The Next Market Crash Will Look Like...

If my stock market prediction models do their jobs they should start screaming loud warnings several months or even a year ahead of any major stock market crash -- or at least warn of those crashes that have an economic basis. (The models inherently will miss any market crash that comes from a sudden geopolitical shock.)

We are in a bull market that has been charging along since early 2009. Most traditional stock valuation metrics say prices are already pretty high.  So, sooner or later, rightly or wrongly, my models are going to start shouting out danger. It might not happen for years. It could happen later this year.  But, at some point the models will be waving big red flags.

So, what evidence can you look at to judge if the dire warnings coming from the models should be listened to?  What is the moment before the crash going to look like?  The answer is glaringly simple.

Just before the next stock market crash my forecasts should appear to be totally wrong, even crazy.

Most market busts come as the sudden collapse of an optimistic market boom. If there isn't a lot of hot air in stock prices, there isn't much much of a bubble that can suddenly deflate.  The next market crash is most likely to hit when optimism and 'animal spirits' run high.

At MarketWatch.com this week Jeff Reeves came out with a New Year's  "9 reasons the stock market is optimistic about 2017".    In a nutshell, the article points to strong numbers and high confidence for investors, consumers, manufacturing, home building and small business. For most people and the economy as a whole, times are actually pretty good.  When the market bust finally comes, there should be plenty more optimistic articles appearing and the majority of investors will be really proud of how well their investments have performed.

That's when you need to worry. By the time the next market crash hits, peoples' optimism will probably have become euphoria. People will be hating the Federal Reserve for having raised interest rates by about 3 percentage points from today's level. The economy will seem unbeatable.  And my models' forecasts should seem to be totally wrong.  If they don't seem crazy, then my forecasts are probably not right.

Happy New Year.