indexes in this article
Of course, there isn’t one single clue that gives investors at a glance that it’s time to get their feet wet. However, the combination of several factors that pose a risk to the economy can still be a harbinger of a possible bear market in the near future. What can investors watch out for?
One sign that a market downturn is imminent is an inverted yield curve. This occurs when lenders charge higher interest rates for short-term loans than for longer-term loans. It is usually more risky to lend money long-term than to lend it short-term, so interest rates are higher for long maturities. Higher interest rates on short-term borrowing therefore mean that lenders believe that the market is about to collapse and that the risk of lending short-term is greater than that of longer-term lending.
If the yield curve inverts, it becomes unprofitable for large lenders such as banks to lend. This is because they usually take out short-term loans in order to make long-term loans to the lenders. If the short-term loans are more expensive than the long-term ones, this business is no longer worthwhile, which is why it becomes more difficult to get a loan. Ergo, less money flows into the economy, consumption, etc., which is why there can be a downturn. Every recession since the 1960s has been preceded by an inverted yield curve, so investors should take this sign seriously.
High volatility
High volatility is also often a harbinger of a bear market. The CBOE’s Volatility Index (VIX), also known as the fear barometer, should always be monitored by investors. The VIX symbolizes the expected fluctuation range of the S&P 500 stock market barometer for the next 30 days. If the VIX is expected to fluctuate significantly, the price of options will implicitly rise.
A higher VIX also means that investors are willing to pay a higher price for assets to avoid a sell-off. Since the VIX was first calculated in 1993, every recession has been preceded by a higher-than-average VIX reading. Usually the index moves around the 20 point line. Anything above this mean should set alarm bells ringing for investors – historical evidence suggests that this could be a sign of an imminent market downturn.
Worse consumer climate
If there is a good consumer climate, it means that consumers are willing to pump a lot of money into the economy and also to make larger purchases.
A decline in consumer confidence, which is tracked in an index by the University of Michigan, for example, is a warning sign that consumer spending could soon slow down, which in turn could lead to a weakened economy and an associated slide in the stock market.
Spread between high yield bonds and government bonds
A large spread between high yield bond yields and government bond yields can also herald a crash. High-yield bonds, also known as junk bonds, are highly speculative, but also harbor great opportunities for profit due to the high risk. When investors fear a bear market is imminent, they move their assets into safer asset classes such as multi-year government bonds. The return on junk bonds rises even higher as a result, in order to still find investors for this speculative form of investment. So, a large spread between high-risk and low-risk bonds suggests investors are beginning to panic, which could portend slower economic growth, a recession and an upcoming bear market.
Bubble formation in individual stocks
If the share price of individual companies suddenly and disproportionately rises, this can also be a prophecy for an imminent market downturn. Of course, an increase in share price is good for shareholders, but if the share price rises very sharply out of the blue, this can be an indication of high speculation on the part of investors – or enormous exuberance. As became clear with the tulip mania of the 16th century or with the dot-com bubble at the beginning of the 21st century, when the speculative bubble bursts, there are major problems in the financial world. Speculative highs should therefore always be enjoyed with caution.
Market development not really predictable
Predicting market developments is always just looking into a crystal ball. No one can say for sure in advance whether there will be an upswing or a downswing. However, anyone who looks at the history of the stock market can recognize some patterns that regularly preceded a recession and a bear market. Your own investment strategy should therefore always keep an eye on possible warning signs of a possible market downturn.
Theresa Rauffmann / Editor finanzen.net
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