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!
Equity markets started off strong in May, but volatility later in the month led to a partial pullback. The S&P 500 and Dow Jones Industrial Average (DJIA) indices both hit all-time highs earlier in the month before suffering from volatility. Despite the turbulence along the way, the S&P 500 gained 0.70 percent during the month, and the DJIA saw a solid 2.21 percent return. The Nasdaq Composite fell by 1.44 percent, as the heavy technology weighting led to additional volatility for the index.
Recessions are strongly associated with market drawdowns. In fact, 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, another miss for headline job creation in May for the second month in a row signaled that the economic recovery is still facing headwinds.
With that being said, on the whole, the economic recovery continued to pick up steam in May. Given the improvements we saw during the month, we have kept the economic risk level at a yellow light for now, with an upgrade to green possible in the upcoming months, especially if we see the pace of hiring accelerate.
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 narrowed slightly for the second month in a row. The flattening in May was driven by a decline in long-term interest rates. The 10-year Treasury yield fell from 1.65 percent at the end of April to 1.58 percent at the end of May. The 3-month Treasury yield remained unchanged at 0.01 percent. While short-term rates are expected to remain low until at least 2023, longer-term rates now sit near pre-pandemic levels, reflecting a normalization of growth expectations as economic conditions improve.
While the normalization of rates is a positive indicator that the economic recovery is on the right path, rising long-term interest rates can negatively affect equity markets, as we saw in February and March. Although rates fell in April and May, we did see rates briefly rise in the middle of the month, which contributed to market volatility. Since then, we’ve seen long-term rates fall modestly, which is a trend that has continued into June.
Given the normalization of long-term rates and two consecutive months without a sustained increase, we have upgraded this signal to a green light.
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 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 June, as the CAPE Shiller ratio rose from 36.76 in May to 37 in June. 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 18.74 percent in June, down from a 24.19 percent increase in May. 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 had dropped substantially toward the end of 2019. Following the onset of the pandemic in early 2020, we have seen margin debt increase, setting a new record as a percentage of market capitalization in January 2021. Since then, we’ve seen margin debt as a percentage of market capitalization decline for three consecutive months. The ratio now sits at levels last seen in November 2020, however, so 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, the year-over-year growth in margin debt as a percentage of market capitalization declined in April to 12.74 percent. This is the lowest level of year-over-year margin debt growth since last July and is well below the recent high of 36.76 percent we saw in January.
Given the decline and the improvement on the year-over-year figure, we have upgraded this signal to yellow for now, but the still historically high levels of margin debt are 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 May. The S&P 500, which managed to break above its 200-day moving average at the end of last May, finished above trend for the 13th month in a row. This also marks 11 consecutive 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 May 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.
Looking at the current chart, market complacency has picked up compared with earlier in the year, but we saw a decline in overall complacency in May. The average VIX reading for the month rose from a pandemic-era low of 17.42 in April to 19.76 in May. The forward-looking P/E ratio for the S&P 500 also declined slightly during the month. The combination of rising volatility and lower valuations caused the index to fall from 1.24 to 1.07, which is close to the 1.03 level we saw in March.
Readings above 1.2 have historically been a signal that market complacency is at potentially concerning levels, so this decline following a one-month increase into the historical danger zone is an encouraging development. Given the drop in the index during the month, we have upgraded this indicator back to green for now.
Signal: Green light
Conclusion: Market Risks Declining but Still Present
Economic fundamentals showed further growth in May, driven by continued improvements on the public health front and the associated countrywide reopening efforts. We saw high levels of consumer and business confidence during the month, which should help support continued spending growth. Given the improving economic fundamentals, we are approaching a potential upgrade for the overall economic and market risk indicators, but there are still risks that should be monitored.
One of the primary risks for markets is economic success and the potential effects rising long-term rates may have on equity valuations. We saw this in May, as rising rates led to mid-month volatility for markets. The pandemic still represents a risk for markets, but given the dropping case counts and rising vaccinations, this risk continued to decline in May.
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. With that said, it appears that the worst impact from the pandemic on markets and the economy is likely behind us. Given the improvements for many of the factors that we track in this piece and the continued economic recovery during the month, we have upgraded the overall market risk level to a yellow light—but we may see further market volatility in the months ahead.