Risk Indices Rising

The 4-year period of the continued growth of the US stock market seems to have ended in late August 2015. From August 17 to August 25, the Dow Jones Industrial Average index (DJIA) dropped by almost 11%, which could be called a correction. Since then, the US stock market has been experiencing high volatility. DJIA’s fluctuations have been in the range from 2%-6% over short periods of time, 2-3 days. High volatility shows lack of confidence in the future direction of the market on the part of market players. Volatility often precedes market declines, thus, many market players are currently expecting a renewed weakness in stock prices and trying to use different gauges to calculate chances for a potential decline.

One gauge is the St. Louis Fed Financial Stress Index (STLFSI) which monitors financial market developments and measures its stress. As the St. Louis Fed’s web-site explains, financial market’s stress can be measured by an interest rate spread, or the difference between yields on a risky asset (such as corporate bonds) and a “risk-free” asset (such as U.S. Treasuries), which indicates default risk. Liquidity risk of financial institutions is indicated by their ability to secure funding to finance their short-term liabilities.

To avoid focusing on particular indicators at the expense of others, in early 2010, the St. Louis Fed created the STLFSI, a composite index which uses 18 indicators to measure financial stress in the market. The STLFSI uses seven interest rate series, six yield spreads and five other indicators. As the level of financial stress in the economy changes, these variables are likely to move together.

The average value of the index is designed to be zero which represents normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress. In July 2014, the STLFSI hit its historic low (from December 1993) reading at -1.57. After its peak in October 2008, at the height of the financial crisis, the index has been below zero (with a couple of spikes in June 2010 and September 2011) since late 2009, when the financial markets started to calm down.

Fear ind

After a period of decline, the index started growing in mid-2014 and jumped from -0.975 in mid-August 2015 to -0.513 in late August 2015. In June 2010 and September 2011, the spikes of the index coincided with the declines in the US stock market although, in those cases, the market did not enter correction territory. It remains to be seen whether the current growth of the STLFSI is foretelling the continued trouble for the stock market. At least, so far, the index is saying that the US financial market’s stress is below-average.

The CBOE Volatility Index, referred to as the VIX, is painting a more worrying picture. The VIX is calculated by the Chicago Board Options Exchange (CBOE) based on the prices of several volatility indexes designed to measure the market’s expectation of future volatility implied by options prices. After the spikes in 2008-2009, and in June 2010 and September-October 2011 (which coincided with the spikes in the STLFSI), the VIX remained mainly below 20 up until late August 2015. It almost reached 32 on September 1, 2015 which reflected the volatility in U.S. stocks. The index is currently around 25.

VIX

It’s difficult to predict whether the currently high VIX is a sign that the volatility and weakness of the US stock market will persist. But if the expectation is correct that the FED will delay the rate hike due, in particular, to the high volatility of the markets, it may actually support the US stocks: ample liquidity in the financial markets have been driving the stocks up since 2009.

Michael Zienchuk, MBA, CIM
Investment Advisor, Credential Securities Inc.
Manager, Wealth Strategies Group
Ukrainian Credit Union Limited
416-763-5575 x204
mzienchuk@ukrainiancu.com
www.ukrainiancu.com

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