Three Warning Signs Every Investor Should Watch For

Updated: Jul 02, 2024 | Published: Jul 02, 2024
Verified Investing
By Verified Investing
Three Warning Signs Every Investor Should Watch For

Investors often get comfortable in a bull market, forgetting that trends change. No one knows precisely when a bull market will end, but there are three warning signs to watch for. While not perfect predictors of a recession, it's wise to prepare for one when these warning signs appear.

ONE: Excessive Market Valuations

One warning sign is excessive market valuations. Overly confident investors and those afraid of missing out on big gains keep buying stocks long after prices exceed intrinsic value.

A standard indicator of unsustainable share price growth is stock prices trading at forward P/E ratios exceeding the most bullish earnings forecasts. Abnormally high trading volumes during large gains can indicate a stock price decoupled from fundamentals.

Investors disregard or discount these warning signs when investor sentiment is highly bullish or, as Alan Greenspan famously called it, caught up in "irrational exuberance."

TWO: A Narrowing Bull Market

A narrowing bull market is another advanced warning sign of a possible market correction. One hallmark of a narrow bull market is major stock indices closing higher on the strength of relatively few major companies as large-caps begin outperforming small-cap stocks. This results in overall lower market volumes as more companies fall out of favor

Another indication of a narrow bull market is a divergence in the performance of different market sectors, with gains concentrated in fewer sectors. Narrowing bull markets have fewer new 52-week highs than new 52-week lows and fewer stocks trading above their 200 DMA while indices continue to gain.

Narrow bull markets often have a theme. Examples include the dot-com bubble, the real estate bubble of the early 2000s, or the rush in 2023 to add AI to everything that sparked the domination of chipmakers and AI software companies over the market.

THREE: Widening Yield Spreads

A third warning sign for investors is a rise in yield spreads. Yield spreads are the difference in interest rates between two bonds. They show the risk premium investors would receive when purchasing the riskier bond. Yield spreads are usually used to compare high-yield corporate bonds (aka "junk bonds") to Treasuries, which are considered risk-free.

Falling investor confidence leads to a demand for higher bond yields to compensate for the increased risk. This can be due to the company's performance, but it can also be contagion from other companies in the same economic sector that see more loan defaults and bankruptcies compared to the broader market.

Widening yield spreads often signal the start of an economic downturn. As corporate default rates rise and lending standards tighten, companies find it more expensive to issue debt. This causes debt service to consume more of a company's revenue, putting further pressure on its credit rating.

Without a substantial change such as a restructuring or outside investment in the company, increasing debt loads can push a company into bankruptcy. The savvy investor will see the yield spread widening and take action before it becomes a crisis.

Nothing Is Infallible

These three warning signs should not be the only things investors watch for. The more data points one has, the better informed they will be. That said, review each metric that you use when making investment decisions. As an example, for decades an inverted yield curve between the 2-year and 10-year Treasury notes was thought to be a warning of an impending bear market. These assumptions have been proven wrong.

The 2-10 curve has been inverted for over two years, and the stock market has regularly broken records. New research on the yield curve has taken a more granular approach and found that the bull market ends when the 2-10 yield curve disinverts at the end of a period of inversion.

Investors need to look for this sort of development before taking information gleaned from one source as gospel. Market analysis changes, and investors need to stay abreast of these changes.