The Signs of a Stock Market Crash Are Building

While no one can predict a stock market crash with certainty, the signs one will strike before the end of 2021 are rising.

[Yesterday’s] decline may just be a taste of what’s to come.

That stocks are overvalued is just one of several signals that we’re ripe for a pullback.

And yet the odds are we’ll see more all-time highs before we see a stock market crash.

If that seems contradictory to you, just bear with me.

While many aspects of the markets are looking shaky, there’s still plenty propping it up.

Leading the way is the U.S. Federal Reserve. The Fed’s easy money policies have played a big role in the sharp market rebound since the sudden COVID-19-induced pullback a year ago. We’re talking about near-zero interest rates, the resumption of quantitative easing (QE), and generous lending to banks, corporations, and state and local governments.

Then you have President Joe Biden’s $1.9 trillion stimulus package, which should pump still more money into stocks.

We’re also seeing rising market optimism as more people receive COVID-19 vaccinations. The thinking is that the economy is getting closer to a return to “normal,” which will boost the earnings of many companies.

But despite all that, the markets are flashing multiple warnings. Eventually these issues will trigger a stock market crash.

Here’s why investors need to keep this on their radar…

The Signs of a Stock Market Crash Are Building

Since the lows of last March, the S&P 500 index is up about 75%. Even if you go back to before the COVID-induced stock market crash, the S&P 500 is up more than 15% and is not far below its all-time high.

That takes you to the plainest argument for a stock market crash – companies are simply overvalued.

The Shiller P/E ratio is over 35 right now – its highest level since the dot-com bust in 2000. To put that in perspective, the average Shiller P/E over the past 148 years is 16.78. So valuations are more than double the historical average.

Here’s some more perspective: The Shiller P/E was 32.56 on the eve of the 1929 stock market crash.

Another commonly used metric, price-to-sales, is also flashing a warning.

The Shiller P/S ratio is sitting at 2.86 right now – 81% higher than its average since the year 2000.

To get an idea of how far out on a ledge the markets really are, I created a screen on YCharts to see how many stocks currently have a P/S of more than 10. Generally speaking, a P/S over 10 for a company is considered a red flag. It means investors in that stock are paying $10 for each $1 of revenue generated.

The screen included stocks on all U.S. exchanges but excluded real estate investment trusts and banks for which the P/S ratio does not work well. That produced a list of 7,401 stocks, 733 of which had a P/E over 10. That’s nearly one out of 10 stocks.

A Financial Times opinion piece from last September using Bloomberg data pointed out that 6.2% of all U.S. stocks had, at that time, a P/S over 10. The previous high was 6.6% – in March of 2000, the peak of the dot-com bubble.

The idea of the article is that “hot sectors” drive a market higher with exaggerated valuations that sooner or later must come back to earth. That “reset” usually happens suddenly, dragging everything down in a painful stock market crash.

When I filtered that YCharts data for the Technology sector, I found that 27.5% of the 640 companies have a P/S of more than 10.

I also filtered for megacaps (companies with market caps of $200 billion or more). Of the 36 companies, nearly a third have a P/S of more than 10.

Meanwhile, less exciting sectors had far lower percentages of companies with high P/S ratios. These sectors – Industrials (4.93%), Utilities (3.85%), and Energy (3.86%) – have ratios much closer to historical norms.

And there are plenty more cracks in the foundation if you know where to look…

Those All-Time Highs Are Built on Debt and Leverage

Here are more signs of trouble:

  • Corporate debt. The $6 trillion U.S. companies had on their books in 2010 ballooned to $11 trillion as of the third quarter of last year. Industries hard hit by the COVID-19 shutdowns borrowed to just stay alive. Those that didn’t go bankrupt were left weakened.
  • Global debt is higher than ever. According to the Institute of International Finance, global debt stands at $281 trillion. So even a small uptick in interest rates will be a problem. And we’re already seeing it. This week, U.S. 10-year and 30-year Treasury yields rose above 1.3% for the first time in almost a year. Any hint of inflation ticking higher than the Fed would like will trigger talk of pulling back on the easy money. That would pull the rug out from under stock prices.
  • Excessive leverage among investors trying to increase their exposure to stocks as prices rise. According to FINRA (Financial Industry Regulatory Authority) statistics, margin debt among U.S. investors rose from $561.8 billion in January 2020 to a record $778 billion in December. When markets start to tumble, overleveraged investors will be forced to sell.
  • The dominance of the Big Tech stocks. According to Bloomberg, just three of the Big Techs – Amazon.com Inc. (NASDAQ: AMZN), Apple Inc. (NASDAQ: AAPL), and Microsoft Corp. (NASDAQ: MSFT) – accounted for half of the S&P 500’s gains in 2020. That recalls one of the 10 rules for investing created by Wall Street veteran Bob Farrell, who served as the chief investment advisor at Merrill Lynch: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”

How to Prepare for a Stock Market Crash in 2021

Some investors think the best way to prepare for a stock market crash is simply to sell almost everything at the slightest hint of trouble. Or they panic sell after their stocks are down 20% or 30%. Don’t do those things.

Instead, take a hard look at your portfolio now. Consider selling the laggards. You might also want to lock in some profits by selling off a portion of your big winners – stocks that are up 100% or more. Both moves will create some “dry powder” – a little cash to keep on the sidelines.

You’ll also want to make a shopping list of stocks you’d like to own but are now overvalued. When a crash happens, you can use your cash to snap up these stocks “on sale.”

Another smart strategy is to tighten your trailing stops. A trailing stop will trigger automatically if a stock falls by an amount or a percentage you specify. That can limit your losses on days when the markets go down hard.

Putting a portion of your money (5% to 10%) into hedge investments, such as gold and Bitcoin, can also help mitigate losses. Bitcoin has the additional advantage of having extraordinary upside potential.

Finally, investors should make sure they have money in areas that will best weather a stock market crash while offering the prospect of strong long-term returns.

Those areas include value stocks as well as emerging market stocks. Investors should seek out funds that combine both, such as the American Funds Developing World Growth and Income Fund (MUTF: FDWGX).

Another area with good long-term prospects is renewable energy and anything related to climate change.

“Anything to do with renewable energy, the electrification of the system, electric cars, etc. These are all going to have top-line revenues that dwarf the declining growth rate of the rest of the global economy,” legendary investor Jeremy Grantham told Bloomberg last month. “It will take trillions of dollars to decarbonize the global system. If you have to own U.S. stocks, they’re the ones to own.”

— David Zeiler

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Source: Money Morning