Are easy financial conditions a risk to the U.S. stock market today?

The Goldman Sachs Financial Conditions Index (GSFCI) looks at how “easy” U.S. financial conditions are right now.
This is generally used as a contrarian indicator. When conditions are “too easy”, one expects the financial markets to tighten and stocks to fall. Here’s GSFCI today.

Bears state that whenever financial conditions were this easy, the stock market made a bear market (in 2000) or a significant correction (in 2015). Our Medium-Long Term Model predicted both of these in advance.

Problems with Goldman’s Financial Conditions Index

This Index only goes back to 1995. Index’s with more historical data are more valid. We don’t know what the Index did before the 1990 significant correction. We don’t know what the Index did before the 1980 significant correction. We don’t know what the Index did before the 1973 bear market etc. Like VIX, the Goldman Financial Conditions Index has a very limited history compared to the S&P 500 (going back to 1950).
But more importantly, you can see that this index is far from perfect. Financial conditions in 2007 were just as easy as they were in 2013. The U.S. stock market and economy ROARED in 2013.
In addition, this indicator was too early in 1999. The Index bottomed in early-1999, an entire year before the S&P 500 topped in March 2000.

Let’s break down the Financial Conditions Index

We have to break down this index in order to understand why financial conditions are so easy right now.
This FRED article looks at various financial conditions indexes. It is well worth a read. As of today, all financial conditions indexes (constructed by multiple institutions) are very “easy”. They are all constructed along the following lines.

Each individual index comprises various financial variables and typically covers one of five main categories: (i) short-term Treasury rates, (ii) long-term Treasury rates, (iii) credit spreads, (iv) the foreign exchange value of the dollar, and (v) equity prices.
A common approach to constructing each index is to use a weighted average of the financial variables or a statistical technique called principal component analysis (PCA).

The 2 most important parts of any financial conditions index are:

  1. U.S. equity prices. The general thinking is “high stock market valuations = investors are exuberant”.
  2. Credit spreads. The general thinking is “low credit spreads = investors have a strong appetite for risk”.

High valuations.
Yes, U.S. stock market valuations are very high. However, our Medium-Long Term Model states that valuations alone are not enough to kill the stock market. The stock market follows the economy in the long run. So unless the economy deteriorates significantly, the stock market will not enter into a bear market like 2000-2002 or 2007-2009. The U.S. economy is very strong right now.
Here’s Tobin’s Q (valuation indicator).

In addition, valuations have been elevated for the past 20+ years. This is partially because interest rates are EXTREMELY low. Even if the Fed continues to hike rates a few times, rates are still very low (historically speaking). Hence, the “chase for yield” forces many bond market investors into stocks.

Also read An overvalued stock market doesn’t have to crash
Credit spreads
A credit spread is the difference between 2 bond yields of different credit quality. When credit spreads narrow, investors are more risk-tolerant because they want to buy riskier debt. Hence, financial conditions are “easier”.
Credit spreads have narrowed significantly since 2015. Even low-grade debt yields have tanked as investors chase yields. Here’s BofA Merill Lynch’s U.S. High Yield Index

Here’s BofA Merill Lynch’s U.S. High Yield Spread Index. This spread = “a basket of high yields” – “a spot Treasury curve” (Treasurys are considered to be the safest of all bonds).

You can see 2 things from the above charts.

  1. High Yields tend to rise before a bear market or significant correction (e.g. 2015). High Yields are flat right now. So I am not concerned about this unless High Yields start to rise. High Yields can flatten for a long time.
  2. Credit spreads were lower in the 2000’s and 1990’s. Like High Yields, I am not considered about credit spreads until they start to widen. Credit spreads can remain flat for years.

My thoughts on 2018

Based on current data, the Medium-Long Term Model does not foresee a significant correction or bear market for U.S. stocks in 2018.
Financial conditions are easy, which is normal for the final few years of a bull market. (Based on current data, the Medium-Long Term Model states that this bull market has 2-3 years left.)
However, various studies all hint that 2018 will be much choppier than 2017 (Click here, here, here, and here). The S&P 500 will probably close higher in 2018 vs 2017’s close, but there will be small corrections along the way. (Unlike 2017, which did not have a single small correction).
Happy New Year everyone! I wish you all the best in 2018 🙂

3 comments add yours

  1. Hey Troy,
    Was your model able to predict the Great Recession? If yes, when did it issue a sell signal?

  2. Thanks Troy, for another great post – Very informative and delivered in a way the layman can relate to and understand. Much appreciated…

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