There are many market risk factors to monitor. For this post I want to introduce key risk factors that I find to be relevant and add valuable context. This regular update aims to do both.
Valuation (P/E Ratio)
The cyclically adjusted Shiller P/E ratio, which looks at average earnings over the past 10 years, is useful in determining overall value for US Equities. When the ratio is low stocks are on sale and when the ratio is high stocks are expensive. Below we can see the dotcom bubble in 2000 when stocks were sky high and the recession of 2008 when stocks fell significantly.
Valuation (The Buffet Indicator)
Warren Buffet looks at corporate equities to GDP ratio to determine valuation levels. Though we are some distance from trouble, the recent uptick suggests stocks are getting a bit pricey.
Credit is the fuel to the modern economy and is at the center of every bull market and cause of every recession. People and businesses borrow money to buy more goods, services and financial assets that they otherwise could not afford which in turn fuels rising incomes and prices. Similarly, when people and business accumulate too much debt, credit contracts, and the economy starts a downward cycle. Here we can see the credit contraction during the 2008 recession and the massive credit expansion that is fueling the current bull market.
The current VIX index value quotes the expected annualized change in the S&P 500 index over the next 30 days. The VIX is quoted as an annualized standard deviation. For example, if the VIX is 11, this represents an expected annualized change, with a 68% probability, of less than ~11% up or down or an expected monthly change of ~3.4%. The VIX has hit records lows the past few weeks which tells us traders don’t see any material changes in prices, good or bad, in the next 30 days.
Similar to the VIX, the SKEW Index is derived from the price of S&P 500. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. Simply put, as SKEW rises, traders are protecting themselves against an unexpected large down move in the S&P 500.
While these trends will not necessarily help us understand what will happen in the future, they do shed some light on where we are now.
Have a great week!
The Risk Runner