By Daniel Demian, Senior Financial Advice Expert at Albert
Since the financial crash of 2008, there have been five stock market corrections, the longest lasting 157 days in 2011. Experience teaches us that market corrections, even crashes, are expected in the long-term. While a correction typically represents a decline greater than 10% but lower than 20%, a crash can be unpredictable and much larger. When volatility spikes, fears kick in, and thoughts become cloudy.
Thinking rationally, and not emotionally, can help protect your portfolio during volatile times. Here are three factors that can help you spot a market crash or correction:
1. The financials
You don't have to be an analyst digging through multiple financial statements to understand the health of a company or the overall market. Instead, familiarize yourself with key indicators, such as the P/E ratio, and profit margin.
Indexes are a great way to get an overall sense of how the market is performing since they track the performance of a group of companies. Let’s take the S&P 500 as an example. Preceding the last two market crashes (2007 & 2020), the S&P 500 forward P/E ratio was at an all-time high, and then dropped along with the price of most stocks. Similarly, profit margins for the S&P 500 peaked before the last three recessions of '20, '08, and '01.
Although they’re not an immediate or 100% accurate indicator of a crash or recession, these two financial indicators are ones to watch if you suspect a market crash or correction is around the corner.
2. The technicals
Over the last few years, the prominence of technical trading - especially momentum trading - has grown as software innovations, barriers to investment, and new money have enabled investors.
Among the hundreds of indicators out there, experienced investors typically watch these two: Relative Strength Index (RSI) and Moving Averages (MA). Although they can get, excuse the pun, technical; simply overlaying a standard index, or stock, with these indicators will help you spot “red zones” - a price level that may precede a market correction.
Relative Strength Index (RSI) uses price changes to determine whether a stock is overvalued (>70) or undervalued (<30). While a neutral level between 30 and 70 can provide a sense of safety, it’s important to see if the trend is moving towards overbought or oversold territory. According to mean reversion theory, prices often return to their long term averages. So, an overbought or oversold investment experiencing a correction may return to a lower price or higher price respectively.
Moving averages (MA) display an investment's average price over a specific time period. The 50 and 200-day simple moving average help technical traders identify patterns, such as the death cross - a sign indicating a potential sell off. A death cross occurs when an investment's 50-day MA falls below its 200-day MA, and it’s often followed by a drop in price caused by the sell off.
3. Economic indicators
Regardless of their views, economists will agree that the economy is subject to a "cycle." That means we go through periods of growth, peak growth, recessions, the bottom of a recession, and repeat. Economic indicators can help you track where we are in the cycle and potentially signal when we're near the top. There are three categories:
- Leading indicators, such as the number of permits builders are applying for and the money supply in the U.S., may provide insight into where the economy is heading.
- Lagging indicators, such as inflation and unemployment numbers, help confirm our beliefs about the economy and have no predictive power.
- Coincident indicators, such as GDP and personal income numbers, provide a current snapshot of what's happening.
Using them all together may help you get a clearer picture of where the economy is headed. For example, rising inflation coupled with low rates of housing starts (leading indicator) and lower income numbers could be a sign of a looming recession or market crash.
Protecting your portfolio
When markets crash, it can become harder to keep calm, remember your investing thesis, and why you made certain decisions. If you're new to investing, consider creating your own investment policy statement (IPS)--a document usually prepared by an advisor summarizing a tailored strategy for investors. This is a great way to keep track of your investment guidelines and goals.
If you suspect a crash is coming, first, check the factors listed above. Next, check the health of your investments against your IPS. And last, consult with your advisor. These three steps should help you formulate clearer thoughts and guide your future decisions.
Disclaimer: this content is for informational purposes only and should not be considered specific investment, tax or legal advice for your situation.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.