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In reference to this paper:

Can risk aversion indicators anticipate financial crises?

and the investable UBS Risk Adjusted Dynamic Alpha Strategy:
http://www.ibb.ubs.com/mc/strategyindices/ubsrada/downloads/rada_factsheet.pdf
(see here for their UBS Dynamic Equity Risk Indicator and here for a real track record of this product on the DAX).

My questions are:
Do you know of any other research on the topic, i.e. different levels of financial markets stress (however measured) that forecast rising, flat or falling markets?

It would also be interesting to know if there are any other strategies, products, funds etc. out there that have comparable approaches.

EDIT:
Since some of the answers are about sentiment indicators: That is not what I mean! I am more interested in "hard" measures of risk (like volatilities, swap spreads, credit spreads etc.) and their relation to future equity returns.

EDIT2:
Two of the links were broken - fixed them.

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5 Answers

up vote 4 down vote accepted

This is one index I find to quite credible (Kansas City Fed Financial Stress Indicator): http://www.kansascityfed.org/research/indicatorsdata/kcfsi/

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Thank you! I did a comparison with the UBS indicator: 1) The UBS indicator is more international, e.g. it includes the VDAX and currency volatilities. Therefore UBS captured e.g. the Asian financial crises in the summer of 1997. 2) The Kansas indicator incoporates only stress related input indicators. UBS additionally adds beta-outperformance and momentum measures. 3) In terms of methodology the Kansas indicator is based on PCA whereas UBS uses an approach where the input indicators are weighted by their rolling correlation to equity markets. Both normalise their respective input indicators. –  vonjd Aug 10 '11 at 7:13
    
CXO Advisory Group did research on a possible exploitability of this indicator: cxoadvisory.com/15599/economic-indicators/… - unfortunately the results are quite sobering. –  vonjd Aug 15 '11 at 12:49
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An excellent example is the Federal Reserve Bank of Chicago’s National Financial Conditions Index (NFCI): http://research.stlouisfed.org/fred2/series/NFCI

CXO Advisory Group just published a report which came to the following conclusion:

[...] evidence from simple tests suggests that the Federal Reserve Bank of Chicago’s NFCI may be a useful indicator of future U.S. stock market returns, principally by helping to avoid parts of crashes.

Full report here (subscribers only):
http://www.cxoadvisory.com/23420/economic-indicators/chicago-fed-nfsi-as-u-s-stock-market-predictor

More info on the indicator itself can be found here (papers, videos etc.): http://www.chicagofed.org/webpages/publications/nfci/index.cfm

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Here is another paper I found recently on using sentiment to predict equity markets:

Risk Sentiment Index (RSI) and Market Anomalies

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There is considerable literature on the role of sentiment in predicting stock market returns. Sentiment is often used as the proxy variable to explain Risk Aversion.

I would check out the following for details:

  1. Neal & Wheatley - Do measures of investor sentiment predict stock market returns

  2. Stambaugh - The Short of it: Investor sentiment and stock market anomolies

  3. Charenarook - Does Sentiment matter?

  4. Also, take a look at CAY - a variable describing the consumption-to-wealth ratio: Lettau and Ludvigson - Consumption, Aggregate Wealth, and Stock Returns

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Post-crisis there has been some research that uses return series for financial institutions to predict downturns. I think the major ones are CoVaR (Adrian and Brunnermeier) and CATFIN (Allen, Bali, and Tang). These lit reviews in these papers should provide a lot of background.

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