Big market losses often start before the crash. Many people get hurt in the final months of a long rally. That is when confidence is high and prices feel “safe.” Felix Prehn, who runs Goat Academy, studied major market tops going back to 1929. He found that the same warning signs show up again and again.
The 4-stage market cycle
Felix Prehn explains that market tops often follow four stages:
1 . Stage 1: Rational rise. Stocks go up for clear reasons. Company profits grow. Many sectors rise together.
2. Stage 2: Fast rise. Returns speed up. More new investors jump in. Bad news gets ignored.
3. Stage 3: The “feels best” top. Prices get extreme. Risky bets become popular. Only a few big stocks push the index higher.
4. Stage 4: The break. Fear returns. Selling spreads. Prices fall fast or keep falling for a long time.
A key idea is simple: by stage 4, it is often too late to act calmly. The better time to reduce risk is usually earlier, when warning signs start flashing.
Two valuation tools that can warn investors
Felix Prehn highlights two common measures:
- CAPE ratio (Cyclically Adjusted Price-to-Earnings). This is like a P/E ratio, but it uses a 10-year average of profits and adjusts for inflation. That smoothing helps because company profits can jump around year to year. Very high CAPE levels have often appeared near major tops.
- Buffett Indicator. This compares the total value of the stock market to the size of the economy (GDP). In simple terms: it asks if stock prices are growing far bigger than the economy that supports them.
These tools do not predict the exact day of a crash. But they can help show when prices are stretched.
A simple early warning: sector rotation
“Sector rotation” means money moves from one type of stock to another. Late in a cycle, investors often shift toward defensive sectors. Defensive sectors are areas people still pay for in hard times, like healthcare, utilities, and consumer staples (food, household items, and basic needs). At the same time, “wants” can weaken. These are consumer discretionary stocks, like travel, luxury goods, and entertainment.
Watching these shifts can help investors spot when confidence is changing under the surface.
To learn more about Felix Prehn and Goat Academy, readers can visit: About Felix Prehn Goat Academy