Credit crunch jaws: How to know when it's safe to go back in the water

By Stephen Foerster
Globe Investor Magazine Online,
September 26, 2008

Stephen Foerster is Professor of Finance and holder of the Paul Desmarais/London Life Faculty Fellowship in Finance at the Ivey Business School, University of Western Ontario.

As U.S. President George W. Bush recently said while reflecting on the market turmoil, "These are not normal times." Investors around the world are spooked by the recent gyrations in the stock market. There are huge uncertainties related to the fallout from the credit crunch with a stream of bad news in the past year related to the demise, bailout or acquisition of financial stalwarts Bear Stearns, Freddie Mac, Fannie Mae, AIG, Merrill Lynch, and Lehman Brothers. No wonder investors are bewitched, bothered, and bewildered. Is it time to sell, buy, or stay pat? A look at risk may help investors figure out when the markets have returned to a state of "normalcy" making it safe to go back in the water.

The key to knowing when markets will have calmed down - and we certainly are not there yet - is to understand how market participants are perceiving risk in both the stock and bond markets. Much of the current financial mess can be attributed to a mispricing of risk related to subprime mortgages. Lenders and investors grossly overestimated the creditworthiness of borrowers and underestimated mortgage default rates.

With complex products tied to these mortgages, and in a low interest rate environment, investors became greedy and were searching for that little extra bit of return while overlooking the risk side of the equation. Much of the problem was also tied to assumed unrelenting increases in house prices.

As Warren Buffett once noted, "A pin lies in wait for every bubble and when the two eventually meet, a new wave of investors learns some very old lessons." The current lesson is that the potential for increased returns must invariably come with increased risk.

So how can we possibly know what investors think about risk today? Fortunately, there are a couple of readily available indicators, both market-driven, that capture investor risk perceptions.

The best measure of stock market risk is the Chicago Board Options Exchange (CBOE) Volatility Index, also known as the VIX. This is a measure of market expectations of near-term volatility transmitted by S&P 500 stock index option prices. Volatility of security returns is a fundamental input to the well-known Black-Scholes option pricing model. Conversely, if we observe actual option prices such as calls and puts on S&P 500 stock index prices, we can "back out" the market's implied expectation of volatility used to arrive at the actual option prices, which is what the VIX represents.

The average VIX measure since 1986 is around 20 per cent. If we consider average annual historical stock returns of around 10 per cent, and if we also assume stock returns are distributed like the classic bell-shaped curve (a reasonable approximation) then this implies that we would expect stock returns to be in the -10-per-cent to +30-per-cent range - i.e., the average return plus/minus the volatility measure - about two-thirds of the time.

We can also think of this range as the 67-per-cent confidence interval. But if the VIX is around 35 per cent, which is near the current level, investors expect stocks to be in a much wider range of -25 per cent to +45 per cent two-thirds of the time. In particular, the perceived downside is much more negative when the VIX is higher.

Another measure of risk that focuses on the bond market is captured by comparing the short-term borrowing costs of good quality corporations that regularly issue three-month commercial paper with the corresponding costs that the government faces through its treasury-bill issues. This spread, for the most part, reflects the market's perception of the risk investors face lending to corporations rather than the government, and hence the extra return required to compensate for the additional risk. Default on commercial paper in Canada is a rare occurrence but most memorably happened in 1992 with Olympia & York.

As the charts indicate, not only are we experiencing a considerable amount of perceived risk today in both the stock and bond markets, the converse was true just a few years ago: as much as risk is now being overpriced, investors had under-priced risk.

In January 2007, the VIX was around 10 per cent or half the level of its historical average. Between 2004 and mid-2007, the commercial paper-treasury-bill spread averaged only 13 basis points (one basis point is one-hundredth of a percentage point), below the historical average since 1956 of around 50 basis points.

Today the VIX is about 1.75 times its 22-year average and the commercial paper-T-bill spread is about four times its 22-year average. Until these two measures get closer to their norms then it's a sign that investors are still worried and markets have not yet calmed down. So keep an eye on the VIX (cboe.com) and the spread (bankofcanada.ca) and you'll know when the great white shark is once again far from shore and you can wade into the markets without fear.

Special to The Globe and Mail