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!
Markets took a breather in January, as month-end volatility led to a mixed month for major equity indices to start the year. This volatility caused the S&P 500 to decline by 1.01 percent during the month, while the Dow Jones Industrial Average dropped 1.95 percent. The Nasdaq Composite managed to record a 1.44 percent gain. While we have seen markets largely recover to start February, the month-end volatility is a good reminder of the risks markets continue to face.
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, most of the major economic indicators we cover monthly remain at concerning levels, despite continued economic recovery during the month. As such, we have kept the economic factors at a red light for February.
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 started the year inverted, and it un-inverted in March, where it has remained throughout the pandemic. This un-inversion was initially driven by a sharp drop in short-term rates, caused by the Fed’s decision to cut the federal funds rate to effectively zero percent in March. The 3-month Treasury yield fell to start the year, from 0.09 percent at the end of December to 0.06 percent at the end of January. The 10-year yield rose during the month, from 0.93 percent at the end of December to 1.11 percent at the end of January, driven in large part by rising expectations for additional federal stimulus spending and faster economic growth. This brought the 10-year yield to its highest month-end level since it ended February 2020 at 1.13 percent. While short-term rates are expected to remain low until at least 2023, longer-term rates have started to approach pre-pandemic levels.
Although the spread between the 10-year and 3-month Treasury remains near the recession zone, it is approaching the level that historically has signaled a recovery. While this normalization process is a good sign, rising rates can have a negative effect on stocks. In light of that, and with the spread remaining near the recession zone, we are leaving this indicator at a red light for now.
Signal: Red 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.
Valuations continued to rise in February, as the CAPE Shiller ratio rose from 34.5 in January to 34.8 In February. This left valuations at their highest level since the dot-com bubble, as the CAPE ratio ended the month above the previous pre-pandemic high-water mark of 33.3 that was set in January 2018. This marks five straight months with rising valuations.
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 34.1 percent in February, down from a 39.1 percent increase in January. 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 for the past six months.
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 notably throughout most of 2020, with margin debt as a percentage of market capitalization ending 2020 at a record level. 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, December’s debt level increased by 25.3 percent on a year-over-year basis, up from an already high 21.2 percent increase in November, which indicates that risks are rising. This marks the largest increase in margin debt since February 2008, when year-over-year debt levels increased by 28.2 percent. Given the increase in debt on both a monthly and yearly basis, and the fact that the overall debt level remains historically high, this risk is rising, and we have kept this indicator at 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 January. The S&P 500, which managed to break above its 200-day moving average at the end of May, finished above trend for the ninth month in a row. This also marks seven 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 January 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 approaching dangerous levels. While valuations have rebounded along with the market, there has been enough volatility to cause the VIX to remain elevated compared to pre-pandemic levels. After the index grew to slightly more than 1 in December, rising volatility and lower valuation levels in January caused the index to fall back to 0.86, which is below the 0.88 reading from November.
We are keeping this indicator at a green light due to the fact that the index still sits below the historical trouble level and that the volatility in January led to a decline in the index during the month.
Signal: Green light
Conclusion: January Volatility Highlights Continued Risks
Economic fundamentals showed continued growth in January, but the pace of the recovery remained relatively slow. Markets understandably took a pause in January, leading to a mixed start to the year for equities. While the pandemic remains a risk for the economy and markets, mass vaccination efforts have begun to pick up steam, and we made notable progress in lowering new case counts in January. Additionally, the federal stimulus announced at the end of 2020 should help the economy weather the risks in the short term.
Given the continued risk posed by the pandemic, we are keeping the overall market risk indicator at a red light for now, although an upgrade to a yellow light is looking increasingly possible as we see improvements on the public health front. The road back to normal is likely going to be long with the potential for setbacks that could lead to additional market pullbacks. Given the uncertainty created by the pandemic and the possibility for further volatility, investors should remain cautious on equity markets for the time being.