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Ray Dalio is a famous investor that runs "Bridgewater", the biggest hedge fund in the world. He particularly excels in market cycles. Is the stock market currently in a bubble? Will we experience a market crash? What are the patterns that will help us predict market trends? Hey, welcome to Stock Market Mate.
In today’s video, we’ll look into Ray Dalio's 6-point checklist for spotting a market crash. Before we get into it, make sure to subscribe to the channel and hit that notification bell to help us beat the YouTube algorithm. If you’re done with that, then let’s get right to it. Dalio is not just looking at bubbles but he's also looking at particular bubbles that are delicate enough to pop and eventually crash in the market.
His 6 indicators suggest that stocks aren't trading unsustainable prices and could potentially increase. Number 1: Prices are high relative to traditional measures This phenomenon actually happened in the internet bubble in 2000 and in the 1920s as well. With this given metric, Dalio predicts that emerging technology stocks are contributing factors for creating bubbles.
We can look into the P/E Ratio. If you pay attention to the s&p 500 ratio, you'll see that it's sitting at an increased amount at the moment. 45.3; this is much higher than the average that we have witnessed. Dalio makes a valid point by saying that this can be compared to other asset classes. By this, we can have something to measure it against.
In order to do this, a little bit of math has to be involved. So the P/E Ratio is now at 45.3. If we apply a little bit of algebra, this will result in an earnings yield of 2.2%. If the market had no apparent growth, a 2.2% return would be ensured. However, we need to include growth, and right now, business growth in the USA is only around 2% over the past 10 years.
To support this, Dalio uses the yield of US government bonds as a basis. Now, if we add the 2% growth to the 2.2 earnings yield, we get a total return of 4.2%. If you pay attention to the bond market, bonds are currently yielding around 1.5%. That's the 10 year treasury bond. If we compare the return we get in the stock market relative to the return that we get in the other main asset, which is bonds.
So that is how Ray Dalio views his first measure. Number 2: Prices are discounting unsustainable conditions Dalio says that the nature of the purchase, who is buying it and how this demand is supplied will not be sustainable, producing corrections or a fall in prices. This criterion indicates that the stocks of emerging technologies would be just “bubbly”, while, in general, the market would be far from a bubble.
This essentially means that investors think that the good times are going to last for a lifetime. As you can observe in terms of supply and demand, investors are buying in a relatively sustainable way in terms of the overall market. If you pay attention to the emerging tech, conflicts start to arise.
This is a frothy amount of unsustainable investing. Dalio and his firm, with Bridgewater, have developed a proprietary metric to evaluate this criteria. This measure calculates the earnings growth rate that is required to produce stock returns in excess of what investors and bonds could receive. This pointer or indicator is at the 77th percentile for the aggregate stock market.
It also shows that while stock prices are increased in relation to the absolute returns they are to provide, they are not necessarily high in relation to their bond market competitors. Number 3: New buyers have entered the market The entry of new investors, according to Dalio, could be a sign of a bubble.
While the global stock market has gained new entrants, the situation, he points out, is even more alarming in technology stocks. According to him, “People who were never involved are investing”. This criteria measures the number of people who previously had no interest in stocks or investing but now suddenly want to be the next Peter Lynch or Warren Buffet.
In fact, Lynch actually called this the "cocktail party effect". According to him, you can tell how overvalued the stock market is based on the number of people that approach him in a party and talk about stocks. If a lot of people are eager to talk to you about stocks because it's trendy, then the market is overvalued or expensive.
However, if there aren't people who aren't interested in stocks because nobody wants to invest, then that is the best time to put your entire net worth into the stock market. Generally, it's actually great that a lot of people are getting interested in investing. However, Dalio sees these new investors as an indicator of a bubble.
The best way to quantify and measure this is to pay attention to the number of new accounts at retail brokerages like Robinhood. Number 4: There is broad bullish sentiment This is a signal where the general vibe in the market is that you can always make money. People are optimistic and hopeful for high future returns.
Dalio claims that the more bullish the sentiment, the more money people have already invested. The stock market will only continue to go up and there's a lot of quick profits to be made. You just need to be very invested in the market. A big example of this is the DotCom bubble. Advertisements with influential celebrities started flocking the media, showcasing investing in the market.
Dalio points out that just like this time period, the bullish sentiment surrounding the stock market is heavily focused on the bubble stocks rather than most stocks. So everyone wanted nothing but to make a quick profit and those who weren't in the loop, felt dumb. "Not having a certain asset will make you feel stupid" says Dalio.
By investor analysis, this metric already points to a bubble in emerging technology stocks and a “bubbly” market situation. According to Dalio's measures, this criteria is sitting in the frothy range. This means that it's partly dangerous and partly in a bubble as well. If we pay attention to emerging tech, the signal points towards a bubble again.
Number 5: Purchases are being financed by high leverage According to Dalio, another way to predict a bubble is by figuring out how much leverage is in the system. Simply, this is using leverage when investing is an investment strategy that magnifies your return or loss. Are people using their money to invest in the market or are they merely borrowing it?
Now, we all saw how the housing bubble popped in 2008 when there was too much borrowing and debt for mortgages. So, going back to leverage, there are two significant ways that an investor can utilize it. The first is what we call "margin". With this, an investor borrows money and then invests that borrowed money.
Second, is "options". Essentially, options allow investors to look closely at a stock. With the latter item, a 2-3% move in a certain stock can result in a 20-30% move if not more in the value of the option. To have a gist of how much leverage is being utilized in the stock market, we have to know that purchases make investors more vulnerable to foreselling in a downturn.
This foreselling causes a huge ripple effect in the stock market, which leads to further declines as more selling of stocks take place. According to Dalio, this criteria is in the somewhat frothy zone. This means that there is a significant amount of borrowing but it's somehow sustainable. However, looking at the tax sector, there are obviously some bubble signals because there are too many people who are borrowing money.
Number 6: Buyers/ businesses have made extended forward purchases Normally, a typical person would just purchase commodities like bread, sugar, corn, or oil, only when we need it. However, a forward purchase is when you purchase more of these than you would normally need because you're concerned about increasing prices.
If there's apparent extended forward purchases, then more people are doing this to a further extent. This is actually a sign of investors being scared of the future economic conditions that may happen. In today's current market, there is no bubble when it comes to extended forward purchases. “Those who use commodities, instead of buying for some purpose, would be accumulating in stock to protect themselves against the rise in prices”, he says.
This, according to Dalio, was also part of the situation in the period before the subprime crisis, but, in general, it is not happening today. As stock prices continue to hit record all time high prices, investors keep on wondering if there's going to be a market crash. However, thanks to Ray Dalio's 6-point checklist for spotting a market crash, we can now analyze the stock market and prepare ourselves.
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