A Helpful Risk Barometer

4/17/2017


Hardly a week goes by without a news story proclaiming that stocks are overheated and due for a sharp correction. Admittedly, stocks aren't cheap. S&P 500 stocks have an average trailing P/E ratio of 23, above their 20-year average of 21. Stocks have been more expensive in just 21% of months over the past two decades.

Stock valuations, however, can remain elevated for years before returning to historical norms. Other ways to gauge the market's temperature include fundamentals, investor sentiment, and the collective behavior of individual stocks. We measure this last factor by looking at the Intermediate Potential Risk Indicator.

The Intermediate Potential Risk Indicator shows the percentage of stocks on the New York Stock Exchange (NYSE) trading above their 200-day moving average. It can be viewed as a popularity index for stocks and a useful contrarian signal for measuring the market's risk level.

Think of the 200-day moving average as a stock's equilibrium price. When a large number of stocks trade above that price, we expect mean reversion to eventually kick in, sending the market down. The opposite occurs when stocks trade below their equilibrium level.

The Intermediate Potential Risk Indicator tends to be most effective when its readings are at extremes. The S&P 500 has historically performed best following periods when less than 20% of stocks traded above their 200-day moving average. Readings above 70% tend to signal that the market is at higher risk.

For all the chatter about an overvalued market, the Intermediate Potential Risk Indicator currently stands at 65% — elevated, but not yet in the high-risk area. A reading above 70% would signal increased risk of a market pullback. A reading above 90% would raise worries about a more immediate correction. With the Dow Theory bullish, we are inclined to view a decline as a correction within the bull market.


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