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.
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. In fact, valuations are now at the highest levels ever, with two exceptions: 1929 and 1999.
- 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. The markets are very expensive, and they have been for some time.
Since valuations remain below the 2000 peak, you might argue that this metric is not suggesting immediate risk and that we might get further appreciation. At the moment, I would agree. Of course, that assumes we could head back to 2000 bubble conditions, which isn’t exactly reassuring. Risk levels remain high, but the risk is 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.
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, with the recent market rally after the election, we have moved out of the trouble zone and into positive territory. Still, this metric will bear watching.
Risk factor #3: Margin debt
Another indicator of potential trouble is margin debt.
After climbing for several months, margin debt as a percentage of market capitalization dropped back, but it has since spiked again to a level typical of the past couple of years. This is likely a return to a recent normal, lowering immediate risk. It’s worth noting, however, that the average level of the past couple of years is still well above that of 2007–2008. So although immediate risk looks low, overall risk remains high by historical standards. This metric bears watching, but more over 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.
As with the previous metric, the absolute risk level remains high, but the immediate risk level has recently turned down, 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.
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, this indicator has started to move back toward the danger zone. Though we’re 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, a mix of improving fundamentals and positive sentiment could 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 signals an immediate problem, although several suggest risk may be rising.
Article by Brad McMillan, Commonwealth Financial Network