Risk factor #1: Valuation levels. When it comes to assessing valuations, we find longer-term metrics—particularly the cyclically adjusted Shiller P/E or price-to-earnings ratio, which looks at average earnings over the past 10 years—to be the most useful in determining overall risk.
Please note: Due to data limitations, the Shiller P/E data is the same data from last month's update.
Valuations continued to rise in July, as the CAPE Shiller ratio rose from 37.05 in June to 37.98 in July. This marks four consecutive months with rising equity market valuations, and it left the Shiller CAPE ratio at its highest level since late 2000.
Even as the Shiller P/E ratio is a good risk indicator, it is a terrible timing indicator. To get a better sense of immediate risk, we can turn to the 10-month change in valuations. Looking at changes, rather than absolute levels, gives a sense of the immediate risk level, as turning points often coincide with changes in market trends.
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. This relationship held last March, as valuations and the index both rolled over before rebounding. On a 10-month basis, valuations rose by 23.1% in July, up from the 18.9% increase that we saw in June. Given the historically high valuation levels, we have kept this indicator as a yellow light for now, despite the fact that valuation changes have remained outside of the danger zone since May 2020.
Risk factor #2: Margin debt. Another indicator of potential trouble is margin debt.
Signal: Yellow light