How I’m dealing with this red flag that suggests we could be due a stock market crash

Over in the US, a popular valuation metric is currently indicating a very high value. Some cite this as a reason for thinking an a stock market crash is imminent. Yet being forewarned is being forearmed, so there are some ways I’m able to reduce my risk to this potential event happening. Here are the details.

Setting the scene

I’m referring to the price-to-earnings (P/E) ratio of the S&P 500, which currently sits just under 28. This marks a similar high level to what was seen just before the tech bubble crash back in 2002. It’s worth noting that the ratio has been above 30 for five other quarters since the turn of the century. But these other cases were distorted due to sharp share price movements related to events such as the pandemic and the global financial crisis.

If an investor ignores these outliers and focuses on more ‘normal’ market periods, the elevated P/E ratio right now could be a cause for concern. Naturally, some might feel that the US stock market is overvalued and could crash.

Obviously, I can’t predict the future. But I do agree that some US stocks look a little overvalued, which limits the potential to rally further from here. Fortunately, I have several options to address this scenario.

Diversification

As a UK-based investor, more of my portfolio revolves around UK stocks than US stocks. However, I’m sure I’m not the only one who has materially increased my exposure to the US in recent years, given the outperformance of stocks across the pond. Yet the concern around valuation allows me to benefit from my geographically diversified portfolio.

UK stocks still trade at a much more attractive valuation than US peers. Maintaining (and even increasing) my UK portfolio makes me less impacted if the US stock market falls.

Relative value

Further, now is the time for me to build a watchlist of US stocks that I like but feel are too expensive. That way, if we do see a market correction or even a crash, I can easily find value and snap them up quickly.

Take Tapestry (NYSE:TPR). It’s a US luxury fashion holding company that owns well-known brands including Coach and Kate Spade. Over the past year, the share price has rocketed 145%, with a P/E ratio of 25.7.

The business is doing well, and I like it because it owns multiple brands that appeal to various audiences. For example, Coach appeals to established luxury buyers and Kate Spade to more aspirational consumers. Both have a very different style too.

It’s sensitive to fashion cyclicality and consumer sentiment swings, but it has shown resilience with brand strength and pricing power.

However, at current prices, I think it’s too expensive for me to want to consider buying. Yet if we saw a correction as part of a broader market fall, it’s definitely be a stock I’ll buy.

The post How I’m dealing with this red flag that suggests we could be due a stock market crash appeared first on The Motley Fool UK.

Should you invest Â£1,000 in Rolls Royce right now?

When investing expert Mark Rogers has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for nearly a decade has provided thousands of paying members with top stock recommendations from the UK and US markets.

And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if Rolls Royce made the list?

See The Six Stocks

More reading

Jon Smith has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.