21st November 2016
Is the Current Stock Market Recovery Overdone?
The Acanto Financial Markets Risk (FMR) Index is a proprietary index based on the acceleration (resp. deceleration) of the volatility in financial markets.
As can be seen from the chart below, the FMR Index has rightly indicated the major crises in financial markets over the past 30 years, starting with the stock market crash of October 1987 up until the stock market crisis in the summer of last year...
Each time the index penetrates the area 101.8/102.0, a significant stock market crisis follows, with a variable time lag.
True, the statistical notion of ‘risk’ gives even weight to each side of the return distribution whereas, in financial markets, we are more preoccupied with downside risk.
Accordingly, the second chart below shows, alongside the S&P500 index, the mirror image of our FMR index since January 2006. This mirror image can be viewed as a financial markets crash (FMC) index.
The drop of our index below 98.20/98.00 has coincided with or warned of major falls of the S&P500 since January 2006 (and conversely a return of the FMC index above this 98.20/98.00 area has coincided with or warned of significant recoveries in the S&P500). Our FMC index has also breached the 98.20/98.00 area to the downside in mid-July last year and has consistently remained in or below that area ever since, in line with the equity markets gyrations since that time.
Right now, the FMC index is still below the 98.00 level, despite the stock market rebound since mid-February 2016. The scissors movement between the FMC index and the S&P 500 is indeed worrying (see chart below) and only an upside breach of the 98.20/98.00 area would, in our view, indicate a more lasting market recovery...
E. Engstrom, Forecasting Stock Market Crashes is Hard - Especially Future Ones: Can Option Prices Help?, Board of Governors of the Federal Reserve System, May 2014.