Is the Stock Market Going to Crash Soon? – Two Cents – Lifehacker

Is the Stock Market Going to Crash Soon? – Two Cents – Lifehacker

Dear Lifehacker,
I’ve been reading a ton about the stock market hitting more new records. Nobel Prize winning economists are warning that the market is overvalued. Does this mean a crash is coming? What should I do?

Sincerely,
Intimidated Investor

Dear Intimidated,
There are a few levels to your question, but let’s start with the main one: Is the stock market going to crash? Yes, absolutely. That’s the easy part. Is it going to crash now? Well…that, we don’t know.

The Market Always Cycles

As long as there has been a stock market, it has gone up and down. In this chart of the Dow, you can clearly see how the stock market has continually moved in cycles from 1900 to the present.

Two things stand about the chart:

  1. The market follows a cyclical pattern: it goes up, then down again, then up again, down again, over and over. That makes it a no-brainer to declare it will go down again—it always does. Always.
  2. The good news is: it always goes up again, too. The news gets even better: as you can tell from the chart: the ups outweigh the downs by handsome margin over time.

Before we continue, let’s clarify what we mean by a crash. The market never goes up in a straight line: there are always dips and peaks as it generally moves up. However, there are a few drops which goes way beyond what we could call “normal.” Two recent examples were the “dot-com” bust right after 2000 and the 2008 market crash. If you look at this Google Finance chart of the S&P 500 you can see the distinction between the small dips and two major crashes clearly:

Now you can see why saying the market will crash is the easy part — it always does. The hard part is: when will that happen next?

Peaks Do Not Equal Impending Doom

No matter what anybody tells you, nobody knows when the market will drop. No matter how many degrees someone has, how many millions they made or how many books they sold, the fact is nobody can tell the future consistently and accurately. For example, take a look at this chart of the stock market, with the dates stripped away. It just reached a peak, so is it ready for a crash?

It’s hard to tell. You wake up in the morning and you see the beginning of a little dip there in the top right hand corner. Oh, man! The market has (as you can see) been growing for a while, so is this the time that it does its cyclical crash thing?

As it turned out, no. Here is the same chart continued. The dotted red line shows where it was that critical morning when you woke up and wondered:

The fact that the stock market is at a peak is no predictor of a major crash.

True, every crash is preceded by a peak, but not every peak is followed by a crash. In fact, as you can see from the chart above, there are hundreds of peaks which are followed by higher peaks. So, don’t let anybody point you to a peak and proclaim that it presages a crash.

So, what about those talking heads who keep predicting imminent doom, especially the ones who claim they called the previous one(s)? They’re playing a game involving math and memory. The math part says if they say every month the market will crash, sooner or later they’ll be right (see above). Then (the memory part) they hope you forget all the times they cried wolf, and they’ll crow, “See! I told you the market was going to crash! You can get my book at Amazon for $24.95.” They might even try to sell you a subscription service at $2,000 a year. (Hey, if you fall for the book, who knows? You can’t fault them for trying!)

But the bigger question for you is…

What Should You Do?

Now that you know you don’t know, and never will know, when the stock market’s going to crash, what should you do? Or, don’t do?

Your clue is that first chart. Take another look. The market always recovers and reaches a higher peak. The only exception to that was that first big crash to the left, the big 1929 crash, which led to the Great Depression in the 1930s. The peak following is the only one lower than the previous peak. All the other peaks were higher than any preceding peak.

What that means for you is two things:

  1. The market will recover. It always does. It never feels like it when everyone is all doomy and gloomy, but it does. And then it goes even higher than before. If you simply keep doing what you did before the crash, you eventually recover and reach higher highs.
  2. Whenever the market crashes, the smart investors like Warren Buffett swoop in and scoop up all the bargains they can get (“Fire sale!”). They do that with cash they set aside and don’t invest when the market is on the high side, which it seems to be now.

High side? Really? How can you tell? Here is how you do not tell: the charts you looked at above.

Say what? We spend all this time looking at the charts and now they’re not what we should look at?

Right. At least not to determine if the market is overvalued. Let me explain.

How to Look at the Price of a Stock

The numbers you see every day on the news reflect the price of the market, just like it reflects the price of a stock. But the price of a stock doesn’t tell you if it’s expensive or not.

Let’s take two examples I love using: Apple and Whole Foods Market. Apple’s stock price is around $120-130 these days, while the Whole Foods stock price is around $55. So, does Apple stock have more value?

No, Whole Foods is twice as expensive, even though it’s half the price. When valuing a stock, we don’t look at the dollar price, we look at the price as multiple of their earnings.

Apple’s stock trades at a PE ratio of around 17 times its earnings, while Whole Foods trades at about 34 times earnings. That means you pay twice as much for Whole Foods Market’s income stream than you’re paying for Apple’s. That’s why Whole Foods stock is twice as expensive as Apple’s. (And you thought only the stuff they sell was expensive.)

The stock market is nothing but the combination of all the stocks trading there. Like an individual stock, the market as a whole therefore trades at some multiple of the earnings of all those companies. These days, the S&P 500 (the total of the 500 largest stocks) trades at a multiple of about 17 times earnings. So, is that high or low?

This isn’t something doomsdayers like hearing, but the market’s PE ratio of 17 is pretty close to its historic average, as you can see from this chart:

The chart clearly shows how the market’s PE ratio went out of whack (scientific term, according to My Cousin Vinny) at the time of the major market crashes. Now, you tell me: is the market’s PE out of whack at the moment? I don’t think so, either. (In case you want to use the Shiller CAPE ratio, first read the detailed explanation of that measure here.)

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Again, nobody knows what the future holds, but it’s hard to make the case that the market is overvalued today, despite the weekly new market highs. Stock prices are high because companies are reporting high earnings.

Regardless of whether the market is ready for a crash, the best strategy for most people is to just keep doing what they’re doing now.

Sincerely,
Lifehacker

Title image remixed from John T Takai (Shutterstock).

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Is the Stock Market Going to Crash Soon? – Two Cents – Lifehacker

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