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.

Going broke and not taking profits

Good investors focus on risk. Risk is the downside. Bernard Baruch said it well when he said nobody ever went broke taking a profit. - Sam Zell

This is a classic rule in trading, yet it has little meaning. Anytime you have a positive profit, you can take it, yet you are likely leaving money on the table. Simply put, do you take profits on what could be noise or price variation due to current volatility? 

Perhaps better to take profits against valuation. This requires some valuation statement that may be a mistake, but it is a better requirement for profit-taking. 

Nobody ever went broke selling at or above fair value. 

Follow the equity risk premium

 

There should be an equity risk premium over bonds. Equity is riskier than bonds, yet the current market does not suggest this. The bond market has disconnected from equities. One can always say that bondholders are pessimists relative to equity optimists, yet there is more going on than just behavior. 

Bonds are pricing stagflation, while equities, through cap-weighted indices, are pricing an AI productivity revolution. Perhaps both can be right, but that does not bode well for holding equity in traditional companies. 

Risk management is in the preparation

Don’t panic. Yes, it is time to start to panic. But what is panic? It is a forced action in response to the threat of uncertainty. An investor does not know what to do. There is no precise plan of action because the environment and market behavior are unclear and highly dynamic. Market actions, as reflected in prices, are unclear, and players' actions within the market cannot be determined. 

The only way to deal with a panic is through careful planning. But how can you plan for what may not have been anticipated? The only solution is to run scenarios or thought experiments on possible reasons for panic and then work through possible responses. This is not easy, and there is no reason you will get the drivers of panic right, but by conducting these exercises, you will identify common themes for addressing the unknown. 

Uncertainty about signals and price impact

Every model will have signal noise or uncertainty, and every model will have imprecise impact uncertainty from trading. This is a certainty because any training set will have to be imperfect. Hence, we should expect performance problems due to parameter uncertainty. Modelers should take this into account in their work. 

First, the model’s Sharpe ratio will be lower than expected from what is generated from the training set. There will be estimation error and model misspecification. Second, the model will affect transaction costs, with the impact being greater for smaller and less liquid stocks. Notably, weak signals will have less impact on trading costs, while strong signals will have a greater impact on trading costs. See “Trading with Uncertainty about signals and price impact”.

How do you solve these problems? One way to solve the problem is to define a reference model and then assess the costs associated with variations from it. The uncertainty can be managed to lock in a reasonable Sharpe around the reference level. The math in this paper is not easy, but the key is to be aware of the problem and to place bounds on what is possible.  

Good News - Bad News - overreaction to the bad news

There is good news and bad news that comes to the markets through new information that impacts expectations. News will have a differential impact, and investors should always be ready for it. Good news will drive prices higher, and of course, bad news will have the opposite effect, yet news will have a differential impact. Good news will usually be met with underreaction, while bad news, at the extreme, will be met with overreaction. To put it simply, the bad news forces investors to sell, and there has to be a buyer on the other side of the trade. To find the buyer, the markets will have to overreact to provide the buyer with a premium for considering the higher risk posed by the bad news. In the case of good news, there is no forced selling that requires new buyers. There will be a reaction, and there may be some extreme buying, but the buying excess is driven by a supply shortage, not by a need for a premium to induce buyers. 

Risk appetite is always worth following - Currently, normal

We have been following the Wilmot Risk Appetite Index for decades, when it was first called the Credit Suisse RAI, as developed by Jonathan Wilmot, who is now in private practice. It will be provided to investors through HedgeIndex LLC in the coming weeks, along with their broad set of alternative indexes. The basic construction is provided below. 

The current reading indicates that risk appetite is within the normal range, though it is rising. There may be individual assets with extreme values, but the RAI does not indicate a general market extreme.

 

What are the big risks of 2026?

Each year, the World Economic Forum provides a global risk perception survey. This is one of the most comprehensive risk surveys, and it provides useful context on what business leaders are thinking about potential disruptions to the global economy. The benefit of this survey is that it provides overall rankings for each year and measures change from the prior year.

By far, the current global risk landscape identifies geoeconomic confrontation as the top risk, followed by state-based conflict. Now, for anyone reading the news, this seems very logical, but it is sobering to see it in print. It has moved up from the eighth spot last year to number one. Along with confrontation, economic downturns, inflation, and bubbles pose key risks. These risks are important in both the short and long term, although climate change is still considered a long-term risk.

What does this mean? First, it is hard to believe that risky assets will continue on the current path with these views. Second, as noted in a recent post, Bonds are not always a safe asset; holding bonds may not provide the desired safety during an armed conflict or war.

 

Combining volatility (fear indexes) - a strong indicator

 

We know that many investors use the VIX index as a fear gauge or just a measure of market risk. We also know that the same investors use the MOVE index to measure volatility and fear in the bond market. Some researchers decided to look at the divergence between these two indices as perhaps a stronger signal; see "Divergence of Fear Gauges and Stock Market Returns". The authors find that the divergence of fear indexes (regressing MOVE on VIX and using the residuals and the MOVE/VIX ratio) is a negative predictor of future equity market returns. This predictor does well for both in-sample and out-of-sample tests. 

Looking at the difference between MOVE and VIX indexes is a simple measure that can be followed by almost any investor. Simplcity may make this indicator obsolete if "everyone" is using it, but in the near term, we think this is a good, simple signal tool that I have been using for some time in different forms.

 

Risk means more things can happen than will happen  - Elroy Dimson 

I view risk as the dispersion of countable events. Uncertainty is the events that are not countable, yet the Dimson definition hits home as a key description. It is the range of what is possible, both good and bad. For volatility, the dispersion from the mean says more things can happen than will. For uncertainty, more possibilities are riskier than fewer. Although we focus on the bad, risk can also be a positive.

Risk is not uncertainty

“For uncertain matters there are no calculable probabilities whatsoever. We simply do not know.” -Keynes 

As we move into the new year, we hear projections about what will happen in 2026. It is a fool's errand. These projections are often not grounded in risk assessments, which are countable and measurable. They are framed in narratives. More importantly, they are focused on uncertainty, which means there are no calculable probabilities. Some have defined this as radical uncertainty, but we do not need the adjective. We just do not know the likelihoods, and in most cases, the analysts of these forecasts will not provide probabilities. They are just stories and should be viewed as such. 

FT geopoltical mood index - another way of viewing sentiment

 

The FT has developed a new geopolitical sentiment model by using an LLM that identifies positive and negative stories, which are then weighted by relevance. This model is correlated to some other geopolitical models, but with a weekly frequency, it may provide a better estimate. The intuition is reasonable and consistent with actual events in 2025. For quant, it would be nice to see that this adds value in telling us the direction of market risk premia.

 

Where are the expected shocks for next year?

A Fed survey shows that the most significant potential shocks or risks in the market are not bubble risk and overvaluation but policy uncertainty and geopolitical risks. These macro risks are more complex to hedge for the long-only crowd and harder to handicap, as they are based on events that most investors will have a hard time researching. The expansion of the war in Ukraine or tensions with China cannot be assessed in a balance sheet or an income statement. 

Watch the macro risks that are hard to handicap. 

Watch the market liquidity - hidden risk

 

A key statistic to watch is the market liquidity in equities and Treasuries. If there is a market shock that increases risk, there will be a move out of equity and into bonds. If there is a rate shock affecting the safe asset, there will be a shift out of long-dated Treasuries into cash. In both cases, a key cost will be the bid-ask spread and the cost of exiting the market. 

Equity liquidity is still below average, though higher than during the spring period associated with tariff shocks. Treasury liquidity has increased substantially since the second quarter, but liquidity in the 2-year Treasury remains low. 

Liquidity is not a concern until you need it, so risk management should consider the exit costs before a crisis.

The big events - they will always be coming

 

Graham Capital provides a simple infographic on the major market crises for the last 30 years. They happen frequently. While crises are not an annual event, investors should expect unique crisis events more frequently than expected if economic policy is working effectively. Interestingly, most of these crises can be linked to bad policy choices. There will be a reckoning when monetary and fiscal mistakes are made.

Volatility and tail risk - The need for liquidity

Graham Capital provides some helpful charts on the current volatility environment in its paper, "Tail risk as a structural feature of modern markets." The MOVE index of bond volatility has shown significant increases since 2022, following a prolonged period of benign movements during the post-global financial crisis (GFC) period. The VIX has also shown an extended period of volatility. There is an ebb and flow with volatility, but the greater concern is cross-asset volatility, which indicates that we have seen more spikes in volatility over the last five years. These spikes are particularly hazardous for investors, especially when they occur frequently.  

Graham argues for adaptive risk management frameworks that combine quantitative and discretionary approaches through both top-down and bottom-up approaches. These approaches include stop-loss and profit-taking. We agree in principle that this is an adjunct to risk management; however, it is not clear exactly how it should be implemented. One beneficial idea is that under a high-risk environment, there is a strong need for liquidity. Liquidity provides embedded optionality through allowing investors to change direction during periods of high uncertainty. When there is a breakdown in correlation and higher volatility, liquidity allows investors the chance to pivot, even if it's just to cash.

The era of sudden shocks - we don't have an explanation

A recent FT article by Robin Wigglesworth highlights the thought that we are in a period of sudden shocks or short bursts of uncertainty. While economic volatility has declined, as described by the Great Moderation, even with the Global Financial Crisis (GFC) and COVID-19, there have been short-term shocks in financial volatility. The current volatility, as measured by the VIX, is close to the long-term average. Still, the volatility of vol is elevated, and there are these periods of volatility shocks. 

Is there an explanation for this vol shock environment? There is no easy answer. It could be related to the higher leverage in the marketplace, but that does not explain the short-term nature of these shocks. It could be quick policy responses, but there have been more short-term spikes than Fed responses. It could be what a friend has referred to as the "wall of money" that will invest when there is a short-term reversal. That could be a reasonable explanation, yet it does not explain why we have the shocks in the first place. 

The investment implications for this are worth reviewing. Currently, it states that investors should not be concerned about these shocks, even if they are frequent. For some strategies, such as trend-following, it is a negative outcome where managers get whipsawed by these spikes. Trading strategies require more activity, not less. 

 

Paul Slovic - there is a difference between risk as feeling and risk as analysis

Paul Slovic, one of the leading behavioralists in the field of decision-making, stated that there is a distinction between risk as a feeling and risk as an analysis. This is his way of thinking about the fast and slow thinking problem as described by Dan Kahneman. Risk, as feelings, is our natural reaction to danger, which could be called our jumpiness when faced with a risk. It can also be described as our experiential system. This is in contrast to risk analysis, which examines decisions under uncertainty as an analytical issue of measuring costs and benefits. 

While most investors will always focus on fast and slow thinking, the Slovic approach is a nice addition or contrast to what we already know about decision-making.

From Risk as Analysis and Risk as Feelings: Some Thoughts about Affect, Reason, Risk, and Rationality

The difference between certainty and uncertainty

Certainty - firm conviction, with no doubts, that something is the case

Uncertainty - the conscious awareness of ignorance 

-from The Art of Uncertainty by David Spiegelhalter 

All investors deal with issues of certainty and uncertainty. Importantly, there is no certainty. Get that out of your head. We live in a world of probabilities from what is countable and a world of uncertainty based on ignorance. Uncertainty is foremost what we do not know, so the job of any analyst is to reduce uncertainty from ignorance. There is some uncertainty that we will not be able to fully learn our way out. In those cases, we have to make some subjective probabilistic judgments. 

All investment research is about reducing uncertainty and increase the precision of our probabilistic estimates.