John here. Today's post is from Commonwealth Chief Investment Officer Brad McMillan. Last week, Brad published his "Monthly Market Risk Update" for July, which I have reprinted here. What I enjoy most about Brad's writing is how he really makes you think. View more by visiting his daily blog: The Independent Market Observer.
Monthly Market Risk Update: July, 2019
It’s time for our monthly look at market risk factors. Just as with the economy, there are several key factors that matter for the market in determining both the risk level and the immediacy of the risk. Although stocks remain close to all-time highs, the recent volatility is a reminder that, given valuations and recent market behavior, it is useful to keep an eye on these factors.
Recessions are strongly associated with market drawdowns. Indeed, 8 of 10 bear markets have occurred during recessions. As I discussed in this month’s Economic Risk Factor Update, right now the conditions that historically have signaled a potential recession are not in place. There are, however, growing signs of weakness, with consumer and business confidence remaining yellow and a recent yield curve inversion. On an absolute basis, all the major signals are not yet in a high-risk zone. But trends are growing more negative, and four of the signals are now at yellow. As such, I have kept economic factors at a yellow light for July.
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.
A quick price spike like we saw in both 2017 and 2018 is not necessarily an indicator of trouble, especially as the subsequent declines took this indicator well out of the trouble zone. Despite the recent increases in oil prices, they remain down over the past year, suggesting no risk from this factor. Therefore, this indicator remains at a green light.
Signal: Green light
The price of money. I cover interest rates in the economic update, but they warrant a look here as well.
The yield curve spread was at zero at the end of May and has since inverted—for the longest period of this recovery—as longer-term rates pulled back on notably dovish Fed commentary. As the length of the inversion lengthens, it is getting close to starting a recession countdown. But it is not quite there yet. Given that, and the delay between such an inversion and the actual start of a recession, the immediate risk remains low, although recent policy moves and market action suggest risks are rising. As such, along with other signs of weakness, the indicator remains something to watch. I am keeping this measure at a yellow light this month.
Signal: Yellow light
Beyond the economy, we can also learn quite a bit by examining the market itself. For our purposes, two things are important:
- To recognize what factors signal high risk
- 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, I 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.
The major takeaway from this chart is that despite the recent decline, valuations remain extremely high. They are still above the levels of the mid-2000s, although down from recent highs. Also worth noting, however, is the very limited effect on valuations of the recent pullback in stock prices. Despite the drop, stocks remain quite expensive based on history. High valuations are associated with higher market risk—and longer-term metrics have more predictive power. So, this is definitely a sign of high risk levels.
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. After the decline at the end of last year took the market into the risk zone, recovery in the past couple of months has taken us back close to even. Given the recent recovery in equity prices and the fact that we remain above the levels of 2011 and 2015–2016, I am keeping this indicator at yellow, although the recent pullback on tariff worries suggests downside risks remain material.
Signal: Yellow light
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization have dropped substantially over the past year, to close to the lowest levels of the recovery, although there has been a substantial jump in recent months. Margin debt remains at the low end of recent history, but it remains high by historical standards. The overall high levels of debt are concerning; however, as noted above, high risk is not immediate risk.
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 remains well below zero, despite a jump over the past couple of months. This indicator is not signaling immediate risk at this point but has been volatile in recent months. Given that, and the fact that the overall debt level remains very high, it is worth watching. So, we are keeping this indicator at a yellow light.
Signal: Yellow 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 I follow are the 200- and 400-day moving averages. I 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.
Last year’s declines took all three major U.S. indices below the 400-day trend lines, a significant support level. The subsequent recovery has since brought them back above both that level and the 200-day level. But in May, we had a brief break back below the 200-day trend line, which suggests that risks may be rising again—although we have since seen markets bounce back. Given the pullback, and despite the recovery, the risk of the trend turning back to negative looks to have increased. The probability that the markets continue to rebound is still the base case, however, so I am leaving this indicator at yellow.
Signal: Yellow light
Conclusion: Market risks moderate, but economic risks rising
Market risks have been at the yellow light level for the past 15 months and recently dropped even further with the addition of some red lights. But market conditions have improved over the past couple of months, with the continuation of the rebound from the decline at the end of last year. On the other hand, economic risks have risen as the incoming data remains weak, and there have been a couple of potentially significant breakdowns. On balance, this leaves us solidly in the yellow zone of increased risks.
The continued market recovery is encouraging, the overall economic environment remains supportive, and neither of the likely shock factors is necessarily indicating immediate risk. But the rising signs of economic weakness, combined with the fact that several of the market indicators continue to point to an elevated level of risk, suggest that volatility may return. The pullback at the start of this month, on trade worries, only reinforces that possibility.
As such, we are keeping the overall market indicator at a yellow light. This is not a sign that risks have passed. Instead, it is a recognition that despite the recent market turmoil, basic conditions remain supportive and that while risks are real, the most probable course is more appreciation—even though further volatility is quite likely.
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