A correction in the stock market also has advantages for investors: it offers the opportunity to invest in stocks at a cheaper price or to buy stocks at a better price. However, it is not always easy for investors to distinguish whether it is just a correction or whether it will turn into a major decline, a crash.
• Corrections on the stock market offer entry opportunities
• Correction and beginning of a crash sometimes difficult to distinguish
• Four signs pointing to a major decline
Every bull market comes to an end at some point and some end with a spectacular crash. However, it is sometimes difficult for investors to distinguish whether this is just a normal correction that investors often use as a buy-the-dip opportunity, or whether this decline may be the start of a larger crash. Fortune magazine has found four signs that – at least if they occur together – should ring alarm bells for investors because they could point to a major decline.
Price-earnings ratio
Investors and experts often become concerned when the market is overvalued. One way to determine this and evaluate the affordability and price potential of stocks is the price-to-earnings ratio (P/E ratio). This shows investors what they get for their money. Since the market tends to revert to its mean at some point, if the P/E ratio gets too high, it is likely to fall back to a more sustainable level, which could be a painful experience for some investors.
Another important key figure is the cyclically adjusted price-earnings ratio of Nobel Prize winner Robert Shiller, known as CAPE or Shiller P/E ratio. This is defined as the share price divided by the average profits over the past ten years and adjusted for inflation. This smooths out earnings fluctuations over the last ten years and gives investors a longer-term view of valuations.
Actions by the US Federal Reserve
Another classic indicator of a market downturn, Fortune says, is that the Fed is raising interest rates too much because higher interest rates made borrowing less attractive and thus reduced corporate profits.
Inverted yield curve
An inverted yield curve is considered a fairly reliable signal of an impending recession. With an inverted yield curve, the yields for shorter maturities are higher than those for longer maturities – the opposite is usually the case. A bond with a longer term usually brings a higher return than one with a shorter term, as investors are compensated for not using their money for other purposes in the long term and a kind of risk premium is offered for the greater risk of inflation and interest rate changes longer term. However, when the economic situation deteriorates, investors tend to increasingly resort to ten-year bonds. This drives up the price of the bond and thus lowers the yield because the price and yield move in opposite directions.
As Fortune reports, the yield curve has inverted before every recession in the past 50 years, producing a false positive only once.
Black swans
A black swan is an event that is very unlikely and – at least at first it is thought – occurs completely unexpectedly, even if in retrospect there are sometimes signs that could have indicated that this event occurred. Nassim Nicholas Taleb, financial mathematician, philosophical essayist and researcher in the areas of risk and chance, first used the term “The Black Swan” to report on “The Power of Highly Improbable Events” – which is also the title of one of his books. He had previously written about these events in his book “Fooled By Randomness” (2001).
According to Fortune, identifying black swans is not an exact science. A big clue, however, is when official wisdom dismisses an obvious and growing major problem. In 2007 it was said that the mortgage chaos could be “controlled” – history shows that this was not the case.
Editorial team finanzen.net