Signal: Yellow light

Risk factor #3: Technical factors. A good way to track overall market trends is to review the current level versus recent performance. Two metrics I follow are the 200- and 400-day moving averages. I start to pay attention when a market breaks through its 200-day average, and a break through the 400-day often signals further trouble ahead.

Last year’s declines took all three major U.S. indices below the 400-day trend lines, a significant support level. The subsequent recovery has since brought them back above both that level and the 200-day level, which takes the market back into an uptrend. This switch from downtrend to uptrend is a significant change. Although the risk of the trend turning back to negative remains, investor psychology appears to have shifted. The probability that the markets continue to rebound is therefore more solid; given that, I have taken this indicator back to yellow from red.

Signal: Yellow light

Conclusion: Risks Are Materially Reduced, Due To Improving Conditions

Market risks have been at the yellow light level for the past 11 months and recently dropped even further with the addition of some red lights. But market conditions have improved over the past month, with the continuation of the rebound from the decline at the end of last year. Plus, both political and economic risks have moderated. This takes us away from the red zone but still leaves us solidly in the yellow zone of increased risks.

The continued market recovery is encouraging, the overall economic environment remains supportive, and neither of the likely shock factors is necessarily indicating immediate risk. But the continued volatility and the fact that several of the market indicators continue to point to an elevated level of risk suggest that volatility may return.

As such, we are keeping the overall market indicator at a yellow light. This is not a sign that risks have passed. Instead, it is a recognition that despite the recent market turmoil, basic conditions remain supportive and that while risks are real, the most probable course is more appreciation—even though further volatility is quite likely.

Brad McMillan is the chief investment officer at Commonwealth Financial Network.

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