Mr. Market’s Wary Outlook: Less Severe But Still Worrisome

Mr. Market’s cautious outlook of late is less acute at the moment relative to recent history, but it’s not obvious that all’s well. True, the US Stock Market Crash Risk Index is less threatening and a markets-based estimate of US business cycle risk has pulled back after briefly spiking higher in late-August and early September. Does that mean that it’s safe to go swimming in risky waters again? Maybe, but only for investors who: 1) can tolerate a fairly high degree of loss if they’re wrong and 2) are comfortable with a high-risk strategy of attempting to be early. For everyone else—particularly for “conservative” investors—the outlook is still sufficiently hazardous to remain cautious until a more convincing round of risk-on signals emerge.

On the plus side: a markets-based estimate of US recession risk has eased recently. After spiking to more than 20% in August for estimating recession-risk probability for the US, this probit model-based estimate of macro trouble has pulled back to around 5% as of yesterday (Oct. 12). Even at the height of the August surge, this measure of economic risk never moved beyond the tipping point of roughly 50%. The message: risk is elevated, but it’s not yet obvious that a recession is fate. No wonder, then, that the economic numbers proper align with that view, based on last month’s profile of the macro trend.

Meanwhile, the US Stock Market Crash Risk Index is less threatening at the moment. Of the US Stock Market Crash Risk Index that comprise this benchmark, only one is flashing a warning—the Hidden Markov model (HMM) that’s telling us that US equity trend (S&P 500) is in a bear market—a regime shift that started on Aug. 26 and remains in effect, according to this indicator.

Here’s a closer look at the Crash Risk data. Note that the S&P drawdown has eased lately (black line in chart below), which offers a degree of comfort for thinking that the market’s correction isn’t moving into the land of no return, at least based on numbers through yesterday (Oct. 13).