When the stock market crested in 1929, or 1987, or 2000, were you caught up in the euphoria -- and did you eventually get buried when the house of cards tumbled down?
The next time stocks take you on a wild bull run, you can determine whether a day of reckoning is at hand by looking for these ten indicators:
1) Extremely high trading volume.
This symptom enriches brokers and generates a lot of paperwork at brokerages, but it’s often a sign that the market is getting frothy. In an overheated market, brokers tend to churn ‘em and burn ‘em, racking up fees for themselves.
2) Widespread public infatuation with highly leveraged investments.
When your cab driver or local barber is dabbling in futures, options or margin accounts, it may be time to pull back on your stock investments. These leveraged plays allow average investors, usually those who are impatient and greedy, to control a large block of assets with a small down payment. When the number of amateur speculators suddenly spikes, it means that Wall Street is becoming more like a casino and is heading for a losing streak.
3) Valuations are off the charts.
It’s a warning bell when valuations are at historical extremes in terms of price-to-earnings (P/E) ratios, dividend yields, book values and corporate earnings.
4) Bad breadth.
No, I’m not referring to halitosis. A sign of a market peak is when fewer and fewer stocks are participating in the upswing. It usually means that the major indices are lurching toward their final climax.
5) The Fed is getting stingy.
When the Federal Reserve increases interest rates and squeezes credit, it causes money supply growth to nosedive -- an unmistakable sign that the stock market will soon run out of gas. In fact, in the year leading up to the dot-com bust, the Fed increased interest rates six times. Historically, money supply growth has exhibited a very close correlation with stock price movements. An increasing money supply boosts stocks; decreasing money supply puts the brakes on stocks.
6) When “distribution days” are packed into a short amount of time.
A distribution day is the term for a down day in the market on heavier than usual volume. When the stock market has a half dozen distribution days within, say, a 2-4 week time period, it means the market is getting very wobbly.
7) The market leaders are losing steam.
Bull runs often are propelled by a relatively small number of strong stocks that are 'market leaders.' When these stocks begin to falter, it could mean that the rest of the troops will follow.
8) Imminent government invervention.
If lawmakers on Capitol Hill are preparing a sweeping 'reform' legislative package that affects Wall Street or broad sectors of the economy, it often means that regulations and restrictions are about to be imposed on major companies, against their will. Also, if the normally slow-to-act Congress is actually addressing a perceived problem in the economy, it usually means that there’s an unbalance somewhere that is waiting to trip up a bull market.
9) Overwhelmingly bullish consensus among analysts and advisors.
Don’t succumb to “group think.” When analysts and investment newsletters are all caught up in the bullish euphoria, it’s time to cool it and reduce your exposure to stocks. [Want to learn more about profitting from going against the wave of market conformity? Read Contrarian Investment Strategies to Help You Stand Out From the Crowd.]
10) Signs of economic slowdown in cyclical industries.
P/E ratios for high-flying cyclical stocks can be deceiving. During prosperous times, companies in the auto, homebuilding, steel, and retail industries report huge profits that propel their P/E ratios to nosebleed heights. However, as soon as economic conditions in these sectors start to sour, their stock prices plummet.
That’s why a savvy investor doesn’t just buy and hold and ignore the news. It behooves you to continually monitor the state of the economy, in all major sectors. Don’t be deaf to major news developments. Think of a market crash as a financial shout, for the hard of hearing.