Traders have access to countless tools designed to help predict future price movements, ranging from technical to economic indicators. While no individual indicator can definitively predict a market rally or decline, savvy traders can draw conclusions by looking at the story that multiple indicators are telling. The 2008 crash provides an excellent example of how certain readings can predict problems.
In this article, we will take a look at five indicators that foretold the 2008 crash and how savvy traders could have taken advantage of the knowledge. Traders should keep in mind, however, that every bear market is different and the same indicators may not apply during the next bear market that hits.
#5. Monthly Supply of Homes
A house is the single largest asset that most people own, accounting for a significant portion of their overall net worth. Demand for housing is typically driven by high levels of employment and rising wages, while a contraction in the economy leads to slower home sales and a glut of supply. In 2008, the collapse in U.S. housing prices was a crucial contributor to the subsequent global financial crisis.
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Data from the U.S. Federal Reserve suggests that housing supply may be an accurate predictor of pending U.S. recessions. In the 1970s, 1980s, and 1990s, a sharp rise in housing supply was immediately followed by a recession. The rise in supply could have been attributed to overconfidence on the part of homebuilders or simply a growing lack of demand among homebuyers as the market became overheated.
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#4. Market Caps vs. GDP
Billionaire investor Warren Buffett has often said that the ratio of market capitalization to gross domestic product (“GDP”) is the single best measure of where valuations stand in the equity markets. When the metric stands at greater than 100% of GDP, the Oracle of Omaha believes that investors should be wary about holding common stocks, since they may be overdue for a correction.
In 2007, as the housing bubble was bursting, the ratio of market capitalization to GDP stood at over 100%, suggesting that the market was significantly overvalued and due for a correction that ultimately took place the following year. Even before the 2008 crisis, the same metric could have been used to predict the dot-com bubble and many other market-crashes throughout U.S. history.
#3. Tobin’s Q
James Tobin is a well-known economist that developed the fundamental principles surrounding Keynesian economics and advocated for government intervention to stabilize output and avoid recessions. Ironically, one of his post popular indicators Tobin’s Q has become popular in Austrian economics circles as a way to predict market downturns by looking at the ratio between market and replacement values.
Tobin’s Q is calculated by dividing the value of the stock market by total corporate net worth. If the ratio is greater than the ~0.7 mean, the market may be topping as was apparent during the 2008 housing crisis and the 1999 tech bubble. Investors buying stock only during low-Tobin’s Q periods in the 1980s and 1990s would have enjoyed stronger returns than the market averages have produced.
#2. Historical P/E Ratios
The price-earnings (“P/E”) ratios is perhaps the most common metric used by investors to value publicly traded companies. While it does not account for growth rates by default, it represents a simple metric that can be compared over long periods of time. Lofty P/E multiples can predict market declines when growth starts to slow down, since investors can no longer justify the higher valuations.
In general, the S&P 500’s historical mean P/E ratio has been 15.51x with a median P/E ratio of 14.54×. These numbers are significantly lower than the greater than 60x P/E ratios seen during the 2008 market crash, as shown in Figure 4 above. In the past, similarly high P/E ratios relative to the long-term mean were seen during the 1999 and 2001 recessions when valuations soared higher.
#1. Jobless Claims
Employment indicators are among the most watched economic indicators, for a good reason: consumer spending, which is fueled by gainful employment and rising wages, drives the U.S. economy. Jobless claims represent a good proxy for determining the strength of the U.S. workforce, since it directly measures those filing for unemployment claims rather than relying on a survey.
In the years leading up to the 2008 crash, jobless claims hit a low and then began rapidly accelerating. Similar dynamics were seen before other market crashes in the 1990s and 2000s. While jobless claims tend to quickly drop after a recession, traders should keep in mind that other dynamics may be at play, including changes in discouraged workers and consumer spending trends.
The Bottom Line
There are many different indicators that foretold the 2008 crash, as well as similar crashes that happened throughout history. Traders should keep these indicators in mind, but should also realize they may not always apply to future crashes. For example, quantitative easing and other unconventional monetary policy may have changed the market’s dynamics when comparing the current situation to historical norms. Check out VTI for an ETF that tracks the total U.S. stock market.