>

The folks at the St. Louis Fed – about whom I can’t say enough good things — produce a proprietary Financial Stress Index, a full explanation of which can be found here [PDF].

A full deconstruction of the Index is, frankly, a bit above my pay grade.  What’s not, though, is exploring the correlation of the Index to the S&P500 and discovering that while it’s generally well-correlated, that correlation has increased dramatically since the recession began at the end of 2007, as can easily be seen in the chart above.  (I’ve inverted the S&P500 to better display the correlation.)

The question I need to explore, of course, is whether — or how — this information might be useful in the context of equity exposure.

Note that the Index can dip below zero, and that it is still well off its lows.  Should “financial stress” continue to ease — the Index is updated weekly — it would suggest to me more S&P upside.  The biggest caveat, of course, is that all correlations work — until they don’t.

>

BR: I would add that peaks in economic activity precede recessions — they start with economic stress rather low. So if we extrapolate from the (very limited data) above, we still have 12-24 months before the real heavy stuff starts coming down.

That said, 2 is not a statistically significant sample

Category: Data Analysis, Economy, Investing, Markets, Research

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

11 Responses to “A Correlation Worth Noting?”

  1. Ted Kavadas says:

    I’ve been following the STLFSI for about a year. While my thoughts on its overall value and predictive ability are complex and lengthy, I will say that I think it is worth monitoring.

    The STLFSI is updated weekly; however, the values lag by almost a week. For example, the last update was on February 9, incorporating values from February 3.

    Invictus: Agreed that the lag is a bit problematic. That said, I also (obviously) agree that this metric is worth watching.

  2. wally says:

    The chart is probably an example of traders learning the latest meme and trading in accordance with it. In other words, the herd slowly begins to move in the same direction… until the next big idea develops.

  3. Centurion 9.41 says:

    “That said, 2 is not a statistically significant sample”

    True.

    But how many times do economic or financial theorists and prognosticators ever have statistically significant samples?

    How often are they ever able to control the variables in a way that allows for any scientific method to produce reliable conclusions?

    This at root is what separates the Chicago vs Austrian schools. The former believes, like the fantasy of Lost In Space and the 1950′s Tupperware generation, that with enough data science can know the mind of God and man. The latter knows that knowing the mind of man, and such foolishness as Rational Behavior, EMT and government policy, will result in the taming of man’s invisible hands and the risks of the economic creation and destruction cycles.

    But then again, why let the scientific standards of hard science that produces laws get in the way of Wall Street marketeers and commentators who make a living off of selling ideas…

  4. Thatguy says:

    Did you calculate an r squared on that? Just curious how close it really is. I guess I could dig up the data and do it myself, but I have a day job.

  5. Francisco Bandres de Abarca says:

    Equities typically appreciate in valuation if yield spreads are narrowing or compressed, businesses can secure loans, and money markets are not overly-daunted by this fear and that, etcetera.

    Of course, the current global round-robin central banker easing/liquidity provisions contest can’t hurt, either.

    Many are concerned that the February ~$300B LTRO will be a ‘sell the news’ point, and it may well be. But, gee, do ya think there will be another central banker ready to step into the spotlight as soon as that wears off? Eh, bonds are nothing more than currency plus duration–instruments to be managed by central banks in an effort to control interest rate volatility. After all, if those derivatives blow . . . whoa Nelly!

  6. dead hobo says:

    I think it has been quite obvious that market crashes are tightly correlated with liquidity crises. If the liquidity crisis is fixed, the crash reverses. If this isn’t obvious, then those who are confused or those who disagree haven’t been paying attention. Central banks eliminate liquidity crises. If a crisis is repaired while the market is far below trend then indexes skyrocket to trend. Once trend is matched, the chickenshits appear. Nobody wants to be first to plunge into the unknown without confirmations such as earnings or supporting macro statistics that include rising incomes that can pay for rising commodity prices. 250,000 new minimum wage jobs isn’t enough to jostle the HFT programs into real risk.

  7. [...] Financial stress and the stock market.  (Big Picture) [...]

  8. dead hobo says:

    PS: If a liquidity crisis goes unrepaired for too long, it causes recessions due to lack of lending available for working capital loans, and the unemployment that results. Again, this should be obvious to anyone who has been paying attention.

    No liquidity crisis, no Lehman-type issues and no consequential recessions.

  9. Northeaster says:

    dead hobo:

    “No liquidity crisis, no Lehman-type issues and no consequential recessions.” -

    What happens if The Fed were to stop doing these:

    http://www.newyorkfed.org/markets/tot_operation_schedule.html

    “no Lehman-type issues” -

    You mean like a government sponsored theft or fraud against The People? Just because it’s not in the news,, and since no one will obviously be indicted, arrested or jailed at certain banking and corporate levels, doesn’t mean everything is fine.

    “no consequential recessions” -

    For whom? Because you know, the Market IS the economy right? Well, I guess it is for some.

  10. Jeff Miller says:

    We did quite a bit of work on this last summer, but only reported the summary. It shows the data in a different way which readers might find interesting. http://oldprof.typepad.com/a_dash_of_insight/2011/08/interpreting-the-st-louis-fed-stress-index.html

    This is a very useful measure, and BR is correct — descending periods are the best for the market, since fears are being met. (That conclusion was not in the article, but it is in our data).

  11. TimT says:

    I would certainly hope that a comment or two would actually look at what is “the basis of the index”.
    1) BR included the link.
    2)This is “NOT” a trading indicator. “PERIOD”.
    3)It is a “rule based” reliable indicator that needs “confirmation”.
    4) “A full deconstruction of the Index is, frankly, a bit above my pay grade.” Call Jeff
    5) Short-term it will “put you in the poor house”, long-term it is one significant “free” indicator that makes sense. When it is up, “caution” for a portfolio regardless of the politics, press, or current trends.

    Thank you for allowing me to:
    Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data, ability to repeat discredited memes, and lack of respect for scientific knowledge. Also, be sure to create straw men and argue against things I have neither said nor even implied. Any irrelevancies you can mention will also be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

    Bottom line: It measures data that will not necessarily repeat, but it “tells” you something. The something is important to your capital long term.