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Moorad Choudhry on the Investor's Crystal Ball

The reference to death and taxes captures two of life's certainties. A third one is market volatility. Even without sudden unexpected events such as the "Arab Spring" or the Japan tsunami, market volatility is ever present and generates risk aversion issues for investors.

Sharon Lorimer

The CBOE's VIX volatility contract was up at over 23 Friday from 16 just 30 days ago – what a difference a month makes. The February levels were at 12-month lows, demonstrating yet again how geo-political events cause rapid changes from previous stable sentiment.

With all this constant uncertainty, investors could be forgiven for desiring the services of a trained clairvoyant. Of course, if we had this skill to hand, we might give up bonds and stocks and simply play the lottery this Saturday, but some form of reliable advance indicator would certainly help.

And there's the conundrum: most economic and market statistics are backward-looking. It's easy to spot the market downturn when looking at the graph – as long as it has already occurred. It's a bit trickier to forecast it in real time…

What are the most common market indicators that banks and fund managers monitor for advance warning of stress points? Here is a small sample:

  • The overall level of lending in the economy, both as an absolute level and as a percentage of gross domestic product. A decline in this number suggests a slowing economy;
  • The rate of increase in retail lending, for example credit card and residential mortgage approvals, as well as the rate of increase in lower-credit-quality lending. Again, decreasing levels suggest an impending slowdown;
  • The rates of return on equity on bank capital, and whether this is running at above long-run averages. Perhaps a sign of an over-heating economy about to tip over the edge?
  • World and regional trade volumes, rate of growth month-on-month;
  • The Baltic Dry Index (bulk carrier shipping prices).

Alternative Statistic

The crucial question is how many of these statistics are actually leading rather than lagging indicators? Most of them are unconvincing forecasting measures. Take the Baltic index: it reached an all-time high in May 2008, which was right at the start of the UK recession. Most indicators, rather than suggest an impending downturn, are more of a hindsight high-water or low-water mark of the business cycle.

In a world of information overload, I suggest this statistic instead: the ECRI Leading Indicator index, more specifically the weekly index because of its timeliness. There are 10 components of this index:

  • Vendor performanceBuilding permits
  • Manufacturers new orders for consumer goods and materials
  • Growth rate of M2 plus long-term Household Mutual Funds
  • JOC-ECRI Industrial Price Index, growth rate
  • Initial claims for unemployment insurance (inverted scale)
  • Moody's seasoned corporate bonds, Baa rating (inverted scale)
  • NYSE Composite Stock Price Index
  • Spread between 10-year Treasury bonds
  • Baa corporate bonds
  • Mortgage applications.

As we can see, this statistic is calculated for the US market but it would be relatively straightforward to construct it with the equivalent inputs for the UK or euro zone. It has a reasonable record as a leading indicator, although the indicator with the best record is of course the humble government bond yield curve.

Traditionally, an inverted curve suggests an impending recession. But yield curves are positive sloping right now and yet risk aversion is growing. We need additional data. A weekly look at an ECRI-type metric might be worthwhile.

Of course, almost by definition no statistic constructed out of historical recorded data can ever be a genuine crystal ball. We still need savvy judgement and a dash of luck. Next week we'll address the multiple risk factors we are confronted with right now: the impact of the Japan Tsunami, oil price volatility, euro zone sovereign debt problems and an impending tightening of monetary policy (in Europe at least). It's going to get bumpy again…

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The author is Dr Moorad Choudhry, head of business treasury, global banking & markets at the Royal Bank of Scotland, and visiting professor at London Metropolitan University.