The Buffett Indicator, Valuation Levels, Margin Debt, And More

By Brad McMillan - Commonwealth Financial Network

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.

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