With the stock market seemingly pushing record highs with every passing week, investors and analysts alike are concerned about a coming market correction. Although forecasting absolutes when it comes to stocks is a fool’s errand, investors and financial professionals sniff about looking for clues that might indicate something wicked this way comes. In other words, everyone is looking for the Holy Grail in investing, which is recognizing possible signs a major correction might be in the cards.
When one has been looking at the markets for decades as I have, one does start to notice clues as to when a correction might be manifesting itself. Cataloging what preceded market crashes in the past may give hints as to what may happen in the future.
Although no one can absolutely predict market direction, nevertheless, much like dark clouds MAY precede a rainstorm, markets may tend to exhibit specific signs of stress before sell-offs, which often (but not always) signal portfolio risk is on the increase.
Bonds (which are simply IOUs) tend to move opposite of stocks. This is the reason it is commonplace to have a mix of both in a portfolio. Keeping that in mind, if bond prices start to rise, it may be a signal investors are attempting to mitigate some stock risk for whatever reason. The specific reason is not important and may not even be known. What is important is that investors may be beginning to sense some sort of danger in the market environment and swapping out stocks for bonds.
Consumer staple stocks (the companies that make the basic necessities of life) tend to rise when market risk increases, as investors move toward things that are less discretionary to consumers.
For instance, if times get tough, one may not eat out as often, but still have to buy toilet paper and light bulbs. Companies that make packaged foods and cereal are also thought to be more of a defensive holding when things get dicey. Investors tend to shun the growth stocks in lieu of the old, stodgy type of stocks that have been around for decades making the things people have to buy, instead of things they want to buy.
If stocks fall and then continue to fall over a prolonged period, this can indicate the wind is coming out of market sails and that the momentum may have changed from a previous euphoric period.
Stock of utilities might rise more than normal and fixed income holdings may increase as risk increases. Fixed income refers to preferred stocks, bonds, treasury funds (Government IOU”s) and securities that offer a fixed interest rate of return instead of the allure of a rising stock price. Precious metal prices may also start to rise when intrepid investors get the “willies”.
There are non-stock indicators as well that don’t specifically center around what investors are buying or selling that may also give clues as to investor sentiment.
Interest rates may start to rise indicating money is getting tight as investors are not so eager to lend out their money and are demanding higher interest rates to do so.
There are also fear and volatility indexes and they may rise prior to market problems.
Contrarian indicators, things that typically occur during market tops, can also signal things have gone too far, too fast.
Margin debt, which is the amount of money borrowed to buy more stock than an investor has money, can reach historically high levels, which may also indicate excessive speculation. This can occur during times of extreme optimism, which can be a precursor to market sell-offs.
Although seemingly contrary to common sense, markets tend to reverse down when everyone thinks the market can do nothing but keep going up. Along those same contrarian lines, markets tend to stop falling when everyone is “jumping out the window” sort of speak, which signals investor capitulation and extreme market despair.
In conclusion, although no indicator can forecast market direction with 100% accuracy, there may be certain historical events that occur from time to time that may very well signal that the markets are getting ready to change direction, and quite possibly in a very big way.
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