Stock Market Risk

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Previously, we identified which economic indicators predict stock market performance. By tracking these indicators, you can get a sense of when stocks are relatively cheap or expensive. Over the long term, you should be able to achieve excess returns by following a disciplined approach to asset allocation. But that’s only one side of the story. Stock market growth tends to happen slowly over an extended period of time, while negative shocks tend to happen quickly. It’s not uncommon for a year’s worth of gains to be erased in a week. So what can be done? In this article, we look at which indicators may be able to give advance warning of negative returns.

Correlation Coefficients

We looked at correlations between several common risk indicators and subsequent stock market declines. The table below summarizes the correlation coefficients and the following plots show the historical data versus bear markets.

Stock-Bond Yield Spread

As we defined in previous analysis, the Stock-Bond Yield Spread is the difference between the effective yield of stocks (inverse of the PE Ratio plus divided yield) and the yield of corporate bonds. There seems to be a local trough just before the bear markets in 2001 and 2008.

Financial Stress Index

The St. Louis Fed’s Financial Stress Index shows a huge spike during the 2008 financial meltdown, but otherwise does not appear to provide much predictive value for bear markets. There is a relatively sharp increase after a period of low levels in the year prior to the 2008 bear market, but there was not similar behavior prior to the 2001 bear market.

VIX

The VIX is a very fast moving indicator. It appears to show some correlation to short term declines, as indicated in the by the correlation coefficient of 10%, but the historical data plot does not seem to show any characteristic behavior prior to bear markets. There is an increase in the index to above 20 prior to the 2008 bear market, but there is no similar behavior prior to 2001. In fact, prior to 2001, the VIX had remained above 20 for several years during the late 90s bull market.

Leading Indices

Leading economic indices are published by both the Federal Reserve and the Organisation for Economic Co-operation and Development. They tend to behave similarly, but have shown some divergence during the late 1990s and mid-to-late 2000s. Prior to the 2001 and 2008 bear markets, both indices exhibited drops. However, prior to the bear markets of the 80s, leading indices actually rose.

Conclusion

None of these indicators show foolproof prediction of market downturns. However, there does exist small but significant correlation between this data and periods of negative stock market performance. Taken together, they can be monitored as indicators of stock market risk and used to inform intelligent asset allocation decisions.