History has a lot of tell us about the cyclical nature of the stock market. There are upturns and downturns, bullish and bearish markets, and, it does seem, what goes around comes around. Therefore, history should also teach us a considerable amount about what indicates a stock market crash.
There certainly appear to be some events and signs that indicate a market downturn. Yet, the difficult and exciting thing about the stock market is that these indicators and signs the market is about to crash are not always accurate. Nor are they always apparent to everyday investors and event savvy hedge funds before it is too late. In the past, market crashes have taken most people by surprise .
Defining a Crash
The definition of a stock market crash is a market index dropping 50% or more from a previous high . This is an extremely rare event in the history of the stock market, but it has happened. More than likely, it will happen again.
Most famously the stock market crashed in 1929, leading to the Great Depression. The Great Depression began with the crash of the stock market on October 29, 1929. Between that day and December 31, 1929, investors in the stock market lost over $40 billion dollars . What followed was a period of decreased consumer spending and bank failures that precipitate the poverty and unemployment of many Americans.
In 1987 Black Monday brought the markets down in a single day. It is still the largest one-day crash in the history of the United States markets, and it was characterized by fearful sell orders from investors around the world. Again the market crashed by just over 50% in 1999, the start of another recession for the United States.
Here are five important signs of a market crash that we have learned from these important historical events and the crash of stock markets around the world.
Stocks in a Bubble
The stock markets are normally in a bubble before a crash. This is the opinion of many Wall Street analysts, historians, and, essentially, the words of Donald Trump in regards to why he would not recommend increasing or purchasing new shares in the stock market during the year 2016 .
The way many on Wall Street explain this phenomenon is that the market accelerates, but then it surpasses, sometimes widely surpasses, the anticipated growth earnings . The theory is this bubble between the actual growth earnings and stock prices causes a sharp and sudden decline when the natural course of free markets corrects this bubble.
Warnings from Commodity Costs
A precursor to the stock market trends can be what happens on the commodity markets. As with all indicators of a market crash, there is no certainty behind this bet. However, when it comes to accurate indicators, this is one of the better ones.
For instance, in mid-2015 commodity prices dropped to record lows. Most noticeably, the price of crude oil, the commodity behind daily work and life for humans the world over, fell around $50 a barrel from a high of over $140 per barrel about a year and a half earlier .
Just a few days later, news outlets around the world were reporting on the falling stock market prices. The DOW lost nearly 1,000 points over the course of a few days . Most of this activity on the stock market was explained as a correction, but it is hard to deny the similar downward turn of commodity trading days before. Afterwards, more traders and hedge funds keep an eye on the commodities market for a sign of upcoming stock movement.
Effect of Raising the Fed Interest Rate
In December 2015 the Federal Reserve raised the benchmark interest rate for the first time in nine years. The initial expectation was a sharp and heavy-hitting reaction by investors in a number of markets, however markets corrected nicely after the initial increase to 0.25%. This surprised investors who expected that the 0% interest rate helped the market maintain growth between 2009 and 2016 .
The Federal Reserve is expected to raise the interest rate again. The Fed Chair Janet Yellen has indicated as much since summer 2016, and 2017 is nearly certain to see a jump to at least 0.50%. However, this is a serious question of timing for the United States government.
If this second increase comes too soon, it is likely to leave stock markets in disarray. A hike in the benchmark interest rate trickles down to lending opportunities for companies, possible profits from refinancing, and eventually the price of shares . As well, it leaves investors uncertain of how U.S. currency will rise, where inflation may land, and how consumer spending will react.
Events in Other Markets
A look at the market downturn in August 2015 reveals another important factor of the next market crash. The events of foreign markets will invariably and inevitably affect the United States stock market . The world operates on a global economy, and what happens elsewhere reverberates through our financial sector.
In August 2015 the Chinese economy experienced a period of immense uncertainty and panic. This followed the Chinese government’s announcement to devalue its currency, an unexpected and unprecedented maneuver. The Chinese markets fell 40% . However, the Chinese market no longer operates, rises, or falls in isolation. With the 40% fall by the Chinese, there was a corresponding 10% fall by United States markets.
The larger economies in the world, from Brazil to India, all affect the United States. It is a tenuous system that can tumble or build on a singular event . If a number of these economies begin to suffer, then the American markets will also suffer. Many investors look to the strength and control of central banks in these foreign markets for signs that a downturn is ahead for the world economy .
- Reflection of Fear and Uncertainty
Alternatively, other purveyors of Wall Street’s cycles feel that the risk built up during a long stretch of bullish markets leads to the crash. A sharp rise in a market, such as the DOW, leads investors to take more risks and move on unlikely stocks.
However, it is a false high. The market is overvalued and eventually that must even out. When it does, there is a natural tendency to swing too far in the other direction. Hence, the relationship between the bubble and a market crash.