Thursday, April 2, 2020

Behavior from common factor shock following expected pattern

"These markets are crazy!" How many times have you heard that phrase over the last month? I have tried to ban it from any discussion. Markets  have not been crazy in the sense of behaving as expected when faced with a large common factor risk shock. Markets are constantly moving up and down but most of that movement is associated with idiosyncratic risks that can be diversified. There are long-run factors like the business cycle which will drive market returns through time, but there are few sharp common factor shocks that will impact all markets. The COVID19 pandemic is one of those common factor shocks. 

When there is a strong negative common factor shock, we should expect three things: 
1. An increase in volatility that is related to commonality, intensity, and level of surprise. If the shock has more uncertainty on how it will affect the economy and firms, volatility will see a non-linear increase.
2. Correlations will increase to one. Diversification benefits will collapse.
3. Market dispersion will increase. This is not counter intuitive versus correlation increasing. All stocks may go down, but lower quality firms may be hurt more. 

Small comfort, but this is what we have seen in March. The return pattern is consistent with other negative common factor shocks. You can be surprised by the intensity, but you should not be surprised by these second order statistics as evidenced with stocks in the major equity indices.

What should we expect next?  Usually common factor shocks will see a slow decay in volatility which will last longer than the initial spike. The same decay effect will be seen with correlation and dispersion. These patterns may be more consistent than returns. 

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