Just 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

Two things jump out from this chart. First, after a pullback at the start of 2016, valuations have again risen above levels of 2007–2008 and 2015, where previous drawdowns started. Second, even at the bottom of the recent pullback, valuations were still at levels above any point since the crisis and well above levels before the late 1990s.

Although now at their highest level since 2000, valuations remain below the 2000 peak, so you might argue that this metric is not suggesting immediate risk. Of course, that assumes we might head back to 2000 bubble conditions—not exactly reassuring.  Risk levels remain high, although not immediate.

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. Although we were getting close to a worry point, the recent post-election rally has moved us well out of the trouble zone and into positive territory. Although the risks may not be immediate, this metric will bear watching.

Risk factor #3: Margin debt

Another indicator of potential trouble is margin debt.

Market Risk

After climbing for a while, margin debt as a percentage of market capitalization has dropped back in the past couple of months to a level typical of the past two years. This suggests a return to a recent normal, lowering the immediate risk. It’s worth noting, though, that the average level of the past couple of years is still well above that of 2007–2008. Although the immediate risk looks low, overall risks remain high by historical standards. This metric bears watching, particularly in the medium term.

Risk factor #4: Changes in margin debt

Consistent with this, if we look at the change in margin debt over time, spikes in debt levels typically precede a drawdown.

Market Risk

As with the previous metric, the absolute risk level remains high, but the immediate risk has recently dropped, as the change in debt indicator is flat on the year. Overall, this metric suggests that immediate risk has actually declined.

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.

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Market Risk

On an absolute basis, the Buffett indicator has been encouraging; although it remains high, it had pulled back to less extreme levels. In recent months, however, with the post-election rally, the indicator has started to move back toward the danger zone. Although we remain some distance from trouble, the recent uptick suggests risks are rising, so this metric will bear watching.

Technical metrics are also reasonably encouraging, with all three major U.S. indices well above their 200-day trend lines and close to new highs. With improving sentiment across the board (consumers, business, and investors) and rising earnings, it’s quite possible that the advance will continue. Given favorable conditions—particularly with the Dow’s recent break above 20,000—a mix of improving fundamentals and positive sentiment could continue to propel the market higher, despite the high valuation risk level.

On balance, all of the metrics are in what has historically been a high-risk zone, so we should be paying attention. But, as I’ve said many a time, there’s a big difference between high risk and immediate risk—and it is one that’s crucial to investing. As it stands, none of the indicators suggests an immediate problem, although several suggest risk may be rising.

Article by Brad McMillan - Commonwealth Financial Network