Sticky Risk

"Looks like the University of Illinois!"
--Joel Goodson (Risky Business)

From where I sit, it seems like markets are increasingly incapable of discounting potential future scenarios, particularly bearish ones, until events are practically on top of us. The macro conditions underlying the US credit market meltdown in 2008 were a mile wide and visible for years. Yet, it wasn't until big financial institutions began taking on water that markets really seemed to grasp what was going on.

Perhaps this 'sticky risk' thesis is erroneous. After all, it has long been observed that markets ramp higher on slopes with lots of horizontal run compared to the verticality of elevator shaft-like declines. Optimism is sticky until the last ounce of hope is poured into the boat.

But if there is something to the sticky risk thesis, then what factors might be contributing to the phenomenon?

The rise of high frequency trading (HFT) is one possibility. Estimates suggest that computerized trading now comprises anywhere from 30%-50% of daily trading volume. Trading in any form is often short-term oriented, but the algorithms of automated trading may exacerbate the situation, since computer programs may not account for longer term fundamental or macro headwinds that may be approaching.

On the other hand, HFT has only recently become dominant in daily buy/sell volume. It was no where near as prevalent in 2007-2008 when markets dislocated.

A second possibility is the presence of buyers that are not price sensitive. The conspiracy theorist crowd (of which I'm one) believe that, in addition to the publicly telegraphed market interventions that governments do daily in currency and debt markets, governments have been buying stocks to prop up stock markets in the face of adverse news and events. In other countries, this is legal. For instance, the BOJ was buying the Nikkei during the spring earthquake in Japan. In the US, however, it is illegal for the government to buy stocks.

Governments can also intervene overtly by restricting two sided markets. For example, the US government prohibited short sales on certain stocks during domestic market turmoil 2-3 yrs ago. Now, we're seeing similar bans on short selling being imposed in Europe...

A third factor at work is moral hazard. Moral hazard is taking more risk than you otherwise would because you think that someone will have your back if something goes wrong. Stated differently, people take more risk when they think that their behavior is insured. All government interventions to keep markets from falling can be viewed as fueling moral hazard, and research suggests that market participants indeed take more risk knowning that central banks and other government entities will act to bail them out if risk runs awry.

In the context of our present discussion, moral hazard drives market participants toward higher time preference (short time horizons) and reduces propensity for risk management. Even in the face of evidence that risk is high and should be reduced, individuals are likely to keep risk on longer than they otherwise would because they know that government will come to the rescue if things get bad.

Finally, a fourth factor is leverage. Leverage is using borrowed funds (i.e., debt) to magnify potential returns. Leverage, however, is a two edged sword in that, when prices move against you, losses are magnified. By definition, people take on leveraged positions when appetite for risk is high.

It is plausible that leverage makes people skittish and cause them to jump ship at the first sign of trouble. Perhaps, but empirical evidence using volatility and other measures suggest that leverage tempers volatility during upmarkets and exacerbates volatility in down markets. Perhaps prospect theory is at work--i.e., emotions keeping people in risky positions longer than they would sans emotions (or the leverage).

With leverage at world record levels (and increasing daily), this factor may be the most salient in explaining the sticky risk phenomenon.

position in SPX