There’s a lot of fear surrounding stock market crashes, so it’s natural to wonder if we’re on the cusp of a crash and what to do about it.
While you can’t predict the stock market, knowing how to spot the signs of a market crash can help you prepare for an impending downturn.
Before we dive in, I want to be clear: knowing a crash could be coming will only get you so far.
Think about it. If you see the warning signs of a market downfall, but haven’t put in the work to confidently know what you should and shouldn’t be invested in both now, and after the market drops – where does that really leave you?
That’s why in this post I’ll show you not only the warning signs of a market crash approaching, but also what to do about it and how to spot companies that will survive any market volatility.
Let’s dive in.
Signs of a Stock Market Crash
After the tumultuous year that we’ve had, a lot of people have been asking “Will the market crash in 2021?”
Seeing the future clearly is impossible, especially when it comes to the upward and downward movements of the stock market. BUT, if we take a good look at stock market history, we’ll learn that there are signs of a stock market crash before it occurs.
So, is there a market crash coming? This is what I’m looking at to get an answer:
An Inverted Yield Curve on Bonds
When yields on long-term bonds fall below yields on short-term bonds, you get an inverted yield curve. This means that bondholders can earn more interest on short-term Treasury notes than they can on long-term Treasury notes, and it could be an indication that a crash is coming. In fact, an inverted yield curve on bonds has reliably predicted recessions for half a century.
The Biggest World Economies are Shrinking
Another predecessor to stock market crashes is slowing growth around with world. When Gross Domestic Product (GDP) decreases consistently, it’s a sign that the economy is shrinking, which often leads to a recession.
To determine if this is occurring, you can look at the recent growth of major industries in big world economies or at the GDP of the biggest world economies. If numbers are consistently decreasing, instead of increasing, it’s a good sign that we’re headed for a recession.
Valuation Across the Market is Extremely High
High valuations market-wide are one of the biggest signs of a stock market crash. How do you know if the market is overvalued?
Warren Buffett said that Market Cap to GDP “is probably the best single measure of where valuations stand at any given moment.” This indicator, often referred to as the Buffett Indicator, measures the long-term valuation of the market. It’s a great tool to look at to determine if the valuation across the market is extremely high.
I like to look at the P/E or price-to-earnings ratio on the S&P 500 as well. Historically, the average P/E ratio on the S&P 500 is around 15, so anything higher than that means it’s overvalued, and anything much higher could signal it’s near time for a market correction.
When companies are priced too high relative to their actual worth, the price will almost always come back down sooner or later, but there’s no saying when.
How to Prepare for a Stock Market Crash
When all signs point to a stock market crash, don’t wait for it to come to take action. If you want to come out of a market crash having made money, not having lost it, you have to put in the work now.
This means making sure you don’t own any companies that are headed downhill and you do know how to pick companies that will survive a crash and come back stronger.
This requires research. Trust me, the time you put in now will pay off big time later. Plus, you’re not alone. I’ll walk you through exactly what you need to do to prepare…
Make Sure You Don’t Own These Types of Companies
Whenever you invest in a company it’s important to research that company from top to bottom. If a company has any of these red flags, you need to stay far away, especially if the market is heading for a crash.
While these warning signs should apply to any potential investment, they also apply to companies you’re already invested in. Take a good look at your portfolio and re-evaluate your investments; if any of them have debt, bad management, or a weak moat, now is the time to sell.
Companies With Debt
Companies that have debt can get into hot water when the stock market crashes, so it’s one of the first things you should look for when evaluating an investment.
You’ll need to look at a company’s cash flow statement to calculate how much debt it has. Subtract capital expenditures from operating cash to arrive at the number you need.
Then, compare that number with the company’s free cash flow. I always want to see debt no greater than two times the free cash flow. This means if they do business as usual, they can pay off that debt in two years.
Of course, if the market crashes, business likely won’t be as usual, so it may take a little longer. For this reason, it’s essential to ensure they don’t have more debt than they can take care of.
Companies with Bad Management
Companies with bad management are another type to steer clear of. How do you know if the management is poor? For one, if they have a track record of making decisions that take the company into a lot of debt or controversy. Another way to spot bad management is if they are buying back stock at historically high prices.
Companies with a Weak Moat
Next, you shouldn’t be invested in companies that have a week moat, or no moat at all. A moat is what gives a company a leg up on the competition. A strong moat is essential to sustaining free cash flow during a recession and recovering quickly from a market crash.
Learn How to Pick Great Companies
If you haven’t invested in any of these bad types of companies yet, you’re in good shape. But there’s still work to do. I want you to be able to take advantage of a market crash and buy wonderful companies at the bottom. To do so though, you have to learn how to know what makes a company great.
Study up on the following ways to evaluate a company so you can pick up great stocks when they go on sale.
Know the 4 Ms
The best companies to buy when the market crashes are ones that meet the 4 M’s of Rule #1 Investing. This means they have to have an impenetrable Moat and good Management, as I mentioned above, they have to have Meaning to you, meaning you understand the business and how it works, and you have to be able to buy the business with a Margin of Safety that all but guarantees a 15% annual return over the next ten year period.
The best companies will meet all of the 4 Ms, which is important because only the best companies will recover quickly from a market crash.
Evaluate the Financials
After you ensure a company meets all of the 4 Ms, you have to check out its financials. I use these key financial metrics to evaluate any company I want to invest in. Evaluating its financials will also help you determine the company’s value, which will tell you what price to buy it at so that you can purchase it with a margin of safety.
If the company’s financials check out, you can add it to your watchlist—a list of companies that are worthy of your investment when the time is right.
What to Do When The Market Crashes
If you prepared at the first sign of a stock market crash warning, you’ll be ready to invest in the right kinds of companies when the market drops. A market crash is a prime opportunity to get great companies on sale—the foundation of Rule #1 investing.
To take advantage of this opportunity, have your watchlist ready and wait for the company or companies you want to hit the margin of safety price you calculated. Then, buy.
While it may seem like a sweet deal to pick up a ton of companies when the market hits bottom, stick to your watchlist. Your watchlist should only be made up of the companies you have researched and can feel confident buying during a market crash because all signs point to their ability to recover.
Don’t just buy companies because the price is lower. Bankruptcy is a very real possibility for a lot of companies you go through a recession, and you definitely don’t want to put your hard-earned money into a company that may not even be around in a couple of years.
If you can avoid the temptation to buy regular old companies on sale and stick to buying the wonderful companies you researched who have what it takes to survive the crash and possible recession, you will be in good shape.
Whether the stock market crashes in 2021 or not, grab your Stock Market Crash Survival Guide so you’ll be ready.
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.