Is the Stock Market Going to Crash Soon?

Dear Ritesh,

I've been reading a ton about the stock market hitting more new records. Does this mean a crash is coming? What should I do?

Sincerely,
Intimidated Investor

Dear Intimidated Investor,

There are a few levels to your question, but let's start with the main one: Is the stock market going to crash?

Yes, absolutely. That's the easy part. Is it going to crash now? Well...that, we don't know.

The Market Always Cycles

As long as there has been a stock market, it has gone up and down. In this chart of the chart, you can clearly see how the stock market has continually moved in cycles from 1998 to the present.

Two things stand about the chart:

1. The market follows a cyclical pattern: it goes up, then down again, then up again, down again, over and over. That makes it a no-brainer to declare it will go down again—it always does. Always.
2. The good news is: it always goes up again, too. The news gets even better: as you can tell from the chart: the ups outweigh the downs by handsome margin over time.

Before we continue, let's clarify what we mean by a crash. The market never goes up in a straight line: there are always dips and peaks as it generally moves up. However, there are a few drops which goes way beyond what we could call "normal." Two recent examples were the "dot-com" bust right after 2000 and the 2008 market crash. If you look at above Google Finance chart of the sensex you can see the distinction between the small dips and two major crashes clearly:

Now you can see why saying the market will crash is the easy part — it always does. The hard part is: when will that happen next?

Peaks Do Not Equal Impending Doom

No matter what anybody tells you, nobody knows when the market will drop. No matter how many degrees someone has, how many crore they made or how many books they sold, the fact is nobody can tell the future consistently and accurately. For example, take a look at this chart of the stock market, with the dates stripped away. It just reached a peak, so is it ready for a crash?

It's hard to tell. You wake up in the morning and you see the beginning of a little dip there in the top right hand corner. Oh, man! The market has (as you can see) been growing for a while, so is this the time that it does its cyclical crash thing?

As it turned out, no. Here is the same chart continued. The dotted red line shows where it was that critical morning when you woke up and wondered:

The fact that the stock market is at a peak is no predictor of a major crash.

True, every crash is preceded by a peak, but not every peak is followed by a crash. In fact, as you can see from the chart above, there are hundreds of peaks which are followed by higher peaks. So, don't let anybody point you to a peak and proclaim that it presages a crash.

So, what about those talking heads who keep predicting imminent doom, especially the ones who claim they called the previous one(s)? They're playing a game involving math and memory. The math part says if they say every month the market will crash, sooner or later they'll be right (see above). Then (the memory part) they hope you forget all the times they cried wolf, and they'll crow, "See! I told you the market was going to crash! You can get my book at Amazon for Rs.250." They might even try to sell you a subscription service at Rs.2,000 a year. (Hey, if you fall for the book, who knows? You can't fault them for trying!)

But the bigger question for you is…

What Should You Do?

Now that you know you don't know, and never will know, when the stock market's going to crash, what should you do? Or, don't do?

Your clue is that first chart. Take another look. The market always recovers and reaches a higher peak.  The peak following is the only one lower than the previous peak. All the other peaks were higher than any preceding peak.

What that means for you is two things:

1. The market will recover. It always does. It never feels like it when everyone is all doomy and gloomy, but it does. And then it goes even higher than before. If you simply keep doing what you did before the crash, you eventually recover and reach higher highs.
2. Whenever the market crashes, the smart investors like Warren Buffett swoop in and scoop up all the bargains they can get ("Fire sale!"). They do that with cash they set aside and don't invest when the market is on the high side.

High side? Really? How can you tell? Here is how you do not tell: the charts you looked at above.

Say what? We spend all this time looking at the charts and now they're not what we should look at?

Right. At least not to determine if the market is overvalued. Let me explain.

How to Look at the Price of a Stock

The numbers you see every day on the news reflect the price of the market, just like it reflects the price of a stock. But the price of a stock doesn't tell you if it's expensive or not.

Let's take two examples I love using: A Stock is IT company and B stock is pharma company. A stock price is around Rs.120-130 these days, while the B stock price is around Rs.55 So, does A stock have more value?

No, B is twice as expensive, even though it's half the price. When valuing a stock, we don't look at the price, we look at the price as multiple of their earnings.

A stock trades at a PE ratio of around 17 times its earnings, while B trades at about 34 times earnings. That means you pay twice as much for B Market's income stream than you're paying for A. That's why B stock is twice as expensive as A. (And you thought only the stuff they sell was expensive.)

The stock market is nothing but the combination of all the stocks trading there. Like an individual stock, the market as a whole therefore trades at some multiple of the earnings of all those companies.

These days, the NIFTY (the total of the 50 largest stocks) trades at a multiple of about 21 times earnings. So, is that high or low?

This isn't something doomsdayers like hearing, but the market's PE ratio of 21 is pretty close to its historic average, as you can see from this chart:

The chart clearly shows how the market's PE ratio went out of whack (scientific term, according to My Cousin chandu) at the time of the major market crashes.

Now, you tell me: is the market's PE out of whack at the moment? I don't think so, either. 

Again, nobody knows what the future holds, but it's hard to make the case that the market is overvalued today, despite the weekly new market highs. Stock prices are high because companies are reporting good earnings.

Regardless of whether the market is ready for a crash, the best strategy for most people is to just keep doing what they're doing now.

So, as Conman investor What Should I do, I am still confuse with stock selection should i buy Pharma stock or Infrastructure stock or banking?.

I personally fill one should buy Diversified Mutual Funds instead of buying stocks,

and  next question will be when to buy Mutual Fund

The father of value investing, Benjamin Graham once wrote that making money on investing should depend “on the amount of intelligent effort the investor is willing and able to bring to bear on his task” of security analysis. He defined the intelligent investor as an enterprising individual that has the time and energy to do his or her own investment research. In contrast to the intelligent investor is the defensive investor who would prefer to have another individual pick stocks, bonds and other financial assets on his or her behalf. Hiring a financial advisor is certainly one alternative, but most retail investors (and also many institutions) prefer to hire a manager through the purchase of a mutual fund. Below is an overview of when it might be a good time to invest through the purchase of mutual funds.

There is money to be made in mutual funds, but investors fall into several pitfalls that keep them from maximizing their profits when investing in funds. Getting too focused on short-term results can be a big problem. As with individual stock, chasing performance can be a large negative when buying mutual funds. For starters, there is little evidence to suggest that a mutual fund manager that performs well for a quarter, or even a couple quarters in a row, has investment skill. Short-term fluctuations are arguably random. The only surefire way to determine if a mutual fund manager has more investment skill than luck is to measure his or her performance through a full market cycle of three to five years. A manager with a few bad quarters, but a great long-term track record, could still end up being a great mutual fund to buy into.

Investors also have a track record of chasing performance and this can have significant impacts on mutual fund performance. As alluded to above, buying into a fund following a strong short-term run and great performance is unlikely to be repeated unless the manager has a solid long-term track record. Fund flows can also end up hurting performance. Mutual fund managers in small-cap stocks can start to lag if they become too popular; with high asset levels it can become too difficult to find opportunities in smaller companies. Rapid inflows and outflows can also hurt performance because the mutual fund manager may be forced to invest new funds or sell to meet redemption, which means she or he is forced to make buy or sell decisions that may not be based on if a stock or bond is a good value at the current price.

Benefit by investing through SIPs

The biggest benefit of a SIP is that it allows one to invest regularly without being bogged down by questions about the right time to jump in. SIP is not a product or a fund. It is simply an investment process. Instead of basing investment decisions on expectations of how the market will behave, SIPs facilitate a disciplined participation in the market through ups and downs. Since a fixed amount is invested across time, SIPs enable a reduction in average cost. Therefore, the returns from an SIP are not likely to be different from those of the mutual fund in which the investment is made.

No point in comparing lump-sum investments and SIPs. I have seen research trying to establish when and under what conditions a SIP can beat lump-sum investment. Actually, they are two completely different ideas, and the latter will typically beat SIPs. When you invest a lump sum, a larger chunk of your money works for a longer period of time.

On the other hand, a SIP is a slow model, where you build your wealth with each installment. Had you invested Rs 10,000 per month in the Sensex since its inception in 1979—406 months in all—you would have about Rs 1.6 crore today.

A lump-sum investment of the same amount, Rs 4.06 lakh at that time would be worth over Rs 8 crore today. If you have a lump sum handy, you are better off not trying to go for an SIP unless you think the market is falling and you want to invest at lower levels.

The Bottom Line

When it comes to buying a mutual fund, investors must do their homework. In some respects, this is easier than focusing on buying individual stock.

-- 

Regards,

 

Ritesh.Sheth CWM^®

CHARTERED WEALTH MANAGER

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