It is difficult to predict when a stock market crash will occur, although some famed investors have made their fortunes by accurately predicting market declines. Investors should consider a high level of margin debt, an overheated initial public offering (IPO) market, and a high level of mergers and acquisition (M&A) activity as possible indicators of a market topping, since these elements were present during prior market crashes. Investors may also want to consider technical considerations such as an abnormally low VIX reading for an extended period of time.
Major stock market crashes have rocked the financial markets over the years, with the 2008 financial crisis being the most recent example as of September 2015. Stock market crashes are usually followed by a recessionary period of low economic growth.
Each market crash seems to bring with it a set of new financial regulations designed to prevent a future crash. Still, markets have constant exposure to systematic risk, which is difficult to predict and impossible to completely avoid. A long-term investment in the stock market generally goes up over time. However, investors should remain aware of a possible stock market crash to shore up their risk or even hold cash as opposed to stocks.
Bubbles and Crashes
Bubbles occur when there is a rapid increase in the price of a stock or asset followed by a substantial decline. Bubbles are phenomena that have been around for hundreds of years, as represented by the Dutch tulip bubble in the 1600s. Bubbles can form as a result of a structural shift in business patterns or a larger paradigm shift such as the dot-com bubble during the late 1990s and early 2000s.
Bubbles may be a byproduct of human emotion and frailty. At the height of bubbles, most everyone believes there can never be a drop. Anyone who is not following the crowd is missing out. Then, some initial shock occurs to the financial system or an inherent structural weakness begins to show. People start to sell off their stocks or other assets. This selling accelerates and values head down. This pattern increases into a vicious cycle of panic selling causing a massive market decline. Only in retrospect is it clear how a bubble formed with an inevitable decline.
High Margin Debt
A high level of margin debt is one factor many use to see if a market is topping. Using margin allows investors to buy and sell stocks with borrowed money. High levels of margin debt coincided with stock market crashes in 2000 and 2007. Some experts note that margin debt is higher in 2015 than those previous periods. A high degree of margin is part of the reason for the Chinese stock market crash in 2015.
High margin debt can be a sign of a euphoric market in which investors are loading up on stocks to try and make quick money. Investors use the borrowed money to buy stocks, which causes the market to go up quickly in a self-reinforcing cycle. However, stocks eventually go down. If stock prices begin to fall rapidly, investors receive margin calls and are forced to quickly liquidate their positions. This can cause panic selling as investors all flee the market at the same time.
IPO Market Activity
Another sign of an impending stock market crash can be a great deal of IPOs. Companies often rush to offer shares for investors to buy to take advantage of a strong stock market, wanting to get in on the action.
There was substantial IPO activity before the stock market crash in October of 1987. There were 500 IPOs that year with a record of $22.5 billion raised in capital. The dot-com bubble also had a great deal of IPO activity with 406 IPOs in 2000.
There has been a great deal of IPO activity in the biotech sector in 2014 and 2015. There were 50 biotech IPOs during the first half of 2015, raising over $5.1 billion. Strong performance in the biotech sector is one of the driving factors for the bullish market during that timeframe. A lot of the activity is for new and promising oncology therapies that have received approval from the Food and Drug Administration (FDA). Whether this high level of IPO activity is a portend of a market crash remains to be seen.
Mergers and Acquisitions
Similar to IPOs, a high level of M&A can also be a sign of a potential stock market bubble. There was a lot of M&A activity before the 2000 dot-com crash and the 2008 financial crisis. M&A activity has been high during 2014 and 2015 as the strong stock market and cheap debt have fueled many deals, including a number of blockbuster M&As in the health care sector. Many companies seek to enhance their revenues by buying competitors or acquiring nonrelated companies, especially if revenue growth is lagging. Some experts believe the wave of mergers in 2014 and 2015 is a sign a bull market is stalling.
Those who use technical analysis go by a different set of tools to try and predict a stock market crash. Paul Tudor Jones predicted the 1987 crash and made over 200% for his hedge fund that year. He examined technical chart similarities between 1987 and the crash of 1929 in predicting the crash. Technical analysis may look for certain bearish chart indicators such as the death cross moving average indicator.
Another technical sign of a market top is a low VIX level, also known as the fear index. The VIX is a measure of the market’s expectation for volatility over the next 30 days. It is calculated using the implied volatility of options on the S&P 500.
Stock market crashes coincide with rapid and dramatic increases in the VIX level. An extended period of low VIX levels can be an indication the market has become too bullish and investor complacency is too low. The first half of 2015 saw record low VIX levels. The VIX then made its largest one-month jump ever in August 2015, and is still relatively elevated as of September 2015.