Dear Clients and Friends,
It’s the time of month when we invite our friends Brad McMillan and Sam Millette to share their economic and market risk updates. While the three of us see the markets in a very similar light, (which is why we like to share this monthly piece with you) our writing style differs quite a bit. Sam’s description of various risks is written with a great deal of professionalism and reserve. I, on the other hand, when concerned usually say something like, “that scares the s#@t out of me.” Two factors currently terrify me: market valuations as indicated by P/E ratios, and the sky-high level of margin debt. So, as we pass the conch to Sam, keep this in mind. And I will make a few comments at the end.
Sam, mic is yours…
Equity markets continued to rally in April, with all three major U.S. indices setting new all-time highs during the month. The Dow Jones Industrial Average gained 2.78 percent in April, while the S&P 500 saw a 5.34 percent increase. The Nasdaq Composite led the way with a 5.43 percent gain. Markets were supported by improvements on the public health front and falling long-term interest rates. The 10-year Treasury yield declined in April, breaking a three-month streak of rising long-term rates.
Recessions are strongly associated with market drawdowns. Indeed, 8 of 10 bear markets have occurred during recessions. As we discussed in this month’s Economic Risk Factor Update, the National Bureau of Economic Research declared that a recession started last February. On top of that, a slowdown in job growth in April served as a reminder that there is still work to be done to get back to pre-pandemic activity levels.
With that being said, April saw a continued increase in economic activity, which could signal potential faster growth looking forward. Given the improvements we saw during the month, we have kept the economic risk level at a yellow light for now, with an upgrade to green possible in the upcoming months if we see further improvements.
Economic Shock Risk
One major systemic factor is the price of money, otherwise known as interest rates. This drives the economy and financial markets and has historically had the ability to derail them. Rates have been causal factors in previous bear markets and deserve close attention.
Risk factor #1: The yield curve (10-year minus 3-month Treasury rates). We cover interest rates in the economic update, but they warrant a look here as well.
The yield curve narrowed slightly during the month, marking the time that the curve has narrowed in a month since last November. The flattening was driven by a decline in long-term interest rates. The 10-year Treasury yield fell from 1.74 percent at the end of March to 1.65 percent at the end of April. The 3-month Treasury yield fell from 0.03 percent at the end of March to 0.01 percent at the end of April. While short-term rates are expected to remain low until at least 2023, longer-term rates now sit near pre-pandemic levels, reflecting a normalization of growth expectations as economic conditions improve.
While the normalization of rates is a positive indicator that the economic recovery is on the right path, rising long-term interest rates can negatively affect equity markets, as we saw in February and March. Although rates fell in April, they’ve started to rise again in May, and markets have experienced volatility. Given the fall in rates in April, we have left this indicator at a yellow for now, but the potential for rising long-term interest rates remains a risk for equity markets.
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, we 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.
Valuations increased in May, as the CAPE Shiller ratio rose from 36.94 in April to 37.04 in May. This marks eight consecutive months with rising equity market valuations, and it left the Shiller CAPE ratio at its highest level since late 2000.
Even as the Shiller P/E ratio is a good risk indicator, 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. This relationship held last March, as valuations and the index both rolled over before rebounding. On a 10-month basis, valuations rose by 54.1 percent in May, down from a 28.1 percent increase in April. Given the historically high valuation levels, we have kept this indicator as a yellow light for now despite the fact that valuation changes have remained outside of the danger zone since last May.
Signal: Yellow light
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization had dropped substantially throughout much of 2018 and 2019. Since then, we have seen margin debt increase, setting a new record as a percentage of market capitalization in January. March saw the overall margin debt ratio decline modestly, but this still represents the third-highest level on record. The high level of debt associated with the market is a risk factor on its own but not necessarily an immediate one.
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, March’s debt level increased by 40.3 percent on a year-over-year basis, up from the 23.8 percent year-over-year increase in February. This represents the largest increase in year-over-year margin debt since 2000. Despite the modest decline in the margin debt ratio during the month, the accelerating year-over-year growth indicates that risks are rising, and we have kept this signal as a red light.
Signal: Red 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 we follow are the 200-day and 400-day moving averages. We 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.
Technical factors remained supportive for equity markets in April. The S&P 500, which managed to break above its 200-day moving average at the end of last May, finished above trend for the 12th month in a row. This also marks 10 straight months with all three major indices finishing above trend.
The 200-day trend line is an important technical signal that is widely followed by market participants, as prolonged breaks above or below this trend line could indicate a longer-term shift in investor sentiment for an index. The 400-day trend line is also a reliable indicator of a change in trend. The continued technical support for markets in April was encouraging, so we have left this signal at a green light for the month.
Signal: Green light
Risk factor #4: Market complacency. This is a recently added risk factor that aims to capture a standardized measure of market complacency across time. Complacency can be an uncertain term, so this chart aims to identify and combine two of the common ways to measure complacency: valuations and volatility.
For the valuation component of the index, we are using the forward-looking price-to-earnings ratio for the S&P 500 over the next 12 months. This gives an idea of how much investors are willing to pay for companies based on their anticipated earnings. Typically, when valuations are high, it signals that investors are confident and potentially complacent. For volatility, we have used the monthly average level for the VIX, a stock market volatility index. When volatility for the S&P 500 is high, the VIX rises, which would signal less complacency.
By combining the two metrics in the chart below, we see periods where high valuations and low volatility have caused peaks, such as 2000, 2006 to 2007, and 2017. We saw market drawdowns roughly within a year following each of these peaks.
Looking at the current chart, market complacency appears to have picked up recently. Volatility fell notably in April, as the average level for the VIX dropped from 21.84 in March to 17.42 in April. This marks the lowest average VIX level for a month since January 2020. This brought the index from 1.02 to 1.24. Readings above 1.2 have historically been a signal that market complacency is at potentially concerning levels.
We have downgraded this indicator to a yellow light for now given the fact that the index now sits above 1.2, but next month’s reading will be an important look into whether the recent increase in market complacency is temporary or part of a sustained trend.
Signal: Yellow light
Conclusion: Market Risks Remain Despite Economic Improvement
Economic fundamentals showed further growth in April, driven by continued improvements on the public health front and the lingering tailwind from the most recent federal stimulus bill. We saw encouraging results for consumer and business confidence during the month, which should help support faster spending growth in the months ahead. Given the improving economic fundamentals, we are approaching a potential upgrade for the overall economic and market risk indicators, but there are still risks that should be monitored.
One of the primary risks for markets is economic success and the potential effects rising long-term rates may have on equity valuations. We saw this in February and March as rising rates caused market turbulence, especially for riskier asset classes. While long-term rates fell in April, they have started to rise again in May, and markets have experienced volatility. The pandemic still represents a risk for markets, although given the declining case counts and rising vaccinations, this risk continued to decline in April.
Ultimately, the path back to a more normal economic environment is likely going to be long, and we can expect setbacks along the way. Given the possibility for further volatility, investors should remain cautious on equity markets for the time being, and we have left the overall market risk indicator at a red light for now.
Red light? I would probably put a purple light on valuations and margin debt. For reference, in aviation, purple is one notch beyond red. Sort of like- red is bad, purple is really really really bad. On the other hand, market levels may accurately predict a significant rise in earnings. P/E valuation ratios are [price divided by earnings]. As earnings rise, valuations fall. But with valuations and margin debt both higher than the great recession of 2008, it’s hard not to be worried.
So, what are we going to do about this? Nothing. We maintain a solid position in low volatility assets, and the trend is our friend for now. But our eyes are peeled, and we are paying very close attention.
One more thing- inflation. I know a lot of you are worried about inflation and we will write about that in a weekend reading soon. For now, it is important to remember that very low inflation, which we experienced for several years, is also bad. The recent increase is alarming in some ways, but it is not something we are overly concerned about. We made several changes to our portfolios earlier this year in anticipation of rising inflation, so we feel that we are appropriately positioned for time being.
The weather is warm and the sun is shining! With that, we wish everyone a wonderful weekend.
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
firstname.lastname@example.org | www.morwm.com
The majority of this content was written by Commonwealth Financial Network®. 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.