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Financial stress is a primary driver of market results, and has been critically important in the wake of the GFC and the ongoing eurozone crisis. This article covers two widely available financial stress indices. It attempts to quantify the relationship of stress, market level and returns, and goes on to speculate about future market trajectory based on the information developed.

St. Louis Financial Stress Index

The STLFSI is maintained by the St. Louis Fed, and updates are available at no cost by subscribing to an e-mail service. The methodology (pdf) considers 18 variables that are affected by financial stress, and combines them in an index that is scaled to a standard deviation of 1. A reading of 0.0 is average; a reading of 2.0 or above is indicative of severe stress. Here's a chart:

(Click charts to enlarge)

Kansas City Financial Stress Index

A similar index is maintained by the Kansas City Fed. Like its cousin, updates are available by email subscription. The KCFSI uses 11 variables, and goes back to 2/1/1990, while the STLFSI goes back to 12/31/1993. The KCFSI is published once a month, and was most recently updated for February on 3/8/2102. The STLFSI is updated as the constituents become available, most recently on 3/8/2012, when a reading of 0.300 was recorded.

Relationship to Market Level

For the purposes of this article, market level is developed by constructing a ratio of the S&P 500 (SPY) to GDP, using data from 12/30/1983 to the present. Applying the Excel Standardize function, the data are presented on the same scale as the STLFSI, in units of 1 standard deviation.

The relationship is fairly symmetrical: the higher the stress, the lower the market. Three observations:

  • stress levels under 0.0 are associated with markets levels above 0.0, to better than 3 in the period of irrational exuberance
  • the market reaction to the two most recent episodes of stress is relatively symmetrical
  • The STLFSI has been trending downward recently, and is now approaching the 0.0 level

Both the Fed and the ECB are doing everything in their power to reduce financial stress. If these efforts continue successful, it may enable a move higher. A market level 1, comparable to what prevailed just before the GFC, would translate to 1,550 on the S&P.

A caveat: standardizing the level of the S&P 500 involved the selection of time periods to determine the mean and standard deviation. The mean looks back to 1984; the standard deviation looks back 10 years on a rolling basis. Perceptions of how high is up, or how far is down, change over time.

Relationship to Equity Returns

The question is, what returns can an investor realistically expect over the next year investing in a basket of U.S. equities? The following chart presents one way of looking for an answer:

Looking at one year forward returns, and grouping by stress level, a number of observations apply:

  • Investors who had the courage to commit capital with stress in the 2-6 area were amply rewarded
  • With stress at the 0.0 to -1.0 level, one year returns have been approximately 12%, and profitable 85% to 88% of the time

A Scatter Chart

Clearly financial stress is not the only driver. However, the simple linear regression does provide a way of considering whether the current market level is consistent with observed financial stress. The 3/9/2012 data point is highlighted in red. A number of data points are labeled with dates, to get a feel for the use of the regression as a method of entering or exiting the market during crises.

The 3/9/2012 reading would equate to 1,500 on the S&P, applying the linear regression equation.

Investment Implications

Investors who wish to track financial stress in an objective manner can subscribe to the update service for KCFSI and/or STLFSI. Monitoring the stress level, if it goes under 0.0 for any substantial period of time, it is possible that the market will move markedly higher.

At the end of February, and earlier this month, I raised cash in my portfolio up to 33%, under the belief that there was no compelling reason to be in equities at the current market level. As a practical matter, my methods call for holding 30% cash, and it was a welcome opportunity to get back to a more balanced position.

However, after further thought it looks like the market has room to go higher. With that in mind, I'm investing in ways that will be profitable if the S&P reaches 1,500, either this year or next.

I plan to hold my current positions and monitor the stress level, as well as economic conditions. The Philadelphia Fed maintains the ADS (Arouba-Diebold-Scotti Business Conditions Index), which is constructed along similar lines to the STLFSI, but looks at economic indicators. A similar analysis of that index provides additional support for the view that further market gains are within the realm of possibility.

Disclosure: I am long U.S. equities.

Source: Financial Stress As It Affects Market Level And Returns