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My colleague Sam Millette, senior investment research analyst on Commonwealth’s Investment Management and Research team, has helped me put together this month’s Market Risk Update. Thanks for the assist, Sam!!
Equity markets continued to rally in March, although a rise in long-term interest rates during the month led to some volatility, especially for growth and technology companies. The S&P 500 gained 4.38 percent, while the Dow Jones Industrial Average rose by 6.78 percent. The Nasdaq Composite's heavy technology weighting dragged down its performance, resulting in a gain of only 0.48 percent during the month. Despite the volatility, both the Dow and the S&P 500 ended the month close to all-time highs, and the Nasdaq has since bounced back. Markets remain in rally mode, although the risks are still significant.
Recession 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, the National Bureau of Economic Research declared that a recession started last February. On top of that, two of the major economic indicators we cover monthly remain at concerning levels, despite the continued economic recovery.
With that being said, March saw a noted increase in economic activity, which could signal 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 future. The economy still poses a risk to financial markets, but that risk continues to decrease.
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 continued to widen during the month, primarily driven by rising long-term interest rates. The 3-month Treasury yield fell modestly from 0.04 percent to 0.03 percent, while the 10-year yield increased from 1.44 percent to 1.74 percent. This brought the 10-year to levels last seen in January 2020. 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 continue to improve.
Given the normalization of long-term interest rates and the expectation for short-term rates to remain low for the foreseeable future, the yield curve should remain near levels that have historically signaled a recovery. Rates are now consistent with levels from before the pandemic, which should limit any further increases. This is a good sign for the ongoing economic recovery.
Although rising rates resulted in volatility last month, as they approach normal levels, the risks of further increases lessen—and so does the risk of negative effects on financial markets. In light of how much the spread has increased, coupled with the lower risks of future increases, we have changed this indicator to a yellow light.
Signal: Yellow light
Market Risk
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 April, as the CAPE Shiller ratio rose from 35.19 in March to 36.61 in April. This marks seven consecutive months with rising equity market valuations, and it left the Shiller CAPE ratio at its highest level since early 2001.
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 26.9 percent in April, down from a 28.8 percent increase in March. 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 February. 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, February’s debt level increased by 26.9 percent on a year-over-year basis, down from the 35.5 percent year-over-year increase in January. Despite the improvement compared to January, this still represents the second-largest increase in year-over-year margin debt since June 2000. While the decrease from January is a positive development, the increase in overall debt levels in February combined with the still high year-over-year growth indicates that risks remain, 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 March. 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 11th month in a row. This also marks nine 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 March 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 market, market complacency does not appear to be at dangerous levels. While valuations have increased along with the market this year, there has been enough volatility to cause the VIX to remain elevated compared to pre-pandemic levels. The market complacency index increased modestly during the month, rising from 0.92 in February to 1.03 in March. This leaves the index in line with the 1.0 level we saw last December.
We are keeping this indicator at a green light due to the fact that the index still sits below the historical trouble level of around 1.2.
Signal: Green light
Conclusion: Markets Face Risk Despite Economic Improvement
Economic fundamentals showed faster growth in March, driven by continued improvements on the public health front and the stimulus checks that hit bank accounts during the month. We saw encouraging results for consumer and business confidence during the month, which should help support faster spending growth. 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 at the end of February and throughout much of March as rising rates caused market turbulence, especially for riskier asset classes. The pandemic still represents a risk for markets, although given the declining case counts and rising vaccinations, this risk appears to have subsided recently.
Ultimately, the road back to normal is likely going to be long with the potential for setbacks to cause further market pullbacks in the months ahead. 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.
