Aug 23, 2013

Assessing Credit risk in the markets

When the whole investing world is feeling unsafe, where will they rush to? Answer: US Treasuries OR may be Gold. But Gold has many other purposes as well, like inflation hedge, Store of value, etc. So let's confine ourselves to the US Treasuries here.

US treasuries are a safe haven at times of distress and when credit crisis prevails in the market. So by measuring the price performance (hence money flow) of the US treasuries against various risky assets, we can get a sense of Risk ON/OFF scenario.

The following chart shows the ratio of S&P 500 over Long term US Treasuries - depicting credit risk in the market.

But when there is interest rate risk in the economy then long term treasuries are susceptible to rising interest rates. To account for the interest rate risk, you need to also look at the ratio of S&P 500 against short term treasuries.

Between the 2 charts, you should be able to get a general assessment of credit risk in the market.

Another way to assess the credit risk in the market is by looking at the ratio of Junk bond yields over investment grade bonds or US treasuries of same duration. (Note that the bond prices are sensitive to duration). High Yield bond ETF (HYG) and Aggregate bond ETF (AGG) has similar weighted Duration and is used in the chart below.

Rising line for risky assets like SPY or HYG (and declining TLT or AGG) indicates Risk ON condition in the market and the opposite is true for Risk OFF condition.

Aug 6, 2013

US Housing market - general health, trend and implications to the overall economy

Consumer spending accounts for 70% of the US economy. Homes and Cars/Auto are the biggest ticket items that consumers spend their money on. Unlike other purchases that may use money earned in the last paycheck, the money spent on Homes and Auto are from loans and mortgages that are borrowed from the future 3 to 30 years. Therefore Housing and Auto spending has immense impact on the economy - in both directions, up and down. This was very evident in the 2003-2004 recovery after the tech bubble burst and then during the meltdown into 2008-2009 recession.

In this post, let's take a peek at how the Housing spending is ensuing.

The first chart below shows the variation of nationwide Housing price with respect to Affordability and new private housing starts. Affordability of 100 implies that the median income family has just enough money to buy a median price home in the country.

The second chart below shows how 3 key housing indicators vary with interest rates. They are:
  1. House prices (Median in green, Average in orange), 
  2. Inventory (as monthly supply of homes in blue) and 
  3. Number of days houses are on the market (as median number of months on sales market for newly completed homes) 
All these housing indicators vary with respect to interest rates (10 year treasury as a representative for 30 year FRM and other ARM loans) in the chart below.

The next chart below shows how

  1. Private residential construction spending (in blue diamond)
  2. S&P Case-Shiller 20 city home price index
  3. Housing Affordability Index

vary with interest rates. I have chosen 30 year conventional mortgage rate to represent the interest rate here.

The chart below shows how the Real disposable personal income and Housing affordability index are varying with respect to year ago change. You might see some early warning signs in the percent-change-from-year-ago charts.

Finally, keep an eye on health of housing by checking how the market is pricing the Home builders ETF, XHB in relation to the S&P 500.

Aug 1, 2013

US Recession Probabilities, Financial Stress Index STLFSI, Yield Curve indicators

There are many economic models to predict recessions and these models are primarily based on Business cycle variables, bond yields and yield spreads.In this post, lets look at a couple that are readily available on FRED website.

I. Smoothed U.S. Recession Probabilities

Smoothed recession probabilities for the United States are obtained from a dynamic-factor markov-switching model applied to four monthly coincident variables

  • non-farm payroll employment, 
  • the index of industrial production, 
  • real personal income excluding transfer payments, and 
  • real manufacturing and trade sales. 

This model was originally developed in Chauvet, M., "An Economic Characterization of Business Cycle Dynamics with Factor Structure and Regime Switching," International Economic Review, 1998, 39, 969-996. (

The same chart zoomed in for the recent 10 years.

II. St. Louis Fed Financial Stress Index (STLFSI)

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. 

Jeff Miller's blog "A dash of Insight" quotes "Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions. The STLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses."

The STLFSI 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. 

Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together. The latest STLFSI press release, with commentary, can be found at 

How to Interpret the Index 
The average value of the index, which begins in late 1993, is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress. 

More information 
For additional information on the STLFSI and its construction, see “Measuring Financial Market Stress” ( and the related appendix ( As of 07/15/2010 the Vanguard Financial Exchange-Traded Fund series has been replaced with the S&P 500 Financials Index. This change was made to facilitate a more timely and automated updating of the FSI. Switching from the Vanguard series to the S&P series produced no meaningful change in the index. 
Copyright Federal Reserve Bank of St. Louis.

Below is the STLFSI indicator for the past 5 years..

III. The Yield Curve as a Leading Indicator - NY Fed

Jul 16, 2013

S&P 500 Valuation using Relative Value Method (using Price/Earnings PE ratio)

We talked about valuing S&P 500 Intrinsic valuation in the previous post, lets value the S&P 500 index using relative value method in this post.

We can use many valuation measures for comparing the value of the security against other securities or against the security's historical values. Though ratios like Price/Book value or Price/Sales or Price/Cash Flow can be used a measure to compare, Price/Earnings (P/E) is by far the most popular valuation measure today.

The Excel spread sheet shows the current P/E ratio for S&P 500 and the valuation for S&P 500 based on historical P/E ratio Averages. The data source for the calculation is from:

Legendary value investor Benjamin Graham and others have proposed using 10 year average earnings in the denominator of the P/E so that it accounts for the fluctuations in the Business cycle. This ratio is generally denominated as "P/E10". Valuation of S&P 500 based on P/E10 is also shown at the bottom of the table.

Jul 1, 2013

"S&P 500 Intrinsic Value Calculator"

While the technical analysis of various indexes and ETFs can reveal overbought and oversold conditions, keeping an eye on the intrinsic valuation of the equity market can be like a compass to navigate the Investment hike.

The details of the valuation calculator is at the bottom of this post if you want those details first, but lets begin with the calculator itself. Before I could get started with any calculation, I saw that Prof. Aswath Damodaran has already been publishing the S&P 500 Intrinsic valuation blog post for the past 2 years. So what additional value could I have added? I noticed that his valuation calculator is for a point in time - year beginning. So I just migrated this to Google excel sheets and made it pull the latest price for S&P 500 and the 10 year yield. Here is the Intrinsic value for S&P 500:
(For some reason, Google Docs is not showing the 2nd sheet in the same spreadsheet. So click on SP500 valuation tab in the sheet below)

I agree that some of the inputs are not updated everyday, like - Cash yield (dividend and buy back yield), growth rate expectations and Equity risk premium. But we may not want these inputs to be changing daily - may be just quarterly or annually.

Now that valuation was based on me choosing the input to the calculator based on my judgement. But what if we would also like to Scenario analysis for S&P 500. So I varied the inputs in such a way that the calculator gives the Maximum and the Minimum values separately. Below table shows the range for the S&P 500 Intrinsic value based on different scenario inputs.

Now that we have already seen the intrinsic values, let get down to the nuts and bolts of the calculator itself. There are 4 variables the go into the calculation:
Cash returned to equity investors: Ultimately, we buy stocks to get cash flows in return, with those cash flows evolving over the last three decades from almost entirely dividends to a mix of dividends and stock buybacks. Holding all else constant, the more cash that is returned to investors in the near term, the more you will be willing to pay for stocks.
Expected growth: The bonus of investing in equity, as opposed to fixed income, is that you get to share in the growth that occurs in earnings and cash flows in future periods. Other things held equal, the higher the expected growth in earnings and expected cash flows, the higher stock prices should be. 
Risk free rate: The risk free rate operates as more than base from which you build expected returns as investors. It also represents what you would earn from investing in a guaranteed (or at least as close as you can get to guaranteed) investment instead of stocks. Consequently, stock prices should increase as the risk free rate decreases, if you hold all else fixed. 
Risk premium: Equities are risky and investors will demand a “premium” for investing in stocks. This premium will be shaped by investor perceptions of the macro economic risk that they face from investing in stocks. If the equity risk premium is the receptacle for all of the fears and hopes that equity investors have about the future, the lower that premium, the more they will be willing to pay for stocks. 
Please read the entire post here for the details on judging the inputs and interpreting the out of the valuation.