Blog | Paper Assets

Is this the Beginning of the Big Stock Market Crash?

Where we are, where we might be going, and how I plan on profiting no matter what direction the stock market decides to go

I’ve had some requests to explain a little bit about the recent roller coaster activity in the market. There have been a lot of big drops and then big rises.

I’ve spoken a lot about how I am skeptical of the high price of this market. I still am. People are asking me, “Andy, is this the big drop you’ve been talking about?” To answer this question that seems to be on everyone’s mind, I want to explain what I think is happening right now in a way that anyone should be able to understand.

Looking at current charts of the market, I do see some spikes in in volatility. This shows me that the market’s unpredictability is increasing. But do I think that this is a big one? No, probably not. However, I think there are some things that we should start watching more closely.

When I say that the market seems to be too expensive or overvalued, here’s what I mean: How much does it cost us in price to earn a dollar of profit? It’s another way of looking at the idea of earning a return on our investment.

In the stock market, there are many big investing companies (“institutions”) that buy and sell huge blocks of stock. These institutions are probably the biggest force in the market to affect prices. When the market is going up rapidly like it has been over the past year, these institutions want to ride it as long as possible. But at the first sign of trouble, the institutions will start selling immediately. These days, this is usually the cause of our big market drops.

What can this mean for the average investor like you and me? Well, I think it’s very important to know as much as possible about any type of investment you want to get involved with. So let’s spend a few minutes to understand how a company or a market gets valued.

Suppose you had a money machine. When you turn the crank on your money machine, it spits out a dollar for you. These dollars you create are your earnings.

In the world of business, there are all kinds of money machines. If the company is Apple, the action that turns the crank is the devices they sell. If the company is Pfizer, they turn the crank through the sale of pharmaceuticals. The more the crank gets turned, the more money they earn.

For investors like us, our two main questions are:

• How much does it cost to buy a particular money machine?
• How much earnings does that money machine generate?

When we know the answers to these two questions, we can do a little math to come up with the Price to Earnings Ratio (PE Ratio).

If you are familiar with real estate investing, this is very similar to the Cap Rate (except the values are flipped). Overall, it’s a way for us to quickly understand if a particular investment is a good value, or if it’s too expensive.

In the world of stocks, many investors keep and eye on the Shiller PE index, a price earnings ratio based on average inflation-adjusted earnings from the previous 10 years,. The median Shiller PE Ratio has historically been around 16 - 17. It’s a good barometer of what value we should be targeting. Again, a PE of 16 means that it costs us about $16 for every $1 of earnings we receive from that stock.

Looking back in time, we can see that there have only been a few times that the PE Ratio for the S&P 500 has been above this level. Before the crash of 1929, prices almost doubled and people were paying up to $30 for every dollar of earnings from the S&p 500. And during the dot-com boom people were paying HUNDREDS of dollars for companies that had zero earnings.

When the price of stocks gets really high, we’re forced to answer these questions: Are these high-priced companies cranking out enough dollar bills to still be valuable investments to buy? Are the profits worth the expensive price tag? The moment investors see that the PE ratios are too high, they will only continue to buy if they see growth. And if the outlook for growth becomes pessimistic, selling can insue.

Of course, this doesn’t mean that the market is going to crash immediately. But as we look back historically, there have only been a couple of times in the past I mentioned before when investors have been willing to pay this much for stocks. As the dot-com bubble showed, when investors were paying $44 for $1 of earnings, they eventually said it wasn’t worth it anymore. That’s when the big crash occurred.

The Risk Of Having A 401(k) Account

Most people with retirement accounts such as a 401(k) have not been worried over the past few years. They hope the value of their accounts go up and up. For those who have these types of accounts, there are two things to keep in mind:

1. The value of your account does NOT mean you have that much money waiting for you. Instead, it represents the current value of all the investments that are held in your account. When you want to get money out of the account, your account manager will sell shares at whatever the current market value on the date you sell.
2. When the market goes up, the value of your account will go up with it. But when the market drops or crashes, your account value drops with it. There is no protection for you.

Protecting With “Stock Insurance”

Insurance is a great tool to protect things that you value. We buy insurance for our homes, for our cars, and for our health. We don’t need insurance every single day, but we buy it to protect us when those rare bad events happen. It’s impossible to predict exactly when a bad event will happen, but it’s easy to prepare for it.

One of the great tools available for stock investors is to buy “insurance” on your stock positions. This is what we teach our students every week in my Mentor Club. We show how to protect yourself from any anticipated market problems, and also how to turn that into cash flow. In fact, many times we can structure positions so that we generate enough cash to actually pay for this insurance.

The tool we use to buy this insurance is called a stock option. When we are educated on how options work, and how to maximize them for different situations, we can control our risk and predict our cash flow very accurately.

The key is to know when to buy the insurance. It’s a lot cheaper to buy insurance when you don’t need it than when your house is going up in flames. The same is true with stock protection.

Even though we don’t know exactly when a big crash will happen, we can spot early signs based on what has happened in the past. This allows us to buy insurance via options at lower prices versus buying in the middle of a crash. We call this kind of insurance a “hedge.”

Our Students Learn To Do This With Zero Risk

One of the advantages of learning to trade stocks and options is you can do it risk-free with a practice account. Also known as paper accounts, these allow you to make trades using real market prices and information – but you can practice and improve your skill without risking any real money.

Virtually every online brokerage allows you to open and use these types of practice accounts. They’re virtually the same, so you can open one with any brokerage you choose.

We teach these strategies and techniques in our Mentor Club. This is our weekly training service where you get to follow along as we find profitable trades, set them up, make adjustments as needed, and show you exactly how much we make or lose on every trade.

Our students learn how to set themselves up to profit no matter if the market is going up or down. They also learn how to protect themselves from big market crashes that hurt the typical stock investor who sits on a buy and hold account.

Anyone can join The Mentor Club risk-free for 30 days. It’s a great way to see if this type of cash flow investing is right for you. You can get full details at AndysMentorClub.com.