Distress Index and Stock Returns
Posted in Economic Indicators
November 17, 2009
Since 1967, the Foundation for Economic Education has calculated early in each month the “Distress Index”. This index combines currently available U.S. readings of: unemployment; consumer price index; gross domestic product; total capacity utilization;and, household financial obligations as a percent of disposable personal income. Is this index informative about future U.S. stock returns? Using monthly values of the Distress Index and monthly closes of the S&P 500 Index from January 1967 through October 2009 (514 months), we find that:
The following chart compares the level of the S&P 500 Index and the Distress Index over the entire sample period. Visual inspection suggests that there may be, at least sometimes, an inverse relationship (negative correlation) between the two series.
For greater precision, we relate monthly stock returns to monthly values of the Distress Index.
The following scatter plot relates the monthly change in the S&P 500 index to the prior-month Distress Index over the entire sample period. The Pearson correlation for the relationship is 0.03 and the R-squared statistic is 0.00, indicating that variations in the Distress Index explain none of the variations in next-month stock market return.
For the first half of the sample (January 1967 through May 1988), the correlation is 0.13. For the second half of the sample (June 1988 through October 2009), the correlation is -0.12. These results suggest that the relationship may not be stable.
Might there be a delay of more than a month in the relationship between stock market return and the Distress Index?
The final chart summarizes relationships between S&P 500 index monthly return and the Distress Index for various lead-lag scenarios, ranging from stocks lead the Distress Index by 12 months (-12) to the Distress Index leads stocks by 12 months (12), for the entire sample. The strongest indication is that stocks lead the Distress Index by six months to a year with a negative relationship (correlations -0.12 to -0.18). In other words, stocks have already fallen (risen) well before the Distress Index rises (falls). There is a very slight indication that stocks tend to rise after a high Distress Index (correlations no higher than 0.06).
In summary, evidence from simple tests indicates that the Distress Index is of no use to investors for predicting stock market behavior.
