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, several of the trends are improving. On an absolute basis, conditions remain good—with healthy job growth, high levels of consumer confidence, and expansionary 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. Recently, prices rose again, approaching a level of concern. In the past couple of months, however, the price increase turned down. Just as in 2017, although the risks from this measure are rising, they are not yet material or immediate. Therefore, the indicator remains at a green light, although we are getting closer to a high risk level.
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 widened a bit further in October, as longer-term rates rose to post-2011 highs even as the Fed raised short-term rates. Although rising rates may be a concern over time, the larger spread remains well outside the trouble zone. As such, the immediate risk remains low. Arguably, the fact that longer-term rates are rising is overdue and a healthy development. But the fact of higher rates overall, in combination with the Fed’s expected rate increases, suggests that this indicator remains something to watch. With continued increases in long-term rates, I am taking this measure to a yellow light this month. This change reflects the fact that interest rates do indeed appear to have moved into a new and higher range in recent weeks.
Signal: Yellow light
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. In fact, despite recent declines, they remain close to 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 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. Last month, valuation changes dropped into the risk zone. But with a recent partial recovery, they may have stabilized—we will have to wait and see. Although the long-term trend in valuations remains at a positive level, the decline in the trend shows that risks continue to rise. I am keeping this indicator at yellow, as we have seen similar declines before without further damage. But rising risks mean I am adding a shade of red.
Signal: Yellow light (with a shade of red)
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Debt levels as a percentage of market capitalization ticked further down last month, but they remain 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 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 again, moving below zero over the past couple of months. This indicator is not signaling immediate risk and, in fact, is showing decreasing risk. Still, the overall debt level remains very high. As such, the risk level is worth watching, although there has been some improvement. We are keeping this indicator 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.
Last month’s declines took all three major U.S. indices below the 200-day trend lines and close to—but not below—the 400-day trend line. Again, this is not necessarily a sign of further trouble, but the risk of the trend turning even more negative has risen materially. The most probable case continues to be that the markets rebound and continue to rise, which has been supported by the recent partial recovery. But given the fact that both the Dow and the S&P remain below their support levels—and that the rebound has been modest—risks of more volatility have increased. So, I am keeping this indicator at yellow and adding a shade of red.
Signal: Yellow light (with a shade of red)
After taking the market risk indicator to a yellow light for the first time seven months ago, markets have taken another downturn and violated some important support levels. The yellow light rating recognized that risks have risen, and the recent decline exacerbated those risks.
The overall economic environment remains supportive, and neither of the likely shock factors is necessarily indicating immediate risk. But 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. I am not yet ready to go to a red light, given the supportive fundamentals. But the weakening market data does suggest conditions have gotten more dangerous.
As such, we are keeping the overall market indicator at a yellow light but adding a shade of red. This is not necessarily 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 even further over the past couple of months and that, even as the market recovers, further volatility is quite likely.