Dear Clients & Friends,
It’s time for our monthly Market Risk update. Before we get to the content, I wanted to briefly update everyone on where the market is now in comparison to our forecast of six months ago. In late June we made several predictions regarding short and midterm market performance. All of which were predicated on the hypothesis that the market would continue to grow in the short run, but begin to show signs of impending recession sometime between late 2018 and mid-2019. The specific numbers discussed were 6-16% growth from the S&P 500 before a meaningful inflection. As of this writing, the S&P 500 is up 9.99% since July 1st - just under half of the range of this forecast.
There are several other facets to the forecasts we made at that time, including the high likelihood of a short term and short lived sell-off at any time prior to the inflection mentioned above. This is a behavior-based assumption given the traditional frequency of fear-based and emotionally-biased sell-offs. However, in the simplest terms, the market seems to be moving as we’ve anticipated; therefore, we have no reason to alter our forecast at this juncture. We do think that the duration of this late-stage bull market could be extended if new tax legislation is passed. However, if that happens, we fear that it will cause a harder landing and unfavorable long term effects because the proposed tax legislation generates $1 trillion of debt which the plan does not pay for, even while including the economic growth expected by advocates of this legislation.
In short, we are making no changes to our forecasts. That being said, lets get into the risk update from the Independent Market Observer.
Market risks come in three flavors: recession risk, economic shock risk, and risks within the market itself. So, what do these risks look like for December? Let’s take a closer look at the numbers.
Recessions are strongly associated with market drawdowns. Indeed, 8 of 10 bear markets have occurred during recessions. Right now the conditions that historically have signaled a potential recession are not in place. As such, economic factors remain at a green light.
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.
As we saw with the price spike earlier in 2017, a quick spike—it did not appear to reach a problem level and was short lived—is not necessarily an indicator of trouble. The subsequent decline also took this indicator well out of the trouble zone. That said, we have seen prices start to rise again, to relatively high levels for the period since the crisis, and it bears watching. Overall, however, there are no signs of immediate risk from this indicator, so it remains at a green light.
Signal: Green light
The price of money.
The yield curve spread contracted again in November, taking it to a new post-crisis low. It is still outside the trouble zone, so the immediate risk remains low. But the fact that it is at a post-crisis low, combined with this move downward and the Fed's expected rate increases, suggests that caution is warranted. I am leaving this measure at a green light for now, but it is getting closer to yellow.
Signal: Green light (with a shade of yellow)
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 chart above is interesting for a few reasons. Since the presidential election a year ago, equity valuations have increased to levels not seen since the early 2000s. In addition, gains this year have pushed valuations even higher, to the second-highest level of all time. Right now, they are below only 1999, as you can see from the chart.
Although they are at the highest level since 1999, valuations remain below that peak, so you might argue that this metric does not suggest immediate risk. Of course, this argument assumes we might head back to 2000 bubble conditions, which isn’t exactly reassuring.
The Shiller P/E ratio is a good risk indicator, but it’s a terrible timing indicator. One way to remedy that is to look at changes in valuation levels over time instead of absolute levels.
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. Strong stock market performance has kept the long-term trend in valuations at a healthy positive level, well above the trouble zone. Therefore, this indicator shows low immediate risk.
Signal: Green light
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization have moderated over the past couple of months, although they remain close to recent all-time highs. The overall high levels of debt are concerning; however, as noted above, high risk is not immediate risk, and the recent moderation is a positive sign.
For immediate risk, changes in margin debt 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 has dropped back over the past couple of months, leaving it close to zero. Still, this indicator is not signaling immediate risk. But the overall debt level remains very high, and we have seen something approaching a spike in recent months, so the risk level remains worth watching. We are keeping this 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.
These indicators remain positive, with all three major U.S. indices well above both trend lines. Even as markets continue to reach new highs, it’s quite possible that the advance will continue given growth in earnings and positive consumer, business, and investor sentiment. As we continue to break into new territory, this seems to be actually propelling the market higher, despite the high valuation risk level. With the index well above the trend lines, the likely trend continues to be positive.
Signal: Green light
Conclusion: Conditions weakening, remain favorable overall
We remain at a green light for this month.
The pendulum always swings too far, right? Well, in a vacuum, we believe that the market is fully valued and showing signs that the end-stage of the bull market has begun. However, a pendulum swinging with significant momentum doesn’t just stop in mid-air. Rather, it swings far past neutral and begins to slow down before it actually changes directions. That’s where we believe we currently are. We think that the economy is firing on all cylinders and that it is in many ways, as healthy as it has been in decades. But we also think that the pendulum has already swung past neutral. In the spirit of buying low and selling high, we are becoming more focused on preservation than on growth. As I’ve said many times in the past few months, while we have been easing pressure on the gas, we’ve not yet slammed on the brakes and we look forward to one or two more late-stage market surges.
With that, we bid you all a wonderful weekend.
Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a registered investment adviser. Fixed insurance products and services offered through CES Insurance Agency. Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. As stated above, commentary for the 5 risk factors provided by Brad McMillan and published in the Independent Market Observer. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. The S and P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.