Yet Another Sign of a Shaky Economy  

In the past few months, the risks of a double-dip recession -- or, at the very least, a severe slowdown -- have been steadily mounting. Warren Buffett's favorite economic indicator is trending down, the U.S. consumer is showing signs of fatigue, and first-quarter GDP was recently revised downward for a second time, from an original estimated growth rate of 3.2% to a restated 2.7%.

Simultaneously, we've witnessed a rise in the St. Louis Fed's Financial Stress Index.

The what index?

No worries; this one is new to me, too. Designed to measure the level of financial stress in the economy, the St. Louis FSI tracks the weekly movement of 18 financial data series. These 18 variables, in turn, measure such items as short- and long-term yield spreads, inflation expectations, investor sentiment, and key interbank activities (the degree to which banks trust one another).

During the goldilocks years of 2006 and 2007, the index reading was close to -1. At the height of the financial crisis, the FSI peaked at roughly 5. And in the past several months, the index has moved from a range of 0.1-0.4 to nearly 1, notwithstanding a slight pullback in recent weeks.

Notably, all of the index's components track changes in the financial markets, not activity in the real economy. For instance, the Vanguard Financials ETF is one such component, which means that changes in the stock price of Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Goldman Sachs (NYSE: GS  ) (all top 10 holdings in the ETF) impact the FSI's weekly reading. For those investors who rightly focus on economic and company fundamentals more than weekly stock fluctuations, this fact may diminish the FSI's perceived value as a meaningful economic indicator.

Well, maybe. But I would point out that share prices do reflect at least one fundamental reality -- the equity cost of capital. Furthermore, the majority of the index's components, such as LIBOR, the TED spread, and the federal funds rate, are in fact crucial measures of both real and perceived financial markets health. The events of 2008-09 taught us that the financial markets, and the credit market in particular, are closely linked to the well being of both Main Street households and corporate income statements.

So what's the takeaway here? Look, if the FSI were the only data point flashing orange, I wouldn't be sounding a cautious note. But it's not. Beyond worrisome industry and agency statistics, companies themselves are offering at best a mixed picture. During its first-quarter conference call, Capital One Financial (NYSE: COF  ) , for instance, told investors that nonperforming loans in its commercial segment were continuing to rise, even as the consumer lending business was improving. Meanwhile, CEO of mining giant Freeport McMoran Copper & Gold (NYSE: FCX  ) has called out China's potential slowdown as a "risk to the world's market place in the near term."

All things considered, I'd be looking athigh-quality stocks, and exercising restraint on companies whose prospects are closely linked to global GDP, which includes the likes of aforementioned Freeport and fellow cyclical U.S. Steel (NYSE: X  ) .

My gut sense is that there'll once again come a time to aggressively pursue risk assets, but we're not there yet.

Fool contributor Mike Pienciak holds no financial interest in any company mentioned in this article. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy.


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