Qualifying and Quantifying Current Equity Market Risks

Posted on Posted in Equities, Views From The Hill

Given the fact that the bull market in equities has now extended 9 years since the March-2009 low and that the seasonally ominous month of October is arriving soon, I thought now might be appropriate to quantify (technical) and qualify (fundamental) some of the risks confronting the market. Below is a monthly chart of the SP-500 December-2017 futures contract to provide perspective.


Click to enlarge


Technical Risks

To be clear, the technical condition of the market is extremely bullish and this week marked another significant breakout above resistance. Year-to-date, the SP-500 cash market has advanced @ +11.5% and more than +274% from its March-2009 low. We have yet to experience any significant declines, but trees don’t grow to the sky, especially without pruning. For the sake of risk assessment, let’s consider a hypothetical bearish Fibonacci retracement of the trough to peak market performance for the equity benchmark index (see chart above for reference). Below is a “napkin-math” table analysis quantifying risks at various levels. (Anything beyond 61.8% would have more of a secular vs cyclical overtone, a shift I do not anticipate, and therefore limited pessimism stop there.)


Retracement Price Risk P/E* Earnings Yld* F-PE** F-Earnings Yld**
0% $2496.25 0% 24.89 4.02% 17.66 5.66%
23.6% $2064.25 -17.3% 20.58 4.86% 14.60 6.84%
38.2% $1797 -28% 17.92 5.59% 12.71 7.86%
50% $1581 -36.7% 15.76 6.34% 11.19 8.93%
61.8% $1365 -54.7% 13.61 7.34% 9.66 10.35%


*Based on GAAP Earnings @ $100.29 as reported by Barron’s online

**Based on Forward earnings projections @ $141.33 provided by Yardeni Research


Fundamental Risks

It is often said that bull markets climb walls of worry and this bull has certainly not disappointed as it has demonstrated resiliency on many levels. Some of the current risks overhanging on this market are as follows:


Inflation is always a concern for equity investors as it the harbinger of higher interest rates, which typically precede contraction in the economic cycle. At present, inflation remains below the Fed’s 2% target. Although Chair Yellen and her central banksters are inclined towards higher rates, circumstances dictate caution.  Hiking rates while simultaneously winding down a $4.5 trillion dollar balance sheet as the country absorbs the recent economic shock of Hurricanes Harvey and Irma is asking just a bit too much. In fact, I think most of those bond purchases will be unloaded via maturity vs selling. The Fed has created a bond market bubble and needs to cautiously manage an orderly exit without accelerating rising rates.

Volatility or the lack of such is reflecting an extreme amount of investor complacency. The market is currently at levels comparable to the $VIX’s December-2006 lows, which is right before it exploded to the upside and annihilated the portfolios of many investors, thus making the dot-com bust of the year 2000 era seem like a picnic. If you find yourself or others arguing that this time it’s different, this alone should induce humility and respect for the concept of market cycles in relationship to the economic cycles.

Continued Weakness in the US Dollar Index is becoming a higher probability since peaking January-2017 @ $103.82. After Trump’s election victory, the dollar surged upon hopes of fiscal stimulus via infrastructure, less restrictive regulations, legislative repair of health care, and tax reform. However, the administration’s honeymoon glow is fading towards reality, thus the reshuffling of cabinet advisors and tempering of earlier extremist campaign rhetoric and policy initiatives. Never short of surprises and using the currency of a loyal political constituency who almost regard him as infallible, POTUS #45 is now pursuing bipartisan efforts to salvage his political agenda. Meanwhile, the unresolved debt ceiling crisis could be a tipping point for the Dollar’s violation of the May-2016 low @ 91.92 and convergence towards support @ 88-89. Currency depreciation is not necessarily a bad thing as multinationals would benefit from a surge in profits and be inclined to maintain or expand operations in the US. This all dovetails nicely with Trump’s agenda to create more manufacturing jobs and increase exports, but might not be too economically palatable for Europe, Japan and China, which have endured substantial currency appreciation. Uncertainty of their ensuing response is a risk itself.

Valuation risk, in spite of the market’s extended advance, ranks low among other factors cited in this report. If one truly accepts the premise that stocks are valued upon the future prospect of earnings, then the markets are reasonably valued as indicated by the standards I have applied in the above table for technical risks and their impact upon valuations. Projected forward earnings, without significant downward revisions and tectonic shifting of fundamentals, make it hard to conceive of valuations approaching these levels, given the comparative spread between the earnings yield and 10-year treasury yields.

Last but not least is consideration of Geopolitical issues. Two of the most critical ones are North Korea and NAFTA. North Korea’s nuclear ambitions are tethered to China’s strategic geopolitical interests, part of which lie in a divided Korea along the lines of North and South. Too many strong neighbors blunts its ambitions to project uncontested power in this region. Regarding NAFTA, without question, it is probably one of America’s most important trading relationships as it integrates the economies of the US, Mexico and Canada and accounts for a third of America’s exports. Granted, the agreement itself can be improved upon, but one should not downplay the strategic value it adds to the economy. Elimination of it without a credible alternative substitute would not bode well and be highly disruptive to the markets. For now, neither of these risks seem to be a real cause of concern for the markets, absent tangible confirmation of “worst things happening”.



I’ll be the first to admit that the current lofty “price” valuations of the market keep me awake at night. However, when looked at from the perspective of future earnings and the economic momentum that is driving them, the market seems reasonably valued. Fundamentally, the Fed cannot abruptly or even gradually exit from this bond market bubble without inflicting severe collateral damage upon stocks, while in pursuit of normalization, and it realizes this. The above mentioned fundamental risks, with exception to volatility, confronting the market are real, but presently neutralized. The initiation of a bear market often comes without warning and it is the element of surprise that often inflicts the most carnage. With that said, the best way to manage stock market risks, besides constantly evaluating the underlying facts supporting them, is to monitor the technical condition, which is robustly bullish. Until then, the trend is still your friend.

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