Although expensive valuations are a noted risk factor in past bear markets, they don’t give us much to go on timing-wise, as markets can stay expensive (or get much more expensive) for years and years. We can, however, try to:
That’s precisely what this monthly update on market risks is designed to do. Just as with the economy, there are several key factors that matter, both in determining the risk level and assessing the immediacy of that risk.
When it comes to assessing valuations, I 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.
Two things stand out here:
Although close to their highest levels over the past 10 years, valuations remain slightly below the 2000 peak, so you could argue that this metric isn’t suggesting immediate risk. Of course, that assumes we might head back to 2000 bubble conditions, which doesn’t exactly mean risks are low.
As good as the Shiller P/E ratio is as a risk indicator, it’s a terrible timing indicator. One way to remedy that is to look at changes in valuation levels over time instead of absolute levels.
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 falls shortly thereafter. With the recent recovery, we have just about moved out of the trouble zone and continue to advance in the right direction. Although risks remain, they may not be immediate.
Another indicator of potential trouble is margin debt.
Thanks to the market recovery and some de-risking by borrowers, debt levels (as a percentage of market capitalization) have moved down, although they still remain high. I think this continues to be an indicator of higher risk, but with recent improvements, not necessarily immediate risk.
Consistent with this, if we look at the change in margin debt over time, spikes in debt levels typically precede a drawdown. Therefore, even as the absolute risk level remains high, the immediate risk does not.
The spike in debt that led the most recent pullback is coming down, away from the risk zone. Though the absolute level of margin debt is high, and so is the risk level, the trigger seems to be getting farther away.
Said to be favored by Warren Buffett, the final indicator is the ratio of the value of all the companies in the market to the national economy as a whole.
On an absolute basis, the Buffett indicator is actually somewhat encouraging. Although it remains high, it has pulled back to less extreme levels. On a change-over-time basis, however, downturns in this indicator have typically led market pullbacks—and once again, we see that here. With the recent uptick, though, this indicator also suggests the risks are not immediate.
Technical metrics are reasonably encouraging as well, with the Dow, the S&P 500, and the Nasdaq all well above their 200-day trend lines. Even as markets approach new highs, it is quite possible that the advance will continue. Despite the high valuation risk level, a break into new territory might actually propel the market higher.
On balance, all of the metrics are in a high-risk zone, historically speaking, so we should be paying attention. But there’s a big difference between high risk and immediate risk—and it is one that's crucial to investing. None of the indicators suggests an immediate problem, and several suggest risk may be receding.
From a valuation perspective, then, a bear market does not seem to be pending at this time.
Tomorrow, we’ll wrap up this series with some thoughts on different types of bear markets, plus how you can incorporate this type of analysis into your own investing practice.