Five ways to tell if the stock market is about to crash

There is an old adage in the investment world: it’s about time in the market, not timing the market. 

But the truth is staying invested for a long time does not reduce the risk that comes with investing, and good timing can make a huge difference to the size of your portfolio. 

The problem is calling the bottom or the top of the market is near impossible, and waiting around could cost you returns.

But, as Telegraph Money explains, there are ways to spot warning signals, as well as ways to find out when might be a good time to buy in. 

Valuations get too high

Most investors obsess over the “valuation” of stocks – this a judgement on how expensive a company’s share price is, usually relative to its profits. 

This can be measured various ways,  but when these indicators start looking too high, investors get worried the market is due for a “correction”. This is when valuations normalise and share prices usually fall. 

Victoria Scholar, of the broker Interactive Investor, said: “If profit margins are excessively high and price-to-earnings ratios are sharply higher than their long-run averages, that is something to watch out for.” 

Price-to-earnings, or “PE”, ratios are a quick and simple way of valuing a company: you can calculate it by dividing a company’s share price by its earnings per share, which will be in its annual report.

Inverted yield curves

Ms Scholar added that investors should also keep an eye out for an inverted yield curve. “This is when long-term interest rates drop below their short-term equivalents, which has historically been a successful recession predictor,” she said. 

Market watchers pay particularly close attention to the yield curve on American government bonds, or “Treasuries”, because the dollar is at the centre of global finance and US businesses are among the largest in the world. 

The yield curve on Treasuries has been inverted for almost a year – it broadly means the American government pays short-term bondholders better rates than long-term bond holders. 

Economic cycles trigger a sell-off

The stock market and the global economy do not always operate in sync – a recession could go hand-in-hand with a bull market. But sometimes when there is a significant economic shift, it can trigger a sell-off in stocks. 

For example, when interest rates start to rise, as they have done over the past year, businesses that had borrowed a lot of money suffered a correction to their share price as their debt was revalued. 

It is important to remember the market is constantly forward looking – when investors first become concerned about a recession, that is usually when stocks first suffer. 

Once the economy enters a recession, shares can still rally if investors believe there are better times ahead. 

Black swan events 

It is often unexpected “black swan” events that spook investors and trigger a market-sell off.   

“Most major market corrections are often initiated by an unexpected ‘black swan’ event, such as the onset of Covid-19 in 2020, or the subprime mortgage crisis in the banking sector in 2008,” Ms Scholar said. 

“Watch out for an aggressive spike in the Vix index, Wall Street’s so-called fear index, which indicates there is a lot of nervousness among traders and investors and tends to come hand-in-hand with a heavy sell-off.” 

Beware the death cross 

There are more technical indicators that can help investors navigate the market, including the “death cross”. 

This is a chart pattern in which a short-term moving average crosses below a long-term moving average. 

This is what traders call a “bearish” breakout pattern and suggests a stock or index is building momentum downwards. The chart below shows a “death cross” for housebuilder Persimmon, which has experienced a downturn in demand for new homes.

When the reverse is in effect – the short-term moving average crossing above a long-term moving average – this is known as a “golden cross” and is a bullish indicator. The graph below shows a “golden cross” for building materials giant, CRH.

Chris Beauchamp, of the broker IG, said: “Essentially, these crossovers are signals that a trend might be changing. They don’t work all the time but are useful ways of looking at price movement. 

“Golden crosses suggest that an uptrend is beginning, and death crosses are a sign that a sustained fall may be ahead.” 

These indicators are often used incorrectly, he added. 

“Traders think the crossover itself is the sign to go long or short. In fact, because moving averages are lagging indicators, they reflect previous movements, and you often see the price reverse course and bounce after a death cross, or fall after a golden cross.”

Instead, investors should use them as signs to either buy the dip after a golden cross, or sell the rallies after a death cross, he said. 

Mr Beauchamp added: “One of the good things about indicators is they are agnostic as to the instrument you’re trading, though it has to be said stocks and indices do tend to have longer trends – you often get a lot of whipsaws or reversals in other markets.”