Risk Models and the Credit Crisis

Posted by Tim Hope on 10/2/08 10:08 am

Pundits and politicians are spending much time and energy looking for scapegoats and policy solutions to the current credit crisis.  Little has been said, however, as to one of the possible root causes of much of the credit market turmoil – value at risk modeling.  Value at risk modeling is a financial technique designed by Wall Street financial engineers with the goal of capturing the degree of potential risk (and thus total dollar exposure) in a given investment.  At the heart of such risk model assumptions is that asset risk and returns are normally distributed, in other words, they have a familiar “bell curve” shape.  Under such an assumption, extreme outlying events can be shown to be so unlikely that they could be discounted as being nearly impossible (the “once in a century” term comes to mind).  However, remove the normal bell curve assumption and suddenly extreme events can occur far more frequently.  Thus, investment losses can be far greater and more frequent that expected – much more so that the model would otherwise predict.  The continued over reliance on the accuracy of value at risk models may be a continued thorn in the side of the capital markets. Click here for an easy to understand article on the subject.

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October to be a test of the credit default swap market

Posted by Tim Hope on 9/30/08 12:58 pm

Given the recent failures and takeovers within the financial sector, October may prove to be a significant test for the multi-trillion dollar credit default swap (CDS) market.  Insurance firms and other investors are believed to have created CDS contracts on a number of financial institutions that are now in default of the contract terms.  As a result, extremely large sums may need to be paid out in coming weeks which could be made more difficult given the tight credit conditions in the current market.  How much is at stake?  Consider that CDS contracts involving Fannie Mae and Freddie Mac are estimated to be about half a trillion dollars.  According to the Financial Times, the Fannie/Freddie settlement auction is scheduled for October 6th.  In the case of Lehman, consider that the bonds of the now defunct firm are currently trading in the range of roughly 15-19 cents on the dollar.  Investors who wrote CDS contracts on Lehman debt will likely have to pay out about 81 to 85 cents on the dollar.  Lehman CDS settlement auctions are reported to be scheduled for October 10th.  The impact of failed CDS contract settlements on the capital markets would be difficult to predict.  Click here to read more.

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Financial Sector an Earnings “Boat Anchor”

Posted by Tim Hope on 9/22/08 12:11 pm

With the disarray in the financial sector, excluding the sector can offer an insightful look at the earnings outlook for the rest of the market.  Interestingly, when the “boat anchor” financial sector is excluded, the S&P 500 is still shown to be producing double digit forward earnings growth to the tune of about 10.9%. 

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Derivatives:  How much is too much?

Posted by Tim Hope on 9/17/08 11:56 am

With the derivative market tripling in size in the past five years to over $180 trillion in total notional dollar amount, it is possible that recent upheavals in the financial markets (and the financial industry itself) may have been a result of concern for the proper functioning of the derivatives market.  With so much at stake, there is little margin for error should risk models used by market participants prove to be inadequate in terms of failing to capture unexpected negative eventualities.

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Broken Irrational Market

Posted by Tim Hope on 9/9/08 11:31 am

Even though September is but a few days old, it is already delivering significant extremes in the performance behavior of stocks.  Stocks with strong, attractive, fundamentals are being battered while stocks with comparatively poorer characteristics are being handsomely rewarded.  It is such a market that turns conventional investment thinking on its head.

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Energy and Financial Sector PEG Ratio Comparison

Posted by Tim Hope on 9/8/08 11:26 am

The PEG ratio (a ratio of P/E divided by expected earnings growth) is a popular valuation measure as it allows for a convenient method of comparing stocks with different growth rates.  The same principle can be applied to industry sectors.  Recently the energy sector has been particularly hard hit in terms of performance while just the opposite has occurred with respect to the financial sector.  However, when looking at the PEG ratio for each sector it can be argued that the energy sector is now at a point where it is more attractive than the financials.

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Is Cash Signaling an Opportunity?

Posted by Tim Hope on 9/4/08 10:17 am

With the stock market currently struggling through a rough patch, it can be instructive to examine a ratio of cash levels (as measured with money market assets) relative to the market.  The reason is that such a measure can help to identify the degree to which liquidity is available as fuel for market advances.  Currently, cash assets on the sidelines are at a level that has not been seen in over 25 years.  Given that after taxes and inflation money market fund returns are, likely to be negative or close to it, equity investors may find that the opportunity cost of sitting in cash will look less and less attractive.  Of even greater interest for investors is that the last time cash levels were so high, the S&P 500 more than doubled in the following three years.

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The Dow Jones Industrial Average and Record Highs

Posted by Tim Hope on 8/28/08 12:37 pm

Interestingly, since 1904 there have been 61 years in which the Dow Jones Industrial Average did not make a new high.  However, of greater interest for investors is what has occurred in the following year.  Historically, the median return in such a year has been 10.5%.  While anything can happen before the year draws to a close, a least history is on the side of the investor for next year.

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Hurricane Season and the Market

Posted by Tim Hope on 8/25/08 12:13 pm

As the 2008 hurricane season continues to unfold, it is instructive to examine market behavior in the months following major storms that battered the United States (seven category 4 and 5 since 1954).  Interestingly, for the periods examined, mean and median market performance was uniformly positive.

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A tale of two PPI inflation stories.

Posted by Tim Hope on 8/22/08 10:10 am

Each month the U.S. Bureau of Labor Statistics publishes the Producer Price Index (PPI) which is an index measuring changes in wholesale prices.  Despite the fact that food and energy prices have increased significantly over the last few months, they are routinely excluded in official inflation figures so as to arrive at a “core” rate.  While the current “core” rate is a relatively modest 3.5%, it is at a 17 year high.  In addition, it is also 75% higher than the high end of the Fed’s 1-2% target rate.  Looking at the PPI as a whole, the index is at a 27 year high of 9.8%.  Since some use the PPI as a precursor to movements in the Consumer Price Index (CPI), such developments may have a significant impact on the behavior of consumers and wage earners.

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