The stock market usually runs in cycles. The market does not rise and then crash overnight. There would be a catalyst that would trigger the downfall, which will then be continued by momentum. This implies that if the market went up too high, the crash will also be sharp and quick.
There are certain indicators you can use to predict the advent of a stock market crash.
Rampant Speculation
The first step toward the crash is when speculation becomes rampant. This amount of speculation ensures that a positive feedback loop is prevalent in the market. Therefore, the stocks are driven higher than their true value. As an outcome, a bubble is made. Current high prices become the reason for expecting future hikes in prices.
To most savvy investors, the creation of such bubble is the first step that predicts a market plummet. Minor market corrections often deflate smaller bubbles. On the other hand, when the bubble continues for a prolonged period, the result is a market crash.
The fall is prices is usually steep, giving the investors nearly no chance to recover. The safest thing to do is to err on the side of caution. This may mean that the investor might make less money. But the risk of losing money is also reduced largely. Therefore ,speculative bubbles must not be followed till the peak.
Peak Valuation
The valuation of stocks is normally at its peak just before a market slowdown. For example, if historical records show that the average stock has traded at 15 times EBIT and at the present moment the same stock is trading at 27 times EBIT. Then the valuations are stretched.
The stocks of even good companies fall when valuations are fairly stretched. The historic record should not consider very long period of time. Recent price movements are more accurate indicators of the valuation of the stock. The ideal range would be around 3 to 5 years.
Low-Interest Rates
The root cause of any kind of bubble is the presence of too much money in whichever market. When the central banks lower down the interest rates, they incentivize banks to create more money by the fractional reserve lending process. This process has almost always resulted to a bubble and crash in the long term.
Low Growth Rates
A slowdown in the overall economic growth is a huge indicator that the stock market is going to crash. A slowdown, by itself, does not mean that the market will collapse. On the other hand, rampant speculation and a slowdown in growth rate are potent ingredients for a market crash.
Economists use several indicators as barometers for economic growth. The gross domestic product is among the most common of these indicators. Other factors include unemployment, and inflation. If these indicators are in the negative while the market is still booming, there exists a disconnect between stock markets and economic conditions. This exuberance usually doesn’t end well for the market.
