How FMOC Sentiment Could Predict the Next Major Market Crash

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How Federal Open Market Committee Sentiment Could Predict the Next Major Market Crash

It is not a question of if, but when, the next market correction or crash will happen.  The Federal Reserve (“Fed”)’s quantitative easing policy is propping up the stock market.  How the markets will react when the Fed unwinds its balance sheet and raises interest rates is of particular interest to hedge funds. Hedge funds are shorting the VIX, an index fund measuring market volatility, more than they ever have before.  Many parallels have been drawn to the 1987 stock market crash and The Great Recession of 2008, when investors also believed volatility would not explode.  Market prediction analytics can help hedge funds preserve wealth by predicting the next stock market crash.  Hedge funds could hedge their bets on the bull market with bets of an upcoming bear market, which will start with a spike in volatility.  

“The fact that everyone has been incentivized to be short volatility has set up this reflexive stability — a false peace, but if we have some sort of shock to the system, all these self-reflexive elements reverse in the other direction and become destabilizing as opposed to stabilizing.”  - Christopher Cole, Managing Partner at Artemis Capital     

Sentiment Analysis                         

Figure 1.  Normalized chart showing the decline in interest rates and volatility as the Fed circulates more money to stimulate the U.S. Economy (DJIA and S&P 500); the effects of quantitative easing.

Figure 1.  Normalized chart showing the decline in interest rates and volatility as the Fed circulates more money to stimulate the U.S. Economy (DJIA and S&P 500); the effects of quantitative easing.

Stratifyd analyzed 237 documents including FOMC statements and minutes, news articles, Federal Reserve statistics, and market price histories between 2007 to 2017.  We applied the uncertain, positive, and negative sentiment lexicons and stop word lists for financial sentiment analysis.  We also applied a term frequency-inverse document frequency (“tf-idf”) weighting mechanism in order to generate more accurate measures of word impact.  The FOMC’s negative and uncertain sentiments towards the stock market and U.S. economy are of particular interest.        

Negativity vs. Uncertainty

The percentage of negative and uncertain word frequencies in FOMC minutes have an inverse relationship (r = -0.50).  Uncertainty peaked a year before the Recession and nearly two years before negativity reached its peak at the height of the Recession in October 2008.  Negativity is positively correlated to the VIX price history (r = +0.46), suggesting that market volatility is sensitive to negative monetary policy outlook.  The uncertainty percentage of FOMC minutes could potentially be used as a predictor of market volatility.  
News Sentiment for the month of September 2017 has an average combined uncertainty and negativity sentiment score of -0.92.  Top N-grams include “financial crisis” (-0.91) and “mortgage backed security” (-0.95), suggesting that analysts are uncertain of how the Fed will raise interest rates and unwind its balance sheet without harming the U.S. stock market. 

Reaction

Figure 2.  Plot of uncertainty and negativity frequency indices shows an inverse relationship. 

Figure 2.  Plot of uncertainty and negativity frequency indices shows an inverse relationship. 

Uncertainty is rising in recent months and diverging from negativity, a pattern observed prior to the 2008 financial collapse.  Investors can use this data to hedge their portfolios by going long on the VIX fund; anticipating that it will spike in the future.  Liquidating investments into cash at the current height of the bull market may be the best strategy.  Market downturns present a unique opportunity to buy stocks at very low prices and hold them throughout a market recovery for extraordinary gains.  

Conclusion

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Planning for the next financial downturn, stock market correction, or economic recession can save investors millions of dollars. Sentiment analytics are increasingly being used by hedge funds to execute trading strategies.  Hedge funds that utilize sentiment analytics consistently outperform their peers.  Hedge funds can use Stratifyd to gain predictive power over the market. Stratifyd’s platform provides sentiment analytics with powerful insights for trading strategies, allowing for lightning speed market intelligence to make effective trading decisions. 

 

 

 

References

 1. A monetary policy in response to the financial crisis in which the Fed buys mortgage-backed securities and Treasurys on credit, which is essentially the same as printing more money in order to artificially lower interest rates.

2. “Hedge Funds Have Never Been This Short The VIX.” ZeroHedge, 28 Sept. 2017, 
www.zerohedge.com/news/2017-09-29/socgen-says-reduce-risk-hedge-funds-have-never-been-short-vix.

3.  Sentiment lexicons and tf-idf weighting mechanisms developed by Bill McDonald and Tim Loughran, professors of finance at the University of Notre Dame in 2011

4.  https://www.valuewalk.com/2017/01/ai-hedge-fund-returns/

Nathan Breidenbach