So far this year, stock markets around the world have differed in performance. The tech heavy NASDAQ is down almost 10% since the start of the year. In the UK, the FTSE 100 has fared better and is in the green by 1.5%. But a common question going around is whether the global markets could be due for a stock market crash. Although it’s impossible to predict this kind of event, here are some of the warning signs that I look out for.
Overvalued stocks
One metric that usually helps to forecast a stock market crash is when the index is overvalued. How can I pin down what the value is? One tool I can use is the price-to-earnings ratio. As a general rule of thumb, the higher the number, the higher the chance that a stock is overvalued. When I consider the FTSE 100, the index has an average price-to-earnings (P/E) ratio.
As of the end of 2021, the FTSE 100 P/E ratio was 14.86. When I compare this to the numbers over the past few years, this isn’t that high. At this time last year, it stood at 17.55, and two years ago, it was 16.30. So this isn’t a warning alarm that should be sounding concerns at the moment.
A note of caution here is that this considers the full index. If I just consider individual stocks, then the specific P/E ratio should be used instead. In this way, I can find some great companies with low P/E ratios, such as Royal Mail Group with a ratio of just 8.
Fear and greed concerning a market crash
Another warning sign I use is the fear and greed index. This is a number, from 0-100, that is published each day. The low represents fear, and 100 would be ultimate market greed. It’s put together using different tools, including market volatility, momentum, and relative strength. Although it’s geared towards the US stock markets, I apply it equally to the UK. After all, history shows that a stock market crash usually involves most developed countries around the world.
At the moment, the index is at 52. Therefore, this doesn’t seem to highlight to me a market crash is imminent. In fact, it confirms to me that if anything, investors are fairly well balanced in their actions right now. If I’m still concerned, I can consider buying a defensive stock, such as utility provider SSE.
Interest rate projections
A third pointer I use is the forecasted interest rates. Typically, when interest rates are being cut, the equity market starts to perform better. This is because cutting interest rates should help to stimulate economic growth. Consumers have a greater incentive to spend rather than save.
The inverse is also true. As we stand, some major banks are calling for three rate hikes from the Bank of England this year. This is likely to be matched in the US. So in terms of a warning bell for a stock market crash, this point does concern me.
I don’t think it’s the end of the world, as central banks clearly will be cautious in raising rates due to Covid-19. What I can do in this regard is look to buy stocks that benefit from higher interest rates, such as banking stock NatWest Group.
Jon Smith and The Motley Fool UK have no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
