How to Predict and Prepare for a Stock Market Crash

As we sit in the 11th year of a record bull run, pundits nationwide are “predicting” a stock market crash in 2021. Central banks globally have driven rates into negative yield territory. Lower yields tend to drive up asset prices. While I don’t know the exact time it will happen or magnitude of the crash that will occur, a significant correction will eventually occur.

A stock market crash is defined as a drop in the overall stock market of 20% or more at a given moment. Per Investopedia, the stock market has built-in triggers or circuit breakers to prevent an utter catastrophe reminiscent of the 1929 crash.

The triggers have been set by the markets at three thresholds – 7% (Level 1), 13% (Level 2), and 20% (Level 3). A market decline that triggers a Level 1 or Level 2 circuit breaker after 9:30 a.m. ET and before 3:25 p.m. ET will halt market-wide trading for 15 minutes. A market decline that triggers a Level 3 circuit breaker, at any time during the trading day, will halt market-wide trading for the remainder of the trading day.

What happened in 2020 was not a crash but reaction to the financial environment amid COVID-19. Something similar happened in December 2018. The market dipped but rebounded quickly. Typically, a crash takes months or even years to recover from. Luckily there are indicators that can predict if a crash is on the way.

How to Predict a Potential Crash

10-Year / 1-Year Treasury Yield Curve / Spread

One of the most popular indicators of a potential market crash has been the Treasury Yield Curve / Spread.  Typically, the interest rate of the 1-year Treasury Bond is lower than the 10-year Treasury Bond. This makes sense since there is less risk to buy something maturing 1-year away that it is 10-years away. However, every once in awhile, the 2 rates flip-flop or invert where the 10-Year yield has a lower rate than the 1-Year yield. This is significant since once this inversion occurs, a recession has occurred thereafter. Once the yield spread flip-flops or inverts, it has predicted the last 7 recessions within 20 months of occurring. It doesn’t matter the size of the negative spread. Once the spread goes negative, a recession has occurred within 20 months of occurrence.

This anomaly was discovered by Duke University finance professor Campbell Harvey back in the 1980’s. The chart below is from GuruFocus and shows the historical 10-Year / 1-Year Spreads for every year since prior to 1970. As can be seen below, the inversion of the yield curve has predicted the last 7 recessions. Also shown below is the most recent inversion that occurred on August 2019. If history repeats an 8th time, the occurrence back on August 2019 means that a recession should occur sometime in 2021.

Shiller P/E Ratio

Another indicator of a potential upcoming recession is the Shiller P/E Ratio. It was discovered by Robert Schiller, a Yale economics professor, in the 90’s and was used to predict the tech bubble crash. What the Shiller P/E Ratio (aka CAPE ratio) measures is the earnings per share (EPS) of an equity index such as the S&P 500 for the past 10 years. Earnings are inflation – adjusted to today’s dollars and the 10 -year average is found. To get the ratio, the current level of the S&P 500 is then divided by this value.

The chart below from shows the historical Shiller CAPE P/E Ratio for the S&P 500. The historical average ratio is approximately 16. Currently the ratio is at approximately 34 and climbing. While this ratio is not as consistent as the inverted yield curve for predicting recessions, it does have some merit. There has been only a handful of times the ratio has been above 25 and among these are the recessions of 1929 (aka Black Tuesday), 2000, 2008. In fact, the current ratio is the 2nd highest all-time only topped by the tech bubble of 2000.

Wilshire GDP

A 3rd indicator of a potential upcoming recession is the Wilshire GDP. It has been popularized by Warren Buffet and is also called the Buffet Indicator. Wilshire GDP is measured by dividing the total market cap of all publicly traded U. S. companies by the U.S. Gross Domestic Product (GDP).

If the valuation ratio falls between 50% and 75%, the market can be said to be modestly undervalued. Also, the market may be fair valued if the ratio falls between 75% and 90%, and modestly overvalued if it falls within the range of 90 and 115%.

The historical mean average is approximately 80%. The current ratio is 186%. This means that the total U.S. market capitalization is 1.86 times greater than the gross domestic product of the United States!

The chart from below shows the historical Wilshire 5000 / GDP ratio dating back to 1970. While it has not consistently coincided with the majority of the last 7 recessions, it is worth noting that the ratio has been above 1.0 in 2000 and 2008. This coincides with the last 2 recessions. Also worth noting is that the ratio is currently at an all-time high by a large margin.

So, what does this indicate about our current situation? If you look at any of these individually, it may appear that the market is currently overvalued. Given that all 3 indicators have “tripped”, this is a very strong indications of the market currently being overvalued. It also seems highly likely that a recession could occur in 2021.

If a recession is coming, there are a couple of ways to handle the situation:

  • Stay in the market and ride the up’s and down’s
  • Strategically exit the market and go to cash for the time being

Staying in the market has pro’s and con’s. Portfolios can recover given enough time. The risk is for people closing in on retirement. Their window for recovery is narrower plus withdrawals start to occur since money to live off of is now required.

To me, the safer play is to strategically exit the market for the time being, locking in your earnings, and wait until the market stabilizes. When it is safe to go back into the market, buy stocks at a reduced cost.

Let me be clear, I am not hinting nor proposing timing the market. It is impossible to know exactly when the market will turn south. What I am proposing is learning when the conditions for a recession may occur and that indicate a strategic exit may be prudent. The current situation might just be one of those times.

An obvious question may be, “why hasn’t a crash occurred yet?” Let’s delve deeper into that question.

Why Hasn’t the Crash Occurred Yet?

QE and Its Impacts

One possible reason for the lack of a stock market crash is that the Federal Reserve has been pumping money into the economy for quite some time. Dubbed “quantitative easing” (also called QE), it is essentially a monetary policy whereby long-term securities (i.e. government bonds, mortgage – backed securities, etc.) are purchased by the Federal Reserve.

The goal of quantitative easing is to increase the overall money supply and to encourage lending / investment by banks.  By increasing the money supply and keeping money circulating in the economy, economic growth is stimulated because banks are more willing to lend out money to businesses. A side effect of this policy is that increasing the money supply also lowers the cost of money. A lower cost of money leads to lower interest rates.

In the past, this economic growth has been stimulated organically through natural economic cycles that occur. Since the Great Recession, the Federal Reserve has used various amounts of QE to stimulate the economy and avoid another recession. According to Investopedia, the Federal Reserve plans to continue QE at a rate of $80B / month in U.S. Treasuries and $40B / month in mortgage-backed securities (MBS) for the foreseeable future.

Through this artificial stimulation of the economy, interest rates have stayed historically low, money lending is at an all-time high, and unemployment (before COVID struck) was near all-time lows.

The downside is that people and financial institutions are starting to rely solely on the federal government for economic stimulation. The economy may seem great but with all this outside assistance artificially propping up the economy, it doesn’t appear to be self-sustaining. An indicator of this is the Federal Funds rate that banks charge each other for borrowing money on a short-term basis. Current rates as of this writing are near zero.

I have noticed that this tends to be a litmus test for true economic stability. A couple of years ago, the Federal Reserve attempted to raise the rates above 2% (which is still historically low) and the market quickly rejected it. Borrowing slowed down quickly and intensely. The flow of money in the economy slowed down to the point that the Federal Reserve quickly lowered the rate to below 2% to keep the economy stimulated.

What appears to be happening is that the Federal Reserve is effectively” kicking the can down the street” and hoping this will resolve on its own organically. Personally, I am not confident of this since it is inevitable that the bill will come due one day. IT ALWAYS DOES. When it does, my fear is that the oncoming crash will affect every aspect of the economy. I hope I’m wrong but only time will tell. In the meantime, there are things that can be done to prepare for a market crash.

How to Prepare for a Crash

Understand that crashes are part of stock market investment cycle

In order to prepare for an upcoming market crash, the 1st thing a person needs to understand is that crashes, as well as high’s, are a natural part of the financial cycle. Dips in the market should be viewed as a great opportunity to buy good companies at below market value prices. It’s like going to the grocery store and your favorite bag of potato chips is on sale for 50% off! 😊

The absolute worst thing that can be done during a crash is panic selling a stock portfolio. This really exacerbates an already bad situation. If caught off-guard when a dip occurs, you really have no choice but to ride out the dip until losses are recouped.

Instead of being caught off-guard, it is better to anticipate that a market crash will occur and to develop an action plan when it does occur. The way I see it, there are 3 possible options when a crash is anticipated:

  • Do as the pundits recommend. Stay in market and ride the highs & lows.
  • Diversify away from the stock market into negatively correlated alternative assets.
  • Move out of the stock market into cash and cash derivatives.

Before you shudder at the thoughts above, let me explain my experience after the 2008 crash and why I am skeptical of staying in market during crashes. During the 2000 market crash, I remained invested in the market. I was new to investing and my account was very small. I rode it out and my account not only recovered but thrived.

I continued to follow the pundit’s advice again in 2008 and rode the crash out. I remained invested in the market thru 2008-2009. In 2010, I started a new job and unfortunately it was at a huge pay cut. We could not continue to invest in our 401K.

I watched the balances of our investment from 2010-2012 barely make any progress. By the time I was able to start reinvesting in late 2012, my 401K portfolio had taken a beating and barely made any recovery. Looking back, I realized that if not for my constant contributions, it would have taken the better part of a decade just to recoup those losses.

This is why I am considering moving to cash. Moving to cash will allow me to take advantage of a market downturn. As my old accounting professor always told us, “Cash is King” 😊. Maximizing cash for the foreseeable future will allow buying during the dip and will allow me to be an opportunist. Moving to cash also prevents losses during a downturn. While it also prevents gains in the short-term, to me, it is better to protect what I have & avoid losses during a downturn than try to figure out how to make gains.

There is also something to consider about moving some of a portfolio to alternative investments. As I mentioned in a previous article, alternative assets that have a negative correlation to the stock market can be a useful tool in your toolbox to combat a market crash. Investing is things that are not impacted by a market crash allows portfolio stability over a variety of conditions.

Whatever is decided, ensure that it is thought through and consequences weighed against personal risk tolerances. Personally, I’m a firm believer in Warren Buffet’s 1st rule about investing: Don’t Lose Money.

Get Finances Outside of Portfolio in Order

Before a stock market crash hits, ensure your financial house is in order.

Stock market crashes tend to be associated with a softer job market and weakened economy. This environment may negatively impact a person’s ability to find or even maintain a job. Therefore, a person needs to anticipate this possibility and plan accordingly.

While things are good, develop a plan to pay down debts and optimize cashflow. Paying down debt now opens up options later including creating a sufficient emergency fund and freeing up cash for future investing. Options during times of uncertainty is a good thing.

Eventually stock prices will stop falling and prices will be a bargain. Be prepared to take advantage when this shift occurs. Right sizing finances will enable cash flow optimization and the buildup of cash reserves. Start building the pile of cash sooner rather than later as a strategic action to a potential market crash.

While things are going well, take the necessary precautions and develop a plan to ensure things stay good even in the face of an economic downturn.

Understanding Time Horizon to Retirement

Understanding worst / best case estimates for how long before retirement starts enables understanding of the time horizon for recovery in case one gets caught up in an economic downturn.

For example, if chosen to stay in the market and there is a 20-year window before retirement starts, there is a high probability of recovery.

On the other hand, if there is only a 5-year window before retirement, the probability of recovery before retirement starts has reduced significantly.

The reason for this is that once retirement starts, not only does the portfolio have to continue its recovery but withdrawals will start as well. This exacerbates the need to accumulate savings to offset the losses incurred and potentially puts retirement at risk.

Knowing your time horizon means also knowing your risk tolerance and asset allocation. Plan ahead as retirement approaches to ensure that if a worst-case scenario were to occur, you and your assets are protected.


As we proceed to Year 12 of a record bull run, a stock market crash it inevitable. While it is impossible to predict exactly when this will occur, there are indicators that point to a potential crash coming sooner rather than later.

What is important to remember is that stock market crashes happen and are a natural occurrence. Don’t panic and start planning ahead because options exist. Just because a market crashes doesn’t mean that the sky is falling. It just means that a person needs to be aware of what indicators to look out for, make decisions that both protect the nest egg & create as much cashflow as much as possible, and understand an individual’s time horizon to retirement.

Train yourself and discipline yourself to look past these moments of crisis and plan for a better future. Don’t let panic set in. Panic is usually caused by a person being unprepared. Don’t let this happen to you. Take the necessary steps to take control of the situation or the situation will take control of you.

I’d love to hear your thoughts and comments on this topic. Agree? Disagree? Let me know 😊

Live the Life You Love, Want, and Deserve! 😊