August 2019 Market Risk Update
Dear Clients & Friends,
It’s that time of month for Market Risk Update from our good friend Brad McMillan. My intro this week will be short since our forecasts remain relatively unchanged. However, I would be remiss in not mentioning the recent increase in market volatility. We expect this volatility to continue for the foreseeable future for three reasons.
First, overwhelming political turmoil continues to worsen. Last week, the President suggested that Federal Reserve Chairman Jerome Powell, a Trump appointee, is an enemy to the US, on par with Chinese President Xi Jinping. Within minutes of this tweet, the Dow Jones Industrial average plunged 600 points. Regardless of economic opinion or political affiliation, tweets like these are careless, irresponsible, and hurtful to the investing public. Second, the state of the economy is still growing but losing steam quickly; something we’ve been predicting would happen around now since early 2017. Third, the current tariff war and the exploding national deficit created by a tax plan that is now considered a failure by most authorities is starting to show severe negative impact. (The tax plan is considered to be a failure because the “trickle down effect” has created only a fraction of economic activity necessary to pay for the cost of the tax cuts.)
The good news is that we are ready for this level of volatility. While we are not shielded from it, we have reduced risk over the past several months in order increase portfolio stability. While we may sacrifice some short-term upside, clients have more money in less aggressive areas that can be re-deployed during the market lows of the next recession. Don’t forget that the actual recession induced market drop could take quite a bit of time to occur. In fact, if (when) Trump exits the tariff war, which he will have to do if he wants any chance of winning re-election, the market may shoot up significantly. But we shall ignore unreliable what-ifs, and remain disciplined long-term investors. Hence our reduction of risk for the time being.
Now, lets give the mic to Brad...
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, signs that the risk is growing, with consumer and business confidence weakening 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 becoming more negative, and four of the signals are now at yellow. As such, I have kept economic factors at a yellow light for August.
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.
Despite a 25 basis point cut to the federal funds rate at month end, the yield curve remained inverted in July. Rates on the longer end of the curve remained relatively stationary during the month, but shorter rates fell in anticipation of the rate cut. The 3-month Treasury yield fell from 2.16 percent to 2.07 percent during the month. 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 through the first half of the year took us back close to even. Although the recent pullback on tariff worries suggests downside risks remain material, I am keeping this indicator at yellow due to the fact that we remain above the levels of 2011 and 2015–2016.
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. 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, and seems to be on a general downward trend. 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 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, followed by a recovery, and then another brief break below in July. Given the pullback, and given recent volatility, 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 17 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 recent volatility may continue. 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.
This is your captain speaking. We are experiencing moderate turbulence, so we are leaving the fasten seatbelt signs on. We assure you that you have good pilots in the cockpit, and we’ll keep you posted on the weather regularly.
Have a great weekend.
-Your crew at MORWM
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
The majority of this content was written by Brad McMillan, CFA, CAIA, MAI, Chief Investment Officer at Commonwealth Financial Network. 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.