Monthly Market Risk Update: March 2018

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Mar 13, 2018 1:15:18 PM

and tagged Market Updates

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market riskThis is another special edition of the market risk update, following a significant bounce from the February pullback. Overall, the conclusion of a green light last month was correct, as much of the damage proved to be temporary. But it is worth taking a look at what happened and why. Where special comments are needed, they will be in italics.

Market risks come in three flavors: recession risk, economic shock risk, and risks within the market itself. So, what do these risks look like for March? Let’s take a closer look at the numbers.

Recession risk

Recessions are strongly associated with market drawdowns. Indeed, 8 of 10 bear markets have occurred during recessions. As I discussed in this month's Economic Risk Factor Update, right now the conditions that historically have signaled a potential recession are not in place. In fact, the economy appears to be strengthening, supported by high job growth and consumer and business confidence. As such, economic factors remain at a green light.

Economic shock risk

There are two major systemic factors—the price of oil and the price of money (better known as interest rates)—that drive the economy and the financial markets, and they have a proven ability to derail them. Both have been causal factors in previous bear markets and warrant close attention.

The price of oil. Typically, oil prices cause disruption when they spike. This is a warning sign of both a recession and a bear market.

market risk

As we saw with the price spike earlier in 2017, a quick spike—it did not appear to reach a problem level and was short lived—is not necessarily an indicator of trouble. The subsequent decline also took this indicator well out of the trouble zone. Although prices have started to rise again, that rise appears to be topping out. This suggests that the risks from this indicator, already low, are not getting any worse. Overall, there are no signs of immediate risk from this indicator, so it remains at a green light.

Signal: Green light

The price of money. I cover interest rates in the economic update, but they warrant a look here as well.

market risk

The yield curve spread opened up a bit more in February, taking it further away from the post-crisis low in December and back to levels that prevailed in most of 2017. It is still well outside the trouble zone, and the immediate risk remains low. The fact that the spread continues to widen, despite the Fed's expected rate increases, suggests that conditions may be improving. I am leaving this measure at a green light for now, and it is getting farther away from yellow.

Signal: Green light (with a slight shade of yellow)

The economic fundamentals showed surprising strength in many areas in February, particularly in hiring and confidence, and they continue to show no signs of an imminent recession. As such, the odds of a sustained market drawdown remain low, as demonstrated by the rapid recovery of much of the loss from the recent pullback. While a further decline is certainly possible, if it does happen it is likely to be similar to the last one—and not be that bad or last that long. Favorable economics support the stock market even during pullbacks.

Market risk

Beyond the economy, we can also learn quite a bit by examining the market itself. For our purposes, two things are important:

  1. To recognize what factors signal high risk
  2. To try to determine when those factors signal that risk has become an immediate, rather than theoretical, concern

Big-picture comment here: you will notice that the recent pullback looks quite small on the following charts. That is because as bad as it felt, in historical terms it was perfectly normal. This illustrates, once again, the importance of keeping a big-picture perspective and looking at individual events in a historical context.

Risk factor #1: Valuation levels. 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.

market risk

The chart above is interesting for a few reasons. Since the presidential election more than a year ago, equity valuations have increased to levels not seen since the early 2000s. In addition, gains this year have pushed valuations even higher, to the second-highest level of all time. Right now, they are below only 1999, as you can see from the chart.

Although they are at close to the highest level since 1999, valuations remain below that peak, so you might argue that this metric does not suggest immediate risk. Of course, this argument assumes we might head back to 2000 bubble conditions, which isn’t exactly reassuring.

The Shiller P/E ratio is a good risk indicator, but 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.

market risk

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. Even with the recent pullback, strong stock market performance has kept the long-term trend in valuations at a healthy positive level, well above the trouble zone. Therefore, this indicator shows low immediate risk.

Signal: Green light

Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.

market risk

Debt levels as a percentage of market capitalization rose again over the past couple of months, taking them back close to all-time highs. The overall high levels of debt are concerning; however, as noted above, high risk is not immediate risk. 

For immediate risk, changes in margin debt 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.

market risk

As you can see in the chart above, the annual change in debt as a percentage of market capitalization has ticked back down in the past month, moving closer to zero. So, this indicator is not signaling immediate risk. But the overall debt level remains very high, and we have seen something approaching a spike in recent months, so the risk level remains worth watching. We are keeping this at a yellow light.

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 I follow are the 200- and 400-day moving averages. I 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.

market risk

These indicators remain positive, with all three major U.S. indices well above both trend lines. Even as markets continue to reach new highs, it’s quite possible that the advance will continue given growth in earnings and positive consumer, business, and investor sentiment. As we continue to break into new territory, this seems to be actually propelling the market higher, despite the high valuation risk level. With the index well above the trend lines, the likely trend continues to be positive.

As noted last month, the S&P 500 actually dropped slightly below its 200-day moving average on a daily basis at the bottom of the recent drop, then bounced and moved higher. If anything, based on the data so far, this suggests that the markets are likely to move higher, since they failed to break support even at the nadir. This has not happened yet, but the strong bounce keeps it alive as a real possibility. Both the bounce and the recovery suggest that the immediate risk is low; nonetheless, the fact that the index did hit its support level raises risks, so I am keeping this indicator at yellow.

Signal: Yellow light

Conclusion: Conditions improving, remain favorable despite higher risks

The overall economic environment remains supportive, and neither of the likely shock factors is necessarily indicating immediate risk. Similarly, while several of the market indicators point to an elevated level of risk, that risk has not proven out yet. Overall, the risk levels have increased moderately, and may deteriorate further, but the market environment remains favorable in the near term.

We remain at a green light for this month, as the market looks likely to have weathered the recent pullbacks with risk rising only moderately.

market risk

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