My colleague Sam Millette, manager, fixed income on Commonwealth’s Investment Management and Research team, has helped me put together this month’s Market Risk Update. Thanks for the assist, Sam!
Markets rebounded in March, but it was not enough to offset earlier losses in January and February. The S&P 500 gained 3.71 percent in March, while the Dow Jones Industrial Average (DJIA) rose by 2.49 percent and the Nasdaq Composite increased by 3.48 percent. But the selloffs in January and February caused all three indices to end the quarter in negative territory. Despite the March gains, the S&P 500 lost 4.60 percent for the quarter, while the DJIA dropped 4.10 percent and the technology-heavy Nasdaq dropped 8.95 percent. The market decline to start the year is a reminder that risks remain that should be monitored going forward.
Recessions are strongly associated with market drawdowns; in fact, 8 of 10 bear markets have occurred during recessions. The National Bureau of Economic Research, which declared that a recession started in February 2020 when markets plunged, announced that it ended shortly thereafter. Despite that and the ongoing expansion since then, economic risks remain.
On the whole, the economic recovery continued in March, although uncertainty about the path forward remains. The primary risk is a deeper slowdown in growth as tighter monetary policy from the Fed starts to bite. Given the uncertainty surrounding inflation and the war news, we have kept the economic risk level at a yellow light for now. Although the most likely path forward is continued economic growth, the lowered confidence is a reminder that the recovery pace is uncertain, and we will likely see setbacks along the way.
Economic Shock Risk
One major systemic factor is the price of money, otherwise known as interest rates. They drive the economy and financial markets—and, historically, have been able 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 widened slightly in March. This result was caused by long-term rates rising faster than short-term rates during the month. The 3-month Treasury yield increased from 0.35 percent at the end of February to 0.55 percent at the end of March. The 10-year Treasury yield rose from 1.83 percent at the end of February to 2.32 percent at the end of March.
The rise in both short- and long-term yields was primarily due to rising expectations for rate hikes from the Fed throughout the course of the year, due to high levels of consumer and producer inflation.
Economists expect to see the Fed focused on combating inflation in 2022, which could lead to more frequent rate hikes as the central bank tries to normalize monetary policy. Economists view the expected Fed rate hikes as a signal that the Fed views the economy as healthy enough to endure a faster return to normal.
While this normalization process is a good sign for the ongoing economic recovery and could help tamp down high levels of inflationary pressure, rising rates can have a negative effect on stocks, as we saw to start the year. Given the potential negative impact of rising rates on equities, we have kept this signal as yellow for now with a potential downgrade to red in the months ahead.
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 which factors signal high risk
- To try to determine when those factors signal that the risk has become an immediate—rather than theoretical—concern
Risk factor #1: Valuation levels. When assessing valuations, we find longer-term metrics (particularly the cyclically adjusted Shiller P/E or price-to-earnings ratio, which looks at average earnings over the past 10 years) to be the most useful in determining overall risk.
Valuations increased in April after declining in every month since November. The Shiller CAPE ratio rose from 34.91 in March to 36.31 in April. This result left the index below the recent high of 38.58 that we saw in November of last year.
Even though the Shiller CAPE ratio is a good risk indicator, it’s a terrible timing indicator. To get a better sense of immediate risk, let’s turn to the 10-month change in valuations. Looking at changes rather than absolute levels gives a sense of the immediate-risk level because turning points often coincide with changes in market trends.
Above, 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 at the start of the pandemic, as valuations and the index rolled over before rebounding. On a 10-month basis, valuations declined by 1.06 percent during the month, down from the 4.49 percent decline that we saw in March. This now marks three consecutive months with declining year-over-year valuations. Given the continued year-over-year decline in valuations and the historically high valuation levels, we have kept this indicator as a red light for now.
Signal: Red light
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization increased notably at the start of the pandemic and throughout 2020. Since then, we have seen margin debt largely decline from the recent highs we saw in late 2020. Margin debt increased modestly in February after falling notably in January. Despite the recent declines in margin debt, the overall level of margin debt remains high on a historical basis. 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, margin debt as a percentage of market capitalization declined by 8.2 percent on a year-over-year basis in February, following a 12.9 percent drop in January. This now marks three consecutive months with declining year-over-year margin debt.
Although margin debt as a percentage of market capitalization declined on a year-over-year basis in February, the high absolute level of margin debt as a percentage of market capitalization is worth monitoring. We have kept this indicator at a yellow light for now.
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 200-day and 400-day moving averages. We start to pay attention when a market breaks through its 200-day average, and a breakthrough of the 400-day average often signals further trouble ahead.
Technical factors for major U.S. equity markets were mixed in March. The S&P 500 ended the month above its trend line after falling below this important technical level at the end of February. The DJIA and Nasdaq, however, both finished below trend for the second month in a row.
The 200-day trend line is an important technical signal that is widely followed by investors, as prolonged breaks above or below 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. While the rebound for the S&P 500 by the end of March was encouraging, the negative technical signals for the DJIA and Nasdaq during the month are a cause for concern; therefore, we’ve kept this indicator as red for now.
Signal: Red 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 identifies and combines two 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 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, 2006–2007, and 2017. We saw market drawdowns within roughly one year following each of these peaks.
Source: Haver Analytics, FactSet
Looking at the current chart, market complacency remained unchanged in March following four months of consecutive declines. The average VIX reading increased from 25.75 in February to 26.97 in March, marking the highest average monthly VIX level since October 2020. The forward-looking P/E ratio for the S&P 500 increased during the month, rising from 18.5 in February to 19.5 in March. The combination of increasing volatility and valuations offset each other and kept the overall index unchanged in March at 0.72, which ties the lowest level for the index since October 2020.
Readings exceeding 1.2 have historically been a signal that market complacency may be at concerning levels. The result for the index in March is a sign that complacency continued to remain outside the potential danger zone we hit in October 2021. Given the unchanged result for the indicator in March, we have left this signal as a green light.
Signal: Green light
Conclusion: Risks Remain Despite Market Rebound
The market rebound in March was a welcome development; however, the sell-offs earlier in the quarter serve as a reminder that real risks for the market exist and should be monitored. Inflation and interest rates continue to be a potential cause for concern, and the continued Russian invasion of Ukraine adds further uncertainty for markets.
Another component worth noting is the change in oil prices. This was originally an indicator we tracked, but given steady pricing over the past decade, we stopped using it. Now that prices are highly volatile—and at the highest level in years—we took another look, and this, too, is at a red light. Given this, the risks to the market are clearly to the downside.
That said, it is certainly possible that we will see continued market appreciation in the months ahead, provided we see continued economic growth. But right now, the risks have moved significantly higher.
Ultimately, the path back to a more normal economic and market environment will likely be long, and we can expect setbacks along the way. Given the fact that many of the indicators we track in this update have dropped to red, we have kept the overall market risk level at a red light for now.