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What are the stock market warning signs of a financial crash?

By Jenal Mehta


Updated

Man shocked at financial news
The current economy is showing some red flags of a recession – Photo: Shutterstock

Turmoil in the global economy has investors wondering whether a financial crisis is imminent. Experts have mixed views.

Some red flags point toward a recession. The US S&P 500 is up 15% over the past year. Meantime, the Federal Reserve is on track for multiple interest rate hikes to combat high inflation driven by supply chain constraints. This has resulted in a possible signal of a recession – the yield curve of US Treasuries inverting for the midterm, with short-term rates pushing longer maturing debt, implying investors are lengthening their tenors.

Despite this, there is little consensus on whether a stock market correction is looming. This is mostly due to the current economic climate. And also, like in previous recessions, there are unique events which may eventually push the economy into a downturn, most of which are only seen in hindsight.

What economists and analysts do agree on, is that exposure to commodities will provide the best protection to investors in uncertain times. This is a point of agreement between Steve Keen, an award-winning economist, and Peter Schiff, CEO of Euro Pacific Capital, during a recent debate hosted by Capital.com.

For an equity investor, careful sector selection is the key to protecting your portfolio.

 

What factors cause a financial crisis? Three warning signs:

1. Overvalued stocks

Unusually large stock market bubbles are often seen as one of the first signs of a market correction, as stock markets in the long term always revert back to the mean. Price bubbles have higher equity fundamentals, such as an inflated price/earnings (P/E) ratio. The P/E for S&P 500 is currently at 26, far greater than the historical average of 19. The S&P 500 P/E reached the 30’s during the dot-com bubble of early 2000s. During the late 2008, ahead of the Great Recession, the value reached 70.

2. Inverted yield curve

Normally, long-term bonds yield are higher than short-term yields, as investors demand compensation for holding a security long term. This results in an upward sloping yield curve. When investors sense economic uncertainty, they tend to invest in more longer term bonds in hopes of finding safety, increasing their prices and thus reducing their yield. This flattens or even puts a downward (inverted) slope to the curve. Current Bank of England data shows an inverted yield curve for the the UK for the midterm.

3. Interest rate increases

Central banks often use monetary policy as a tool to achieve price stability in an economy. Inflation is often dealt with by increasing interest rates. Higher interest rates do curb consumer spending, but often at the expense of the businesses selling goods and services. Increased rates also increase funding costs for businesses. The US Federal Reserve increased its key rate by 25 basis points this month, and may potentially increase them further during 2022.

Alastair George, Chief Investment Strategist at Edison Investment Research, believes a spike in corporate credit costs is one of the biggest red flags for an immanent stock market correction: “For us, the biggest red flag in the very short term is funding stress in interbank markets or a sharp increase in corporate credit costs, both of which reflect fears within the market that there are hidden losses or undercapitalisation within the financial system.

"The best early warning signals for the medium term are indications of financial exuberance, whether that is equity valuations well in excess of historical norms or significantly increased issuance of more speculative securities.”

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What are the first signs of a recession?

Even with all the above signs, there are a number of exogenous events which may tip the economy in either direction. However, identifying these events are a point of contention.

Peter Schiff, CEO of Euro Pacific Capital, correctly predicted the 2008 financial crash in 2006. He explained on MSNBC in 2009 that a recession was imminent due to over consumption and borrowing and not enough production and savings.

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Steve Keen, an award winning economist and professor, also predicted the financial crash. In a recent blog post on The Conversation, he explained the ratio of private debt to gross domestic product (GDP), which spiked both during the Great Depression and 2008 financial crises, should be the focus in dealing with policies. He explains in his 2006 data report The Recession We Can't Avoid? that private debt is a far more important economic issue than the rate of inflation.

Is a recession coming?

Due to differing opinions on what may cause a financial crash, the outlook is mixed on whether one is coming.

  • Peter Schiff believes yes, a crash is approaching. He told Capital.com it is inevitable.

It could be very different than 2008, and I think it will be different. I think it will also be a lot worse. But at this point, I don't know whether it's stocks that are going to crash, real estate that's going to crash or if it's going to be the dollar that's going to crash”

  • Alastair George sees mixed signals, and says it all depends on how central banks react.

“We have seen some signs of credit stress within the banking system following the Russian invasion of Ukraine but of an insufficient magnitude to give a clear signal and in fact risk appetite has returned more recently. However, looking further out we have definitely seen equity valuations well ahead of historical norms and increased issuance of more speculative securities over the past year. As central banks increase interest rates and inflation is set for a further surge on rising energy prices, it remains to be seen whether overvalued equities will deflate slowly or more quickly”

  • Meanwhile, Oren Klachkin, lead US Economist at Oxford Economics, told Capital.com that though the economy is not healthy, we are far from a recession.

“Financial markets are flashing some warning signs right now. Certain consumer and business sentiment surveys are eye-catching. But all in all, I think we’re still far from a recession in the US. I think the [current] economy is in a very different place today than in 1929 and 2008. It’s easy to forget amid all the current events, but the US economy still maintains a lot of underlying momentum. This is doesn’t mean we can ignore the risks, but I don’t think the economy is mired in a recession currently.”

  • Steve Keen points out that the current inflationary period is caused by supply issues, increasing interest rates will rectify this, but will instead cause debt payment issues.

“I think we're going to have a sustained inflation from the supply side, and that's what's different to any previous crisis. Now, the Fed's tools are all directed at reducing demand driven inflation. When you put interest rates up, you make it harder to finance your debts and you therefore caused a downturn in demand.” He adds that this eventually increases production costs.

How can equity investors protect themselves?

Although the potential of a recession is debatable, the method of protection is not. A loud and clear message by all is to underweight your equities, and overweight commodity exposure.

Schiff believes the winners in the coming years will be those investors who invest in “real things”: “I think we're going to see a return to a more traditional value, dividend type of investor where the stock pickers are going to start to make money, not the indexers.

“I also think you're going to see a rotation out of US assets, which have done extremely well on a relative basis over the last decade out of US assets into a developed foreign markets, but also in particular, a lot of the emerging markets.”

Steve Keen says: “I think it's going to be commodities players that make more sense in the future. But don't bet against the capacity of the Fed to re-inflate the stock market because it has unlimited capacity to finance that.”

George says: “Active investors could consider tactically reducing equity weightings, raising cash positions, and avoiding overvalued markets, sectors and securities. Sector allocations also come into play depending on the economic factors behind any slowdown.” He says high inflation will benefit the energy sector performance and low GDP will help defensive stocks.

Related reading

The difference between trading assets and CFDs
The main difference between CFD trading and trading assets, such as commodities and stocks, is that you don’t own the underlying asset when you trade on a CFD.
You can still benefit if the market moves in your favour, or make a loss if it moves against you. However, with traditional trading you enter a contract to exchange the legal ownership of the individual shares or the commodities for money, and you own this until you sell it again.
CFDs are leveraged products, which means that you only need to deposit a percentage of the full value of the CFD trade in order to open a position. But with traditional trading, you buy the assets for the full amount. In the UK, there is no stamp duty on CFD trading, but there is when you buy stocks, for example.
CFDs attract overnight costs to hold the trades (unless you use 1-1 leverage), which makes them more suited to short-term trading opportunities. Stocks and commodities are more normally bought and held for longer. You might also pay a broker commission or fees when buying and selling assets direct and you’d need somewhere to store them safely.
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