1 Stock Market Crash Indicator Flashing Red; 20%-30% Decline Possible? Lombardi Letter 2017-11-17 14:17:02 stock market crashp/e ratiostock market valuationsstock market crash aheadstock indices Investors are starting to dislike stocks, but valuations remain extremely high. Is this an indicator of stock market crash ahead? Here’s the full story. 2017,News,Stock Market Crash https://www.lombardiletter.com/wp-content/uploads/2017/11/stock-market-crash-indicator-150x150.jpg

1 Stock Market Crash Indicator Flashing Red; 20%-30% Decline Possible?

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Investors Disliking Stocks Predicting a Stock Market Crash Ahead

There’s an interesting phenomenon taking place these days. It suggests that investors are getting nervous, and that we could see a stock market crash ahead. Sadly, almost no one seems to be paying attention to it.

How can you tell that investors are getting nervous?

One way to look at this is to see how investors are reacting to earnings.

You see, generally, investors tend to buy the companies that are reporting earnings that are better than expectations (positive earnings surprise), and they tend to sell the companies that are reporting earnings that are below expectations (negative earnings surprise).

If you see investors selling the companies that report earnings severely below expectations, while also punishing the companies reporting better-than-expected earnings, it’s a worrisome sign.

Now, consider that, as of November 10, over 90% of S&P 500 companies reported their financial results for the third quarter. In response to the earnings reports, we saw investors selling stocks no matter what the results. This is one of the clearest signs that investors are rethinking stocks, and it foretells a stock market crash. (Source: “Earnings Insight,” FactSet Research Systems Inc, November 10, 2017.)

To provide some more perspective, if you look at the stock performance of companies two days before earnings and two days after earnings, this becomes very clear.

For 47% of the S&P 500 companies that reported better-than-expected earnings, over the four-day period, their stock declined by 3.6%, on average.

For 67% of the S&P 500 companies that reported earnings below what was expected, over the four-day period, their stock price tumbled by 6.4%

Looking at the bigger picture, in the last five years, if an S&P 500 company reported better-than-expected earnings, its stock price increased by 1.2%, on average, in the four-day period.

It can’t be stressed enough that this is not good. After the stock market crash of 2008–2009, investors never really got nervous owning stocks.

Are Investors Paying Attention to Valuations?

Looking at this, I am asking one question: Are investors starting to pay attention to the real fundamentals?

Stock market valuations are extremely high; we haven’t seen something like this in a while.

Consider that, currently, the 12-month forward price-to-earnings (P/E) ratio for the S&P 500 stands at 18.00.

How significant is this number? This is higher than the five-year, 10-year, 15-year, and 20-year average of the 12-month forward P/E ratio.

Dear reader, at times it may look like a stock market crash just happens out of nowhere. This is not the case, and don’t let anyone tell you otherwise. There’s usually a backstory that leads to a sell-off.

Go back to the 2008–2009 stock market crash, for example. Prior to the sell-off, there was a brewing housing crisis and banks had run out of liquidity. If I recall correctly, in July 2007, there were individuals calling for key stock indices to soar higher, and we were told to ignore everything else.

I don’t want to call any market tops; it’s impossible to do so. Once a top is formed, it will be very clear. But, this time around, I suspect a stock market crash could happen over concerns about valuations.

What do I mean by this? Valuations tend to fall back to or close to their historical averages. Right now, valuations are way too extreme. As investors become hesitant over this, they could be looking to sell. In the midst, we could see a sell-off that takes key stock indices 20%-30% lower very quickly.

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