In bullish times many investors share the view that markets seem riskless. In early 2007, credit spreads were tight and equity markets roared as China drove Australia through what seemed to be a commodities super-cycle.
Upbeat commentaries outweighed the sober views of market doomsayers, and while quantitative value-at-risk (VaR) models recorded early subprime shocks, they were overlooked by the herd. Occasional press articles advised investors to keep dancing but to stay within sight of the exit. Alan Laubsch, who heads RiskMetrics Labs Asia, says the first warning preceding the credit crisis was a 300 per cent spike in volatility, between December 12 and 21 in 2006, on a VaR forecast model tracking the 2006-1 AAA tranche of securitised subprime mortgages on the ABX index.
Two months later, on February 23, 2007, the model recorded another tremor: after HSBC sacked its head of US mortgage lending on the back of losses totalling US$10.5 billion, volatility leapt to 350 per cent, and spreads on the 2006-1 AAA vintage rose from 11 to 30.8 bps. Even after this alarming signal, it was not too late to hedge, Laubsch says. Spreads contracted to a low of 14.08 bps on June 25 before soaring to today’s heights. Of course, the significance of these warnings is much easier to understand with hindsight.
Risk management is a valuable input into the investment process, but it is never an exact science guaranteeing safe outcomes. “Volatility can spike upwards and then normalise,” Laubsch says. “An early warning sign can go either way.” Around June, many Australian equity investors seemed to believe that residual portfolio risk was falling, says Martin Conlon, head of Australian equities at Schroder Investment Management. But risk increased as listed property trusts and financial houses thrived on leverage, and commodities prices surged upwards.
“Everybody looking at the market should have known that risk was increasing,” Conlon says. Paradoxically, however, volatility measures of the ASX200 consistently fell. Investors then felt comfortable taking on more risk. Volatility, like most things in markets, is cyclical. And the worst time to increase exposure to volatility is when it peaks. Conlon says the resourcesheavy index was no longer a risk-neutral neutral benchmark in late 2007 (and it rarely is risk-neutral, since it is dominated by energy, materials and financial companies, which usually have high intra-sector correlations).
As the credit crunch hit, leverage began to unwind and commodity prices fell, the index started shedding capital. Then, just as bearish sentiment took hold, the breadth of the market narrowed, as the majority of stocks underperformed. Since the market was driven mainly by one sector, breadth collapsed at an especially bad time. About 20 per cent of stocks outperformed while 80 per cent underperformed, Conlon says, providing stockpickers with few options. Risk is often measured by statistical methods, but can be more accurately recognised in the underlying business of a stock, Conlon says.