5 Signs of Trouble in the Stock Market

Daniel Penzing
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There are clear signs that the stock market is in a downturn.

The market is uncomfortable with the growing debt levels in the Federal Reserve system. Interest rates are about to rise. There are many unknowns in the world like the flow of refugees from Syria that will add uncertainty to the economy.

So if not a recession what might we expect in the stock market in the first quarter of this year? Well you would expect to see signs of turmoil in the market, and the market is showing us some warning signals that we need to watch out.

Is it going to go bad, and end in a year? Maybe yes, maybe no, no one knows.

We all need to realize that the market is a place where things are bought and sold, and if the buy side isn’t there, the sell side isn’t there, and things will collapse. It’s not a surprise to anyone that the stock market is not like it used to be, and that it is all manipulated.

How will you know? Here are 5 signs that will tell you that maybe the stock market collapse is looming.

The Inverted Yield Curve

The inverted yield curve is the most reliable indicator of a coming recession. An inverted yield curve occurs when the interest rates of short-term debt instruments (for example, one year bonds) are higher than those of long-term debt instruments (for example, 10-year bonds).

The interest rate of long-term debt instruments is usually higher than that of the short-term bonds. When the interest rate of long-term bonds fall below that of short-term bonds, it is usually a sign of a coming recession.

The inverted yield curve means that a recession is very near. Though this indicator is highly reliable, it can sometimes be a false alarm. According to Verisk Maplecroft:

“Over the past 20 years, the inverted yield curve has accurately predicted nine out of 10 U.S. recessions; the two exceptions were in 2000 and 2006. The yield curve has inverted before every U.S. recession of the past 30 years.”

However, the inverted yield curve doesn’t always persist in forecasting a recession. There have been instances where there was an inversion of the yield curve but no recession followed.

Widespread Complacency

Most people have a rough idea of what the stock market is and what happens there, even if they don’t fully understand the ins and outs of it. They know that the stocks rise and fall based on the fortunes of companies.

But for the average person, worrying about the health of a particular company is a waste of time. After all, your average investor doesn’t buy stock in a company. They buy a share of many companies. While you may be concerned that Company X is doing poorly, you’re not going to sell your entire portfolio because Company X is struggling.

This is what complacency means in the financial world. The average investor isn’t worried that Company X is doing poorly, because they aren’t worried about Company X. On the other hand, if Company Y is doing well, it doesn’t matter to them because all of their money is invested in Company Z, which is doing admirably. The only time people get concerned about a particular company is if they’ve invested a substantial amount of money in it.

Common Measures of Market Sentiment

Following cues left and read by the average trader or investor is a useful tool, but it can be a major mistake to follow such cues unthinkingly. In fact, it can be a complete mistake to follow the momentum of the average market very closely. To find out why, we have to look at how stock index levels move in the first place.

Typically, an economic indicator or news story is announced that has a bearish impact on the economy. That news, combined with the negative sentiment surrounding such, will typically cause a drop in the price of the index.

Over time, the market will get a better sense of the story. The drop in stock prices will be followed by a rally. Then, there will be another stock price move in response to another news story that is bad for the market. This will cause the index to drop once again.

Eventually, the market has changed its position enough that the market moves into a bullish period. This shift in bullishness will continue and drive the index back up. (For more, see: How Risky is Trading Stocks?)

Excessive Valuations

I’m not a fan of old expressions like, “It’s time in the market, not time in the trade.”

They sound nice, but what they fail to acknowledge is that a market may not be the right place to be for a good part of the time.

It’s not as if stocks fall in price every year, even though over the course of any one year, over half of all stocks will fall. They generally, however, don’t fall in good years. So it’s usually more profitable to be long during bad times than good times. This doesn’t mean you should miss out on all good times, but it does mean that you should be very careful to avoid bad times.

There are a number of metrics that I use to look for signs of trouble in the stock market.

But That Doesn't Mean High P/E Ratios Are Signaling “All Is Well”

The first two reasons may simply show the rise of stocks. After all, if bull market (a market in which stock prices are rising) numbers are high, we'll have to go back to the pre-crash period of July 2007 to find a higher price-earnings ratio.

Of course, the fact that we've been in a bull market for years doesn't guarantee the market will continue higher. Let's take a look at a few of the other reasons the stock market is performing so well and ask ourselves whether the market is in a bubble.

Pension fund managers and workers are living on the hope that equity markets will continue to rise.

This is a big one. Without corresponding rises in bond markets (which would provide a safer investment vehicle) or without hedging in foreign markets, Americans are betting heavily that financial advisors are correct in their predictions that stocks will continue to rise. If they can't demonstrate steady growth through other vehicles, retirement and pension plans are going to be underfunded.

There have been no financial crises in years and high stock market values are considered a sign of economic prosperity.

This is mostly true. However, consider these other reasons for high stock market prices:

High employment .

High salaries .

Tax deductions for 401K plans.

For 401K plans. Little interest in other investment vehicles.

Declining Credit Quality

When lenders charge higher interest rates, this could mean that their assessment of default risk has gone up … or they are charging a premium to compensate for the fact that they need to sell the loans in the secondary markets at a discount. Either way, it’s a red flag.

An increase in Consumer Balance Sheets.

More and more people are using their credit cards than in the past.

Liquidity.

If you’re looking at the stocks of low capitalization or even some medium capitalized companies, be alert for companies that have to sell assets or make risky investments to meet their cash needs.

An overheating economy.

Heating up means more people have jobs and consumer demand will far exceed demand for products and services. When this happens, stocks can get overvalued.

Over valuations.

Very few companies will ever trade over their intrinsic value. If all the stocks in a sector are roaring ahead, be wary.

Over speculation.

When people are buying and selling stocks based on unsupported or unrealistic expectations, the bubble will pop and prices will fall back to Earth.

Irrational Exuberance — Or, Any News Is Good News

Irrational exuberance is a term coined by Alan Greenspan in 1996, which refers to a time in the life of a financial market when investors are very enthusiastic in buying stocks despite economic factors which might suggest caution in doing so. That phrase was meant to describe the time before the dotcom bubble burst in the year 2000, which was very much reminiscent of the roaring twenties (the housing bubble also prompted the same phrase).

The greats were looking from the bankers boxes only, and their faces were filled with wonder and excitement. They looked at all stock prices (particularly tech stocks) as being way overvalued in comparison with their fundamentals. The “greats” disagreed with everyone else.

This can be the single most important reason that the market turned out as it did in the tech bubble. Why should everyone be so focused on the fundamentals when the experts were so sure that the market would go up? Why not ride the wave while it’s still going.

When the fundamentals are not as strong as the exuberance, it is only a matter of time before the stock market comes back down to earth.

Be prepared for the worst to happen

Here are five signs that the stock market is heading for a major collapse:

Talking heads repeating that there is no recession, bull market, and they are confident.

People tend to repeat what they are hearing and reading. It reminds me of the 2015 Paris terror attacks that were highly publicized, few actually understood Islam or the Quran. Most people parroted the understanding of events that they heard from the talking heads. Smoking is bad, global warming is real, veganism is good. Are these statements facts or parroted opinions?

"It's not that the American people are taxed too little. Government just spends too much." (Al Gore, Former Vice President of the United States)

"Iraq is a very wealthy country that has been destroyed by decades of socialism and decades of war, both originating from this country."(Paul Ryan, U.S. House Speaker)

"Pakistan needs a new strategy, because the current approach is failing." (Ben Carson (1951-), US Presidential candidate)

The CME predicts collapse if trading does not stop.

The CME is the central exchange for the world's largest and most actively traded financial markets: futures and options based on interest rates, equity indexes, foreign exchange, energy, agricultural commodities, and metals.

The CME Group failed to earn its profit margin/recession call two weeks before the 2008 financial crisis.