Warning signs when the market looks toppy

Nine ways to bring overly bullish clients back down to earth

Warning signs when the market looks toppy
Bryce Sanders

No tree grows to the sky.” It’s an old expression. Yet investors often have short memories.

Remember the Crash of 1987? That was almost 35 years ago! What about the DotCom crash? About 21 years ago! If some clients are in their 20’s, 30’s or 40’s, they haven’t had that experience. FYI:  That’s one of the reasons grey hair is an advantage in the financial services business.

Suppose you have a client who thinks the stock market is a one-way bet and they can’t lose? How can you bring them back to Earth? Consider the following warning signs.

  1. Investor sentiment. There are actual measures, but anecdotal evidence is a great barometer. If everyone agrees the market has no place to go but up, that’s usually a bad sign. Put another way, if the majority was always right, then everyone would be rich. They aren’t. There’s an urban legend Joe Kennedy (the father of JFK) advised the Harvard University endowment to get out of the stock market in 1929. Why? While getting his shoes shined, the boy doing the polishing was sharing stock tips. He figured when everyone is eager to get in, that wasn’t a good sign.

Explain: “The market climbs a wall of worry” has been a popular expression for years. It works the other way around too. You must be prepared.

  1. Alternatives start to look attractive. It’s been said one of the contributing factors to the Crash of 1987 was US long (30 year) Treasury bonds were trading at a 10% yield. If institutions (like pension funds) could lock in a double digit return in a basically risk free investment (because they would hold it to maturity) there was suddenly an alternative to the stock market.

Explain: If interest rates rise, bonds become more attractive. This can pull money out of the stock market, bringing it lower. 

  1. Overweighting stocks. You might have seen articles mentioning some investors are moving away from a 60/40 allocation of stocks and bonds towards an 80/20. (1) When clients voluntarily increase their weightings regardless of risk warnings from their advisors, that’s not a good sign.  In this case, it’s important for advisors to talk with clients about their risk tolerance, keep records and update the firm’s records concerning the level of risk they now consider acceptable.

Explain: Former US Federal Reserve chair Alan Greenspan coined the expression: “Irrational exuberance.” Explain what that means.

  1. Real Estate prices spike. You know what I mean. A fellow at my gym remarked: “You could sell your house in a day.” He admitted he was exaggerating, but explained buyers need to be pre approved for a mortgage before they are taken seriously. They need to bid at or above the asking price, being prepared to pay possibly a 15-20% premium. He then defined a bubble very concisely. Prices have moved to a level above where they should be. Eventually the market will calm down. Because of the premium they paid, they will need to wait a few years for prices to return to the level they paid.

Explain: Lots of cheap credit can drive speculation in the real estate industry. It was one of the causes of the 2008 real estate bubble in the US.

  1. People spending like there’s no tomorrow. You see plenty of neighbors building additions onto their houses. Auction prices you might follow are setting records. Everyone seems to own a new car. If the people around you seem to be burning money, it may be because they think the good times won’t stop.  Unfortunately, they do because the markets, interest rates and the economy are cyclical.

Explain: People often spend because of easy credit or the belief their assets will keep going up forever and they can borrow against them.  When stocks decline, the debt still remains.

  1. Friends are considering day trading as a career choice. This under “investing is easy. Anyone can do it. I don’t need an advisor anymore.”  When people start to think all stocks go up, just at different speeds, that’s a bad thing.

Explain:  Every transaction has a buyer and a seller. The person thinking it’s a good time to get into that stock is matched by a person who thinks now is a good time to sell.

  1. Financial advisors are now desired spousal choices. You’ve heard the old jokes about marrying a doctor or a lawyer. There were times when financial advisors were considered salespeople. Insurance agents were lumped in the same category. They weren’t professionals. That’s been changing.

Explain: This warning light isn’t glowing red just yet. Several TV series till portray financial advisors as villains. They aren’t as pure and desirable as surgeons yet.

  1. The words “New Economy” are used in a sentence. That’s what we talked about before the DotCom crash before 2000. Price to earnings ratios were no longer important.  If the company has a good idea, it didn’t matter if they weren’t making money.

Explain:  It all comes down to making money and making sense.

  1. People buying things they don’t understand. I’ve heard there was a rule some German banks used. They wouldn’t lend money for any property (or business) you couldn’t see from the top of the church steeple. The concept was they invested in their local market where they knew the economy, business conditions and the people involved.

Explain: Investors need to know the sequence of “what has to happen” for this investment to work out. When people buy and can’t explain the rationale, that’s a bad sign.

The stock market has often been likened to a rubber band.  It can be stretched in one direction or another, but once you let go, it comes back to it’s original size.  This can be a positive and a negative because when the market dips low, buyers often come in. When the market gets high, the same happens with profit takers.

Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry.  His book, “Captivating the Wealthy Investor” is available on Amazon.

  1. https://www.thinkadvisor.com/2021/11/10/8020-is-the-new-6040-josh-brown/