Financial Stress: Whom to believe?

Investment Analysis Clubs Macro Economic Trends and Risks
1

The Financial Stress Index is reported by the St. Louis Federal Reserve. It’s an important component of my Control Panel since it has spiked during periods that the stock market dropped and skyrocketed during the financial crises of 2008 and 2020. The series runs from 1994 to the present.

The Financial Stress Index began falling in January 2022 and is now at a historic low. This doesn’t seem right. The STLFSI3 measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators.

Since interest rates began rising at that time the index should be rising, not falling. Rising interest rates increase stress on stocks (by affecting corporate borrowing), on bonds and on mortgage rates.

https://fred.stlouisfed.org/series/STLFSI3

I just learned that the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 established an Office of Financial Research (OFR) principally to support the Financial Stability Oversight Council and its member agencies. This is a completely separate government office that is independent of the Federal Reserve.

https://www.financialresearch.gov/about/

The OFR has its own Financial Stress Index. This covers 2000 to the present. The OFR FSI measures systemic financial stress — disruptions in the normal functioning of financial markets. Each variable in the index measures a feature of financial stress.

https://www.financialresearch.gov/financial-stress-index/

The OFR Financial Stress Index began climbing over the “normal” value of zero in January 2022. This is what I would expect to see in a rising interest rate environment with a stock bear market. The OFR FSI includes equity valuation and volatility and these have been rising. The level of stress is lower than during the European debt crisis of 2010-2011, and dramatically lower than the 2008 and 2020 financial crises.

I’m really puzzled as to why the St. Louis Fed FSI is dropping when it should be rising. I will add the OFR FSI to the Control Panel since it seems to be more reliable.

Neither FSI shows worrisome (let alone crisis level) financial stress. Just as the stock market has slipped into bear territory but could get much, much worse as it has in the past.

I will continue to monitor both of these FSIs in the Control Panel. If they both begin to rise rapidly together – hold onto your hat.

Wendy

12 Likes
2

I can’t help but mention the following (“olde news”) in the wake of the Fed’s stress test:

https://money.usnews.com/investing/news/articles/2022-06-27/…

sunray
a man who owns TFC

1 Like
3

Hi Wendy,

Thanks for posting the Financial Stress Test info.

Is it possible the banks, including the FED, have learned their lesson from the Great Financial Crisis? Could it be that the banks are now better prepared for a housing slowdown/recession than they ever have been?

Also, I’m thinking that with AI, loans are being made with greater care so as to minimize delinquency rates and foreclosure rates.

Just some random thoughts.

Thanks again for the info.

fp

2 Likes
4

I did my private financial stress test this morning. Moving from Venezuela to Portugal increased my expenses considerably. Back in Caracas I had my fully paid up condo and basic food is a heck of a lot cheaper. I say basic because imported olive oil, for example, is through the roof. I left Venezuela on April 8, 2019 so I set my start date on April 1, 2019.

From April 1, 2019 to yesterday the S&P 500 is up 33% while NASDAQ is up 43%. After covering all my expenses my port is up 10%. During the bull run I funded an euro account in Portugal, last contribution Feb 2, 2021 good for almost six month. Currently the euro account is good for 5 months total or 16 months local expenses.

Stress test says, “No Stress!”

The interesting thing is that over three years there is no stress in the market, S&P 500 up 33% while NASDAQ up 43% but if you fixate on the recent highs pundits go ape and investors sell low to fund cash at the wrong time.

The S&P 500 high was January 23, 2022 and the NASDAQ high was November 19, 2021. By then The Captain had funded his euro reserves and that’s part of the secret of having a ‘sturdy portfolio.’ Trying to squeeze the last penny out of a bull run is not a good idea. Back then the port had between 10 and 15% cash, now it has a 3.5% margin.

A bear market is not a good time to sell covered calls, too much capital loss. During the six months from December 2021 to May 2022 the covered calls only funded about half of my ordinary expenses. June and July have already funded three months worth of expenses.


LTBH    73.4%
Income  29.8%
Margin  -1.4%
Calls   -1.7%

The Captain

8 Likes
5

<Is it possible the banks, including the FED, have learned their lesson from the Great Financial Crisis? Could it be that the banks are now better prepared for a housing slowdown/recession than they ever have been?

Also, I’m thinking that with AI, loans are being made with greater care so as to minimize delinquency rates and foreclosure rates.>

I agree that what you are saying is true.

That makes me think that the Fed’s Financial Stress Index (FSI) may be tailored to show the stress on banks, which are the responsibility of the Fed. That certainly makes sense. Thank you for pointing it out.

It also means that the Fed’s FSI may be less appropriate for what I am using it for – an indicator of stress in financial asset (stock and bond) markets. If the banks are not in danger the FSI would be low even if the risk in financial markets is high. During the 2008 and 2020 crises the banks were in danger, especially in 2008. In 2020, the Fed immediately came to the rescue with massive, unprecedented loan programs and quickly defused the crisis.

From now on, I will use the Treasury’s FSI which includes the stock market actions and volatility instead of the Fed’s FSI.

Kudos to you for explaining this refinement.

:slight_smile:

Wendy

2 Likes
6

Wendy,

My own thinking if all was well there would be nothing to worry about. LOL

If the Chinese implode financially so does the swap market.

The tests are not looking at the swap market. The tests are not looking at the banks’ exposure to Chinese debt.

This is a very risky time for the financials with major commercial interests.

  • swaps are not on the books by their face values. Not on the balance sheet that is. The swaps are under the derivatives and futures receivables and payables denoting only the interest payments.
7

Also, I’m thinking that with AI, loans are being made with greater care so as to minimize delinquency rates and foreclosure rates.

The problem with your thesis is that the safer things become the more risk people feel they can take on safely. When did people start jumping out of airplanes without a parachute? When they figured out how to do it (relatively) safely. The supply chain crisis is another related example. People figured out how to minimize the cost of warehousing supplies, spare parts, raw materials and other stuff.* It worked until a Black Swan threw a monkey wrench into the works. When the government insures deposits you feel less need to check out the bank’s credentials, the government will keep you safe until the whole banking system blows up.

The Captain

  • Back in the 1970s I used to tell my clients that inventory was a necessary evil, it you could get the stuff just in time there would be no need for inventories. DELL made it a reality two decades later forcing suppliers to build warehouses next door to DELL.

NOTE: The Captain stays well clear of credit risk, it can blow up like a nuclear chain reaction, forced sales, margin calls, bankruptcies… 2007-8!

3 Likes
8

Also, I’m thinking that with AI, loans are being made with greater care so as to minimize delinquency rates and foreclosure rates.

Serious question.
Why is AI any better at reducing delinquency and foreclosure rates?
As opposed to the fact that it might just reduce the amount of human effort to come to the same go-no go decision.

After an AI model is trained, the results are only as good as the data that it is being fed.
If the input data is good wouldn’t a human and some algorithm be about as good as some AI model?

Mike

1 Like
9

If the input data is good wouldn’t a human and some algorithm be about as good as some AI model?

Only if the optimal algorithm was simple and obvious. The point of the AI is that it takes in more data than a human can handle and figures out the optimum algorithm based on that data … one doesn’t know the optimum algorithm going in.

1 Like