Periods of financial stress - the long history

 

A paper that has not received much attention focuses on measures of systemic risk in "Systemic Risk Measures: From the Panics of 1907 to the Banking Stress of 2023". Much of the data from this paper is available from V-lab. The work suggests that there have been more stress periods recently, but their duration has been shorter. There has not been a stress period since the banking crisis of 2023. More importantly, the work examines what happens cross-sectionally to firms when they enter periods of stress and identifies specific institutions that face risk. 

The stress measures focus on US financial firms' stock return comovements and can predict market outcomes like realized volatility and returns, balance sheet outcomes, and bank failures. The stress periods focus on the contribution and exposure versions of CoVaR, marginal expected shortfall MES, and SRISK. 

Stress periods are identified through a two-step process based on narrative analysis, with start and end periods associated with the GZ credit spreads for more recent periods. 

The key finding is that market-based indicators offer distinct information that complements traditional balance sheet metrics for risk assessment. 

SRISK around the globe - Look at China

 

There is concern about the risk in the current markets given the high valuations. In a perfect world, investors would like early warnings of market stress as an indicator that it is time to rebalance portfolios. Identifying different stress indicators will allow investors to triangulate on the true market environment. One that I have been recently focused on is SRISK from the website V-Lab. 

SRISK measures the capital shortfall of a firm conditional on a severe market decline, and is a function of its size, leverage, and risk. The current numbers show that the world SRISK is falling. There has been a significant decline in developed markets, but emerging markets are moving to high levels specifically because of the large increase in China risk. As a large economy, China's risk is passing through to the rest of the world.

The concern is spillover risk from China to the rest of the world.

A dirty secret in private equity

 

The private equity markets have been a darling for many pensions and endowments because of their strong long-term returns. Of course, investors should expect a premium over public markets because money is locked up for a long period of time. The problem is that many funds are nearing the end of their lives, yet many of the underlying investments have not been sold to other firms or IPOed. The money invested 10 years ago has not met expectations for a sale. The funds will have to extend their life. The IPO market has improved in 2026, but the numbers are deceiving since there have been a few very large deals. 

This private market environment suggests that investing in more liquid public markets should be viewed as a more viable option.

A warning sign of a bubble? stock issuance

 

One of the key signs of a stock bubble is the issuance of new stock. Simply put, when the stock market is overvalued, smart firms will issue new stock to take advantage of these high values. The increase in supply will flood the market and generate downward pressure on stocks. We are seeing more issuance in the market this year, but it is not at extreme levels. The large increases in 2020-2021 were associated with SPACs, which cratered the following year. 

On the other hand, stock buybacks will occur when the stock market looks cheap, and CFOs want to increase their companies' stock prices. We are still seeing the numbers increase, although at a slower pace. 

What is important, and what we have not done here, is to adjust buybacks and issuance to the total stock market valuation, which may provide a better relative measure. In that case, buybacks may not seem as excessive, nor does issuance seem to be exceptional. There are still mixed signals on these CFO signals of overvalued stocks.