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As mentioned above, CAPM estimates point when stock market becomes unstable.
It becomes obvious if you take a look on rate of change. When rates of change are more then 1, stock market is considered risky. The more rates of change more it’s risky. When slope is less then 1, we can say that stock market is underestimated and during some period it will aspire to 1.
Variables that we place on different axes can be negative. For instance, to calculate rate of growth for GDP 1980 we have to deduct GDP 1995 from GDP 1980 and this negative deduction compare with 1995 date.
Let’s compare 3 main American indices to find common features. The first one Dow Jones Industrial Average represents blue chip companies, second Nasdaq Composite Index - technology companies, and third one S&P 500, consists of both blue chips and technology companies.
[illustrations]
It’s obvious, that these three main indices have common behavior in these three patterns. Stock market growth rate outstrips economy growth. Stock market is overestimated. This situation is lasting for a long time, and now it’s getting even worse.
It’s clear that stock market indices have dependence. As a result of it let’s review dynamic of main American index Dow Jones.
Linear part locates between 1980 and 1990. It can be revealed by line with an angle 1.14. In this period stock market rate of growth a little bit bigger then economy rate of growth. Beginning with 1994 Dow Jones Industrial Average grows very fast comparing to real economy growth. You can see it on graph. The angle has increased more then 3 times. This means that stock market growth exceeds real economy growth more then 3 times. Such rise lasted till 2000. In 2000 raise changed into fall (angle equals 5.96). During fall stock market rate of growth didn’t reach economy rate of growth. This means that stock market is still overbought. Situation is getting even worse every day. DJIA is growing and getting overheated even more. This situation may cause a stock market collapse. It doesn’t mean that stock market falls today or tomorrow. But it will happen in any case in a future.
If S&P 500 Index looks like DJIA, situation with Nasdaq composite seems even worse. Since 1994 Nasdaq Composite rate of growth grows up more then 12 times. Starting from 2000 Nasdaq fall was much horrible then Dow. Technology index didn’t reach its fair price same as Dow Jones. Beta coefficient equals 5.19 right now. According to these calculations we can say that Nasdaq composite is overestimated at present. It can cause even greater collapse.
So, if index value didn’t reach balanced price, stock market fall possibility will always exist. We’ve got such situation right now. Stock market is overheated already and getting even more overheated. It’s time for traders to think if this a good time for investing or not and what kind of trading strategy to follow.
We are not advising you not to invest in stock market, we just warning you that it’s very risky right now. Stock market collapse is not far off. Traders, be careful!
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