Correction or crash? These signals suggest a larger decline
A correction on the stock market also has advantages for investors: It offers the opportunity to get into stocks cheaper or to buy more stocks at a better price. For investors, however, it is not always easy to distinguish whether it is just a correction or whether this is developing into a major decline, a crash.
• Corrections in the stock market offer entry opportunities
• Correction and the beginning of a crash can sometimes be difficult to distinguish
• Four signs of a bigger decline
Every bull market comes to an end at some point and some of them end with a spectacular crash. For investors, however, it is sometimes difficult to distinguish whether this is just an ordinary correction, which investors often use as a buy-the-dip, or whether this decline is possibly the beginning of a larger crash. Fortune magazine has found four signs that – at least if they happen together – should raise alarm bells for investors because they could point to a bigger decline.
Price / earnings ratio
Investors and experts alike often worry when the market is overvalued. One way of determining this and assessing the affordability and price potential of stocks is the price-earnings ratio (P / E). This shows investors what they are getting for their money and, as Fortune reports, has been at a high level for some time – for the S&P 500 it has recently been 26, which is well above the historical average of around 15 . With the market tending to return to its mean at some point, if P / E gets too high it is likely to slide back to more sustainable levels, which could be a painful experience for some investors. According to Fortune, data and forecasts from FactSet support this assumption: Corporate profits rose in the third quarter of 2021 and FactSet predicts that they will increase by 45 percent for the full year 2021. For 2022, however, the prospects are no longer so rosy: FactSet expects a dramatic decline to 8.5 percent and these profits could fizzle out if there is an economic slowdown.
Another important figure is the cyclically adjusted price / earnings ratio of Nobel Prize winner Robert Shiller, known as CAPE or Shiller KGV. This is defined as the share price divided by the average earnings over the past ten years and adjusted for inflation. This smooths out the fluctuations in returns over the past ten years and gives investors a longer-term view of the valuations. As Fortune reports, the CAPE has lately been around 40 – that is how high it was last during the dot-com bubble.
Actions by the US Federal Reserve
Another classic indication of a market slump, Fortune says, is that the Fed is raising interest rates too much, as higher interest rates make borrowing less attractive and thus reduce corporate profits. Although the US Federal Reserve has so far stuck to its loose monetary policy and left the key interest rate close to zero, it has already indicated that interest rates will be increased from the end of 2022. In addition, Fed Chairman Jerome Powell said a few weeks ago that persistent inflation could lead the central bank to act even earlier and to intervene harder. Economist Jeremy Siegel, a professor at the University of Pennsylvania’s Wharton School, predicts the Fed will change course in the next month or two and stocks will fall as a result, Fortune said.
An inverse yield curve is considered to be a fairly reliable signal for an impending recession. With an inverse yield curve, the returns for shorter terms are higher than those for longer terms – the opposite is usually the case. For example, a bond with a longer term usually brings more returns than a bond with a shorter term, as investors are offered compensation for not using their money elsewhere in the longer term and a kind of risk premium is offered for the greater risk of inflation and interest rate changes over the longer term. However, when the economy deteriorates, investors tend to turn to ten-year bonds. This drives up the price of the bond, thereby lowering the yield as the price and yield move in opposite directions.
As Fortune reports, the yield curve has inverted in the last 50 years before every recession and only delivered a false positive result once. Currently, the gap between two- and ten-year bonds has narrowed, although they are still separated by about one percentage point.
A black swan is an event that is very unlikely and – at least at least initially – it occurs as a complete surprise, even if in retrospect there are sometimes signs that could have indicated the occurrence of this event. Nassim Nicholas Taleb, finance mathematician, philosophical essayist and researcher in the fields of risk and chance, first used the term “The Black Swan” to report on “The Power of Most Unlikely Events” – as the title of one of his books is. He had previously written about these events in his book “Fooled By Randomness” (2001).
According to Fortune, identifying black swans is not an exact science. A big clue, however, is when official wisdom picks up an obvious and growing problem. In 2007 it was said that the mortgage chaos could be “controlled” – history shows that this was not the case. Today the White House and the Federal Reserve insist that the supply chain problems are only “temporary”. However, if they aren’t, it could become a bigger problem.
As Fortune reports, the high price-earnings ratio in the market and the optimism of the authorities regarding the supply chain problems are the only possible signals so far that there could be a major decline in the market. But if the other two factors, the measures of the US Federal Reserve and the inverse interest rate structure, should be added, investors should be careful, according to Fortune.