To illustrate the stability in the relative value of the market at any particular time, the index variables (shown in the graph below) are illustrated using green, yellow and red markers. Green is considered the neutral or low probability zone for the metric to create a condition conducive to a major market correction. Likewise, a yellow marker denotes a cautionary condition, and red denotes a relative measure that has a high probability of causing downward market pressure. Through time as the measurements change, the directional change in each variable is also assessed and if a variable is approaching, but not yet reached a warning condition, then it is outlined in red.
At the beginning of 2015 my commentary on the state of the U.S. equity market based on the Financial Relativity Index was the following:
“The financial metrics as 2015 begins are increasingly cautious, as exhibited by the number of yellow and red markers. The model over the past two years has become progressively more “colorful.”, another way of saying the trend is not your friend at the present time. Based on the research I have done in each categorical area, I expect more of the metrics to reach a red level before the stock market is likely to undergo a sustained severe downturn. The increased areas of caution in many of the metrics, however, set 2015 up in my opinion to be a very volatile year for equity values, with a likelihood of a major intra-year drop at some point.” - Blog Post, January 10, 2015
The metrics referred to in the statement are shown in the table below, and augmented by the status of the metrics as of the end of July, 2015. The July month end metrics, which were updated on the Financial Relativity.com website after the July close, included a warning statement for the first time. The warning was “Deflation Driven Correction Risk Extreme”.
The movement in the metrics since year end 2014 led to the need to post the warning. In particular, the index metrics that have worsened since the first of the year are:
- GDP / Lending Risk - the continued increase risk in U.S. credit markets as loan balances grow to all-time highs relative to the size of US GDP.
- BAA1 / 30 Year Treasury Spread - a major widening of spreads between the Treasury market and investment grade bonds to historical warning levels.
- Fiscal Spending Rate - stagnant U.S. fiscal spending yearly growth continues below historical levels and slowed to -0.1% in Q2 2015.
- Oil Price Levels - rapid commodity price deflation as exhibited in the oil market creates a warning sign on what should be a positive for U.S. consumers.
- Fed Policy - the tightening of monetary policy relative to the world because other countries are devaluing their currencies relative to the U.S. dollar.