Financial Stress Indicators and Forecasting Equity Market Risk
Summary
The document surveys possible research and investment approaches that use financial market stress to anticipate equity returns or downturns. The question focuses on hard measures such as volatility, swap spreads, and credit spreads, while responses point to the Kansas City Fed Financial Stress Indicator and the Chicago Fed National Financial Conditions Index. One cited review describes the latter as potentially useful for avoiding portions of market crashes, though no detailed test results are reproduced here.
Other suggestions include research on sentiment and consumption-to-wealth measures, plus systemic-risk indicators such as CoVaR and CATFIN built from financial institution return series. These are related leads rather than a unified strategy, and some do not match the question’s emphasis on hard stress measures. The document provides references and examples, not a comparative evaluation, performance record, or evidence that any indicator reliably forecasts rising, flat, or falling markets.
Key ideas
- Financial stress measures may be studied as predictors of equity returns and market downturns.
- The Kansas City Fed Financial Stress Indicator and Chicago Fed National Financial Conditions Index are cited as examples.
- CoVaR and CATFIN are mentioned as approaches using financial institution return data to study systemic risk.
- Sentiment and consumption-to-wealth indicators are related research leads but differ from hard market stress measures.
- The document offers references rather than a comparative strategy test or proof of predictive reliability.
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Full text
# Indicators and research for stress-based investment strategies # Indicators and research for stress-based investment strategies In reference to this paper: Can risk aversion indicators anticipate financial crises? and the investable UBS Risk Adjusted Dynamic Alpha Strategy: http://www.ibb.ubs.com/mc/strategyindices/ubsrada/downloads/rada_factsheet.pdf (see here for their UBS Dynamic Equity Risk Indicator and here for a real track record of this product on the DAX). My questions are: Do you know of any other research on the topic, i.e. different levels of financial markets stress (however measured) that forecast rising, flat or falling markets? It would also be interesting to know if there are any other strategies, products, funds etc. out there that have comparable approaches. EDIT: Since some of the answers are about sentiment indicators: That is not what I mean! I am more interested in "hard" measures of risk (like volatilities, swap spreads, credit spreads etc.) and their relation to future equity returns. EDIT2: Two of the links were broken - fixed them. ## Answer by Akshay (score 7, accepted) https://quant.stackexchange.com/a/1622 This is one index I find to quite credible (Kansas City Fed Financial Stress Indicator): http://www.kansascityfed.org/research/indicatorsdata/kcfsi/ ## Answer by Ram Ahluwalia (score 5) https://quant.stackexchange.com/a/1625 There is considerable literature on the role of sentiment in predicting stock market returns. Sentiment is often used as the proxy variable to explain Risk Aversion. I would check out the following for details: - Neal & Wheatley - Do measures of investor sentiment predict stock market returns - Stambaugh - The Short of it: Investor sentiment and stock market anomolies - Charenarook - Does Sentiment matter? - Also, take a look at CAY - a variable describing the consumption-to-wealth ratio: Lettau and Ludvigson - Consumption, Aggregate Wealth, and Stock Returns ## Answer by Richard Herron (score 4) https://quant.stackexchange.com/a/1619 Post-crisis there has been some research that uses return series for financial institutions to predict downturns. I think the major ones are CoVaR (Adrian and Brunnermeier) and CATFIN (Allen, Bali, and Tang). These lit reviews in these papers should provide a lot of background. ## Answer by Tal Fishman (score 4) https://quant.stackexchange.com/a/1647 Here is another paper I found recently on using sentiment to predict equity markets: Risk Sentiment Index (RSI) and Market Anomalies ## Answer by vonjd (score 2) https://quant.stackexchange.com/a/8330 An excellent example is the Federal Reserve Bank of Chicago’s National Financial Conditions Index (NFCI): http://research.stlouisfed.org/fred2/series/NFCI CXO Advisory Group just published a report which came to the following conclusion: > [...] evidence from simple tests suggests that the Federal Reserve Bank of Chicago’s NFCI may be a useful indicator of future U.S. stock market returns, principally by helping to avoid parts of crashes. Full report here (subscribers only): http://www.cxoadvisory.com/23420/economic-indicators/chicago-fed-nfsi-as-u-s-stock-market-predictor More info on the indicator itself can be found here (papers, videos etc.): http://www.chicagofed.org/webpages/publications/nfci/index.cfm
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