Dear Clients & Friends,
This weekend, we return to our monthly risk update from the Independent Advisor. If you’ve read this column for some time now, you’ve probably picked up on a slow but steady change in tone. While we do not see immediate substantial risk, there is no doubt that risk is rising. While I don’t want to give away our secret topics for future articles, I will admit that we are preparing a very noteworthy article regarding our forecast for the rest of this year, and our concerns for 2018 and 2019. For now, let us focus on the risks and metrics at hand. Here’s where we are…
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.
This chart is interesting for a few reasons. First, we can see that, since the presidential election in November, equity valuations have increased to levels consistent with the early 2000s. Second, gains in March kept valuations high—well above pre-election levels.
Although they are close to their highest level in 15 years, valuations are still below their peak, so you might argue that this metric does not suggest immediate risk. Of course, that also assumes we might be heading back to 2000 bubble conditions, which isn’t exactly reassuring.
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. The post-election rally has kept changes in valuations at a good level, so this indicator shows low immediate risk.
Risk factor #3: Margin debt
Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization have moved back to all-time highs in recent months, which raises the risk level considerably. This high level of debt is concerning; however, as noted above, high risk is not necessarily immediate risk.
Risk factor #4: Changes in margin debt
Changes in margin debt are a better indicator of immediate risk than the overall level of 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 change in debt as a percentage of market capitalization remains low—although it is getting higher and closer to the risk zone. Further, although the absolute level of margin debt is high—and therefore so is the risk level—we do not yet see the kind of spike that signals trouble. Immediate risk, therefore, is moderate but increasing.
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 is actually somewhat encouraging. Although it remains high, it has pulled back to less extreme levels. The index has increased since the election, though, so we’ll need to monitor the situation going forward.
Technical metrics are also reasonably encouraging, with all three major U.S. indices well above their 200-day trend lines. Even as markets approach new highs, it’s quite possible that the advance will continue given growth in earnings and positive consumer, business, and investor sentiment. A break into new territory could actually propel the market higher, despite the high valuation risk level.
Immediate risk level is low but increasing
Many of the indicators point to an elevated level of risk, but these high levels, while concerning, don’t signal an immediate problem. Instead, they may be driven largely by the positive sentiment surrounding the post-election rally. What does bear watching is the immediate risk level, which, while low, is starting to increase.
In the coming weeks, we plan to write more about our outlook for 2018 and 2019 which is unfortunately not very rosy. Economics lives within a series of cycles, as do many things in this world. We believe that the current cycle is coming to an end, and we believe that the end may be scary for those who are unprepared. With that in mind, we will do our very best to prepare our clients and set expectations. Risks are rising, but we do not see imminent risk, though we are gearing up to write about when we think that may happen. So stayed tuned because that’s an article for another week. Hint hint….
Matthew Ramer, AIF® Principal, Financial Advisor MOR Wealth Management, LLC
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