Which are the Signals of a Stock Market Crash?

In one of my blog post published in Jun’17, I was anticipating that the Indian stock market will crash in 2018. At that time Sensex was at 30,900 levels, and I thought it was overvalued.

Today in May’19, Sensex is trading at 39,000 levels and it looks resilient as ever. Our stock market is just not crashing. I must confess that, now I’m feeling a bit embarrassed.

Though I will admit that I’ve still not given-up on my expectation of a crash. I may sound a bit sadist, but I’m still eagerly awaiting a market crash. 🙂

One day I was talking to my friend and we raised this topic. We were curious to know about, ‘which are the signals of a stock market crash’. Our discussion was great, hence I thought to write a blog post about it.

Signals to watch out for before the crash

Why the stock market will crash? The crash happens when the stock market has become overvalued. So, in our quest for a market crash we shall look for ‘indicators of overvaluation’.

How to check if the market has overvalued or not? Frankly speaking it is not a difficult process. There are only few parameters which we shall see, and the hint is obvious.

Having said that, this is also true that these hints will only suggest if the market is overvalued or not. How soon will the market react to this overvaluation remains a mystery.

Let’s see few signals which will speak in general about whether the stock market is overvalued or not:

  1. Volatile Surge in Index: Our stock market work in cycles. In one instance it will go up and then it will fall. A controlled rise-and-fall is a normal behaviour of the stock market. But when index starts to grow amid large volatility, it raises concern. This is the time when market is showing signs of overvaluation. Read more about the economic cycles.
  2. PE Trend: Here we are talking about the P/E ratio of a major stock index (like Sensex). We will look at the P/E trend of the past several years (like 10 years). By gauging this trend we will know if P/E is rising or falling. A rising P/E ratio will indicate that the market is becoming overvalued and vice versa. Know more about Low P/E stocks.
  3. Government Bond Yield: When the difference between the yield of ‘long term government bond’ and ‘short term government bond’ is not much, it is a signal of potential trouble. The worst is the phase when long term bond start yielding lower interest rates than short term bonds. [Read more about it below]. This is a signal that the investors are beginning to consider stock market as overvalued. Read more about how buy to GOI Bonds.
  4. Trend of A Broader Index: Which is a broader Index? S&P BSE 500 Index. Compare the last 12 months trend of S&P BSE 500 index with that of Sensex. If Sensex is (say) showing a higher growth rate than BSE 500, it means that the money is not getting uniformly invested in the stock market. This is a signal of overvaluation. Read more about weightage of stocks in Sensex.

What I have suggested above are four reliable indicators. We can use them to check if the stock market is currently overvalued or not. If the stock market is overvalued, it is a signal of stock market crash in near future.

How soon the Market will crash will depend on the degree of overvaluation. Let me elaborate more on the above points. This will also help us to gauge the degree of overvaluation of the stock market.

1. Volatile Surge in Index

Signals of a Stock Market Crash - Surge in Index

The above chart is an example of index growth which is marred with volatility. Between Jun’17 and May’19 (24 months), Sensex has grown from 30,922 to 39,088 points. This is a growth of 12.4% p.a.

Though 12.4% p.a. growth is not an alarming growth, but there are two points to be noted here:

  • Jun’17 Level was already high: In one of my earlier blog post, I have shared how high the Sensex already is in Jun’2017. From that level, today the Sensex has grown to 39,100 levels. This is its all time high. But the point to note here is the volatility in Sensex while growing from 30,900 to 39,000 levels. Volatile growth is a signal that probably the present levels are not sustainable.
  • Duration of Rally: This surge in Sensex is continuing since Dec’16. At the time it was at 26,600 levels. It has already been 30 months that the market has remained bullish. This is a very long bullish period, it cannot continue forever. The market will eventually crash soon. Read more about the cause of 2008 stock market crash.

2. PE Trend of Sensex

Signals of a Stock Market Crash - PE Trend

What we have seen in #1 above is a hint that the stock market may be overvalued. How to get a confirmation of this apprehension? By plotting the PE Trend Chart of Sensex.

The higher is the PE Ratio, more overvalued is the stock market.

I have plotted the PE Trend Chart of Sensex for the last 20 years. You can see that, as on year 2019 (May), PE ratio of Sensex is trading at 28.18. This is even higher than the following:

  • 2001 (Before Dot Com Bubble): 23.89.
  • 2008 (Before Debt Crisis of USA): 22.61
  • 2011 (After the 2008 Crash): 21.60

This trend chart is giving a strong hint that, currently in May’19 the degree of overvaluation of Sensex may be very high.

3. Government Bond Yield

Signals of a Stock Market Crash - GOI BOND YIELD

The above chart has been plotted with yields taken from ‘long term government bonds’ and ‘short term government bonds’ (between Dec’08 and May’19). What these yield numbers shown in the chart say?

In Dec’08 it is showing 0.424, what does it mean? It means the difference between the yield of a 10Y Government Bond and a 1Y government bond was 0.424% on Dec’08.

Note 1: The first thing that is worth noting in the above chart is, the difference between bond yield, post 2008 recessions. See how the gap (between the two bond’s yield) is growing from 0.424% (in Dec’08) to 3.2% (in Apr’10). This is the phase when stock market was most bullish. Why? Because it was coming out of recession.

In such bullish phases, the investors are mostly optimistic and are looking long term for their investments.

Note 2: The second thing to note in the chart is how the difference between yields has diminished post Apr’10.

When the difference between ’10Y bond yield’ and ‘1Y bond yield’ is getting smaller, there the market is becoming less predictable. It is a strong signal that the investors are starting to look ‘less long term’ for their investments.

Note 3: When the difference (between bond’s yield) becomes negative, it is a further signal that the investors are least bullish. Instead, the sentiments are so negative that they are expecting the stock market crash (or correction) soon.

4. Trend of A Broader Index

SLDescriptionSensexBSE 500
Recent Event
AJun’1835,42314,528
BMay’1939,10015,279
ABGrowth 10%5.16%
Post 2008 Crisis
CJan’099,4243,426
DApr’1119,1357,427
CDGrowth 103%116%

When you have a doubt that whether the Stock Market is overvalued or not, you can use this trick to confirm.

What is the trick? Compare the growth of a broader index like BSE 500 Index with Sensex. How to draw a conclusion?

Example 1: When Sensex and BSE 500 Index is growing at a similar rates, it is a good sign. In such a case, investors money is spread in more number of stocks. Hence chances of overvaluation is less. Example:

  • Sensex Growth (post 2008 crisis): 103%.
  • BSE-500 Index Growth (post 2008 crisis): 116%.

Example 2: When Sensex is growing way faster than BSE 500 index, it is a signal of overvaluation. In such a scenario, only few stocks of the market start attracting funds. Why? Because it is the speculators who become the driver of the market in such times. Example:

  • Sensex Growth (Jun’18 to May’19): 10%.
  • BSE-500 Index Growth (Jun’18 to May’19): 5.16%.

Conclusion

Stock market always knows when it is trading at overvalued levels and when at undervalued levels. But it has its own coded transcript with which it communicates with its investors.

Investors who are able to read the coded transcript, gets an advantage. What is the advantage? It helps them to time the market more accurately. Read more about how to become a better investor.

Reading the market code is difficult? Not so much. I have shared few of my findings above, about the signals of a stock market crash. Read more about investing directly in equity by self. I hope you will like the information.

In case you have few ideas of your own, please share it in the comment section below.

Have a happy investing.

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