How The Lipstick Effect Can Predict Market Crashes

A graph of the Lipstick Effect (GDP vs. cosmetic and toiletry sales) from 2008 to 2023.

A stock market crash is defined by a rapid and often unexpected drop in stock prices due to major events, such as an economic crisis. Fear among investors usually worsens the crash. Experts say that while there are measures we can take to soften the market crash, it is difficult to accurately forecast. Nevertheless, there are recognizable patterns to watch out for, such as the lipstick index or patterns indicated by algorithms, and when analyzed side-by-side, they can accurately predict a stock market crash. The origins of crashes are subtle and not often clear. It’s usually a mix of factors, such as panic selling due to speculation, a country’s economic policy, or inflation. It could also be overvalued asset “bubbles,” as they are called, which is what happened in 2001. This led to the 2001 dot-com bubble recession.

The lipstick index, a term coined by Leonard Lauder, Estée Lauder chairman, following the 2001 recession and 9/11 attacks, noted a rise in lipstick sales. It is an economic theory that states that during economic downturns or when consumers think a recession, indicated by weak GDP and rising unemployment rates, is looming, sales for affordable luxury items, like lipsticks, increase. In recent times though, the index has been more closely related to nail polish and perfume. This index, though not economically proven, can be used as one factor to predict an economic recession.  Lauder’s theory was that the stock market and lipstick sales were inversely proportional.

A graph of lipstick sales and GDP from 1989 to 2007.

In the graph above, we can see lipstick sales and GDP from 1989 to 2007. The 2001 recession was caused by the dot-com bubble, which was a stock market bubble that developed in the 1990s due to rising technology (adoption of the World Wide Web, new dot.com startups, etc). Since these types of stocks were worth way more than they were supposed to, due to some subjective economic evaluation, the bubble “burst” in the form of the NASDAQ crash in 2001. NASDAQ is an American stock exchange and one of the largest, so when its market crashed, it triggered a recession characterized by slow GDP growth. In the graph, in 2001, lipstick sales increased by 8%, coinciding with Lauder’s index. Another recession that supports this index is COVID-19, which also stemmed from a stock market crash in 2020.

Experts say the recession started in early 2020, which is exactly when cosmetic sales started drastically increasing (by 7%). Additionally, the GDP is, in fact, inversely proportional to lipstick sales. If you look at 2010 and 2015, either one or the other is peaking, not both. Nonetheless, the lipstick index only analyzes cosmetic sales, which can increase due to other factors, not only due to the approaching recession. Some recessions (caused by stock market crashes) do follow this index, while others don’t, meaning it’s not a reliable source to comfortably predict a recession, though, as the name suggests, it should be taken as an indicator and confirmed with other sources. After all, correlation does not equal causation!

Lately, with the growing rise of technology, computers, and artificial intelligence (AI), there have been other ways to help predict a stock market crash, rather than just analyzing sales. This has involved AI using machine learning (ML). By analyzing the stock area with a high distress probability, ML algorithms can predict which parts of the market can crash. When tested for accuracy, they got 60%-90% correctness in their predictions. This algorithm can also help investors analyze which stocks will increase in value or decrease. Contrary to the lipstick index, artificial intelligence can use data that is vague or contrasting and still conclude the stability (or lack thereof) of the stock market. In a paper by Dr. Sornette from ETH Zurich, the stock market is described as easily collapsible and highly unstable. He writes, “Think of a ruler held up vertically on your finger: this very unstable position will lead eventually to its collapse, as a result of a small (or absence of adequate) motion of your hand or due to any tiny whiff of air. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary.” Sornette says that any unstable position will cause the financial market to collapse, suggesting it has a different cause every time. This makes it hard to predict, even using indicators, which, according to some experts such as Sornette, are not always accurate.

The ML model, when paired with the Lipstick Index, can help investors understand when the economy is nearing a crisis or the stock market is going to crash. Though some experts state that predicting a crash isn’t possible, and the origins are subtle, some aspects can be analyzed in synchrony to reach a stable answer to a market crash trend. As for the question of whether we can fully and effectively predict a stock market crash (leading to a recession), the answer is a no. However, we can still guess based on expert and AI predictions, as well as, of course, the lipstick index.