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June Market Risk Update

Dear clients and friends, It’s that time of the month – here is our monthly Market Risk Update, written by our good friend Brad McMillan. His opinion remains very similar to mine: the economy remains strong, but headwinds are on their way. We bought into the stock market dip of early February for most clients, and the S&P 500 (one of several applicable indexes) has currently recovered about 65% of that correction. We will ride this wave until the market reaches a new high, which we believe will happen prior to year-end, after which we will remain committed to reducing risk in the long term. With that brief introduction to this weekend’s article, let’s once again look through Brad’s risk-goggles.

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 June? 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 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. After a weak first quarter, the economy appears to be picking up again, with healthy job growth and high levels of consumer and business confidence. 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.

A quick price spike like we saw in 2017 (it did not appear to reach a problem level and was short lived) is not necessarily an indicator of trouble. The subsequent decline also took this indicator well out of the trouble zone. Although prices have started to rise again, the increase is still short of the trouble zone. This increase, along with recent pullbacks, suggests that while the risks from this measure are rising, they are not yet material or immediate. Therefore, the indicator remains at a green light, although we are getting closer to a high risk level.

Signal: Green light  The price of money.

I cover interest rates in the economic update, but they warrant a look here as well.

The yield curve spread stayed steady in May, leaving it close to the post-crisis low in December. It is still well outside the trouble zone, and the immediate risk remains low. The fact that the spread remains close to the lows, in combination with the Fed’s expected rate increases, suggests that this remains something to watch. I am leaving this measure at a green light for now, but you can see a shade of yellow.

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:

To recognize what factors signal high riskTo 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 valuations remain extremely high. In fact, they are close to the second-highest level of all time, exceeded only by the dot-com boom. Also worth noting, however, is the very limited effect on valuations of the recent increases in earnings due to the tax cuts. On a shorter-term basis, those earnings increases have markedly reduced valuations, suggesting reduced risk. On a longer-term basis, however, as shown in the chart above, valuations have not pulled back much at all. 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 look at 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. In recent months, valuations have dropped toward the risk zone, even given the bounce back in the past month. While the long-term trend in valuations remains at a positive level, risks are rising. Therefore, this indicator remains at a yellow light.

Signal: Yellow light Risk factor #2: Margin debt.

Another indicator of potential trouble is margin debt.

Debt levels as a percentage of market capitalization ticked down slightly last month, but they remain close to all-time highs. While borrowers have de-risked somewhat in the face of recent turbulence, that process appears to have stopped well before materially reducing risk. 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 has ticked down in recent months, moving below zero. So, 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. As such, 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. As noted last month, though, the S&P 500 continues to bounce off its 200-day moving average on a daily basis, which is a sign of weakness. Looking at monthly signals, as this chart does, there has not been a sustained break. With no convincing movement either way, though, the risk of the trend turning negative has risen materially. The most probable case is that the markets may move back up, since they failed to break support even at the nadir. But given the fact that the index did hit its support level—and has not convincingly rebounded above—risks of more volatility have increased. So, I am keeping this indicator at yellow.

Signal: Yellow light Conclusion: Risks rising, conditions may be weakening

After taking the market risk indicator to a yellow light for the first time two months ago, markets have since recovered. This was more or less expected. At the same time, the yellow light rating recognized that risks have risen. Despite the recovery over the past weeks, those risks are still there. While the overall economic environment remains supportive, and neither of the likely shock factors is necessarily indicating immediate risk, the continued volatility and the fact that several of the market indicators point to an elevated level of risk—combined with the ongoing policy concerns—suggest that volatility may get worse. As such, we are keeping the overall market indicator to a yellow light. This is not a sign of immediate trouble. Indeed, the likelihood remains that the market will keep moving higher. Rather, it is a recognition that the risk level has increased materially and that, even if the market recovers, further volatility is quite likely.

So, there you have it. As I’ve said previously, we think that the economy is strong, and. We think that the market has enough fuel left to hit new highs, and possibly carry upward momentum for up to 1.5 more years.  However, there are also enough indicators that warrant caution and that could signal a longer-term correction coming as early as the end of this year. We plan to remain as we are currently positioned and, hopefully, to profit from this dip as we did in mid-2015 and early 2016. However, when this dip is over, our plans remain unchanged - to reduce risk and proceed carefully. We are in the 9th inning and we’re up by a few runs. There is little reason to swing for the fences. Have a lovely Sunday.


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 and distributed MOR Wealth Management, all rights reserved. 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.

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.


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