Dear Clients & Friends,
Before we begin, in the spirit of Veterans Day, let us honor all those who have served our country, and all those who continue to serve today. Let us always remember those who gave their yesterday for our tomorrow, and let us honor those that risk their tomorrow for our freedom today. Let us honor them all regardless of color, race, religion, or sexual orientation.
Now onto our topic at hand… It’s the second weekend in the month which means it’s time for our monthly market risk update. It’s important to note the name of this particular monthly topic within our grander weekly reading program- “Market Risk” update. We choose this title because at the end of the day, we at MOR Wealth Management always prioritize risk above reward. This will continue to be an important factor as we currently forecast midterm market growth, albeit with a short term market correction and a longer term recession. For the longer term forecast, please refer to our previous articles which can be found on this blog page.
With that said, let’s have a look at our Monthly Market 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 November? 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. As previously discussed, 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.
While we saw a recent price spike, it did not appear to reach a problem level and was short lived. The subsequent decline has also taken this indicator well out of the trouble zone. Overall, 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 widened a bit in October, and it appears to have stabilized over the past couple of months. While the spread between short-term and longer-term rates remains close to the lowest level since the financial crisis, it is still outside the trouble zone, and the downward movement has stopped.
The immediate risk remains low. But the fact that it is close to post-crisis lows, plus the recent downward move combined with the expected rate increases from the Fed, suggests that caution is still warranted. We are leaving this measure at a green light for now, but I will be keeping an eye on it.
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:
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, 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
The overall economic environment remains supportive, and neither of the likely shock factors is necessarily indicating immediate risk. Similarly, while several of the market indicators point to an elevated level of risk, that risk does not look to be immediate. Overall, the risk levels have increased moderately, but the market environment remains favorable in the near term.
We remain at a green light for this month.
But only for this month! Not only are we challenged with differing short, mid, and long term forecasts, but we are witnessing an extremely charged and polarized political climate. Markets do not like uncertainty, and uncertainty/transparency does not appear to be a priority among many currently elected officials. Therefore, we will do our best to keep everyone informed regarding legislation that directly affects the investment markets, such as tax legislation, etc.
Have a lovely weekend.
*Disclosure: 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. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. The S&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. Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation. Copyright Commonwealth Financial Network® 2017.