2020 Was Great, But There Could Be a Big Stock Market Crash in 2021
The stock market is at an all-time high, but don’t get complacent. A stock market crash could happen in 2021.
You see, in the short term, the stock market moves on noise, emotion, and sentiment. In the long term, valuations really matter. The higher the valuations, the higher the risk of a stock market crash.
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Throughout 2020, stock market valuations got really expensive, but the mainstream media did a horrible job at telling investors about this. It’s not just one indicator or measurement saying stocks are expensive. The list of indicators flashing warning signs to investors continues to get bigger.
3 Stock Market Valuations Every Investor Must Watch
There are three basic stock market valuations that investors should pay attention to: the price-to-book (P/B) ratio, the price-to-sales (P/S) ratio, and the cyclically adjusted price-to-earnings (CAPE) ratio.
The P/B ratio tells us how investors value each $1.00 of equity in the stock market. The P/S ratio tells us how investors value each $1.00 of sales, and the CAPE ratio is essentially a better version of the price-to-earnings (P/E) ratio—it tells us how investors value each $1.00 of earnings.
Mind you, the face values of these measurements really mean nothing. You must compare them with historical averages and turning points.
Putting things in perspective…
As it stands, the P/B ratio of the S&P 500 stands at 4.10. The last time this stock market valuation was this high was back in the early 2000s. (Source: “S&P 500 Price to Book Value,” Multpl.com, last accessed January 5, 2021.)
Guess what? That was just before a massive stock market crash.
The P/S ratio of the S&P 500 is currently 2.70. In the last 20 years, the ratio has never been this high! (Source: “S&P 500 Price to Sales Ratio,” Multpl.com, last accessed January 5, 2021.)
Lastly, the CAPE ratio stands at 33.44. The last time this ratio was this high was back in 2001. Moreover, the long-term average of the CAPE ratio is around 17.0, which means the stock market is overvalued by more than 96%. (Source: “Online Data Robert Shiller,” Yale University, last accessed January 5, 2021.)
Here’s what you need to remember: investors are willing to pay these high prices for stocks at a time when the overall economic picture is anything but good, and there’s abundance of uncertainty.
What Should an Investor Do?
Dear reader, I can’t stress this enough: Be very careful.
Sure, in the near term, we may see key stock indices move higher. But the valuations discussed above say the upside could be very limited. In fact, the valuations are painting a grim outlook for 2021. They say a stock market crash is a real possibility this year.
In the meantime, it’s important that investors pay attention to investment management. They should focus on capital preservation: cut their losses if there are any, and even think about taking some profits off the table. Also, when picking stocks, it might be a good idea to be selective. If there’s a stock market crash in 2021, the hottest stocks could face the most scrutiny.
