
6. True Unemployment
The government reported unemployment rate is near record lows. Although, it’s not sustainable. You can see clear trends in the chart below.
Anytime unemployment drops to low levels, a recession isn’t far off. Optimism from a booming market spurs companies to over hire.
Unemployment is a good indicator of market health. Although, there’s a growing divide not reflected in these government numbers. True unemployment is climbing and for more insight, I recommended checking out my research on Universal Basic Income. It’s a unique view you’re not going to find anywhere else.
Potential Stock Market Crash Catalysts
Bull markets don’t die of old age. It’s been a strong run but what’s going to be the catalyst for change? With the 2008 crisis, the housing market broke down. Big banks went bankrupt and sent shockwaves throughout the economy.
This time around the first domino to fall could come from anywhere. It’s near impossible to predict what will spark an economic collapse at any given time. Instead, we can focus on some big themes putting pressure on the economy.
Trade Wars and Tariffs
The recent trade wars are hindering economic output. In general, tariffs lead to a lose-lose situation. Countries often retaliate and it’s a downward spiral. For proof, the Smoot-Hawley Tariff Act of 1930 helped lead to a 66% decline in international trade worldwide.
If current trade wars pick up more steam, it could spark or worsen a stock market crash. This also ties into the next potential catalyst. There’s bipartisan support to keep tariffs in place against countries like China.
2020 Elections and Politics
Presidential elections increase volatility in the markets. Politicians make big claims to win votes and the uncertainty moves the markets. Anything could happen during the upcoming election and spark a downturn… although, election years don’t show a clear pattern of stock market performance.
Predicting what’s going to spark the collapse isn’t where I’m focusing my efforts. Instead, it’s more important to prepare as the inevitable approaches.
How to Prepare for a Stock Market Collapse
To prepare for a stock market crash, I take a move right out of Warren Buffett’s playbook.
As a bull market gets long in the tooth, it’s harder to find companies at reasonable prices. As a result, Berkshire Hathaway’s cash and liquid positions have climbed from $30 billion in 2009 to over $100 billion.
When there’s a bear market, Buffett can use the huge cash reserves to buy beaten down businesses. The cash doesn’t earn much while waiting but there’s no rush. Unlike baseball, there are no three strikes and you’re out. Instead, you can let hundreds of pitches pass by and wait for a perfect one to hit a homerun.
Cash is king and my portfolio is about 60% in three month treasuries. I can keep rolling the positions forward while waiting for better buying opportunities. Then once deployed, I’m in it for the long haul.
Now if most of your portfolio is in the stock market – and you’ll need to liquidate in the next year or two – you can buy protective puts. You’ll pay a premium similar to insurance… but you’ll be able to lock in a minimum price you can sell your shares for up until the chosen expiration date.
It’s a safe technique but puts can also be used to place leverage bets… although, I’m not taking any big speculative bets on a market collapse. I’m sticking to the tried-and-true boring investment approach.
Final Thoughts
I’m not foolish enough to predict a market crash with certainty. Although, a stock market crash in 2020 is looking probable. Markets will continue to boom and bust. So it’s good to use history as a guide. Do you have any market indicators to add to my list?
Invest mindfully,
Brian Kehm
I think right now, things are just plain too negative about all the trade war hype to have a crash. I think that the trade war will be resolved most likely within the next year. That will create massive positive hype. The media websites and tv channels will get very positive. All the while, the true economic numbers will actually get more grim. I’ll be sitting here thinking, we’re on a sinking ship, but 95 percent of the world will think that the bull market will never end. If the 95 percent could more accurately predict the crash, it would cause the entire financial market to turn on it’s head, and the rich poor gap would tighten. The rich would become poor and the poor would become rich. It could never be allowed to happen. The major market movers, I think, in the last year, are moving their money quietly out of the stock market, and into the safe havens. The 20 year weekly charts of the 10 year treasury futures and gold are very interesting these days. I’ll be interested to seethe Senior load officer report from the Federal reserve in the next few quarters.
You’ve passed the CFA exams and keep cash and buy dig is your strategy? Where is fixed income and equity options?
As an investor I have exactly the opposite view, but it is a gut-feeling (can’t prove it) and everybody is entitled to their opinion. I think we are in for a few more years of a bull market until we get an almighty crash. Just a thought. My thoughts are part of my 5 year investment plan. I will be transition some stock into bonds around 2025.
Hey Henry thanks for your optimism 🙂 Since I wrote this, more indicators are pointing towards an economic slowdown… but you’re right, the bull market could very well continue for a few more years. So I’m not making any big bets on a downturn (shorting the market etc.). I’ll continue looking for great companies to invest in when they’re trading at bargain values (like my recent MO purchase).
There’s a better way to do the yield curve inversion calculation.
Instead of relying JUST on the 10 yr-3 mo curve, you can look at every single combination of long vs. short. For example, look at 10 yr-2 yr, 10 yr-1 year, 2 yr-1 yr and so on. There are 44 such combinations.
Right before the 2000 and 2007 market peaks, over 50% of these curves were inverted. Those are the only two times since 1999 that over 50% of these curves were inverted at the same time.
There were times when 4 or 6 of these curves were inverted at the same time (like 2012-2013), but no market crash came. It’s not just one curve that matters.
Over 70% of these curves are currently inverted.
This is only the third time this has happened since 1999.
Greg, thanks for your insight. The 10-year, 3-month inversion is just one of many pieces in the puzzle. I also looked at a few other spreads when doing this research. And I hope to do a more thorough dive into historical spread data. I’m currently learning Python and a few other data analytics tools.
Consumer confidence index. Yes I know it is a lagging predictor but you asked about other indicators. Consumers can crash a market just as quickly as maniacs in planes.
Consumer confidence is another great metric to follow. Thanks! And although it’s generally a lagging indicator, it’s a good predictor of some other market trends.