While markets have had a positive start to 2023, the volatility throughout 2022 serves as a reminder that real risks remain, 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
January 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.
• While the economic expansion continued in December, 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 remained inverted in December. The 3-month
yield increased from 4.37% at the end of November to 4.42%
at the end of December. The 10-year yield rose from 3.68%
to 3.88%.
• This now marks three 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 20.80% in December,
following a 22.96% decline in November.
• This now marks 11 consecutive months of 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
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 and Nasdaq Composite both finished below
their respective 200-day moving averages; however, the Dow
Jones Industrial Average finished above trend.
• Given that the S&P 500 finished the year below trend, we’ve
kept this indicator at a red light.
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 modestly in December. The VIX
fell from 23.44 in November to 21.78 in December, while the
forward-looking P/E ratio fell from 17.1 to 16.5.
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.
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
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