By Colin Barr
November 29, 2010

Just in time for the holidays, we have another tool for tracking financial market fear.

Bank of America Merrill Lynch on Monday began pushing its Global Financial Stress Index, which it claims will do a better job than the oft imitated but rarely duplicated VIX index in predicting big market moves.

BofA Merrill says its research shows the catchily named GFSI is better than the VIX, also known as the CBOE volatility index, in predicting market plunges. As it happens, numerous commentators have spent the past two years calling for a massive market meltdown, not that they have a lot to show for it at the moment.

But BofA Merrill contends that when the big one does strike, the GFSI will give you better warning than the VIX.

Our backtesting shows that the GFSI would have been a better leading indicator than the VIX. Sharp rises in the GFSI have preceded sell-offs in risky assets, particularly equities. It would also have signaled market turning points. The GFSI’s constituents can help identify relative value across assets and cheap hedges, in our view.

The launch of the GFSI comes as Wall Street wracks its collective brain for just the right vehicle to cash in on the fear trade. Banks and exchanges are rolling out products that aim to provide an alternative to the VIX, a measure of short-term volatility in options tracking the S&P 500. Its widespread use has provided an enviable windfall for its licensor, the Chicago Board Options Exchange.

Striving to go one better, BofA Merrill says the GFSI will track 23 financial indicators ranging from stock options volatility to money market flows and credit default swap spreads. It says this approach “enables easy attribution of changes in stress to specific risk factors,” and should help investors  identify something seemingly in short supply at a time of $1,360-an-ounce gold: cheap insurance against market disaster.

Despite the upheaval over this weekend’s Irish bailout and the questions swirling the bond markets in Portugal and Spain, the stress index remains fairly quiet now. It recently measured 0.26, BofA Merrill said, which is some 80% below its 2010 peak during the first euro crisis in May and less than a tenth of its all-time high in the weeks after the Lehman Brothers bankruptcy.

That’s in line with other measures, such as the VIX, which remains relatively muted (see chart, above), or the St. Louis Fed financial stress index (right). But of course, a quiescent fear index isn’t necessarily a good sign either, notes Joseph Calhoun of Alhambra Investment in Coral Gables, Fla.

“Most portfolios are positioned for the economic environment that has existed for the last decade,” he writes. “If it changes – for better or worse – the transition could cause a lot more volatility in markets than is currently imagined by complacent investors.”

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