Markets continued to rise in May, as efforts to reopen state economies across the country took hold. Investors reacted to the reopening with optimism, driving the S&P 500 up 4.76 percent in May following a 12.82 percent increase in April. While the continued rebound during the month was certainly welcome for investors, very real risks to markets still remain—and there are several key factors that matter when determining the overall risk level.
Recessions are strongly associated with market drawdowns. Indeed, 8 of 10 bear markets have occurred during recessions. As we discussed in this month’s Economic Risk Factor Update, the National Bureau of Economic Research (NBER) just declared that a recession started in February. On top of that, all of the major economic indicators that we cover monthly remain at a red light, despite some better-than-expected results during the month. As such, we have kept the economic factors at a red light for June.
Economic shock risk
There are two major systemic factors—the price of oil and the price of money (better known as interest rates)—that drive the economy and the financial markets, and they have a proven ability to derail them. Both have been causal factors in previous bear markets and warrant close attention.
The price of oil. Typically, oil prices cause disruption when they spike. This is a warning sign of both a recession and a bear market. In this case, however, the sudden drop is also a warning of significant disruption.
The price of oil continued to fall dramatically on a year-over-year basis in May, declining by more than 53 percent compared with last May. On a month-to-month basis, however, prices increased from an average of $16.61 per barrel in April to $28.55 per barrel in May. This increase brought the average price of oil just below March’s average price of $29.46 per barrel, indicating that the sharp fall in April may have marked the bottom for oil prices in the short term.
Going forward, sustained oil prices at these levels continue to signal a risk, with the energy industry being massively disrupted, as we saw back in 2015. With local reopening efforts beginning during the month, along with signs of increasing consumer movement, there is some reason to believe that consumers are starting to see some of the benefits from low gas prices. Despite the positive tailwind that low prices create for consumers, we’ve left this indicator at a red light for now given the disruption to the energy sector caused by the large year-over-year decline in prices.
Signal: Red light
The price of money. We cover interest rates in the economic update, but they warrant a look here as well.
After spending the fourth quarter un-inverted, the yield curve re-inverted in January, remained inverted throughout February, and un-inverted again in March, where it remained through April and May. This un-inversion was driven by a sharp drop in short-term rates, which in turn was caused by the Fed’s decision to cut the federal funds rate to effectively zero percent in March.
The yield on the 3-month Treasury remained largely range bound in May, rising modestly from 0.09 percent at the end of April to 0.14 percent at the end of May. The 10-year yield also increased modestly during the month, up from 0.64 percent to 0.65 percent.
While an inversion is a good signal of a pending recession, it is when the gap subsequently widens to 75 bps or more that a recession is likely. We finished May with a spread of 51 bps, just as the NBER did, in fact, declare a recession. With the spread remaining near the critical level, we are leaving this indicator at a red light.
Signal: Red light
Beyond the economy, we can also learn quite a bit by examining the market itself. For our purposes, two things are important:
1) To recognize what factors signal high risk
2) To try to determine when those factors signal that risk has become an immediate, rather than theoretical, concern
Risk factor #1: Valuation levels. When it comes to assessing valuations, we find longer-term metrics—particularly the cyclically adjusted Shiller P/E ratio, which looks at average earnings over the past 10 years—to be the most useful in determining overall risk.
Valuations increased for the second month in a row in May, from 26.03 in April to 27.64 in May. This follows a steep drop to a three-year low of 24.9 in March, at the height of the recent pandemic-driven volatility. Despite the fact that valuations remain well below recent highs, risks still remain given the relatively high valuation from a historical perspective.
Even as the Shiller P/E ratio is a good risk indicator, however, it is a terrible timing indicator. To get a better sense of immediate risk, we can turn to the 10-month change in valuations. Looking at changes, rather than absolute levels, gives a sense of the immediate risk level, as turning points often coincide with changes in market trends.
Here, you can see that when valuations roll over, with the change dropping below zero over a 10-month or 200-day period, the market itself typically drops shortly thereafter. This relationship held in March, as valuations and the index both rolled over during the month before partially rebounding in April and May. Given the continued rebound in valuations and markets during the month, we’ve kept this signal at a yellow light for now, with a downgrade to red possible if volatility picks up in June.
Signal: Yellow light
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization had dropped substantially over the past two years, to close to the lowest levels of the recovery, before spiking dramatically in February to an all-time high. March saw this measure of market debt fall to levels last seen in 2006, as investors de-risked, before rebounding in April along with the market. With the rebound in April, margin debt remains high on a historical level but at levels consistent with those of recent years.
For immediate risk, changes in margin debt over a longer period are a better indicator than the level of that debt. Consistent with this, if we look at the change over time, spikes in debt levels typically precede a drawdown.
As you can see in the chart above, the annual change in debt as a percentage of market capitalization increased dramatically in February, before falling steeply in March and increasing modestly in April.
This modest increase in April’s debt levels following March’s swift drop indicates that risk remains, as debt increased by roughly 3.7 percent on a year-over-year basis during the month, up from the decreases in 2019. Given the increase in debt on both a monthly and year-over-year basis, and the fact that the overall debt level remains high historically, this is worth watching. So, we are keeping this indicator at a red light.
Signal: Red light
Risk factor #3: Technical factors. A good way to track overall market trends is to review the current level versus recent performance. Two metrics we follow are the 200- and 400-day moving averages. We start to pay attention when a market breaks through its 200-day average, and a break through the 400-day often signals further trouble ahead.
Technical factors for U.S. markets were a mixed bag in May. Both the S&P 500 and Nasdaq finished the month above their respective 200-day moving averages, with the Nasdaq spending the entire month comfortably above trend. The Dow Jones Industrial Average was the outlier, remaining below its trend line throughout the month; however, it did make solid progress in moving back toward trend.
The 200-day trend line is an important technical signal that is widely followed by market participants, as prolonged breaks below this trend line could indicate a longer-term shift in investor sentiment for an index. The 400-day trend line is also a reliable indicator of a change in trend. As we saw in May, the S&P 500 was able to rally above its 200-day moving average during the month, after passing the 400-day in April. This is an encouraging signal that has continued into June; therefore, we have upgraded this signal to a yellow light for the month.
Signal: Yellow light
Conclusion: Market risks remain despite rebound
Economic fundamentals largely stabilized during May, and markets continued to react positively, on optimism that the ongoing reopening efforts will continue smoothly. Indeed, much of the market recovery in April and May makes sense given the progress made in controlling the coronavirus and the smoothness so far of the economic reopening. That said, the country is still not out of the woods yet in terms of either containing the virus or fully normalizing the economy, and that is what markets are now pricing as expecting—leaving them exposed to any setbacks.
Setbacks remain likely, whether in the form of a second wave of infections and shutdowns, a slower-than-expected rebound in employment or consumer confidence, or political factors such as the current unrest or pending election. Given the multiple red light indicators, such setbacks could easily result in more volatility.
As such, we are keeping the overall market risk indicator at a red light.
This is not a sign that markets are necessarily headed back to the lows. Instead, it is a recognition that the path back to normal is likely going to be a long road with the potential for setbacks that could lead to additional market pullbacks. Given the uncertainty created by the pandemic and the likelihood for further volatility, investors should remain cautious on equity markets despite recent outperformance.
From Commonwealth CIO Brad McMillan: The Independent Market Observer June 10, 2020