Market Risk Factors: Theory and Practice
When thinking about market risk factors we should worry about, the list is quite extensive. Just googling “economic statistics,” for example, will give you about 365 million results. If you search “stock market statistics,” you’ll get only 8.5 million hits. The question, then, is how can we refine the data points to determine which indicators truly belong on our risk radar?
To answer this question, we need to think about things from a fundamental perspective. In other words, what drives the market? First, of course, is the base economy. After all, 8 of 10 bear markets occurred during a recession, so we have to consider the economy itself.
Consumer spending and business investment are the major variables affecting the economy’s performance. Digging a bit deeper, we find that the drivers of consumer spending are job growth (for the ability to spend) and consumer confidence (for the willingness to do so). Similarly, business investment is driven by business confidence. Both job growth and consumer confidence are also affected by financial conditions (e.g., interest rates). Theoretically, these metrics make sense as risk indicators. But do they work in practice?
Job growth. As illustrated in the chart below, we’ve had a recession five out of the past five times when year-on-year job growth dropped below zero. When considering job growth today, keep in mind that recession start dates are set in retrospect. So, when the change hit zero the last time, it would have been a good predictor. This is a metric that works in both theory and practice.
Consumer confidence. Similarly, when consumer confidence declined by more than 20 points over a year, it has signaled five out of the five past recessions. It should be noted that this indicator has had a couple of false signals (in the early 1990s and 2000s) when the economy slowed but did not tip into recession. Still, it works in both theory and practice.
Business confidence. As shown in the chart below from the Institute for Supply Management (ISM) Manufacturing survey, business confidence has a five-for-five record of signaling recession when it drops below about 45. I use the ISM Nonmanufacturing survey in the monthly market risk update I publish on my blog, The Independent Market Observer. It covers more of the economy but has a shorter track record. Here, I’m using the index that has a much longer record, and it supports the idea that business confidence is a good indicator of recession risk.
Interest rates. Last but not least, the yield curve shows us that when short-term interest rates rise above long-term rates (as shown in the next chart when the line dips below zero), we have a four-for-four recession prediction record. Once again, practice matches theory.
Overall, none of these indicators is even close to the trouble zone. From an economic standpoint, risk of a recession—and, therefore, risk of a severe pullback in the stock market—remains low.
Of course, the stock market has its own risks, which we also need to track and respond to. These risks come in three flavors: recession risk, economic shock risk, and risks within the market itself. We already covered recession risks, so let’s take a look at the other two.
There are two major systemic factors—the price of oil and the price of money (better known as interest rates)—that drive the economy and the financial markets and that have a proven ability to derail them. Both have been causal factors in previous bear markets and warrant close attention.