As I contemplate risk in consideration of the measures that we like to use, I find myself particularly frustrated this month…
Dear Clients and Friends,
For this weekend’s reading, we send out our monthly market risk update.
As I contemplate risk in consideration of the measures that we like to use, I find myself particularly frustrated this month for two reasons. First, it is very difficult for an advisor/counselor/guide like myself to make informed decisions in an environment that lacks visibility and reliability. Obviously this comment pertains to the current political climate, albeit with no political motivation. I am comfortable sharing my informal assessment which reveals that, regardless of political affiliation, the ruckus we’ve seen over the last week, including yesterday’s press conference with President Trump, is making all of our clients nervous to some degree. And this “degree” of concern, as you can imagine, ranges wildly.
The second source of frustration is derived from the reality that the correlation between policy and the public investment markets has been decreasing. Even amid recent turmoil, it appears that investors are wholly focused on new market highs with little attention paid to the economic disruption that poorly considered policies can have. And herein lies my greatest concern- complacency!
I often talk about behavioral finance and the psychology of investing. It’s one of my favorite topics because it is very predictable and largely overlooked by most investors.
Cheap plug: have a listen to our radio interview from last month during which we talk about the human instincts that often derail investors. http://610amsports.com/2017/01/21/ask-the-experts-12117-mor-wealth-management/
Presently, what we may be seeing is an overwhelming example of “projection bias.” Projection bias is the tendency for humans to assume that whatever is happening at any given moment is likely to persist. The particular subset of projection bias that we are seeing is known as the “recency effect”, or “representativeness,” which over-emphasizes current experience as an indicator of the future. This is expressly why investors are often compelled to buy into a high flying stock, and conversely, become “scared out” of a stock that has recently under-performed. It’s also the reason that investors often forget that a rise in the market doesn’t mean that a poorly designed trade tariff won’t cause a material disruption of economic growth and/or market performance.
So here’s the thing folks: we (including myself) must take this month’s risk update with a grain or two of salt. Not until we have some level of visibility and some level of reliability with the communication engine inside the Trump Organization, can we adapt our economic risk to present political risk. In order to adapt said approach, we need truth and trust. Regardless of party affiliation, regardless of whether we agree or vehemently disagree with proposed policy, only with truth and reliability can we make any sense of current conditions.
So before we get into our risk update, regardless of our confidence in the present economy, there is too much uncertainty to let recent profits (which have been considerable to say the least) continue to ride. Although valuations are high, we find the US economy to be robust by virtually every measure. For example, last month’s job creation came in well above expectations yet again, and the labor participation rate clicked up. However, given the aforementioned uncertainty and the risk pertaining thereto, we have made the decision to reduce risk. We will execute this decision next week.
With that, we shall still present our monthly risk update as seen by the Independent Market Observer.
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.
Two things jump out from this chart. First, after a pullback at the start of 2016, valuations have again risen above levels of 2007–2008 and 2015, where previous drawdowns started. Second, even at the bottom of the recent pullback, valuations were still at levels above any point since the crisis and well above levels before the late 1990s.
Although now at their highest level since 2000, valuations remain below the 2000 peak, so you might argue that this metric is not suggesting immediate risk. Of course, that assumes we might head back to 2000 bubble conditions—not exactly reassuring. Risk levels remain high, although not immediate.
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. Although we were getting close to a worry point, the recent post-election rally has moved us well out of the trouble zone and into positive territory. Although the risks may not be immediate, this metric will bear watching.
Risk factor #3: Margin debt
Another indicator of potential trouble is margin debt.
After climbing for a while, margin debt as a percentage of market capitalization has dropped back in the past couple of months to a level typical of the past two years. This suggests a return to a recent normal, lowering the immediate risk. It's worth noting, though, that the average level of the past couple of years is still well above that of 2007–2008. Although the immediate risk looks low, overall risks remain high by historical standards. This metric bears watching, particularly in the medium term.
Risk factor #4: Changes in margin debt
Consistent with this, if we look at the change in margin debt over time, spikes in debt levels typically precede a drawdown.
As with the previous metric, the absolute risk level remains high, but the immediate risk has recently dropped, as the change in debt indicator is flat on the year. Overall, this metric suggests that immediate risk has actually declined.
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 has been encouraging; although it remains high, it had pulled back to less extreme levels. In recent months, however, with the post-election rally, the indicator has started to move back toward the danger zone. Although we remain some distance from trouble, the recent uptick suggests risks are rising, so this metric will bear watching.
Technical metrics are also reasonably encouraging, with all three major U.S. indices well above their 200-day trend lines and close to new highs. With improving sentiment across the board (consumers, business, and investors) and rising earnings, it’s quite possible that the advance will continue. Given favorable conditions—particularly with the Dow’s recent break above 20,000—a mix of improving fundamentals and positive sentiment could continue to propel the market higher, despite the high valuation risk level.
On balance, all of the metrics are in what has historically been a high-risk zone, so we should be paying attention. But, as I’ve said many a time, there’s a big difference between high risk and immediate risk—and it is one that’s crucial to investing. As it stands, none of the indicators suggests an immediate problem, although several suggest risk may be rising.So, as I often conclude my monthly risk update: “There you have it.” Our decision to reduce risk originates from one of our core beliefs: “Safety first always.” We at MOR Wealth Management will always prioritize risk over reward.Now, let us all pray for a weekend without political showmanship, and without schoolyard bullying from either side of the aisle. While this may be an unlikely wish, we can all dream…Have a lovely weekend everyone.
Matthew Ramer, AIF® Principal, Financial Advisor MOR Wealth Management, LLC1801 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: firstname.lastname@example.org | www.morwm.com
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