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After a record runup in stock prices amid the pandemic, stocks are starting to hit a rough patch. The Nasdaq hit its record high on Feb. 12, but less than a month later, it's trending into the red on the year.
With stocks soaring to record highs amid the economic chaos caused by the coronavirus, investors are rightly anxious that stocks could tumble back down in a hurry.
Stocks have been up and down thanks to rising bond yields over the last few weeks. But a bit of bad news about the pandemic or a more hawkish stance by the Fed could send stocks reeling.
But you don't have to fly blind here.
There's a market crash signal you can watch to help make decisions about your portfolio.
Of course, indicators like these are a dime a dozen. We'll show you a few popular signs and why they aren't as reliable as they may seem, and then we'll show you how to use a simpler method.
Why All Market Crash Indicators Are Not Equal
Take the Buffett Indicator, for example. Twenty years ago, in an interview, Warren Buffett said that the ratio of the stock market's total market cap to U.S. GDP was the "best single measure of where valuations stand at any given moment."
Since then, it has become gospel among the pundits and wannabe Warrens of the world to warn us all that the end is nigh because the indicator is at high levels.
The truth is that the indicator has been at high levels for several years now. We passed pre-credit crisis levels back in 2014. Using that as a trigger to exit stocks left a fortune on the table.
We passed the Internet bubble levels as 2020 began. You might have missed the sell-off, but the indicator never even came close to giving you a buy signal, so you would have missed the entire recovery as well.
We also hear a lot about the cyclically adjusted price-to-earnings (CAPE) ratio. The CAPE ratio is a multiple of 10 years' average earnings, adjusted for inflation. A ton of data shows that buying stocks when the CAPE ratio is at high levels offers much lower forward returns than buying stocks when the ratio is at a historically low level.
There is no evidence anywhere that suggests that the CAPE ratio is any good at timing entry and exit points in the markets. Markets that have a low CAPE ratio can keep going lower for years before turning higher.
Markets with a high CAPE ratio can stay high for a long time before eventually turning lower.
Both the Buffett Indicator and the CAPE ratio are reliable indicators of market valuations.
Market valuations are important and can tell us a lot about a stock, but valuation in and of itself tells us nothing about the short- to intermediate-term direction of the stock market.
They are bad timing tools that will cost you a fortune in lost profits and potentially massive declines if you attempt to time the buying and selling of stocks with valuation.
The right tool for the job depends heavily on your time frame and approach to the markets.
Here's how to use a more reliable market crash indicator to adjust your portfolio...
The Market Crash Warning Signs to Watch Now
If you are a trader, then watching the 14-day relative strength index (RSI) can give you a lot of information about the market conditions. If the RSI is above 70, things are getting heated, and the odds of a pullback increase.
If the 14-day RSI gets over 80, it is time for short-term money to exit the playing field. The odds of prices falling are rising rapidly.
But if you're an investor, history tells us it's usually a better ride to ride out most of the market ups and downs. The problem from a long-term point of view is always going to be when to get back in after pulling all of your money from the stock market.
The difficulty here is that it is very hard to ride out those gut-wrenching declines. Remember how it felt in late March?
It was hard to stay in back in 2009, when it looked like the financial system would collapse.
Investors who sell in a panic will find it hard to get back in as prices keep plunging.
They will also want to wait for a pullback once prices start rising.
There is only one number that long-term investors should watch to determine when to enter or exit the stock market.
That number is the 200-day moving average of the S&P 500 index.
You should only check the number on the last day of every month.
If the price of the S&P 500 is above the 200-day moving average, then own stocks.
If the index's price is below the 200-day moving average, then sell your stocks and go to cash.
Using this method of trend following in stocks would have helped you miss the worst of both the Great Financial Crisis and the coronavirus crash in 2020.
You also would have sidestepped the collapse of the Internet bubble.
Using this simple rule would have allowed you to do a little better than the indexes with a lot less volatility over the past 27 years.
Your biggest top-to-bottom declines would have been 16% compared to over 50% for the S&P 500.
You Could Make Your Portfolio "Recession-Proof" with This System
While most investors watched their hard-earned money evaporate during the 2008 recession, Andrew Keene collected thousands per week by developing the ultimate indicator.
He used it to identify the moves all the big players were quietly making... putting him in the know weeks before others caught on.
Today, he's spilling the beans so that you too can turn any market condition into profits!