Dear Clients & Friends,
We published our monthly economic risk review last week. Today we are
publishing our monthly market risk review. Usually, we write one or the other,
depending on which one we find more interesting (or more terrifying, as can
sometimes be the case). Because we didn’t publish either one during last
month’s debt ceiling circus, we thought that we’d write both this month. A
hearty thanks to our good friend Peter Esele and to Dan Levinson here in our
Philly office for compiling data and assisting with our thesis.
May was a mixed month for the equity markets: technology-related stocks
rallied, while most other sectors remained flat or fell. The S&P 500 gained 0.43
percent, while the Dow Jones Industrial Average fell 3.17 percent. The Nasdaq
Composite (the tech-heavy index) led the way with a 5.93 percent gain; it was
supported by an increase in investor enthusiasm surrounding AI at the end of
the month.
Given the concerns about slowing growth and inflation, we have kept the
overall market risk level at yellow for now.
Recession Risk
Recessions are strongly associated with market drawdowns, as 8 of the last 10
bear markets have coincided with economic recessions. According to the
National Bureau of Economic Research, the last recession began in February of
2020, at the start of the pandemic. It ended soon afterwards, following swift
stimulus from the Fed to assist a stalling economy. Fast forward to today:
economic expansion continued throughout the month of May, with strong
hiring leading the charge. The bigger risk is a deeper slowdown in economic
activity as the Federal Reserve battles inflation by tightening the supply of
money.
Economic Shock Risk
Interest rates are a major systemic risk factor. The Federal Reserve controls
the “cost of borrowing money” by raising or lowering the overnight lending
rate that banks use. Because of this, the cost of things like mortgages and
business loans are affected; things that promote economic activity. The higher
interest rates go, the more expensive it is for companies to borrow money.
Therefore, economic activity slows down. (The reverse is also true - low rates
are a form of stimulus.) That being said, let’s take another look at the yield
curve, which is a newsworthy item that we financiers dwell on.
The yield curve is a graph that plots treasury bond yields vs. treasury bond
maturities. Just like with mortgages, normally the longer the duration, the
higher the rate. Easy breezy - the line graph usually goes from bottom left to
upper right. When the line in the graph changes direction (for instance, from
upper left to lower right), that tends to mean that investors are anticipating
lower interest rates in the future due to a slowing economy. Right now, to
some extent, that’s what we have. Let’s explore that and decide if it is
concerning.
As we mentioned in last week’s article, the yield curve inversion deepened in
May. However, let me reiterate that we are taking this inversion with a grain of
salt. Everyone knows that rates are high right now relative to recent years- we
hear about it every day on the news. Traditional thinkers would conclude that
rates will come down eventually, even if they go higher in the short run. So,
an inverted graph may not be alarming at this juncture.
In addition, Fed action tends to affect the “nearer” part of the ‘yield curve’
more quickly, while the “further away” part of the curve takes longer to catch
up. That being said, May 2023 marked eight straight months of a yield curve
inversion. While this does not guarantee a recession, it warns us that we
should be prepared for an economic slowdown in the future. Which, as we all
know, is among the Fed’s objectives as they fight inflation.
There are four major factors that we examine in order to monitor the health of
the market. They are: Valuations, Margin Debt, Technical Factors, and Market
Complacency.
Valuations
The chart above shows the price of the S&P 500 overlaid with the ten-month
change in price-to-earnings (PE) ratios. When the change in PE ratios drops
below zero over a ten-month period, the market typically drops shortly
thereafter. On a rolling ten-month basis, valuations declined 3.55% in May,
which is the largest decline in three months. This now marks 17 consecutive
months of declining valuations, which goes to show the dramatic effect that
Federal Reserve tightening has had on the markets. This metric remains at a
red flag.
Margin Debt
This chart shows us the price of the S&P 500 overlaid with Margin Debt as a
percentage of NYSE Market Capitalization. Margin Debt measures the amount
of money investors borrow against their own portfolios in order to further
invest in the markets. When investors are bullish, they tend to borrow more
for investing. However, this can also be a contrarian metric because investors
often become irrationally exuberant when the markets are doing well. To that
end, over-bullish sentiment can actually indicate a coming market decline.
Margin debt declined 22.4% on a year-over-year basis in February, which was
the 15th straight month of decline. With interest rates on the rise, and higher
borrowing costs, this makes a lot of sense. This indicator warrants a green
flag.
Technical Factors
This metric is a little more technical, but it’s very valuable. The chart above
shows the price of the S&P 500 overlaid with 200-day and 400-day moving
averages. By studying the markets’ movement along the 200 and 400-day
moving averages, we can smooth out day-to-day volatility and observe longer
term trends. In particular, we pay very close attention to when the 200-day
average breaks through the 400-day average; this signals that troubles are
ahead. The three major US indices (the S&P 500, Dow Jones Industrial
Average, and Nasdaq Composite) all finished above their 200- and 400-day
moving averages in May. This is the fifth straight month that all 3 indices
experienced technical support, which earns this indicator a green flag.
Market Complacency
This indicator is also somewhat technical. The “VIX” is an index that measures
market volatility, which is a very important metric. The chart above shows the
S&P 500 PE ratio divided by the VIX. Often, high valuations (measured by the
PE levels) signal that investors are confident and potentially complacent. When
the VIX is high and we see a lot of volatility, there is less complacency. The
reason that we measure these two indicators as a ratio is because periods of
high valuations and low volatility (2000, 2006-2007, and 2017) have typically
preceded a market drawdown by roughly twelve months. As we can see,
market complacency is on the rise: the VIX fell from 17.82 in April to 17.64 in
May, and forward PE ratios increased from 18 to 18.5. That being said, we are
nowhere near danger levels here, and we give this indicator a green flag.
Conclusion
While three of our four indicators received green flags, inflation and interest
rates continue to pose a threat to the markets. However, the successful
resolution of the debt ceiling standoff serves as a reminder that, although risks
are always present, the most likely path forward is continued growth and
economic improvement. Ultimately, the path back to “normal” will likely be
long, with setbacks along the way.
We expect economic growth and market appreciation over the long
term. However, the next two years are expected to be volatile, with swings
back and forth as the economy finds its post-COVID feet. As long-term
investors, we remain disciplined. As tactical practitioners, we plan to exploit
unnecessary fear-based market dips. As humans, we do worry about volatility
affecting our client’s peaceful sleep. Thus, we will continue to keep our family
of clientele informed.
We wish everyone a wonderful long weekend.
-Matt, Dan, and the rest of your MORWM home office crew