The Independent Market Observer's monthly update reported continued recession and market risks in February 2023. Several key economic indicators signaled a potential recession, including an inverted yield curve for the past four months. Market valuations and margin debt also declined for a full year, suggesting drawdowns may be imminent. While markets started 2023 positively, inflation and interest rates pose ongoing risks to the economic expansion and corporate earnings could face further pressure. Overall, the path back to normal economic and market conditions is likely to see setbacks along the way.

1. The Independent Market Observer
Monthly Market Risk Update
February 2023

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.
• The economic expansion continued in January, with the
better-than-expected employment report serving as a
highlight. The primary risks are a deeper slowdown in growth
and tighter monetary policy from the Fed.
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 inversion deepened in January. The 3-month
yield increased from 4.42% at the end of December to 4.70%
at the end of January. The 10-year yield fell from 3.88%
to 3.52%.
• This now marks four 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
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 15.12% in January,
following a 19.35% decline in December.
• This now marks 12 consecutive months of declining
10-month valuations.
Risk
Level

9. Source: Standard & Poor’s, Haver Analytics
Note: Due to data limitations, this is the same chart as last month’s update.
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
26.86% on a year-over-year basis in November, following a
20.79% drop in October.
• This now marks 12 consecutive months of declining
year-over-year margin debt and two consecutive months
of declining debt.
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 S&P 500, Dow Jones Industrial Average (DJIA), and
Nasdaq Composite all finished above their respective 200-day
moving averages in January.
• This is the first month that all three indices experienced
technical support since December 2021.
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 January. The VIX fell from 21.78
in December to 20.20 in January, while the forward-looking P/E
ratio rose from 16.5 to 18.
Source: Institute for Supply Management, Haver Analytics
Risk
Level

15. Conclusion: Market Risks Remain
• While markets have had a positive start to 2023, the volatility
throughout 2022 serves as a reminder that real risks remain.
Inflation and interest rates serve as immediate risk factors, and
we may see further declines driven by these factors.
• We may see risks start to diminish and markets continue to
rebound in the months ahead, 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
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