Dear Clients and Friends,
Though we usually do not have time to craft many creative weekend essays during the depths of tax season, we certainly don’t want to skip our monthly risk update. I promise to author more interesting letters after my week-long nap following this season. J For today, however, let’s look at our risk and market related update because I think we can all agree that, whether it be politics or economics, risk is rising.
Before we review the market related data sets that we usually focus on, there are four points I’d like to mention. Though we’ve not been asked about them specifically, (surprisingly) they are likely on everyone’s mind.
First, over the last month or so, we’ve been reducing risk in almost everyone’s portfolio. We’ve not been selling out of the market by any means because market timing, as we’ve studied together in the past, is almost always a loser’s game. I often use the phrase “It’s time in the market, not timing the market,” which makes the difference. Statistically, we know that far more money has been lost by attempting to time market corrections than has been lost in market corrections themselves. So we are not (and never will) run for the hills; we will always do our best to maintain discipline. However, insomuch as we do not live in a vacuum, we have already taken steps to reduce volatility as well as our exposure to US equity markets in general.
Second, I do not subscribe to the notion that the market is living in a huge bubble. From an economic standpoint, by virtually every measure available for study, the economy is extremely robust right now. Yes, we all know people who are looking for a job, and we will always know people who are looking for jobs because full employment, mathematically, is only about 95%. This means that 1 in 20 people you know will probably be out of work, or in a job that is not of their preference, even in the best of scenarios.
Third, although I do not believe the market is in a bubble, I DO believe that the US equity markets are fully valued and will run out of steam; hence our initiative to reduce risk. More importantly, regardless of economics or valuations, governmental chaos is at such extreme levels both within the US and abroad that valuations need not be high for fear to cause a steep and scary correction. Allow me to point back to the summer of 2011 when Congress bitterly debated the debt ceiling. While nothing of substance ever came from this “debt ceiling crisis,” the fear leading up to it caused the S&P 500 to drop by 15% in about 90 days. There is a resounding truth to Franklin D Roosevelt’s quote, “The only thing we have to fear is fear itself.” Within the realm of public investments, fearing other people’s fear can and should be very very frightening!
Fourth, because we know better than to run for the hills, when I alert others to my concerns, much of my purpose is to set expectations. Proper expectations allow for greater tolerance with respect to deviations from the plan, no matter the subject at hand. Indeed we can take advantage of market corrections as we did in 2016, and we will be excited to do so if the opportunity presents itself. In the meantime, let’s all be cognizant of the environment we are in, and let us share the wisdom it takes to truly be a long-term investor.
With that, from the Independent Market Observer, let’s review current market risk….
Just as we do with the economy, we review the market each month for warning signs of trouble in the near future. Although valuations are now high—a noted risk factor in past bear markets—markets can stay expensive (or get much more expensive) for years and years, which doesn’t give us much to go on timing-wise.
Of course, there are other market risk factors beyond valuations. For our purposes, two things are important: (1) to recognize when risk levels are high, and (2) to try and determine when those high risk levels become an immediate, rather than theoretical, concern. This regular update aims to do both.
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.
This chart is interesting for a few reasons. Since the election in November, equity valuations have increased to levels not seen since the early 2000s. They’re higher than they were in 2007 and are at the third-highest level in history, after 1929 and 1999. Additionally, volatility in March did little to lower valuations. The market, by this metric and many others, remains very expensive.
Although they’re at their highest level in 15 years, valuations remain below the 1999 peak, so you might argue that this metric is not suggesting immediate risk. Still, comparing where we are now to 2000 bubble conditions isn’t exactly reassuring.
Risk factor #2: Changes in valuation levels
As good as the Shiller P/E ratio is as a risk indicator, 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. The post-election rally has kept changes in valuations at a healthy level, with few signs of immediate risk.
Risk factor #3: Margin debt
Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization remain near all-time highs, although growth in this indicator may be slowing. The overall elevated levels of debt are concerning, but given recent improvements, this is not necessarily an immediate risk.
Risk factor #4: Changes in margin 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 change in debt as a percentage of market capitalization remains at low levels. Though the absolute level of margin debt is high, and so is the risk level, the trigger for immediate risk seems to be getting farther away.
Risk factor #5: The Buffett indicator
Said to be favored by Warren Buffett, the final indicator is the ratio of the value of all the companies in the market to the national economy as a whole.
On an absolute basis, the Buffett indicator is actually somewhat encouraging. Although it remains high, the year-on-year change (shown above) is still well below the risk zone. The index has increased post-election, however, and the trend suggests we may be heading into more risky territory, so any increase should be watched.
Technical metrics are also reasonably encouraging, with all three major U.S. indices well above their 200-day trend lines. Even as markets hover near all-time 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.
Risk is high (but not immediate)
Although many of the indicators point to an elevated risk level, they do not signal an immediate problem. Given improving economic fundamentals and earnings, and very positive consumer and business sentiment, we may well see the markets—and risk levels—continue to increase.
High risk is not the same as immediate risk, and although there's reason for concern, the indicators that are best at predicting immediate risk are not in the danger zone. The most likely course for the market in the near term is sideways, but it could take a turn upward if good news, such as positive earnings surprises, appears.
One more thing: the reason discipline requires staying invested is because if Congress magically gets everything right, if we do not engage in any more wars, and if President Trump does not start a trade or currency battle, I would not be surprised if the market continues to creep up. Selling out of the market, or running for the hills, could in hindsight be a poor choice and cost a considerable amount of lost earnings. This brings us back to the very beginning of this article where I preach discipline. We’ve reduced risk somewhat, and can do so again if need be. However, patience and prudence are the cornerstones of long-term profitable investing which means 1) Investing within your long term risk tolerance, 2) Staying the course within said tolerance, 3) Displaying the emotional fortitude to take advantage of market corrections, and finally, 4) Have our expectations are set so that surprises don’t trump your wisdom- pun intended.
Have a lovely weekend, spring is almost here!!
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 |
601 21st Street, Suite 300 Vero Beach, FL 32960 P: 772-453-2810
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&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.