Dear Clients & Friends,
It’s time for our monthly risk update. Not much has changed since last month, except that the President wants to delay tariff negotiations with China until after the next election. Simple logic dictates that this delay is a political move intended postpone the trade negotiations to a time closer to the next election in order to assist with his re-election campaign. Eventually, this tariff relief will likely cause substantial movement in the stock market and a large but temporary spike in domestic GDP. Other than this one (rather large) development, things seem to be about the same. We see a surprisingly strong consumer and labor environment, along with economic concerns that are growing very slowly.
Markets continued their upward climb in November, bringing the major U.S. equity indices to all-time highs during the month. Just as with the economy, however, there are several key factors that matter for the market in determining both the risk level and the immediacy of the risk. And we now turn to our good friends Brad McMillan & Sam Millette for our market risk update.
Markets continued their upward climb in November, bringing the major U.S. equity indices to all-time highs during the month. Just as with the economy, however, there are several key factors that matter for the market in determining both the risk level and the immediacy of the risk.
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, right now the conditions that historically have signaled a potential recession are not in place. There are, however, signs that risks are out there, with consumer and nonmanufacturer confidence both weakening last month. On an absolute basis, most of the major signals are not yet in a high-risk zone. But trends are becoming more negative, and four of the signals are at a yellow light. As such, we have kept economic factors at a yellow light for December.
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 both 2017 and 2018 is not necessarily an indicator of trouble, especially as the subsequent declines took this indicator well out of the trouble zone. Oil prices have remained muted for much of the year, following a large decline at the end of 2018. Even the September attack on Saudi Arabian production facilities that slowed global output was not enough to cause a serious spike in prices. We’ll leave this indicator at a green light for now.
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 widened further in November, as the yield on the 10-year Treasury note rose from 1.73 percent to 1.83 percent during the month. This marks the second straight month where the yield curve has remained un-inverted, which is a welcome return to normalcy. Despite this un-inversion, the risk of a recession in the future still remains, as historically we’ve seen recessions follow un-inversions of the yield curve within 12 months. There is also the chance that we will see another inversion in the short term, as a return to August’s recent low-water yields for the 10-year would leave us inverted. We are keeping this measure at a yellow light for this month.
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.
The major takeaway from this chart is that, with the run-up in 2019, valuations remain extremely high. They are still above the levels of the mid-2000s, although down from recent highs. Despite the drop, stocks remain quite expensive based on history. 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 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. After the decline at the end of last year took the market into the risk zone, recovery through this year has brought us positive for the year. November was another solid month for equities, marking three straight positive months following August’s volatility. We are keeping this indicator at yellow due to the fact that we remain above the levels of 2011 and 2015–2016. But with another month or two of improvement, this indicator could move back to green.
Signal: Yellow light
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization have dropped substantially over the past year, to close to the lowest levels of the recovery. Margin debt remains at the low end of recent history, but it remains high by historical standards. 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. Margin debt as a percentage of market cap is well below highs seen in 2017 and 2018.
As you can see in the chart above, the annual change in debt as a percentage of market capitalization remains well below zero, as has been the case for the entire year. This indicator is not signaling immediate risk at this point but has been volatile in recent months. Given that, and the fact that the overall debt level remains very high, it is worth watching. So, we are keeping this indicator 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 we follow are the 200- 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.
The decline at the end of 2018 took all three major U.S. indices below the 400-day trend lines, a significant support level. The subsequent recovery brought them back above both that level and the 200-day level. But in May, we had a brief break back below the 200-day trend line, followed by a recovery, and then another brief break below in June and further weakness in August. We’ve now had three straight positive months for markets following August’s declines, and a continued market rebound remains our base case. But as we saw to start the month, volatility can strike at any time. So, we are leaving this indicator at yellow for now.
Signal: Yellow light
Conclusion: Market risks moderate, but economic risks remain
Market risks have been at the yellow light level for the past 21 months and recently dropped even further with the hint of some red lights. But market conditions have largely improved over the past few months, despite turbulence at the beginning of December. On the other hand, economic risks have risen as the incoming data remains weak, and there have been a couple of potentially significant breakdowns. On balance, this leaves us solidly in the yellow zone of increased risks.
The market recovery following August’s volatility is encouraging, and the overall economic environment remains supportive. Although neither of the likely shock factors is necessarily indicating immediate risk, the rising signs of economic weakness, combined with the fact that several of the market indicators continue to point to an elevated level of risk, suggest that volatility can appear at any time. As we saw over the summer, outside factors can swiftly affect markets.
As such, we are keeping the overall market indicator at a yellow light. This is not a sign that risks have passed. Instead, it is a recognition that basic conditions remain supportive and that while risks are real, the most probable course is more appreciation—even though further volatility is quite possible.
So, there you have it. We remain cautious and alert. However, as we have done throughout this year, we will maintain a healthy position of growth-oriented investments until the time comes when the deceleration of our economy begins to accelerate (if that makes sense).
Have a lovely 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 |
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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.