Stock market indicators investors need to know – Forbes Advisor UK

When it comes to investing in stocks and shares, no one has invented a crystal ball that can predict the fate that awaits businesses and investors.

But there are indicators that have in the past helped investors anticipate events, from the onset of recessions to major stock market shocks.

Here’s an overview of the signals and indicators used by finance professionals to stay ahead of the curve when it comes to investing.

VIX index

Several signals have their origin in the behavior of the US stock market. For example, the Chicago Board Options Exchange Volatility Indexcommonly abbreviated as “VIX” (also known as the “fear gauge”), is a measure of expected US stock market volatility.

Market volatility is the frequency and magnitude of stock price movements, up or down. The greater and more frequent the fluctuations, the more volatile a market is said to be.

The VIX is designed to reflect investors’ views on future volatility. It assesses how much one of the world’s most influential stock market indices, the S&P 500, could fluctuate over the next 30 days. The higher the VIX rating, the more fearful investors become.

Adrian Lowery, Financial Analyst at Wealth Manager Evelyn Partners, says (June 2022)“The VIX is a far cry from the peak of 82 it reached during the Covid pandemic and when stock markets crashed, or the average level of 57 it continued to hold through March and April 2020. But it has certainly increased this year, almost doubling to its current level of around 31.”

The VIX reached 36 in March 2022 as the war in Ukraine began to take hold. Mr Lowery adds: “But the historical average is around 20 and prolonged periods above 30 tend to suggest worrying times for the stock market.”

Poppy Fox, investment manager at Quilter Cheviot, points out that volatility can be short-lived, adding, “The VIX is a short-term indicator. But it can give you an idea of ​​how the markets react to various information.

“Remarkably, you can also invest in the VIX. But since it is a very volatile index, it is only recommended for the most sophisticated investors.

Inverted yield curve

Regarding the inverted yield curve, Ms. Fox describes it as “perhaps the most watched indicator of financial distress”.

To understand how this works, it’s important to look at the behavior of bonds – IOUs issued by both governments and corporations.

In terms of risk, bonds fall between the relative safety of cash and high-risk investments such as stocks and shares.

The British government issues bonds called “gilts”, while their American equivalents are called “Treasuries”. IOUs issued by companies are called “corporate bonds”. In each case, the bond is issued in exchange for a loan.

The term of the loan can last as little as a few months or, in the case of government bonds, several decades. Either way, in exchange for their money, bondholders usually receive an interest payment that reflects the security of the IOU in question.

The interest payment is known as the “yield” of the bond, and a yield curve represents the yields available on bonds of different maturities.

Adrian Lowery of Evelyn Partners explains: “When yields on longer-dated government bonds fall below those on shorter-dated debt, this is called an ‘inverted yield curve’ and has been in the past a reliable indicator that a recession is imminent.”

Typically, investors demand a higher yield for holding a longer-maturity bond – an IOU redeemable in 10 to 30 years – than for a shorter-maturity version – one redeemable in three months to two years.

Mr Lowery says: “This is because investors need greater rewards for holding longer-term investments, as inflation and default risks are greater over longer periods.

“When yields on short-term bonds begin to match or exceed those on long-term debt, giving an inverted yield curve, this is considered a strong negative indicator of economic growth.”

This year, soaring inflation and expectations of increases in short-term interest rates have pushed up some short-term bond yields relative to longer-term ones.

For example, in the case of Treasuries, the difference in yields between the 2-year and 10-year versions turned negative in March of this year. In other words, the yield curve inverted, albeit narrowly and briefly, for the first time since September 2019.

Chart 1: 10-year US Treasury yield minus 2-year yield

Source: Federal Reserve Bank of St. Louis

At the same time, a similar event occurred between 5-year and 30-year Treasury bills. It was the first time that the spread between these two bonds had turned negative since 2006. The yield curve for the 2- and 10-year Treasury bills inverted again at the beginning of the month.

Lowery says studies have shown a remarkably strong correlation between yield curve inversions and subsequent recessions. Although, as he points out: “The downturn in some cases happened two or more years later, which some say weakens the indicator.”

Ms Fox adds: “While not an absolute indicator of a recession, the inverted yield curve has been quite reliable in the past and therefore attracts a lot of attention from investors.”

Other indicators

business profits

Stock prices are ultimately determined by how much money a company will make in the future. If earnings are expected to fall, the conventional wisdom is that a company’s share price will follow quickly.

In the context of a potential market downturn or recession, it is crucial to analyze the health of companies in your chosen investment area. Earnings results flashing red across the board are not a good sign.

consumer confidence

Just as it is important to check the trust and health of companies, it is also important to determine what consumers are doing.

If consumers say they are holding back on spending or are generally seen as lacking confidence in the economic outlook, warning signs will begin to flash.

Without a healthy consumer base, neither non-discretionary spending (must-have items) nor discretionary spending (nice-to-have items) will hold up, leading to weak economic growth as many businesses struggle in a challenging environment.

A weak consumer base can lead to a recessionary spiral, with households tightening the purse strings in response to economic concerns.

Mr. Lowery says, “Consumer spending accounts for almost 70% of US economic activity, and that figure is 60% globally. Consequently, the fracture in consumer confidence is often presented as a predictor of recession and/or weakness in stock markets.

Consumer confidence in the United States, as measured by the University of Michigan Consumer Confidence Index, has plunged below previous levels seen during the 2007/08 financial crisis and is now at an all-time low. since the late 1970s.

Source: University of Michigan Consumer Surveys

If companies start to suffer from collapsing household demand, inflation-induced rising input prices and corporate earnings start to miss their targets, already anxious investors could sell more of their stocks.

Purchasing managers indices

Purchasing Managers Indices, or PMIs, are monthly surveys of a number of companies in various sectors of the economy to see how confident they are about their business and market conditions.

Any score above 50 indicates that companies expect near-term growth, while a score below that level suggests contraction. PMIs provide a good picture of what is happening within companies and therefore indicate economic output.

Ms Fox says: “Currently in the UK, the manufacturing, services and construction PMIs all have readings around the 55 mark, indicating growth. However, that is slowing after a strong boost following the reopening of the post-pandemic economy, where numbers were comfortably in the 60s.

“A recent survey by the Confederation of British Industry indicated that there would be virtually no growth over the next three months, so it would not be surprising to see these numbers fall below 50, the point where the warning signs will begin to flash.”

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