The Independent Market Observer

Monthly Market Risk Update: May 2017

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on May 10, 2017 1:27:48 PM

and tagged Market Updates

Leave a comment

market riskJust as I do with the economy, I review the market each month for warning signs of trouble in the near future. Although valuations are now high—a noted risk factor in past bear markets—markets can stay expensive (or get much more expensive) for years and years, which doesn’t give us much to go on timing-wise.

Of course, there are other market risk factors beyond valuations. For our purposes, two things are important: (1) to recognize when risk levels are high, and (2) to try and determine when those high risk levels become an immediate, rather than theoretical, concern. This regular update aims to do both.

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 

This chart is interesting for a few reasons. First, we can see that, since the presidential election in November, equity valuations have increased to levels consistent with the early 2000s. Second, gains in March kept valuations high—well above pre-election levels.

Although they are close to their highest level in 15 years, valuations are still below their peak, so you might argue that this metric does not suggest immediate risk. Of course, that also assumes we might be heading back to 2000 bubble conditions, which isn’t exactly reassuring. 

Risk factor #2: Changes in valuation levels

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.

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. The post-election rally has kept changes in valuations at a good level, so this indicator shows low immediate risk.

Risk factor #3: Margin debt

Another indicator of potential trouble is margin debt.

market risk

Debt levels as a percentage of market capitalization have moved back to all-time highs in recent months, which raises the risk level considerably. This high level of debt is concerning; however, as noted above, high risk is not necessarily immediate risk.

Risk factor #4: Changes in margin debt

Changes in margin debt are a better indicator of immediate risk than the overall level of 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 change in debt as a percentage of market capitalization remains low—although it is getting higher and closer to the risk zone. Further, although the absolute level of margin debt is high—and therefore so is the risk level—we do not yet see the kind of spike that signals trouble. Immediate risk, therefore, is moderate but increasing.

Risk factor #5: The Buffett indicator

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.

market risk

On an absolute basis, the Buffett indicator is actually somewhat encouraging. Although it remains high, it has pulled back to less extreme levels. The index has increased since the election, though, so we’ll need to monitor the situation going forward.

Technical metrics are also reasonably encouraging, with all three major U.S. indices well above their 200-day trend lines. Even as markets approach new highs, it’s quite possible that the advance will continue given growth in earnings and positive consumer, business, and investor sentiment. A break into new territory could actually propel the market higher, despite the high valuation risk level.

Immediate risk level is low but increasing

Many of the indicators point to an elevated level of risk, but these high levels, while concerning, don’t signal an immediate problem. Instead, they may be driven largely by the positive sentiment surrounding the post-election rally. What does bear watching is the immediate risk level, which, while low, is starting to increase.

  Subscribe to the Independent Market Observer

Subscribe via Email

New call-to-action
Crash-Test Investing

Hot Topics

New Call-to-action



see all



The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.


Please review our Terms of Use

Commonwealth Financial Network®