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!
U.S. equity markets rallied to record highs in July despite rising medical risks that caused some midmonth volatility. The Nasdaq Composite gained 1.19 percent in July, while the Dow Jones Industrial Average rose by 1.34 percent. The S&P 500 led the way with a 2.38 percent gain during the month. As we continue to hit new highs, what are the risks 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 declared that a recession started last February, as markets plunged, but also recently announced that it ended shortly thereafter. Despite that and the ongoing expansion, economic risks still remain. The primary ones are the economic damage from the growth in COVID cases last month, as well as the continuing shortfall in total employment.
While on the whole the economic recovery continues to be healthy, given these risks we have kept the economic risk level at a yellow light for now. There is the potential for an upgrade to green in the upcoming months, especially if we see the pace of hiring remain strong despite the rising medical risks.
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 flattened for the fourth month in a row. This result was primarily driven by a decline in long-term interest rates. The 10-year Treasury yield fell from 1.45 percent at the end of June to 1.24 percent at the end of July. The decline in long-term yields was largely driven by investor concerns about the rising risk from the Delta variant of the virus.
The three-month Treasury yield increased modestly from 0.05 percent at the end of June to 0.06 percent at the end of July. While short-term rates are expected to remain low until at least 2023, longer-term rates had previously recovered back to pre-pandemic levels before the recent decline. Long-term rates remain well above the pandemic-induced lows we saw throughout much of last year. But the recent decline is worth monitoring, as it could signal rising investor concern about the pace of the economic recovery due to the worsening public health situation.
Given the fact that long-term yields remain above the 2020 lows, we have kept this signal at a green light for now. With that being said, if long-term rates continue to decline, we may see further yield curve flattening and a potential downgrade to yellow.
Signal: Green 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 or price-to-earnings ratio, which looks at average earnings over the past 10 years—to be the most useful in determining overall risk.
Please note: Due to data limitations, the Shiller P/E data is the same data from last month's update.
Valuations continued to rise in July, as the CAPE Shiller ratio rose from 37.05 in June to 37.98 in July. This marks four consecutive months with rising equity market valuations, and it left the Shiller CAPE ratio at its highest level since late 2000.
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 23.1 percent in July, up from the 18.9 percent increase that we saw in June. 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 May 2020.
Signal: Yellow light
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization increased notably with the onset of the pandemic, hitting a new high in January 2021. Since then, we’ve largely seen margin debt as a percentage of market capitalization decline. Margin debt increased modestly in June, but it still remains below the recent high that we saw in January. 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, the year-over-year growth in margin debt as a percentage of market capitalization declined in June to 8.61 percent. This is the lowest level of year-over-year margin debt growth since May 2020 and is well below the recent high of 36.76 percent that we saw in January.
Given the fact that margin debt remains below January’s high and that the pace of year-over-year growth continued to slow, we have left this signal at yellow for now. With that being said, the still high level of margin debt on a historical basis is a risk that should be monitored.
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-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 throughout July. The S&P 500, which managed to break above its 200-day moving average at the end of May 2020, finished above trend every month since. This marks 13 consecutive months with all three major U.S. 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 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 July was encouraging, so we have left this signal at a green light.
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 identifies and combines 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, 2006–2007, and 2017. We saw market drawdowns within roughly a year following each of these peaks.
Source: Haver Analytics, FactSet
Looking at the current chart, market complacency declined modestly in July. The average VIX reading for the month increased from 16.94 in May to 17.60 in June, driven in large part by midmonth market volatility, which was in turn caused by rising concerns about the Delta variant. The forward-looking P/E ratio for the S&P 500 also declined slightly during the month, falling from 21.4 to 21.1. The combination of higher volatility and lower valuations caused the market complacency index to decline from 1.26 in June to 1.20 in July. Despite the decline during the month, the index still sits at its third-highest level since the start of the pandemic.
Readings above 1.2 have historically been a signal that market complacency is at potentially concerning levels, so the fact that the index remained at this important level is worth monitoring. Given the fact that complacency remains near concerning levels, we have left this indicator at a yellow light for now.
Signal: Yellow light
Conclusion: Markets Rally Despite Rising Medical Risks in July
Economic fundamentals showed further improvement in July, as the momentum from recent reopening efforts continued to drive growth despite rising health risks. We saw high levels of consumer and business confidence during the month, which should help support continued spending growth in the months ahead. Given the improving economic fundamentals, we are approaching a potential upgrade for the overall economic and market risk indicators, but increased medical risks in July served as a reminder that very real risks to the recovery remain.
As we saw in July, the pandemic represents a continued risk for markets, as rising concerns over the Delta variant led to some equity market volatility during the month. While the medical risks have still diminished compared with earlier in the year, they still have the potential to negatively affect markets and should be monitored.
Ultimately, the path back to a more normal economic environment is likely going to be long, and we can expect setbacks along the way that could drive further volatility. Given the improvements for many of the factors that we track in this piece compared with earlier in the year and the continued economic recovery during the month, we have left the overall market risk level at a yellow light as we may see further market volatility in the months ahead.