FSU Editorial: "Courting Catastrophe Again?" by Anthony M. Cherniawski 06/14/2006

COURTING CATASTROPHE AGAIN?
by Anthony M. Cherniawski, ChFC
The Practical Investor, LLC
June 14, 2006

Last year I became enamored by the inordinate amount of “portfolio insurance” being sold by Wall Street to individuals, pension funds and insurance companies. This was a fabulous money-maker for firms who were looking for a way to capitalize on a low-volatility, sideways market. The hedge funds picked up on this idea and got into the options selling business as a way to enhance yields for their wealthy investors in a low interest rate environment.

My quest for knowledge led me to an article entitled, Courting Catastrophe, by Kathryn M Welling for Barrons on November 14, 1997. http://home.ddc.net/ygg/inv/gamma.htm This article is based on an interview with Andrew Smithers, Chairman of London’s Smithers & Co., advisor to more than 100 institutional clients based in London, Tokyo, New York and Boston.

Some of the points mentioned in his article were,

"In an overvalued market, “All you can tell from the fact of the extreme overvaluation is that you are running massive risk. And people tend to consistently underrate those risks.”
“Our options study’s broad conclusion is that the growth of the options market does indeed pose a serious threat to the stock market. But more likely one of accelerating a crash and possibly bringing additional financial stress to the financial services industry at a most inopportune time, than one of triggering a crash itself.”
“Investors in the stock market who want to limit their exposure to market declines can, for example, buy a put…The price of the option is the equivalent to the premium paid for insurance.”
“The crucial difference is that unlike fire, life or auto insurance, the aggregate risk is not significantly less than the sum of the individual risks – because it is systemic risk, rather than specific.”
“This means that any reduction of risk of those taking out insurance must be matched by the increased risk assumed by those providing the insurance. What’s more, as the options market expands, the total amount of risk involved in stock market fluctuations rises by more than the increase in market value”
“This is analogous to the increase in risk that accompanies an increase in debt. While there can be no increase in net debt, since every borrower must have an equal lender, the risk of default rises with the expansion of gross debt. Likewise, the expansion of the options market involves increased risks, because of its inherent differences from other insurance markets. What’s more, share-price movements are highly correlated – and this is increasingly becoming true of markets worldwide.”

So, we can conclude from this interview that the expansion of the options market may not be the catalyst for a market crash, but could act as an accelerator in a time of stress. In addition, the practice of using options as a form of portfolio insurance actually adds to the systemic risks involved in the market. Not only could it accelerate a decline in progress, but because it incurs an equal and opposite liability on the seller, and may be difficult to hedge in a highly correlated market, adds to the risk of default by the options sellers.

In a follow-up interview with Andrew Smithers, in Market Meltdown, Part II, http://www.financialsense.com/fsu/editorials/2005/0614.html I had asked him whether he had updated any information regarding triggers for a stock market crash. He named three.

We have looked at the relationship between phases of low and high volatility. By using two log normal distributions rather than one for return/volatility, we improved the fit from a single distribution sharply. We found that, as defined, low volatility occurred 90% of the time and was accompanied by above average returns, while high volatility, occupying the other 10%, gave negative returns. A sharp and persistent rise in volatility could thus be a trigger.
Another possible trigger lies in the level of “buy-backs” which were running at $226 bn per annum for non-financials in the first quarter of 2005 (Flow of Funds Accounts Z1 just published on 9^th June.) Particularly with the sharp rise in corporation tax payments (up $30 bn per annum in Q1) consequent on the ending of bonus depreciation on 1^st January 2005, this level of buy-backs seems hard to sustain.
On a more broadly based approach, it is easy to see the current over-pricing of all financial assets, be they bonds, equities or houses, at least in the UK and US in the latter instance, as coming from an excess of liquidity. This excess liquidity has been the response of governments and central banks worldwide to the ex-ante savings surplus to which Dr. Ben Bernanke has drawn attention. This liquidity is likely to dry up either because the economy improves, in which case the Fed will raise interest rates, or because the economy disappoints and lenders become less accommodating.

I will not claim any expertise on points 2 or 3. However, I can claim some expertise on the Volatility Index, since my most recent article pointed out a sharp and persistent rise in volatility that began in May.

http://www.financialsense.com/fsu/editorials/2006/0602.html

Please note that there is no reversal in volatility. In fact, it has risen even as we approach options expiration. A failure to rally could spell disaster for the options sellers who already had sizeable losses from the May options expiry.

Take another look at the VIX.

Could this be the accelerator to the decline in our domestic stock markets? A spike in volatility at this juncture may catalyze the decline into something more than expected.

Please note: The Practical Investor, LLC is a State Registered Investment Advisor

CONTACT INFORMATION
Anthony M. Cherniawski
President and CIO
The Practical Investor, LLC,
State Registered Investment Advisor
East Lansing, MI USA
Email

The opinions of FSU contributors do not necessarily reflect those of Financial Sense.