What are the indicators that a stock market correction or crash is imminent?
September tends to be the dangerous month for stocks, and the usual string of banks and top investors have been standing on their soapbox warning about an imminent stock market crash.
The Buffett indicator, which measures the ratio of total US stock market valuation to GDP, has been overvalued since January 2021.
But as we explained in these extraordinary times of unprecedented monetary easing, orthodox investing strategies do not work, and unorthodox investing strategies could be one way of achieving alpha returns.
“The Buffett indicator, which measures the ratio of total US stock market valuation to GDP, has been overvalued since January 2021”
Warren Buffet’s investing style is a classic; his great investing insights will be studied by generations of investors to come. But since the financial crisis of 2008, central banks around the world have created over 20T USD of liquidity, which prevented a financial meltdown and social uprising, particularly in the wake of the global pandemic lockdowns.
In these unprecedented financial times, orthodox financial and technical indicators do not work
So, if investors applied the Buffett indicators, which flashed red in January to their portfolios and liquidated their assets they would have underperformed by over 20% of their contemporaries who remained invested in stocks. The DOW is up over 23.63%.
So, we don’t care about what top investor, or bank and whatever analysts armed with the latest charts comes out and talks about a crash. As Darren Winters wrote back in June 2019 in a piece entitled, Bad is Good Logic,
“Stocks continue to bounce off their support levels in a backdrop of rising geopolitical risk and deteriorating economic fundamentals,” which turned out to be a bang on the money call he made more than two years ago.
Seeking Alpha wrote a piece last month, August 2021 entitled, “Good News Is Bad News.”
In other words, the crux to stocks moving higher is central bank liquidity.
“since the financial crisis of 2008, central banks around the world have created over 20T USD of liquidity, which prevented a financial meltdown”
Put simply long-term readers of this blog are two years ahead of Seeking Alpha
But if you have been investing, trading long enough then you too have become humble. The certainty of being on the winning side of a trade is never guaranteed. Everyone gets it wrong from time to time, the trick is not to stay wrong and not to have fixed ideas.
So, these are the indicators that we keep on our radar as an early warning stock market crash or correction.
US dollar index is a good indicator of market sentiment
Despite all the chatter, USD remains the world’s reserve currency and, in a risk-off sentiment, USD shoots higher.
“The size of the Federal Reserve balance sheet is probably the most important indicator of a pending stock market crash” – Win Investing
Crude oil price is another good indicator of market sentiment
Collapsing oil prices has a negative impact on the financial sector, bearing in mind oil is a capital-intensive business. Banks are heavily invested in the oil sector.
Falling oil prices due to lackluster demand for oil also signifies a weakening global economy.
The debt market, particularly the US 10 Year yields is another good of the stock price trajectory
Higher 10 Year yields impact the cost of borrowing in the US and the rest of the world. So, a rising 10 Year yield is negative for growth stocks, or highly leveraged companies.
The size of the Federal Reserve balance sheet is probably the most important indicator of a pending stock market crash
In other words, if the Fed were to decide to completely halt its 120B USD asset purchases per month stocks would collapse.
But besides these indicators, DXY, US T10 yields, Fed’s balance sheet, black swan events could also wreak havoc on the market
China’s property bond bubble could be one such event. Property development accounts for 28% of China’s GDP. Most of it is funded by US dollar-denominated loans. Moreover, foreign investors have been attracted by high-yielding Chinese property bonds, in some cases 10%.
Investors believed that Chinese property bonds were low risk on the understanding that China’s central bank would bail out the banks in the event of a problem.
Well, that problem has arrived with China’s Evergrande largest property developer in China with the most debt in the world owing shadow banks, investors, contractors, suppliers 305B USD, according to Bloomberg. But Evergrande, now desperately in need of liquidity, has not sold one single USD bond since 2020.
“Unless China’s largest property developer can raise funds, either through bank loans, bonds, it will be forced to sell assets already bought with leverage in a falling market” – Win Investing
China’s mantra, housing is for living not speculating, we believe will be exported to western state-capitalist systems. In Germany, Berlin thousands of protesters demand affordable housing. Protest for affordable housing is growing across Europe.
But back to Evergrande’s 305B USD potential property bond blowup, which has been dubbed China’s Lehman moment Moody has thrown the cat among the pigeons by downgrading Evergrande’s debt to junk and is warning that a default is imminent.
Unless China’s largest property developer can raise funds, either through bank loans, bonds, it will be forced to sell assets already bought with leverage in a falling market. There is chatter that the default could be 6-12 months.
But surely it is business as usual with China’s version of bank bailouts if the government fears social unrest is on the way. Will China end the bank bailout bonanza era? If so, this would be a SeaChange where the government forces deleveraging, which would be a bloodbath for property bondholders.
Then our indicators would flash red, bearing in mind that 300B USD of bad loans would be the catalyst for a global USD liquidity crisis sending USD sky-high and making dollar milkshake theory a reality.
But that is fear porn, surely another bailout is on the way. Just a thought, why should China give a damn about foreign investors. Somehow, we don’t see Chinese people taking to the street for a few wealthy foreign investors. On the other hand, China’s reputation as a global financial player could be in jeopardy if these loans blow up. So, we believe China’s Xi will either restructure or bail out the banks.
Nevertheless, we think it is wise to keep the stock crash indicators on your radar and monitor them regularly.