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16 Warning Signs of a Stock Market Meltdown

John Csiszar

A bear market can be a scary thing. The very name makes it sound like you’re going to get mauled to death, and indeed a full-fledged bear market can be emotionally stressful and financially damaging. Although you shouldn’t try to time the market, certain indications make it more likely that a bear market is around the corner. If you see a large number of these warnings signs flashing red, it can be a good time to take some profits and reduce your risk.

So that you don’t fall victim to a bear market, be aware of the more common precursors to a stock market meltdown and learn what steps you might take to avoid some of the damage.

Last updated: Jan. 16, 2020

Declining Corporate Earnings

Although stock prices are impacted on a second-to-second basis by a number of variables, over the long run, earnings are an important factor in supporting stock prices. Every quarter, companies report earnings, and the stock market reacts to them. When earnings start to decline across the board, it can be an indicator that an economic recession lies around the corner. In an environment of slowing or declining earnings, stock market valuations also shrink, triggering a reduction in market prices. When this contraction is severe and prolonged enough, it can turn into a bear market.

A Nonaccommodative Federal Reserve

One of the many stock market axioms is that you shouldn’t “fight the Fed.” This means that when the Fed is being accommodative to the market by providing liquidity and low interest rates, you should invest expecting the market to gain, as has been historically wise. On the contrary, when the Fed is tightening monetary policy, making money less available to the economy, you should prepare for some setbacks in the market. If the Fed begins to tighten interest rates again or indicates that it is shifting toward tighter monetary policy, market sentiment could shift in a bearish direction.

Declining Auto Sales

Auto sales are a leading economic indicator. When consumers slow the rate at which they’re purchasing cars, it’s an indication that they’re either tapped out financially or less confident about making major purchases. As one of the two major purchases that customers make, auto sales can be a great snapshot of how the domestic economy is doing as a whole. When these types of major purchases slow, it can reflect a slowing economy or even a recession, which can trigger a bear market.

Rising Inflation

Inflation, to some degree, is good for the American economy, as it allows businesses to slowly raise prices and generate profits. It can also translate into higher wages over time for American workers. However, rapid or sizable gains in the inflation rate can be a killer for the economy, and inflation scares can spook stock prices as well.

When prices rise dramatically, the cost of operating a business rises as well. Not all of these increased costs can be passed along to consumers, resulting in reduced profits for businesses. Periods of rising inflation also tend to lead to higher Fed interest rates and tighter labor markets, further crimping corporate profits. Once business earnings are impaired, the familiar cycle kicks in: Reduced earnings lead to declines in share prices, potentially triggering a bear market.

Declining Home Sales

Home sales are another leading economic indicator that can reflect the state of the consumer and the American economy overall. When consumers feel good about the economy and have money in their pocket, they’re more likely to make major purchases like a home. If home sales show a decline over an extended period, it can reflect a slowdown in overall American consumer spending, which is one of the major engines of the economy. Thus, when home prices decline broadly, it’s often considered a precursor to a recession and a possible bear market.

Declining Consumer Confidence

Confident consumers are more likely to purchase big-ticket items like homes and autos, but these two indicators alone aren’t enough to get the whole picture of the American consumer. Since Americans only purchase homes and cars once every decade or longer, on average, more immediate indicators are also important.

The Conference Board’s Consumer Confidence Index reflects how the American consumer is feeling about current business and labor market conditions. A slowdown in the consumer confidence figures may indicate that an economic slowdown lies ahead.

The Buffett Indicator

Warren Buffett is one of the most famous investors in the world. The billionaire CEO of Berkshire Hathaway has been dubbed the “Oracle of Omaha” for his stock market prescience (and his hometown). One of Buffett’s favorite market indicators is the ratio of total U.S. stock market capitalization to gross domestic product. When this ratio is too high, Buffett deems stocks overvalued, as he did before the dot-com bubble of 2000 and the Great Recession of 2008. Currently, this indicator is at an all-time high, and Buffett’s company itself is sitting on a pile of about $128 billion in cash.

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Stocks Declining on Good News

In a bull market, seemingly nothing will stop the upward surge in stock prices. Even companies that report bad news can see their stock prices rise, as investors look for optimistic signs for the future. In a bear market, however, stock prices often fall even in the midst of good news. For example, if a company’s stock sells off after it reports blowout earnings and raises future earnings estimates, it can indicate that investors are fatigued or fearful that the future won’t pan out as predicted. This turn in sentiment can lead to investors sitting on their cash instead of investing it, turning broader stock market prices lower.

Euphoric Market Sentiment

This may seem counterintuitive, but when market sentiment is high, look out below. This is often the time when markets are about to sell-off. The reasoning behind this indicator is simple. When investors are pessimistic, they are hoarding cash and not buying stocks. As their confidence grows, money tumbles into the market, driving share prices higher. When investors are euphoric, they’ve generally put all the money they can into the stock market already, meaning there’s not much money sitting in cash to push share prices still higher. As famed investor John Templeton once said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.”

Global Recession

The U.S. has a strong and resilient economy. Often, when there’s a global slowdown, the U.S. can remain relatively immune to its effects, as it has numerous partners to trade with and has a high domestic output fueled by consumer and government spending. However, in a true global recession, in which economies around the world are contracting, even the U.S. can suffer. Other countries have less money to afford American products, which can result in lowered profits for American businesses. This, in turn, can translate into reduced hiring. Ultimately, the American consumer may feel less confident. All-in-all, a true global slowdown is likely to hurt American profits — and share prices — as well.

Domestic Political Instability

For the U.S., 2020 is an election year, and that makes for fertile ground for uncertainty. On any given day, one particular candidate may make a dramatic move in the polls, and the market may react negatively. The market hates uncertainty, and as uncertainty swirls around the election results, stock prices may gyrate wildly. If it looks like a candidate deemed to be antibusiness could be the ultimate victor, the market may dive into a full-fledged bear market. While this may or may not happen, the uncertainty leading into the November election could certainly lead to a bear market.

International Political Instability

Just like the stock market hates uncertainty, it also hates global instability. Geopolitical events, such as the recent military exchanges with Iran, can always lead to greater conflicts with uncertain outcomes. Even if the U.S. isn’t directly involved politically with a global mix-up, fear of how those events could affect America economically can lead to investor caution. If these fears grow or become reality, it can lead to a significant market pullback, such as in 1973 when the Yom Kippur War and subsequent Arab oil embargo resulted in a 48% market sell-off.

Black Swan Event

A “black swan” event is an unexpected event that has severe negative consequences. Coined by Nassim Nicholas Taleb, this moniker has come to represent unexpected market events that wreak havoc on stock prices. By definition, a black swan event is unpredictable, so there’s no point in trying to position your portfolio to defend against one. However, when one occurs, you should recognize that it can often be the starting point of a bear market.

Inverted Yield Curve

An inverted yield curve is one in which long-term interest rates are lower than short-term interest rates. This situation is considered “inverted” because typically longer-term loans involve higher risk and therefore carry higher yields. When long-term rates are lower, this indicates that investors feel the economy will be slower in the future and that rates will fall even lower. Thus, this is one of the indicators economists look at when they are predicting recessions.

There was a lot of discussion about this event in 2019, as investors on both sides argued whether or not that event was the precursor of a recession. Historically, however, an inverted yield curve occurred before each recession of the last 50 years, with only one false signal.

Leading Economic Indicators Weakening

The Conference Board Leading Economic Index is designed to identify peaks and troughs in the American economy. When these indicators fall, it’s an indication that the economy will slow its expansion in the future or even fall into recession. Here are the 10 indicators that comprise the index:

  • Average weekly hours, manufacturing
  • Average weekly initial claims for unemployment insurance
  • Manufacturers’ new orders, consumer goods and materials
  • ISM Index of New Orders
  • Manufacturers’ new orders, nondefense capital goods excluding aircraft orders
  • Building permits, new private housing units
  • Stock prices, 500 common stocks
  • Leading Credit Index
  • Interest rate spread, 10-year Treasury bonds less federal funds

This index is updated monthly.

Weakening Advance/Decline Line

The advance/decline line is a tool used by market technicians to gauge the level of buying interest in the market. Although it may sound like something for financial geeks only, the concept is quite simple. The index simply plots the number of advancing stocks on a daily basis against the number of daily decliners. Each following day, the net advancers or decliners are added to or subtracted from the index, respectively. For example, if the index sits at 48 on a given day, and the following day 10 more stocks advance than decline, the index will jump to 58. If this index starts sloping downward, it indicates the market may be turning direction.

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What To Do if a Bear Market Is Coming

Now that you’ve seen some of the possible indicators of an upcoming bear market, what can you do if you notice some of them occurring? Here’s a look at some defensive strategies you can use to avoid losing a big chunk of your portfolio if and when the next bear market hits.

Review Your Asset Allocation

When you first established your portfolio, you hopefully created an asset allocation based upon your investment objectives and your risk tolerance. If enough bear market indicators are flashing red, perhaps you might consider reducing the risk level in your asset allocation. For example, if you have enjoyed the bull market gains of the past decade with an aggressive growth allocation, you might want to downshift that risk profile into just plain old “growth.” You’ll still have market exposure in case the market continues to surge higher, but you’ll be a bit better protected on the downside if things turn around.

Rebalance Your Portfolio

Even if you don’t want to change your asset allocation, there’s a good chance that your portfolio is out of balance. If you’ve been enjoying the stock market gains of the past decade, it’s likely that the equity portion of your portfolio is now outsized compared to where it should be. For example, if your original portfolio plan allocated 50% to stocks, it’s entirely possible that your current allocation sits at 60% or 65% stocks. In that case, your portfolio is out of balance and exposed to more risk than you originally intended.

Take Profits

If a bear market is around the corner, there’s no better way to protect yourself than to take profits. Remember, all those big gains in your portfolio are currently on paper only. If a bear market unleashes its wrath on stock prices, you may end up with no gains at all — or even losses. An old market expression states that “no one ever went broke taking profits,” and even if you miss out on some future gains, at least you will have locked in those profits by the time the next bear market hits. You may want to consult your tax advisor about selling some of the losers in your portfolio to help offset the tax sting of your gains.

Continue Regular Contributions

Even if you were 100% certain a bear market was coming, it’s still in your long-term interest to keep making regular contributions to your savings and investment accounts. Since no one can predict the market’s near-term future accurately, there’s no telling when a bear market will end or how severe it may be. By continuing to make regular weekly or monthly contributions, you’ll, by definition, be picking up shares in the midst of a downturn, when prices are low. When the bear market inevitably ends and prices make new highs, those shares you picked up at lower prices will look cheap by comparison.

Stop Watching Too Closely

Watching how the market moves every hour of every day during a bear market can be everything from horrifying to gut-wrenching to emotionally draining. The stress you’ll endure while watching prices fall is simply not worth it. In a worst-case scenario — a scenario that is all too common — you may not be able to handle it and will choose to sell out of your investments at the worst possible time.

The key in times like these is sticking with an appropriate asset allocation and continuing to add to your investments throughout the sell-off. Eventually, the bear market will end, as every bear market before it has, and it may not even register as anything but a blip on a long-term chart. There’s no point in stressing yourself out over the day-to-day movements when prices will be higher over the long run.

If Close to Retirement, Trim Down Risk

A caveat to all of these options is that things are different for those who are about to retire or who otherwise might need their invested funds over the short term. Yes, the market has always recovered after a bear market, but it may take years for the market to gain back what it has lost.

While younger investors can take advantage of these sell-offs by continuing to buy shares, if you’re about to retire, the market may not recover in time to gain back your losses. Remember that a 50% drop in the market takes a 100% gain to get back to breaking even, and even a 20% drop requires a 25% gain to reach break-even. These types of recoveries can simply take too long for an investor nearing retirement, so a more conservative asset allocation may be appropriate.

Consider Alternative, Noncorrelated or "Safe Harbor" Assets

The good news about a bear market in stocks is that not every investment goes down along with it. In fact, some investments actually rise when the stock market falls. Bonds, particularly Treasuries, traditionally gain when the stock market sells off, as they are seen as a “safe haven” asset in the midst of uncertainty.

Other investments, such as gold, can also gain during market sell-offs, as investors search for hard assets. As bear markets can often occur during periods of inflation, investments like commodities, which tend to go up in price during times of rising inflation, can also be good diversification tools for a stock-heavy portfolio.

For More Advanced Investors: Hedge Your Portfolio

Hedging is an advanced strategy that investors can use to protect their portfolios against risk. You can hedge your portfolio by owning put options, which are bets that the market (or an individual stock) will go down in value. If you buy put options, you can maintain all of your existing positions rather than having to sell out of them. When the bear market strikes, those stock values will likely go down, but the value of your put hedge will go up, offsetting your losses.

Hedging strategies using put options can get quite complex, so you’ll likely want to work with a fiduciary financial advisor if you’re not an experienced trader. Even relatively simple hedging strategies, like purchasing put options on the S&P 500 index, can be beyond the reach of some investors, so be sure to do your research and consult with an expert before you proceed.

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This article originally appeared on GOBankingRates.com: 16 Warning Signs of a Stock Market Meltdown