The idea that the economy and the financial markets are closely connected, and that each offers clues for projecting the other, is no spring chicken. Nearly a century ago, for instance, William Hamilton outlined the case for a stock market index as a “soulless barometer” as a measure of the broad trend. Analysts have long since taken up the challenge and delivered any number of benchmarks that seek to quantify the link between macro and markets. And now there’s one more: The Capital Spectator Macro-Markets Risk Index (MMRI), a simple measure of fluctuations in four critical markets: equities, the Treasury yield spread, the credit spread, and oil prices.
Regular readers will recognize that MMRI is a subset of the indicators in The Capital Spectator Economic Trend & Momentum indices (CS-ETI and CS-EMI), a pair benchmarks that track the economy’s broad trend for signs of major turning points in the business cycle. Why launch an indicator that’s currently captured in an existing set of benchmarks? Several reasons.
First, one of the incentives for using markets data is the timeliness aspect. Because equity, bond, and oil prices are available in real time, with continuous updates, prices have an edge over conventional economic statistics, which are published with a lag of a month or more. Markets data, of course, is also immune to revisions, which also bedevils economic numbers. What you see is what you get, when you look at financial and commodity prices.
For those reasons, along with the fact that markets data provides valuable information on the crowd’s macro outlook, it’s essential to consider equity, bond and oil prices for evaluating the broad economic trend. That’s why this information is included in CS-ETI and CS-EMI. The problem, of course, is that both of those indicators reflect monthly data. That’s the nature of the beast, since the economic reports arrive monthly; the markets data is adjusted to fit that schedule to favor an apples-to-apples comparison in CS-ETI and CS-EMI. Nonetheless, we may be leaving valuable information on the table by waiting for a monthly review of markets. MMRI tries to address that issue by offering a supplement to the monthly information in CS-ETI and CS-EMI.
I use daily data to calculate MMRI, and I’ll post updates here periodically, especially when the index has made relatively dramatic moves. What should we be looking for? History offers some guidance. Here’s how MMRI compares on a daily basis since August 2007:
Note the deterioration–below the 0% mark–in the months preceding the onset of the Great Recession, as indicated by the gray bar. Note too that MMRI fell below 0% in late-2011 without the arrival of recession. That’s a reminder that Mr. Market’s macro forecasts, so to speak, aren’t flawless. Sometimes prices appear to be anticipating trouble in the business cycle only to find that growth in the broad trend survives. You can’t count on any one variable for assessing economic risk, a caveat that also applies to a mix of markets data. That’s why it’s critical to aggregate a carefully selected sample of macro and markets indicators for a more diversified effort at tracking the business cycle, which is the underlying logic behind CS-ETI and CS-EMI.
Nonetheless, we should still monitor the market signals separately, albeit with a measure of skepticism. If the crowd becomes unusually anxious about the future, that’s valuable information. We can’t rely on this information in a vacuum, but neither should we ignore it. The challenge, then, is creating an index that aggregates the market signals, which is the goal of MMRI. But it should be read in context with CS-ETI and CS-EMI.
The design of MMRI is quite simple. For the stock market, MMRI tracks the 250-day percentage change of the S&P 500 (a 250-trading day period approximates the one-year change used in most indicators in CS-ETI and CS-EMI). Higher equity prices, of course, equate with stronger optimism generally. The proxy for the credit spread is the BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread, which is used in terms of its inverted 250-day change. The intuition here is that when the spread in junk yields rises over Treasuries, the change reflects market anxiety as it relates to the economy. The Treasury yield curve is also included, with no transformation. The curve is defined as the 10-year Treasury yield less the yield on a 3-month T-bill, and taken at face value each day. The idea here is that when the curve inverts, that’s a dark sign for the economy. Finally, oil prices are proxied via the iPath S&P GSCI Crude Oil Total Return Index ETN (OIL), which is considered in terms of its inverted 250-day change to reflect the assumption that higher energy prices at some point are detrimental for the economy. The four inputs are averaged on a daily basis, with MMRI as the result.
On that noted, here’s how MMRI stacks up so far this year, through March 8:
For the moment, the market’s outlook appears relatively upbeat. MMRI has recently been rising and remains well above the critical 0% mark. The four horsemen of the markets, one could say, are convinced that the cyclical gods have been sated… for now. That view is subject to reassessment on a continual basis, of course. When will the market’s broad signal change and signal distress? No one knows, of course, but when the markets anticipate a darker future, MMRI will be falling and break below zero.