World stock markets face 'risk-off' road ahead: Index

Global stocks are entering a potentially negative period, according to one index with a solid track record that is indicating there is more than European debt weighing on investors' minds.

The Global Financial Stress Index, compiled by Bank of America Merrill Lynch, has seen 10 of its 40 components rise to a level associated with risk-off mode in the financial markets, which means investors usually sell more volatile assets like stocks and move to the safety of fixed income.

The GFSI`s Critical Stress Signal last flashed risk-off on July 12, 2011 and remained there until Jan. 4. While US stocks, as measured by the Standard and Poor's 500, fell 2.7% during that period, global indexes tumbled 9%. BofA says the CSS has been accurate more than 60% of the time in predicting global stock drops.

"With risk assets already selling off as European sovereign fears take hold again, we recommend caution if adding risk," BofAML equity analyst Anders Armelius said in a note.

Though it's no secret that global investors fear ramifications from the sovereign debt crisis, which has flared up again after several quiet months, the CSS indicators show there's more than Europe at play.

Half of the 10 indicators that triggered the risk-off signal indeed are related to the debt crisis, but others have different sources. For instance, a measure called "equity skew," which measures volatility in options contrasts, is the leading indicator showing the market will be in risk-off mode.

The index also showed elevated levels of solvency risk and bearish moves in fund flows.

The GFSI measures risk by solvency, volatility and liquidity; hedging demand from equity and currency option skews; and investment risk appetite, gleaned from trading volumes and fund flows.

"Investors have been bullishly positioned into (emerging market) equities and (high yield) bonds since the beginning of the year but have since taken some risk off the table," Armelius said. "Sovereign concerns and bank funding are leading the stressed indicators."

The BofA index showed stress as the US market finally paused off its sharp rally from the October lows. The S&P 500 surrendered more than 4% from its early April peak, but has recouped some of those losses in the past two sessions.

Global markets, meanwhile, staged a convincing rally from late November into March but have stumbled since.

Sentiment polls also have indicated increased levels of bearishness, with the American Association of Individual Investors showing bulls at an eight-month low of 28% in the most recent survey.

The nervousness has come even though economic indicators are mostly positive.

The Federal Reserve's Beige Book, released on Wednesday, showed that all 12 Fed districts reported economic progress ranging from "steady" to "strong." Yet volatility remains high.

Nicholas Colas, chief market strategist at CovergEx in New York, said 18 of 19 sectors or asset classes that his firm tracks for implied volatility are showing elevated levels. Moreover, he said correlation among stocks and asset classes has regained strength, with the S&P 500 sectors moving in unison up to 85% of the time in recent sessions.

The upshot is that, as the BofA survey indicates, investors remain unconvinced that global markets are as settled as 2012 trading indicates, and will continue to move cautiously.

"The rising (implied volatility) levels in the options chains mean the market`s ears are perked up and it is nosing the air to get a sense of what might be lurking over the horizon," Colas said in a note. "And the higher correlations are the pack behavior of a 'risk-off' market, anxious to approximate some level of protection by moving as one."

Copyright 2011 cnbc.com