Learn the Warning Signs of the Next Stock Market Crash

Getty Images

In most years, the stock market goes up. And then, when you least expect it, it plunges. Unfortunately, stock market investors can’t totally predict or avoid the periodic dips, corrections, and outright crashes. But looking back at history’s biggest stock market crashes can help guide your investments going forward — and could give you an inkling of when a market dip may be in the cards.

Does Anyone Know What Causes a Stock Market Crash?

There’s been some research into the commonalities of stock market crashes.

Scott Nations, author of "The History of the United States in Five Crashes," major stock market drops and found that all modern-day crashes included:

  1. An over-valued market
  2. A type of financial engineering or “contraption”
  3. An external catalyst, frequently unrelated to the stock market

Understanding an Overvalued Market

In general, the best indicator of how the market is being valued can be found in its price-to-earnings ratio, or PE (which is also used to value individual stocks). By dividing the aggregate price of the stock market by all of the company’s earnings, you arrive at the price investors will pay for $1 of the company’s earnings or profit. The lower the PE ratio, the cheaper (more undervalued) the stock market.

By examining the market’s historical PE ratio, and comparing it to its current ratio, you get an idea of the stock markets relative value. For example, the is 15.66 and the current PE ratio of the S&P 500 is 24.71.

or 58% overvalued. But, in the words of world-renowned economist John Maynard Keynes, “The market can stay irrational longer than you can stay solvent.”

In other words a stock market can stay overvalued for a long time before it corrects itself. So this alone isn’t enough to predict when a crash will occur.

What’s Financial Engineering or Contraption?

Hindsight is 20/20, and pinpointing the prior financial contraptions is easier than predicting the future culprits. The dotcom crash was facilitated, in part, by the investors’ irrational enthusiasm for all stocks technology-related. The more recent 2008-2009 stock market crash was partially due to mispricing of mortgage derivative securities, a complicated financially engineered product.

Scott Nations posits that algorithmic trading or extremely illiquid ETFs could pressure the markets in the future. Along with the overvalued market and an external catalyst, these investment products could complete the stock market crash equation.

The Catalyst for a Stock Market Crash Could Be Anything

closed for 6 days following the 9/11 attacks in 2001, in an attempt to forestall a market crash. Despite that effort, on the first trading day after the attacks, the market fell 684 points, or 7.1%, for the largest one-day loss in the history of the stock market.

Other crashes can similarly be linked to disasters. The was set off by the catastrophic San Francisco earthquake of 1906, and the 1987 Black Monday crash was partially impacted by the Iran War.

Of course, it’s not always easy to see when a big event will trigger a market crash. That doesn’t stop skittish investors from overreacting to a potential market moving event, though. 

How to Prepare Yourself for the Next Market Crash

We have an overvalued market now. There are sufficient financially engineered investment products in our marketplace. Yet, no one knows what the catalyst will be for the next stock market crash. But in a sense, it doesn’t matter, because you can’t totally prepare yourself for the next stock market crash without completely exiting the investment market.

But you can cushion the blow when the inevitable market crash occurs. Your best bet is diversification: Don’t keep all your money in the stock market. Especially as you get older, you should own some bonds, real estate funds, and cash.

That way, when the market collapses, you’ll have some assets that won’t fall!

And when markets are overvalued, as they are now, consider trimming back your stock holdings. Just be aware that you might also lose some upside potential in the meantime.

As Keynes succinctly implies, markets can remain irrational and overvalued longer than you can remain solvent. Recent history is a testament to that fact. Ultimately, when liquidity is compromised with more sellers than buyers, the markets will drop in value. But when the inevitable market crash will occur is a mystery.