Can several discrete and relative-value metrics signal a major drawdown?
The past two years have brought elevated volatility to the markets. Everyone has accepted it: the long-drawn bull market in stocks, which was extended after a short but sharp downturn during the early onset of the pandemic, has reached its end, and those who only started their investing journey in 2010 are likely finding themselves at sea.
“Starting with the crash in early 2020, there have been a lot more major drawdowns or major declines,” said Connor Kitko, Director of Product Marketing at YCharts. “Volatility has definitely returned over the last two-plus years.”
To help advisors and investors address current market challenges, YCharts analysed data on several leading indicators – which includes a mix of discrete-value and relative-value indicators – going back several decades. The question they aimed to answer: is there any measure that can signal the coming of a major market decline?
“None of the indicators we looked at are that true silver bullet,” Kitko says. “Even the Buffett ratio, which is the best indicator that we looked into, accurately predicted just about half of market declines over the past 50 years.”
The Buffett ratio measures the capitalization in the US stock market as a percentage of GDP; a value above 100% suggests the market is overvalued, and is poised for a correction.
Based on YCharts’ analysis, it accurately predicted just 57% of market declines since 2000. Looking further back to 1971, it performed even worse, predicting just about 50% of market declines.
“Since the year 2000, the Buffett ratio has provided about 11 months of warning for a major market decline,” Kitko says.
YCharts also looked at yield spreads, which are traditionally considered an economic indicator. They found that the spread between 10-year and 3-month yields, as well as the 10-year to 2-year yield spread, offered a reasonably consistent leading indicator of market decline, with negative values tending to point toward a market decline down the road.
“They gave about 10 to 12 months of warning, which were some of the best data that we found,” Kitko says. “That seemed like the most reasonable advance warning that the market is looking pretty overvalued right now.”
Notably, both the Buffett ratio and the yield spreads fall within the bucket of discrete-value indicators that YCharts examined. Apart from being more straightforward to interpret, Kitko says discrete indicators tended to be more consistent predictors of declines over the long term.
Aside from looking at the indicators’ ability to foreshadow declines, YCharts went a step further by looking at how correlated they were to broad market returns. On that front, yield spreads showed no correlation, while the Buffett ratio was fairly well-correlated to forward S&P 500 returns over both 3- and 5-year periods.
Another metric, the S&P 500 CAPE-Shiller ratio, stood out as highly correlated with both 3- and 5-year forward returns. That correlation was more pronounced when YCharts restricted the analysis to data going back over a shorter time period – going back to 2000, as opposed to the 1970s.
“We looked at both short-term and long-term averages for those relative indicators,” Kitko says. “We wanted to just look at what's happened since 2000, because our hunch was that the market is a different animal today than it was decades ago. And that did improve the accuracy for nearly all of the indicators.”
Tobin's Q, which measures the total replacement cost of market capitalization, exhibited a very strong negative correlation with S&P 500 forward returns, especially at the most extreme levels. When Tobin's Q was at a very high level, forward-looking market returns were very low, and when Tobin's Q was at a very low level, forward market returns were very high.
“None of these are a great buy or sell signal to be following religiously,” Kitko stressed. “Looking across multiple indicators, and having multiple inputs in your decision making can help improve that accuracy.”
While YCharts has yet to do definitive research to find the best mixture of indicators, he recommends combining yield spreads with the S&P 500 ratio and the Buffett ratio. As he explains, that blend of metrics gives a barometric reading of both economic forces and market dynamics.
“I think that combining those two pieces would be wise,” he says. “If all of these alarms are going off, then it's probably reasonable to expect that future decline is coming.”
The white paper, titled “Which Leading Indicators Best Predict Market Declines?”, can be downloaded for free and in full on the YCharts website.
