Is it possible to predict a stock market crash?

Most stock market investors look for upswings in the assets they follow, but many would also like to be able to anticipate market crashes. But is it really possible to predict the next crash of the financial markets? This is what we propose to discover in detail through this article.  

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Is it possible to predict a stock market crash?

What is a stock market crash and why does it occur?

First of all, let us take time to recall what is a stock exchange crash and the causes which generate it most often.

In financial parlance, a stock market crash is most often referred to when stock market indices lose more than 20% of their previous highs. But this definition is however called into question by many analysts and economists who consider it as not very precise. Indeed, we could observe in the past important corrections of certain international indexes without for all that that does not involve a true stock exchange crash.

The definition of a stock market crash is therefore complex and cannot be reduced to a simple loss threshold, but requires more subtlety and the consideration of other important elements.

In fact, for a stock market crash to occur, the decline in the financial markets must be rapid and widespread, i.e. it must affect all the markets and not just one isolated market. Most often, this type of collapse occurs after a period of significant euphoria on the markets and following the bursting of what we call here a speculative bubble.

Ultimately, it is only possible to define a stock market crash once it has occurred. It is therefore totally impossible to predict precisely when and how the next stock market crash will occur. However, there are indicators that can give some clues as to how the markets are behaving, which we will discover below.

 

What are the most common causes of a stock market crash?

Let's now look at the most frequent causes of these crashes. In reality, a stock exchange crash depends on the psychology of the investors because it is necessary that the individuals who act on these markets act in the same way at the same time and thus here, by reselling their assets. This effect is often verified in the stock market even if, once again, to foresee these movements remains very complicated.

It is also important to understand that financial markets tend to anticipate cycles, but also that they do not operate rationally.

As we have seen above, a stock market crash generally occurs after the formation and the bursting of a bubble. These bubbles are formed following an innovation which tends to deeply modify our way of living and consuming and which will quickly spread to the general public. Thus, investors will be interested in this innovation and will see a potential for growth in the medium or long term, which will lead to major purchases and an accumulation phase.

Of course, this general euphoria will gradually lead to an overvaluation of the growth potential of this innovation with an increase in the gap between the market price and the intrinsic value of the innovation. Little by little, the market will doubt the growth potential of this innovation and it is enough for some large investors to start selling their shares for the process to start. This is the distribution process. With the loss of return on securities, the depression phase will then begin.

This phase will quickly lead to a situation in which most investors will experience a moment of panic. All of them will try to sell their positions quickly and the sell orders will be extremely numerous on the market with very few counterparts to the purchase. Thus, in order to sell, investors will have to lower their prices, which again leads to an increase in market panic. This is a vicious circle which, if it is intense and fast, can lead to a stock market crash.

Of course, as we will see below, the bursting of a bubble is not the only possible cause of a stock market crash and other events can lead to massive asset sales on the markets.

 

How often do stock market crashes occur?

Now that we know a little better the mechanisms of a stock exchange crash, we can wonder if this type of event is frequent or rather rare. Indeed, the press often speaks about risk of crash of the financial markets but is it simply an effect of announcement or does it account for a real danger?

If we base ourselves on the 20% loss threshold of the major stock market indexes, we notice for example that, since 1929, the American indexes have suffered 17 times this type of fall, that is to say a "crash" every 5 years approximately. But beware! These falls were not all equal. The 1929 crash, for example, affected first the Dow Jones and then the rest of the world. As for the crashes of 1937, 1973, 2000 and 2008, they led to drops in these indices of more than 50%.

Thus and if the stock exchange crashes can be regarded as relatively frequent, their intensity is not always strong and thus their impact is to be relativized. It is moreover rare that these falls are identified by the press as crashes and often, they pass unnoticed because of their short duration and followed by a fast rebound.

 

What are the indicators of an upcoming stock market crash?

First of all, let us recall once again that there is no reliable way to anticipate a stock market crash with precision. However, it is possible to follow certain indicators and to carry out precise analyses of the financial markets which can give indications on a risk of significant fall of the prices. Here are the elements that you can follow within the framework of this type of analysis:

  • The U.S. markets in particular should be watched very closely. Indeed, we know that a fall in the US stock market often has repercussions on the other world stock markets. The US market remains the world's largest financial market in terms of total capitalization. Thus, a crash in the US markets can lead to a crash in the other world markets, but the reverse is rarely true.
  • It will also be advisable to follow the yield curve closely. Indeed, during periods of economic expansion, this yield curve is normal with high interest rates when the maturity is long. But when the economy slows down, the yield curve tends to invert with low growth expectations.
  • The level of unemployment is an indicator that is often closely scrutinized by investors, and in particular the US unemployment rate with its new jobless claims figures, the rise of which is often seen as a sign of an economic slowdown.
  • The number of bank frauds is also part of the elements to be monitored in this analysis. As incomes fall, the rate of bank defaults rises with the inability of some households to repay their loans. We often see a significant rise in these default rates before major economic recessions. This was notably the case during the infamous subprime crisis.
  • Still in the framework of this analysis, we will follow with interest the liquidity of the markets and its drying up. To do this, we will follow the line of advanced declines, which is a specific indicator. This indicator gives an account of the number of shares that participate or not in the rise of the markets and makes it possible to measure the health of the companies independently of their weight in the index. When large investors see a potential end of the cycle coming, they sell their small caps in order to put their capital back into the stronger companies. This is called the distribution phase.
  • In the same way, an overvalued market is monitored by analysts and investors even if it is not in itself an indicator of a stock market crash. Indeed, it happens that an overvalued market continues to rise or stabilizes for several months before a fall. To determine the valuation of a market, one can use certain fundamental indicators such as the Price Earning Ratio.
  • Finally, there are, of course, certain unpredictable events that can lead to a rapid and punctual or lasting disruption of the world economy. The Covid 19 crisis that hit the world in 2020 is an example of this, but it can also involve major geopolitical conflicts, wars or other catastrophes.

The break of a major support, within the framework of a technical or graphic analysis, could also be a worrying sign. This is why chart analysis must also be carried out systematically in parallel with the fundamental analysis we have just discussed in more detail.

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