Risk factor #4: Market complacency. This is a recently added risk factor that aims to capture a standardized measure of market complacency across time. Complacency can be an uncertain term, so this chart identifies and combines two of the common ways to measure complacency: valuations and volatility.
For the valuation component of the index, we are using the forward-looking price-to-earnings ratio for the S&P 500 over the next 12 months. This gives an idea of how much investors are willing to pay for companies based on their anticipated earnings. Typically, when valuations are high, it signals that investors are confident and potentially complacent. For volatility, we have used the monthly average level for the VIX, a stock market volatility index. When volatility for the S&P 500 is high, the VIX rises, which would signal less complacency.
By combining the two metrics in the chart below, we see periods where high valuations and low volatility have caused peaks, such as 2000, 2006–2007, and 2017. We saw market drawdowns within roughly a year following each of these peaks.
Looking at the current chart, market complacency declined modestly in July. The average VIX reading for the month increased from 16.94 in May to 17.60 in June, driven in large part by midmonth market volatility, which was in turn caused by rising concerns about the Delta variant. The forward-looking P/E ratio for the S&P 500 also declined slightly during the month, falling from 21.4 to 21.1. The combination of higher volatility and lower valuations caused the market complacency index to decline from 1.26 in June to 1.20 in July. Despite the decline during the month, the index still sits at its third-highest level since the start of the pandemic.
Readings above 1.2 have historically been a signal that market complacency is at potentially concerning levels, so the fact that the index remained at this important level is worth monitoring. Given the fact that complacency remains near concerning levels, we have left this indicator at a yellow light for now.
Signal: Yellow light
Conclusion: Markets Rally Despite Rising Medical Risks In July
Economic fundamentals showed further improvement in July, as the momentum from recent reopening efforts continued to drive growth despite rising health risks. We saw high levels of consumer and business confidence during the month, which should help support continued spending growth in the months ahead. Given the improving economic fundamentals, we are approaching a potential upgrade for the overall economic and market risk indicators, but increased medical risks in July served as a reminder that very real risks to the recovery remain.
As we saw in July, the pandemic represents a continued risk for markets, as rising concerns over the Delta variant led to some equity market volatility during the month. While the medical risks have still diminished compared with earlier in the year, they still have the potential to negatively affect markets and should be monitored.
Ultimately, the path back to a more normal economic environment is likely going to be long, and we can expect setbacks along the way that could drive further volatility. Given the improvements for many of the factors that we track in this piece compared with earlier in the year and the continued economic recovery during the month, we have left the overall market risk level at a yellow light as we may see further market volatility in the months ahead.
Brad McMillan is the chief investment officer at Commonwealth Financial Network.
Sam Millette, manager of fixed income on Commonwealth's Investment Management Research team, assisted with this article.