Weekend Reading: October Market Risk Update

Dear Clients & Friends,


Its time again for our monthly market risk update, for which we turn to our good friend Brad McMillan, author of The Independent Advisor.  For those of you who may wonder, we look to Brad for approximately 1 in 6 of our weekend readings. Brad and I have very similar viewpoints on the global economy and we enjoy his approach to certain risk metrics.  We are grateful for Brad’s permission to republish his blog for the readers of MOR Wealth Management. Other than Brad’s additions, the vast majority of our Weekend Readings are written by myself, or our staff.

 



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 October? Let’s take a closer look at the numbers.


Recession risk


Recessions are strongly associated with market drawdowns. Indeed, 8 of 10 bear markets have occurred during recessions. As of right now the conditions that historically have signaled a potential recession are not [yet] 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.

 

Oct MR 1 WTI
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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.

 

 

Oct MR Image 2 curve
 

 

 

 

 

 

 

 

 

 

 

 

 

 

The yield curve spread declined a bit further in September, and the spread between short-term and longer-term rates remains at the lowest level since the financial crisis. At the same time, recent increases in long-term rates suggest this spread may be stabilizing.


The spread between the 10-year and 3-month rates remains well outside of the risk zone. But the fact that it is now at post-crisis lows suggests that caution is warranted. I am leaving this measure at a green light for now, but I will be keeping an eye on it given this downward trend.


Signal: Green light (with a shade of yellow)


Market risk


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.

 

Oct MR Image 3 shiller sp
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The chart above is interesting for a few reasons. Since the presidential election in November, 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.

 

Oct MR image 4
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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.

 

Oct MR Image 5
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Debt levels as a percentage of market capitalization bounced back up a bit last month, leaving them close to recent all-time highs. 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 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.

 

Oct MR Image 6 10
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As you can see in the chart above, the annual change in debt as a percentage of market capitalization has moved back up a bit during the month. But it is still not in a spike situation, suggesting this indicator is not signaling immediate risk. Despite this, the overall debt level remains very high, and the growth rate does remain at close to risk levels. Given these two factors, the risk level remains worth watching, and we have put 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.

 

Oct MR Image 7 10 20
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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. A break into new territory could actually propel 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

 



Consistent with several months of our periodic risk updates, we believe that while conditions are weakening, they remain favorable.


The overall economic environment remains supportive, and neither of the likely shock factors mentioned above 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, risk levels have increased moderately, but the market environment remains favorable in the near term. 


We will continue to update our readers on both our short-term and our long-term forecasts which, as our readers know, have some notable differences. 


We wish you all a wonderful weekend.

 

Matthew Ramer, AIF®
Principal, Financial Advisor
MOR Wealth Management, LLC


1801 Market Street, Suite 2435
Philadelphia, PA 19103
P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 |

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Vero Beach, FL 32960
P: 772-453-2810

matthew.ramer@morwm.com | www.morwm.com

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.