The Uncertainty of Financial Markets
by Allan Timmermann
The extraordinarily high daily fluctuations in equity prices experienced during the beginning of 2008 took many investors by surprise. Financial turbulence was swift, widespread and persistent as it continued to influence equity markets for several days. Swings in equity prices of more than five percent per day occurred in many countries, even in well-established markets that had not seen such high levels of short-term volatility since September 2001.
Equity markets were not the only ones to be affected. An accompanying “flight to quality” saw prices on government bonds bid up as increasingly risk-averse investors sought greater levels of safety. Options markets also experienced ripples from the high levels of uncertainty. On January 22, the Chicago Board Options Exchange’s volatility index (VIX), which provides a measure of the market’s view of short-term stock price volatility, closed above 31 percent, having finished 2007 near 20 percent. In the view of options traders, volatility levels had thus increased by 50 percent over less than three weeks.
In common with previous periods of financial turbulence, the current period has experienced a breakdown in the correlation patterns observed during more normal times. In fact, correlation tends to become much stronger during large declines in asset markets, causing gains from diversification to become less reliable and more difficult to predict. Risk managers’ jobs become twice as hard during such periods due to the changing correlation patterns that are hard to track in real time, let alone predict ahead of time. Add to the changing correlation patterns the use of considerable leverage and you have a recipe for trouble among hedge funds in particular.
What were the causes of these distinct oscillations in global asset prices? It is natural to first look for news that perturbed the markets. Bear in mind, however, that what moves stock prices is often a puzzle. For example, no plausible news story has been identified as the reason for the dramatic 20 percent decline seen in U.S. stock prices during a single day on October 19, 1987. Don’t envy the journalists that have to explain market moves even when no specific sources can be identified. Market sentiments and support and resistance levels are often used as heuristics for price movements on such occasions.
Indeed, it is hard to find specific news that justifies the sharp deterioration in prices experienced during January 2008. As far as one of the chief culprits is concerned, namely the subprime debt crisis, even worse news arrived during the fall of 2007 without the same sudden impact on stock prices.
Another puzzle is this: although a large part of the price movements were attributed to uncertainty about the U.S. economy, on many days stock prices in some European and Asian markets were more volatile than those in the United States.
To explain the recent jitters in stock prices, shifts in investor confidence have to be considered. Investors’ reassessment of the significance of the financial sector’s exposure to subprime debt, declining real estate prices and the slowdown in economic growth seem to have had a composite effect. One could make the point that stock markets downplayed the subprime news in August and September of 2007, under the expectation that financial problems would not affect the broader economy. Only now are the risks becoming more transparent and thus we see a stronger reaction among investors.
One source of uncertainty that is less often discussed is the possibility that financial difficulties in one sector cause an asset sell-off that affects a much wider group of investors. This is one plausible reason for the dramatic losses experienced by so-called quantitative investment funds which shared a similar exposure to the unusual patterns in stock prices observed in August 2007.
A defining characteristic of the current financial crisis is that credit and liquidity have dried up to an unusual extent, as reflected in the sudden wide spreads between yields on highly rated corporate bonds and T-bills. Faced with the possibility of large margin calls as a result of volatile price movements, investors are becoming much more conservative in their choices of what are considered safe assets.
Prompted by an increasingly cloudy economic outlook, the Federal Reserve and U.S. policy makers have taken determined actions. The effectiveness of these monetary and fiscal policy initiatives remains to be seen. A cut in short-term interest rates generally takes several months to have an impact on the economy. This makes the Federal Reserve’s decision to cut the Fed fund’s rate by 0.75 percent on January 21 especially surprising, since an interest rate cut was widely expected the following week. The decline in stock prices is likely to have played a role in the Fed’s decision to make such a sizeable interest rate cut, although the fear of a full-blown credit crunch is likely to have weighed even more heavily on the Fed’s mind. Fiscal stimuli may have a more direct, but comparatively short-term effect.
These policy actions do not come without costs. The U.S. government is already running a large budget deficit. More accommodating monetary policy runs the danger of “moral hazard,” i.e. of rewarding those individuals and institutions that took excessive risks when real estate prices were rising and credit was easy to obtain, by accepting too low risk premia. If stock market investors expect that interest rate cuts will be made in the case of sharp declines in stock prices, it could bring about inflationary asset prices.
Going forward, several points are worth making. First, it seems likely that uncertain outcomes in the financial markets will remain for some time. The consequences of the U.S. subprime crisis continue to unfold, and doubts remain about the eventual size of the asset write-downs endured by U.S. and international financial institutions. The lack of transparency about the true risk exposures of financial institutions is causing a drag on the liquidity and lending activity throughout the economy, and will take some time to clear up. Add to this the slowdown in the U.S. housing sector and the weakening growth rate of the economy and it is easy to understand why financial markets are worried and large price oscillations have become so common.
Many indicators suggest that the U.S. economy is currently in a recession. Bear in mind, however, that the average length of U.S. post-war recessions is less than a year. Recession risk is less of an issue, in fact, than the dangers of a sustained credit crunch, which could curtail banks’ willingness to lend money for a long period. If the spillover from the financial markets can be contained, the economy is likely to return fairly soon to its trajectory of robust growth.
Read what Nobel Prize winner Harry Markowitz has to say in response to this article.