Monthly Market Risk Update: April 2017

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Apr 11, 2017 3:24:25 PM

and tagged Market Updates

Leave a comment

market riskJust as I do with the economy, I review the market each month for warning signs of trouble in the near future. Although valuations are now high—a noted risk factor in past bear markets—markets can stay expensive (or get much more expensive) for years and years, which doesn’t give us much to go on timing-wise.

Of course, there are other market risk factors beyond valuations. For our purposes, two things are important: (1) to recognize when risk levels are high, and (2) to try and determine when those high risk levels become an immediate, rather than theoretical, concern. This regular update aims to do both.

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.

april17_marketrisk_1.jpg

This chart is interesting for a few reasons. Since the election in November, equity valuations have increased to levels not seen since the early 2000s. They’re higher than they were in 2007 and are at the third-highest level in history, after 1929 and 1999. Additionally, volatility in March did little to lower valuations. The market, by this metric and many others, remains very expensive.

Although they’re at their highest level in 15 years, valuations remain below the 1999 peak, so you might argue that this metric is not suggesting immediate risk. Still, comparing where we are now to 2000 bubble conditions 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.

april17_marketrisk_2.jpg

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 healthy level, with few signs of immediate risk.  

Risk factor #3: Margin debt

Another indicator of potential trouble is margin debt.

april17_marketrisk_3.jpg

Debt levels as a percentage of market capitalization remain near all-time highs, although growth in this indicator may be slowing. The overall elevated levels of debt are concerning, but given recent improvements, this is not necessarily an immediate risk.

Risk factor #4: Changes in margin debt

Consistent with this, if we look at the change over time, spikes in debt levels typically precede a drawdown.

april17_marketrisk_4.jpg

As you can see in the chart above, the change in debt as a percentage of market capitalization remains at low levels. Though the absolute level of margin debt is high, and so is the risk level, the trigger for immediate risk seems to be getting farther away.

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.

april17_marketrisk_5.jpg

On an absolute basis, the Buffett indicator is actually somewhat encouraging. Although it remains high, the year-on-year change (shown above) is still well below the risk zone. The index has increased post-election, however, and the trend suggests we may be heading into more risky territory, so any increase should be watched.

Technical metrics are also reasonably encouraging, with all three major U.S. indices well above their 200-day trend lines. Even as markets hover near all-time 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.

Risk is high (but not immediate)

Although many of the indicators point to an elevated risk level, they do not signal an immediate problem. Given improving economic fundamentals and earnings, and very positive consumer and business sentiment, we may well see the markets—and risk levels—continue to increase.

High risk is not the same as immediate risk, and although there's reason for concern, the indicators that are best at predicting immediate risk are not in the danger zone. The most likely course for the market in the near term is sideways, but it could take a turn upward if good news, such as positive earnings surprises, appears.

  Subscribe to the Independent Market Observer

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

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. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&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.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®