Measuring Risk In The Economy And Markets

Includes: DIA, IWM, QQQ, SPY
by: Charles Bolin


Numerous indicators are shown to measure risk in the economy and markets.

Risk Indicators give insight into the slowing economy. The largest risks are high debt levels, high market valuations, slowing economy, global economy and shrinking profits.

The New York Federal Reserve Nowcast is for 1.2% growth in GDP in the 2nd quarter. And we are cheering? Some days are chicken and some days are feathers!


I was once asked, "How can you measure risk?" That was before the financial crisis. I have spent a lot of time including various types of risk measurements into my investment model. Most of my focus has been on the business cycle.


In 2015, banks began tightening lending standards, borrowers became more delinquent paying back loans and financial stress while still low, began to increase.

My Banking Indicator is a weighted average of some of these and other indicators.

Financial stress indicators from the Federal Reserve are extremely valuable for compositing various financial risks. They measure foreign exchange rates, real estate, interest rates, yield spreads, volatility indexes, liquidity, yield curve, market indexes, and inflation.

In addition to the Financial Stress indexes, I use the Chicago Fed Adjusted National Financial Conditions Index and Chicago Board Options Exchange Volatility Index (VIX) to come up with my own Risk Indicator. Near 100% are the best investment periods, negative indicators are the risky times to be long in the stock market. When the Risk Indicator is declining toward zero, are times to be looking for opportunities to rebalance to safety.

While the Yield Curve has not inverted, it has been flattening for the past two years as shown below. Short term interest rates are rising and long term rates are falling. It is normalizing of interest rates. This is typically a sign of lower expected growth rates from bond investors.

I also estimate an Interest Indicator as shown below based on bond total return, corporate bond spread, yield curve, TED spread and high yield rates.


Access to money for investment is a large factor in growth of the economy. The next chart shows the high growth rate of credit over the past half century and the lower rate after the financial crisis. This will likely contribute to slower growth.

Financial (TCMDODFS), Domestic (TCMDODNS), and Rest of World (WCMITCMFODNS) credit market Instruments are used to estimate growth rates in total credit (currently $62T) in the US. In "Federal Reserve Indicators To Evaluate The Investment Environment", I show that credit to GDP has nearly tripled over the past half century which I believe to be a bubble. The following indicator also combines Revolving Consumer Credit (FLREVOLSLA) and total consumer credit (TOTALSL) to create my Credit Indicator.


In the media, there are so many estimates of recession probabilities. The Philadelphia Fed's survey of 42 economists puts the probability of recession at 12.5% in the second quarter of 2016 and 18.5% in the second quarter of 2017. "WSJ Survey: Recession Odds Remain Elevated Despite Calmer Financial Markets" describes a Wall Street Journal survey of 70 economists with an average estimated probability of 20% for a recession to start in the next 12 months. Below is the smoothed recession probability (RECPROUSM156N, Feb 2016) and the GDP-based recession indicator (JHGDPBRINDX, 2015 Q4).

Below is my Diffusion Index of 18 indicators (leading, interest, coincident, labor, banking, housing, etc) highly correlated to the two recession indicators above. Recession indicators often attempt to match the "official" dates determined by the National Bureau of Economic Research. I want my Diffusion Index to give more warning that the economy is softening instead of picking a date when a recession starts. There are 8 out of 18 indicators (44%) that are now negative. The economy is "soft".


The St. Louis Fed Price Pressures are a good measure of the risk of inflation and deflation. We are currently in a low inflation environment. Notice that in the past 20 years there have only been two periods where there was much of a probability of deflation.


This Leverage Indicator measures equities of Non-financial corporate business (NCBEILQ027S) compared to Net Worth (TNWMVBSNNCB) to determine periods of probable excessive leverage in the stock markets. The next chart shows the margin debt and free cash in margin accounts from the New York Stock Exchange, as described by Doug Short and used by Lance Roberts. These indicators suggest a more risk off investing environment and deleveraging.


Turning valuation metrics into an investment indicator was difficult because of the high valuation during the Technology Bubble and because of the duration that the markets can be highly valued before falling. The next chart shows how the Wilshire large cap index performed in the year following the peak valuation for the Technology Bubble, Financial Crisis and the current market. There is a risk that the stock market will fall more than 10% in 2016 if the economy fails to improve.

The three highest weighted sub-indexes in my Valuation Indicator are Tobin Q, Cyclically Adjusted Price to Earnings Ratio (NYSEARCA:CAPE) and trailing Price to Earnings Ratio. Also used is the Market Capitalization to Gross Domestic Product. Finally, I shift the allocation index forward 5 months to compensate for the long lead time.


An economy that is not growing has inherent risks. I combine the Philadelphia Fed (USSLIND), Conference Board, and Organisation for Economic Co-operation and Development (OECD) leading indicators into my US Leading Indicator. It shows a slowing economy.


The following indicator is based on a weighted average of Organisation for Economic Co-operation and Development (OECD) leading indicators for China, Japan, Euro Zone and United States. It reflects anticipated global slow growth. It is probably one of the higher risks to the current investment environment, particularly China.


I created the Market Turning Points Indicator based on over 20 indicators to help identify tops and bottoms in the markets/economy. It is more of short term indicator based on percent of positive or negative indicators, technical indicators and rates of change.

From a longer term perspective, the current market (red) as measured by the Wilshire 5000 appears to be returning to the trajectory that follows the bursting of the Technology Bubble and the Financial Crisis as shown below.

From a Technical (momentum) perspective, the market appears to be at risk (red) of continuing to decline.


Most measures of corporate health are worsening such as profits, sales, income, cash flow and inventory to sales ratios. There is often a lag before stock prices reflect profits.


Stocks of small companies tend to fall before large cap companies at the end of business cycles as shown in the chart below.

My Business Indicator is based on the Wilshire Micro Cap Index and the percentage of banks tightening lending standards for small companies.


Below is a chart that I consolidated from " The Era Of Uncertainty" by Francois Trahan and Katherine Krantz (2011) suggesting where to invest based on inflation and growth. I put us in the boxes of low to neutral inflation and low growth. I am mostly invested in bonds, cash and gold. It is great book and worth reading.


This article has not covered risks such as federal and trade deficits, war, China and black swans even though they increase risk to the economy and markets. There is plenty for bears to worry about.

Some indicators are improving and some continue to show weakness. The trends of the indicators below show that we are in a weak (red) economy as we are before every recession.

"Economists say recession threat looms for next president, whether it's Trump, Clinton or someone else" describes a growing number of economists that believe the chances of a recession are high for the incoming President. I tend to agree based on the Risk Indicators described above.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not an investment advisor. Investors should do their own research or consult an investment professional.