The Stock Market Hurricane

If you’re not a news junkie, maybe you haven’t heard about this…but there’s a hurricane headed our way. And like most things in life, there’s an investing lesson to be learned here.

There are three conditions that have to be present for a hurricane to form.

1) Warm water

The storm can only develop over water that’s at least 80 degrees. Warmer water means increased evaporation from the ocean’s surface, which creates the necessary moisture in the atmosphere.

But the warm water also has to go deep enough; that 80 degree water needs to run at least 200 feet deep. Hurricanes don’t form in May or June because even though the surface of the water might be warm enough, the warmth doesn’t go deep enough. But throughout the summer months, the water slowly starts to heat up from the surface down, and by the end of summer, the conditions are ripe.

2) Little to no wind shear

Another important factor is the absence of wind shear, which is the difference in wind speed or direction over short distances. If the wind off the coast of Senegal is blowing west but the wind over Cape Verde is blowing south, while the wind off Sierra Leone is also blowing south, but at a different speed, that would indicate strong wind shear. Not ideal conditions for a hurricane to develop.

3) Cooler atmosphere

Finally, the air in the atmosphere has to be significantly cooler than the air at the water’s surface. The rapid cooling of water molecules as they evaporate allows for condensation and quick development of cloud formation in the storm wall.

Unless you have all three components—warm water, little to no wind shear, and cool atmosphere—you won’t find hurricanes forming.

In many ways, the birth of a stock market crash is similar.

Generally speaking, for a stock market crash to occur, we also need three factors to be present…

1) A long period of rising prices and economic optimism

Except for a very slight downturn in 2015, stock prices have done nothing but go up since March of 2009. Some analysts have classified this as the longest bull run in history. Others consider 2015 to have been a slight bear market, so they see it more as a two average-length bull markets with a small bear in the middle. Either way, the last decade has been a long upward trajectory.

As for economic optimism, there’s actually a polling group that created an index to measure this. In August, that index hit a 14-year high, meaning that people feel better about the economy right now than they have since John Edwards was getting $400 haircuts while he ran for Vice President alongside John Kerry.

2) P/E ratios much higher than long term averages

Understood simply, a high P/E ratio usually means that people are really excited about a company (so the stock price is high) even if the profits aren’t there to back up that excitement.

So when P/E ratios are high across the board, that means lots of people are excited about investing in many companies that aren’t necessarily profitable enough to justify that enthusiasm.

The combined P/E ratio of all stocks in the S&P 500 in September is almost exactly 25.

The average P/E ratio of the last 20 years? About 24.6.

3) Extensive use of debt.

According to the federal reserve, the average American household carries the following debt:

Credit card: $16,883
Auto loans: $29,539
Student loans: $50,626
Mortgages: $182,421

Meanwhile, the median household income is about $60,000. So yes, as a country, we’re heavy on the debt right now.

So where does that put us on our Stock Market Hurricane Score Card?

Two of our conditions are definitely present—a long period of rising stock prices and enthusiasm, and extensive use of debt. But we’re not in bad shape on the P/E ratio metric.

Now, the P/E ratio metric is one that can rapidly change, especially if something goes horribly wrong with some of the major players in the market—Apple, Google, Amazon, Facebook, etc.

So based on this analysis, it’s not wise to buy into any doomsday predictors who tell us that the next market crash is imminent. But it’s also wise to note that the right conditions could develop at any moment.

The water is warm and deep, and the atmosphere is cool. Right now, the wind shear is in our favor, but if that changes…look out.