It’s almost a year to the day when we hit the bottom of the 2020 stock market crash. It’s easy to look back with the benefit of hindsight, a year on. At the time, nobody knew whether the FTSE 100 was going to fall another 10% or even more. Will it happen again? Although the stock market crash caught some by surprise, there are some warning signs that I can look at to try and gauge if another stock market crash is on the way.
Valuations and debt levels
The valuation of a company is one sign. Now, I can’t just look at one company and say that due to the price-to-earnings ratio, the entire stock market could crash. But I can look at the average ratio across the FTSE All Share index and get a good idea. At the moment, the FTSE All Share average P/E ratio is around 21. The average over the past 10 years is around 17. If the ratio gets very high, it leads me to conclude that the market is overvalued and could be due a correction.
It does look like valuations are above average at the moment, but not drastically enough to suggest a 25% stock market crash to bring about a fair rebalancing. And of course, while this warning sign of high P/E ratios is useful, it doesn’t account for surprise events such as a global pandemic. Last year, valuations didn’t look stretched, but we still saw a market crash.
Another warning sign is the amount of debt the companies have. If I’m looking at one company, I can use the debt-to-equity ratio. For the whole market, it’s a little harder to get an accurate figure. So this sign is one I need to look out for as I’m researching individual companies. I’ve seen a lot of FTSE 100 companies increase debt over the past year due to the pandemic. But that was unavoidable for many.
Higher debt levels means more constraints for businesses, as they need to pay back the lender (with interest). If these levels get out of control, a company could go bust.
Market crash warning signs, but not flashing right now
As someone who buys stocks, it might not seen too logical to spend time looking at the bond markets. But bond yields give me a good indication about the future direction of stocks. Higher yields mean investors think interest rates will rise.
So a warning sign for me is the rising yields that we’ve started to see in the UK. If they continue to rise, I think we could see a crash in some form. Higher rates ultimately mean a higher cost of borrowing for corporates.
None of the above signs are out of control, so I don’t see a stock market crash happening in the near future.
As a result, I’ll continue to stick to buying stocks that I believe have good long-term potential. Even with a crash, a good quality company should be able to ride it out in the long run. In fact, by investing small amounts regularly, I’ll be able to bring my average buying price lower if we do see a crash.
Until more of the warning signs start flashing red, I feel comfortable continuing on my investing strategy.
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jonathansmith1 has no position in any of the shares mentioned. The Motley Fool UK has 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.