My colleague Sam Millette, manager, fixed income on Commonwealth’s Investment Management and Research team, has helped me put together this month’s Market Risk Update. Thanks for the assist, Sam!
U.S. equity markets continued to rally in August, with all three major indices setting new record highs during the month. We did see some midmonth volatility, but the Dow Jones Industrial Average gained 1.50 percent, while the S&P 500 experienced a 3.04 percent gain. The Nasdaq Composite led the way with a 4.08 percent return during the month. Despite the continued rally for equity markets in August, there are real risks to the markets that should be monitored going forward.
Recessions are strongly associated with market drawdowns. In fact, 8 of 10 bear markets have occurred during recessions. The National Bureau of Economic Research declared that a recession started last February, as markets plunged, but it also recently announced that the recession ended shortly thereafter. Despite that and the ongoing expansion, economic risks remain. The primary ones are the economic damage from the growth in COVID cases last month, as highlighted by declining business and consumer confidence, and the slowdown in hiring in August.
On the whole, the economic recovery continues, But given these risks, we have kept the economic risk level at a yellow light for now. While the most likely path forward is continued recovery, the slowdown in economic activity in August signals that risks are rising on the economic front.
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 steepened slightly during the month, breaking a four-month streak of flattening. This result was primarily due to rising long-term interest rates, as the 10-year Treasury yield increased from 1.24 percent at the end of July to 1.30 percent at the end of August. The three-month Treasury yield declined modestly from 0.06 percent at the end of July to 0.04 percent at the end of June. While short-term rates are expected to remain low until at least 2023, longer-term rates had previously recovered back to pre-pandemic levels before declining from April through July.
Given the fact that long-term yields remain above the 2020 lows and we saw a modest increase in long-term yields during the month, we have kept this signal at a green light for now.
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 or price-to-earnings ratio, which looks at average earnings over the past 10 years—to be the most useful in determining overall risk.
Please note: Due to data limitations, the Shiller P/E data is the same data from last month's update.
Valuations continued to rise in July, as the CAPE Shiller ratio rose from 37.05 in June to 37.98 in July. 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 23.1 percent in July, up from the 18.9 percent increase that we saw in June. 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 increased notably with the onset of the pandemic, hitting a new high in January 2021. Since then, we’ve largely seen margin debt as a percentage of market capitalization decline. Margin debt as a percentage of market capitalization fell to a 14-month low in July following 2 months of modest increases. Despite the decline in margin debt during the month, the overall level of 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 as well in July. On a year-over-year basis, margin debt declined by 0.5 percent during the month, which is the first year-over-year decline since February 2020 and is well below the recent high of 36.8 percent that we saw in January 2021.
Given the fact that margin debt fell notably during the month and that margin debt declined on a year-over-year basis, we have left this signal at yellow for now. While the improvement during the month was encouraging, the overall high level of debt is still a concern for the short-term; however, further declines in the months ahead could lead to an upgrade to green.
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 August. The S&P 500, which managed to break above its 200-day moving average at the end of May 2020, finished above trend every month since. This marks 14 consecutive months with all three major U.S. 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 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 August 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.
Source: Haver Analytics, FactSet
Looking at the current chart, market complacency increased modestly in August. The average VIX reading for the month declined from 17.6 in July to 17.5 in August. The forward-looking P/E ratio for the S&P 500, on the other hand, increased slightly during the month, rising from 21.1 to 21.4. The combination of lower volatility and higher valuations caused the market complacency index to increase from 1.20 in July to 1.22 in August. The index now sits at its third-highest level since the start of the pandemic; however, it is slightly below June’s 1.26 reading.
Readings above 1.2 have historically been a signal that market complacency is at potentially concerning levels. So, the fact that the index remained at this important level for the third month in a row is worth monitoring. Given the fact that complacency remains near concerning levels, we have left this indicator at a yellow light for now, with a downgrade to red possible if we continue to see complacency rise in the months ahead.
Signal: Yellow light
Conclusion: Market Risks Remain Despite Recent Rally
Economic fundamentals showed slowing growth in August, as concerns surrounding the recent increase in cases served as a headwind during the month. We saw service sector and consumer confidence decline notably during the month, which is a bad sign for future spending growth. We also saw the pace of hiring slow, with much of the slowdown concentrated in the hard-hit retail and leisure and hospitality sectors. It should be noted that while the pace of economic growth slowed during the month, the reports did show a continued economic recovery, just at a slower pace compared with earlier in the spring and summer.
As we saw in July and August, the pandemic represents a risk for markets, as rising concerns over the Delta variant led to some short-lived equity market volatility in both months. Despite the modest volatility in July and August, markets have largely remained resilient, as seen by the swift recoveries following the bouts of volatility.
Ultimately, the path back to a more normal economic environment is likely going to be long, and we can expect setbacks along the way, as we saw in August. Given the fact that the indicators that we track in this piece remained at a yellow light or better despite the slowdown in the pace of the recovery, we have left the overall market risk level at a yellow light for now. But the recent slowdown could lead to further volatility in the months ahead.