Study: financial conditions are still too easy for the bull market to end


The Chicago Fed’s National Financial Conditions Index looks at U.S. financial conditions on a weekly basis. This Index has 3 components.

  1. Risk Subindex. This looks at volatility and funding risk in the financial sector
  2. Credit Subindex. This looks at measures of credit conditions.
  3. Leverage Subindex. This looks at debt.

The National Financial Conditions Index (NFCI) and its components demonstrate that financial conditions are still too easy in the U.S. for a recession and bear market to start. Financial conditions need to tighten significantly before this equities bull market can end.
Pay particular attention to the Credit Subindex. Equity bear markets are accompanied by economic recessions. In a highly leveraged system (i.e. today), it is hard to have a recession without a credit crisis first. It’s hard to have a credit crisis without credit stress.

National Financial Conditions Index: conditions are too easy

The Financial Conditions Index is too low right now. Historical equities bear markets (1973, 2000, and 2007) started when the Index was at least 0. The Index is currently at -0.73 as of October 3, 2018.
In addition, historical recessions that led to “big corrections” in the stock market also started when the Index was at least 0.

Let’s assume the worst case scenario. Let’s assume that financial conditions have bottomed and start to tighten from here.
This is what happened next to the S&P 500 after financial conditions were last this tight (-0.71) during an economic expansion cycle.

*This is a low sample size study (n=3), but we’re using numbers to illustrate the concept that financial conditions tend to tighten before major stock market tops.

National Financial Conditions Risk Subindex: conditions are too easy

The Risk Subindex is too low right now. Historical equities bear markets (1973, 2000, and 2007) started when the Subindex was at least close to 0. The Subindex is currently at -0.87 as of October 3, 2018.
In addition, historical recessions that led to “significant corrections” in the stock market also started when the Subindex was at least close to 0.

National Financial Conditions Credit Subindex: conditions are too easy

The Credit Subindex is too low right now. Historical equities bear markets (1973, 2000, and 2007) started when the Subindex was at least close to 0. The Subindex is currently at -0.75 as of October 3, 2018.
In addition, historical recessions that led to “significant corrections” in the stock market also started when the Subindex was at least close to 0.

National Financial Conditions Leverage Subindex: conditions are too easy

The Leverage Subindex is too low right now. Historical equities bear markets (1973, 2000, and 2007) started when the Subindex was at least 0. The Subindex is currently at -0.37 as of October 3, 2018
In addition, historical recessions that led to “significant corrections” in the stock market also started when the Subindex was at least 0.

Conclusion: Financial Conditions going forward

Financial conditions will definitely tighten and deteriorate as the Fed raises interest rates. But financial conditions are still too easy to start a recession or bear market in stocks.
There’s no point in guessing “when” financial conditions will tighten enough to hurt the stock market and economy. It’ll happen sometime over the next 1-2 years. All we can do right now is know that financial conditions will remain easy for the immediate future. Take things one step at a time. Don’t try to predict 10 steps into the future. Predict the market’s next 1-2 steps.
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