We all know that stock markets have taken a hammering over the past few months. But is this your normal, garden variety equity market sell-off or does the current selling presage a 2008-style economic collapse? To what extent is there systematic risk?
Almost everyone has an opinion on what’s going to happen. They range from an imminent financial apocalypse to the onset of a 20-year bull market. Unfortunately, these opinions are usually based on simple analogies and rely upon anecdotal evidence. That”s not a reliable way to make investment decisions.
A better approach to gauging the level of risk in the financial system is provided by the St. Louis Fed Stress Index (Stress Index). It provides an objective way to define the level of systematic risk and is constructed using 18 variables each of which captures some aspect of financial stress (for more information see this research paper). In simple terms, the higher the index level the higher the systematic risk. Here’s what the Stress Index has signaled since 1994:
The standout spike in the Stress was back in 2008/09 during the global financial crisis. Previous to that the Stress Index spiked in 1998 during the Russian debt moratorium leading the Long-Term Capital Management blowup, and rose to high levels throughout the dot-com crash and 2001 recession.
More recently, the Stress Index has risen. again – not very surprising given the problems in Europe and the potential for another recession. Increased stress levels imply an increased probability of future market declines. Whilst the current Stress Index levels are well below those experienced in 2008/09 they are signifying worrying times ahead.