When risk is literally ‘off the charts’

Good market-risk indicators are hard to come by. While many price- or sentiment-based indicators are good at highlighting what type of risk environment we have been in, precious few can claim to give a contemporaneous – let alone forward-looking – signal that the market is moving into a significantly different regime.

One indicator that we use as part of our risk-environment toolkit has proved useful in flagging such regime changes. Referred to internally as the TIM (Turbulence In Markets) monitor, it uses a similar methodology to State Street Global Markets’ Tail Risk Monitor.

The TIM monitor aims to provide a characterisation of the current financial market environment and the likelihood of extreme losses, based on the combined information from two indicators developed by Mark Kritzman, a professor at MIT: the Systemic Risk Index, which measures equity market fragility, and the Turbulence Index, a measure of ‘unusualness’ in global equity returns.

When equity markets are healthy, volatility can be caused by numerous market drivers or factors. History has taught us that when market volatility is driven by only a few factors, the system itself becomes more fragile and susceptible to large dislocations. The Systemic Risk Index uses a statistical technique called principal component analysis to determine how dominant a few factors are in explaining equity market volatility, and therefore how fragile the system is.

But fragility in and of itself doesn’t cause large dislocations; a catalyst is required. Hence the TIM monitor also uses the Turbulence Index to measure how unusual global equity sector returns have been compared to history. Unusualness can be characterised as either heightened volatility or a breakdown in correlations, and is often both in combination.

The TIM monitor can identify three distinct regimes – Watch, Warning, and Alert – dependent on the level of turbulence and the rate of change in systemic risk. Both sides of the equation need to be elevated for the monitor to move into Alert; a high level of turbulence is concerning, but if it transpires at a time of low market fragility it is much less so.

TIM flies

Needless to say, equity markets proved to be both fragile and extremely turbulent in the first quarter, so much so that the TIM monitor was – quite literally – off the charts. The monitor moved into Alert territory on 25 February, with the S&P 500 index down around 7.5% from its peak at that point; after that the index continued to fall a further 30% to its low on 23 March.

But what since then? The monitor has remained in Alert, and while turbulence has fallen somewhat as equities have rallied from their lows, the Systemic Risk Index has remained uncomfortably high (although as a consequence the rate of change, used in the monitor, has fallen), indicating that worryingly few factors continue to drive equity markets.

This may just reflect the fact that a small number of key drivers have been propelling the market back up again – swift and comprehensive monetary policy responses over the past decade have had a tendency to do exactly that in times of stress. Or it may be that markets remain especially prone to another large shock.

Though there are many inputs to our decision-making process, the warning sign from the TIM monitor is reflected in our positioning: far from chasing the rally, we are being careful not to assume stability in the risk environment. We may well learn that the worst is behind us, and that our caution is unjustified. But if that isn’t the case – well, then the TIM monitor probably needs a bigger chart.