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 experienced a turbulent start to the year, as all three major U.S. indices saw declines in January. Concerns about inflation and rising case growth throughout the first half of the month caused uncertainty and led to sell-offs across equity markets. The S&P 500 lost 5.17 percent during the month, while the Dow Jones Industrial Average (DJIA) dropped by 3.24 percent. The technology-heavy Nasdaq Composite saw the largest losses, with the index declining by 8.96 percent during the month. The story was similar internationally, as both the MSCI EAFE and Emerging Market indices saw declines to start the year. The January volatility served as an important reminder that very real risks to markets remain that should be monitored.
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. The primary risk is a slowing recovery, as seen by lowered business and consumer confidence in January.
On the whole, the economic recovery continued in January, although uncertainty about the path of the recovery remains. Given the remaining risks, we have kept the economic risk level at a yellow light for now. Although the most likely path forward is continued recovery, the lowered confidence is a reminder that the pace of the recovery remains uncertain and that 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 steepened slightly in January. This result was caused by rising long-term interest rates, as the 10-year Treasury yield increased from 1.52 percent at the end of December to 1.79 percent at the end of January. This increase for long-term yields was more than enough to offset an increase in short-term rates during the month. The three-month Treasury yield increased from 0.06 percent at the end of December to 0.22 percent at the end of January.
The rise in both short- and long-term yields was due primarily to rising expectations for a rate hike at the Fed’s next meeting in March. Economists largely expect to see the Fed focused on combatting inflation in 2022, which could lead to more frequent rate hikes as the central bank tries to normalize monetary policy.
While this normalization process is a good sign for the ongoing economic recovery, rising rates can have a negative effect on stocks, as we saw to start the year. Long-term yields have continued to rise in February, and we’ve seen some market turbulence to match. Given the potential negative impact from rising rates on equities, we have kept this signal as yellow for now with a potential downgrade to red possible 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.
Please note: Because of data limitations, this is the same chart that was used in last month’s update.
Valuations continued to rise in January, as the Shiller CAPE ratio rose from 38.68 in December to 39.60 in January. This result brought the Shiller CAPE ratio to its highest level since late 2000.
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 rose 13.01 percent in January, up from the 10.2 percent increase we saw in December. Given the historically high valuation levels, we have kept this indicator at a yellow light for now, despite the fact that valuation changes have remained outside 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 at the start of the pandemic and throughout 2020. Since then, we have seen margin debt largely decline from the recent highs that we saw in late 2020. Margin debt declined in December following a modest increase in November; however, 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 4.91 percent on a year-over-year basis in December. This marks the largest year-over-year decline in margin debt since the start of the pandemic.
Although margin debt as a percentage of market capitalization declined on a year-over-year basis in December, 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 were mixed for major U.S. markets in January. The S&P 500 and DJIA were able to finish the month above their respective 200-day moving averages, but the Nasdaq ended the month below this important technical level. This marks the first time that one of the three major indices has finished the month below trend since mid-2020 and signals potential investor concern for U.S. companies.
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. While it’s too early to say that the drop below trend for the Nasdaq signals a true change in sentiment for investors, the mixed technical signals during the month are a potential cause for concern; therefore, we’ve downgraded this indicator to yellow.
Signal: Yellow 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 dropped in January. The average VIX reading increased from 21.4 in December to 23.18 in January. The forward-looking P/E ratio for the S&P 500, on the other hand, declined during the month, falling from 21.2 in December to 19.7 in January. The combination of increasing volatility and declining valuations caused the overall index to drop to start the year. This market complacency index fell from 0.99 in December to 0.85 in January, which marks 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. So, the continued pullback for the index in January is a sign that complacency continued to fall back from the potential danger zone that we hit in October of last year. Given the continued pullback for the indicator in January, we have upgraded this signal to a green light.
Signal: Green light
Conclusion: January Volatility Reminder That Risks Remain
The market turbulence in January served as a reminder that very real risks for markets exist and should be monitored. Interest rates continue to be a potential cause of concern for equity markets, as we saw throughout much of January. Additionally, political and medical risks are very real and should be monitored.
With that being said, the most likely path forward is for continued market appreciation in the months ahead, provided we see continued economic growth.
Ultimately, the path back to a more normal economic 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 remained at a yellow light during the month, we have left the overall market risk level at a yellow light for now; however, the recent rise in uncertainty could lead to further volatility and downgrades in the months ahead.