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Investing Indicators: Jan '19

Jan. 08, 2019 7:43 PM ETSPY
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Risk Tolerance Indicator

A more detailed description of this indicator can be found here.

As of Jan 5, the Risk-Tolerance indicator has plunged further to -0.141 from 0.254 last week and 0.604 two weeks ago, indicating substantial amounts of fear in the markets, even while economic indicators remain positive.

If we look at a daily chart, we can see the indicator hovering around zero after a steep fall, so while the market remains fearful, there are indications fear is beginning to moderate. If economic conditions were weaker, one might think we are heading into the next recession, but that doesn't seem to be the case (at least so far). There is nothing magical about the zero-point, it's just another number, and there have been other times the indicator has dropped below zero without a subsequent recession.

The indicator ranges between +1..-1, and is based on the volatility spread between traditionally conservative and risky equities. Positive values indicate that investors are exhibiting a tolerance for risk, while negative values indicate risk averseness in the market. The indicator has historically given visibility into changes in market behavior at market peaks, but it is less useful at identifying market bottoms.

The full 19-year chart is below.

S&P Valuation Channel

A more detailed explanation of the S&P Valuation Channel Indicator with a complete 45-year history can be found here.

The valuation channel indicates whether the index is overpriced or underpriced with respect to (delayed) measurements of financial capital flowing into the economy. The valuation channel for the past 27 years is shown below.

As of Jan 5, the indicator remains toward the higher end of the fairly-priced range.

Because the valuation indicator is based on delayed measurements, future values for the valuation channel can be calculated from existing data by estimating the dividend yield of the S&P 500 (approx 2.1%).

Looking forward 2 years, the valuation channel is basically flat, implying that further growth from current price levels is not supported by capital flows. If the S&P continues to grow as it has recently, it would not be unreasonable to expect a bear-market sometime in the next couple years.

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