November's performance was encouraging, but concerns about an economic slowdown may spook investors in the months ahead, says Commonwealth CIO Brad McMillan in his latest Market Risk Update. For more market updates, subscribe to The Independent Market Observer at https://blog.commonwealth.com/independent-market-observer.

1. The Independent Market Observer
Monthly Market Risk Update
December 2022

2. Recession Risk
• Recessions are strongly associated with market drawdowns;
8 of 10 bear markets have occurred during recessions.
• According to the National Bureau of Economic Research, the
last recession began in February 2020, at the start of the
pandemic, and ended soon thereafter.
• While the economic expansion continued in November, the
path of recovery is uncertain. The primary risks are a deeper
slowdown in growth and tighter monetary policy from the
Fed. As a result, our recession risk outlook remains cautionary.
Source: Institute for Supply Management, Haver Analytics
Risk
Level

3. Economic Shock Risk
• A major systemic risk factor is the price of money, otherwise known
as interest rates.
• Interest rates drive the economy and financial markets; historically,
they’ve also played a key role in market downturns.
• So, let’s take a closer look at the yield curve.
Source: Institute for Supply Management, Haver Analytics

4. Spread Between 10-Year U.S. Treasury and 3-Month U.S. Treasury
Yield Curve
(10-Year Minus
3-Month
Treasury Rates)
Source: Haver Analytics
Risk
Level

5. Yield Curve (10-Year Minus 3-Month Treasury Rates)
continued
• The yield curve continued to invert in November. The 3-month
yield increased from 4.22% at the end of October to 4.37% at the
end of November. The 10-year yield fell from 4.10% to 3.68%.
• This marks two consecutive months with an inverted 3-month
10-year yield curve. This doesn’t guarantee that the economy will
enter a recession, but this widely monitored signal could indicate
further slowdowns.
Risk
Level

6. Market Risk
• Beyond the economy, we can also learn quite a bit by examining the
market itself. For our purposes, two things are important:
1. To recognize which factors signal high risk
2. To try to determine when those factors signal that the risk
has become an immediate concern
• Here, we’ll review valuations, margin debt, technical factors, and
market complacency.

7. Source: Standard & Poor’s, Robert Shiller, Haver Analytics
Please Note: Due to data limitations, the valuation charts are the same as last month’s update.
Stock Price Index: Standard & Poor’s 500 Composite
EOP, 1941-43=10
Valuations:
10-Month
Change in
Shiller P/E
Shiller Cyclically Adjusted S&P Price-to-Earnings Ratio
10-Month % Change
Risk
Level

8. Valuations: 10-Month Change in Shiller P/E
continued
• Looking at the 10-month change in the Shiller cyclically adjusted
price-to-earnings ratio is a good gauge of immediate risk.
• When the change drops below zero over a 10-month or
200-day period, the market typically drops shortly thereafter.
• On a 10-month basis, valuations declined 25.77% to start
November, following a 29.11% decline in October.
• This now marks 10 consecutive months with declining 10-month
valuations.
Risk
Level

9. Source: Standard & Poor’s, Haver Analytics
Stock Price Index: Standard & Poor’s 500 Composite
EOP, 1941-43=10
Margin Debt
as % of
NYSE Market
Capitalization
FINRA Margin Debt as % of NYSE Market Capitalization
% Change Year-to-Year
Risk
Level

10. Margin Debt as % of NYSE Market Capitalization
continued
• Spikes in debt levels typically precede a market drawdown.
• Margin debt as a percentage of market capitalization declined
20.79% on a year-over-year basis in October, following a
12.08% drop in September.
• This now marks 11 consecutive months with declining
year-over-year margin debt.
• Although margin debt as a percentage of market
capitalization declined, the absolute level of margin debt is
worth monitoring.
Risk
Level

11. Source: Standard & Poor’s, Haver Analytics
Stock Price Index: Standard & Poor’s 500 Composite
EOP, 1941-43=10
Technical
Factors:
200-Day and
400-Day
Moving
Averages
S&P 10-Month (200-Day) Moving Average
S&P 20-Month (400-Day) Moving Average
Risk
Level

12. Technical Factors: 200-Day and 400-Day
Moving Averages continued
• We start to pay attention when a market breaks through its
200-day average; a breakthrough of the 400-day average
often signals further trouble ahead.
• The Nasdaq Composite finished below its respective 200-day
moving average; however, the S&P 500 and the Dow Jones
Industrial Average both finished above trend.
• This is the first month that the S&P 500 has finished above
trend since March 2022, so it’s too early to say if technical
support is here to stay.
Risk
Level

13. S&P 500 Forward P/E Divided by VIX
Market
Complacency:
S&P 500
Forward P/E
Divided by
VIX
Source: Haver Analytics, FactSet
Risk
Level

14. Market Complacency: S&P 500 Forward P/E
Divided by VIX continued
• Often, high valuations (forward P/E) signal investors are confident
and potentially complacent. When volatility (VIX) is high, there is
less complacency.
• Periods of high valuations and low volatility cause peaks in the
index (e.g., 2000, 2006–2007, and 2017); market drawdowns
occurred roughly one year after those peaks.
• Market complacency increased in November. The VIX fell from
30.01 in October to 23.44 in November, while the forward-looking
P/E ratio remained unchanged at 17.1 for the month.
Source: Institute for Supply Management, Haver Analytics
Risk
Level

15. Conclusion: Monitor the Market Risks
• Despite the positive performance in November, inflation and
interest rates remain immediate risk factors. Rising concerns
about an economic slowdown due to tighter monetary policy
may also spook investors in the months ahead.
• We may see risks start to diminish and markets continue to
rebound toward the end of the year, but we could see further
losses in the markets before we get back to new highs.
• Ultimately, the path back to normal will likely be long, with some
setbacks along the way.
Source: Institute for Supply Management, Haver Analytics
Risk
Level

16. Certain sections of this commentary contain forward-
looking statements that are based on our reasonable
expectations, estimates, projections, and assumptions.
Forward-looking statements are not guarantees of future
performance and involve certain risks and uncertainties,
which are difficult to predict. Past performance is not
indicative of future results.
Diversification does not assure a profit or protect against
loss in declining markets. All indices are unmanaged, and
investors cannot invest directly in an index.
The information contained herein is provided for
informational purposes only and is based upon sources
believed to be reliable. No guarantee is made as to the
completeness or accuracy of the information.
Disclosure