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In the Market - May 2010
May 15, 2010
Systemic Risk Snaps Back: Flashback To 2007
Discuss Systemic Risk more in the Risk Client Community
The recent volatility spike is a reminder that volatility is just one aspect of risk. A sovereign wealth manager recently used a spring loading analogy: potential energy (pressure) builds up slowly over time, and then quickly snaps into realized kinetic energy after a precipitating event. When volatility is low, it’s a perfect time to search for such hidden pressures (think crowded trades and other systemic risks).
By April 19, equity volatility dropped to levels not seen since pre-crisis Feb 2007 (e.g., VIX 15.74), after which a series of escalating risks sent the VIX above 40 on May 6 & 7. Early warning signals started to flash well prior to the May 6 meltdown, which we alerted clients to in our April 28 “Early Warning: Escalating Systemic Risk” Risk Client Community discussion.
While markets closed down only about 3% on May 6, the 8.3% intra-day S&P 500 drop was a whopping 7.8 standard deviation (sd) move. The last downside surprise of such magnitude was on February 27 2007, when a 3.5% drop in the S&P 500 represented a -8.5 sd move, also arising after a period of low volatility (see Chart 1).
Chart 1: S&P 500 95% Confidence VaR Backtest
In “Doomed to Repeat It” Chris Finger shows that Feb 27 2007 marked the sixth largest daily outlier in over 100 year of the DJIA, tagging this date as the beginning of subprime and China risk. Three years later, China’s asset bubble has reflated, and we face another waning liquidity-fuelled rally which Nouriel Roubini calls “The Mother Of All Carry Trades.”
The $1tn EU IMF rescue package announced on May 10 has averted a systemic breakdown and precipitated a broad global rally, with record spread tightening for “Club Med” / PIIGS and a 10% jump in European equities (a +4.2sd move). We saw two such upside outliers in 2008 when rescue packages were announced in US & Europe. On a cautionary note, however, markets continued their downward spiral through March 2009, well after the Sep 19 and Oct 13 2008 rescue announcements (see Chart 2 below).
Chart 2. Euro Stoxx 50 (FEZ) 95% Confidence VaR Backtest
Thankfully, regulators seem to have learned to be more proactive and coordinated with their rescues. But fundamental vulnerabilities remain. For example, it is not surprising that the EUR has given up its earlier gains, since the bulk of the financing must be raised within the Eurozone. Chart 3, shows a number of significant downside USDEUR VaR outliers.
Chart 3: EURUSD VaR Backtesting
Chart 4 shows that clustering of downside EURUSD VaR outliers marked tipping points for a number of major drawdowns (see circled dates in Chart 4).
Chart 4: EURUSD Vs 100 Day Moving Average Downside Outlier Clustering.
Dangers And Opportunities
Historical studies of debt crises are sobering. Of the four archetypal deleveraging paths, McKinsey Global Institute points out that a decade of “belt tightening” is the most likely scenario, although spikes in inflation and default are not uncommon. The rarest recovery path is “growing out of debt,” which has historically been sparked by fortunate events like major resource discoveries or the peace dividend the U.S. reaped post WW2.
In the midst of these turbulent and fragile markets, it is worth examining countercyclical investment strategies that might mitigate systemic risk. One is to consider volatility as an investment strategy. Since equity volatility is highly mean-reverting (e.g, around 20% annualized for many developed markets) and negatively correlated to assets, it can provide strong diversification returns for disciplined investors, while providing welcome relief during financial crises (e.g., buying umbrellas on sunny days to sell when they are needed on rainy days).
We look forward to your feedback and contributions on the Risk Client Community, and feel free to contact alan.laubsch@riskmetrics.com for additional information.