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. Although growth may well have peaked, the economy is still growing—with healthy job growth and high levels of consumer and business confidence. As such, economic factors remain at a green light.
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.
A quick price spike like we saw in 2017 (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, the increase is still modest, suggesting that the risks from this indicator are not yet material—or immediate. Therefore, the indicator 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.
The yield curve spread tightened a bit in April, taking it back toward the post-crisis low in December. But it is still well outside the trouble zone, and the immediate risk remains low. The fact that the spread has tightened again, in combination with the Fed's expected rate increases, suggests that this remains something to watch. I am leaving this measure at a green light for now, but you can see a shade of yellow.
Signal: Green light (with a shade of yellow)
Beyond the economy, we can also learn quite a bit by examining the market itself. For our purposes, two things are important:
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.
The major takeaway from this chart is that valuations remain extremely high—at the second-highest level of all time, exceeded only by the dot-com boom. Also worth noting, however, is the very limited effect on valuations of the recent increases in earnings due to the tax cuts. On a shorter-term basis, those earnings increases have markedly reduced valuations, suggesting reduced risk. On a longer-term basis, however, as shown in the chart above, valuations have not pulled back much at all. High valuations are associated with higher market risk—and longer-term metrics have more predictive power. So, this is definitely a sign of high risk levels.
Even as the Shiller P/E ratio is a good risk indicator, however, it is a terrible timing indicator. To get a better sense of immediate risk, we look at 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. In recent months, even with the recent recovery, valuations have dropped toward the risk zone. While the long-term trend in valuations remains at a positive level, risks are rising. Therefore, I have taken this indicator to a yellow light.
Signal: Yellow light
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization ticked back up last month after dropping, but they remain close to all-time highs. While borrowers have derisked somewhat in the face of recent turbulence, that process appears to have stopped well before actually materially reducing risk. 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 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 annual change in debt as a percentage of market capitalization has ticked down in recent months, moving below 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. As such, 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.
These indicators remain positive, with all three major U.S. indices well above both trend lines. As noted last month, though, the S&P 500 continues to bounce off its 200-day moving average on a daily basis, which is a sign of weakness. Looking at monthly signals, as this chart does, there has not been a sustained break. With no convincing movement either way, though, the risk of the trend turning negative has risen materially. The most probable case is that the markets may move back up, since they failed to break support even at the nadir. But given the fact that the index did hit its support level—and has not convincingly rebounded above—risks of more volatility have increased. So, I am keeping this indicator at yellow.
Signal: Yellow light
After taking the market risk indicator to a yellow light for the first time last month, markets have since recovered. This was more or less expected. At the same time, the yellow light rating recognized that risks have risen. Despite the recovery over the past weeks, those risks are still there.
While the overall economic environment remains supportive, and neither of the likely shock factors is necessarily indicating immediate risk, the continued volatility and the fact that several of the market indicators point to an elevated level of risk—combined with the ongoing policy concerns—suggest that volatility may get worse.
As such, we are keeping the overall market indicator to a yellow light. This is not a sign of immediate trouble. Indeed, the likelihood remains that the market will keep moving higher. Rather, it is a recognition that the risk level has increased materially and that, even if the market recovers, further volatility is quite likely.