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With this economic and financial crisis so deeply rooted in the health of the financial institutions that channel credit through the economy, a gauge for the health of the financial sector has taken on even greater importance. Given the fragility of the financial system, changes in the stress level in the global banking system became highly correlated with stock market returns. Below is a graph of the S&P 500 (NYSEARCA:SPY) returns relative to an inverted graph of the Saint Louis Federal Reserve Financial Stress Index.

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The Saint Louis Federal Reserve Bank's Financial Stress Index (STLFSI) is created using principal component analysis, a statistical method of extracting the factors that are responsible for the correlation of a set of variables. Financial stress has been determined to be the chief factor influencing the co-movement of its designated market variables, and pulling out this factor allows the Saint Louis Fed to create an interpretable index. The index is constructed using weekly data series for a host of interest rate, credit spread, and volatility measures.

On the interest rate side, the index tracks the effective federal funds rate, and the two, ten, and thirty year Treasury yields. From the credit side, Moody's index of Baa-rated corporate yields, the Merrill Lynch High Yield Corporate Master II Index, and the Merrill Lynch Asset-Backed Master BBB-rated index are tracked. The index also tracks longer-term yield spreads in the form of the 10-yr Treasury less the three-month Treasury, ten-year Baa corporate credit spreads, and high yield credit spreads as represented by the aforementioned Merrill Lynch High Yield Corporate Master Index.

Stress in short-term funding markets is captured through the spread between three month LIBOR and the overnight index swap, the three month Treasury and matched Eurodollar, and three month commercial paper less the three month Treasury. Other indicators include the J.P. Morgan Emerging Markets Bonds Index Plus, the Chicago Board Options Exchange Market Volatility Index (VIX), the one month Merrill Lynch Bond Market Volatility Index (Move Index), the breakeven inflation rate captured between 10-year Treasury yields and matched duration TIPS, and the S&P 500 Financials index.

The magnitude of the correlation that this gauge of financial stress has had with the equity market can be seen in a breakdown of the weekly returns. Since 2007, in weeks when the STLFSI has directionally indicated more stress in financial markets, the index has returned on average -0.97% for the week, an annualized return of -39.9%. When stress was alleviated from the market week over week, the S&P 500 rose by 0.84% on average, an annualized return of 54.6%. Understanding the directional movements in financial stress has been critical to generating returns in this market environment.

Unfortunately, the directionality of the index does not have any predictive power for the next week. The returns over the next week are not statistically different based on whether the index was indicating more or less stress in the trailing week. Diving into an analysis of the STLFSI, I hypothesized that this index would offer some predictive value because financial stress has a "memory." Stress in credit and funding markets do not rise and fall over short intervals, but move in longer cycles. The tremendous difference between equity returns in weeks of more stress versus weeks of less stress signals that the stock market is quickly responding to changes in the level of financial stress in the market and adjusting prices accordingly.

If changes in the STLFSI are being quickly reflected in stock prices, then perhaps the overall level of the index, rather than its directionality, can offer a guide to market returns. The table below shows the average weekly returns and variability of weekly returns of the S&P 500 at various levels of the STLFSI index from the beginning of 2007 to current. When the index was at its most stressful readings, average returns were both the worst and most variable.

Readers should not interpret the data and deduce that a financial stress index of between 1 and 3 is the sweet spot for equity market returns. Because the increase in financial stress in the back half of 2008 was more rapid than the alleviation of stress in the first half of 2009, there are more weekly data points in the rising markets of the second quarter of 2009 than the plummeting markets of the fourth quarter of 2008. Sorting the financial stress index readings in ascending order, returns are actually negative on average for weeks where the financial stress index traded above 0.86.

After rising in the back half of 2011 amidst uncertainty regarding the Greek bailout and potential implications for Eurozone banks, financial market stress is again receding. The average index reading since it was first produced at the end of 1993 is zero, meaning financial stress is still slightly elevated versus its long-run mean, but greatly reduced from its financial crisis peaks. With the current market environment still heavily focused on financial sector stress both domestically and abroad, this gauge will continue to have important meaning for equity market investors. Better financial stress readings prospectively are likely to result in both positive and less variable weekly returns over coming periods. Understanding what the level of the index means for risk-adjusted returns can help investors allocate funds appropriately.

Source: Financial Stress Indicator: A Guide To Market Returns