S&P 500has plenty of bullish momentum heading into the end of the year, and the latest jobs report from the Labor Department highlighted just how strongly the economy is rebounding now that COVID-19 vaccinations are widespread.
Yet economic recessions always catch investors off guard, so Brad McMillan, Chief Investment Officer for Commonwealth Financial Network, regularly monitors a handful of recession risk factors to gauge U.S. economic risk.
Yield Curve & Valuation
The first risk factor McMillan is watching is the yield curve between 10-year Treasuries and three-month Treasuries. That yield curve steepened in October for the third consecutive month and has headed back toward historical norms, but McMillan said rising yields can also pose a threat to equity valuations.
The second risk factor is market valuations. The S&P 500’s cyclically adjusted Shiller P/E or price-to-earnings ratio has trended higher for four consecutive months and is at its highest level since the dot-com bubble in 2000. McMillan said investors should understand the Shiller CAPE ratio is an excellent market risk indicator, but has historically been a terrible timing indicator.
Debt, Complacency & Technicals
The next risk factor McMillan is watching is margin debt. Margin debt as a percentage of market capitalization spiked during the pandemic in 2020 before pulling back in early 2021. However, margin debt has once again been on the rise in recent months and is trending back toward its 2020 peak level.
The fourth risk factor McMillan is monitoring is technical factors, or market momentum. Given the S&P 500 is trading above bth its 200-day simple moving average and its 400-day SMA, McMillan said the market momentum is clearly to the upside.
The final risk McMillan is watching is market complacency. McMillan measures complacency by looking at the S&P 500’s forward PE ratio divided by the VIX. In October, that ratio was about 1.2, and McMillan said readings of above 1.2 have historically been a signal of potentially concerning market complacency.
How To Play It
Overall, McMillan said he rates the current economic risk level at a “yellow light,” suggesting investors should proceed with caution.
“Although the most likely path forward is continued recovery, the decrease in economic activity in September signals that the economic risk is still material despite October’s improvement,” he said.
Benzinga’s Take
S&P 500 valuations seem to be stretched at this point, especially if the Federal Reserve begins to raise interest rates in mid-2022 or sooner. However, timing market tops can be extremely difficult, and investors during the dot-com bubble in 2000 know just how much of the upside traders can miss if they dump stocks too early simply based on their valuations.
By Wayne Duggan
© 2021 The Epoch Times. The Epoch Times does not provide investment advice. All rights reserved.
