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« Weighing the Week Ahead: Looking Past the Debt Ceiling Issue | Main | Get Started -- Buy One Stock »

August 03, 2011

Comments

Angel Martin

Actually, looking at 1998 again, the sharpest declines were in july and august - so that's another exception...

Angel Martin

Jeff, I'll be interested to see what you come up with for your exceptional risk project.

One thing I always keep in mind on this topic is the strong seasonality of really big market declines. We have a 400+ year history of market panics, crashes, financial crises etc. and all of them, as far as I know, occurred in the Spring or the Fall. (the closest to an exception was the Japanese market in 1990, which was in late december.)

I assume that the same size negative shock on the market can have a different effect in August vs October. And that a high reading on the St Louis Fed Index is not as important in January as it is in April.

Jeff, are you modelling for seasonality in your "exceptional risk" model?

oldprof

Proteus -- I'll try to sharpen up the terminology as I write more on this.

Most people confuse volatility with downside risk. Volatility goes both ways. Risk tolerance is a personal matter. It only changes if your personal circumstances change. Sometimes people learn that their risk tolerance is not what they thought it was, which is why I emphasized the need for honesty.

Your guessing is better than most!

Jeff

oldprof

scm -- We continue to experience a period of growth that is significantly below the long-term trend. For most people, it feels like we never emerged from the recession. This low growth environment has been enough for robust earnings and good investing. I'll do a separate article on recession forecasting.

You ask a good question about interpreting the SLFSI data, and one that I have been studying carefully. The key point is that the interest rate spreads have always been at least partly the result of Fed policy. Why think that this is different? The QE action reduces the yield slope by a little. Some have estimated that QE II was the equivalent of 75 bps in the Fed funds.

To summarize, I think the implied risk would be even lower without the QE actions. As I said, we are reviewing all of this in the search for an objective, data-based indicator. You can see from the chart that this approach was effective in 2008.

More to come, and thanks for joining in.

Jeff

Proteus

Jeff, you're confusing me by interchanging the terms risk and volatility. In step 2 of The Solution, do you mean Normal Market Volatility? And it's sure not clear to me about exceptional risk (good) or exceptional risk (bad). Looking forward to you expaining more in future writings.

Does risk tolerance change over time? I think there's no denying the market's character has changed a lot over the past two decades. 20 years ago, a 7% decline would have been a buying opportunity. Now, people are rightfully worried, easy media story or not.

I had to laugh when you asked the question about the probability of a 7% decline - I guessed about 40%, but then thought "Sure, and there's a small chance we'll see it all in one day".

scm0330

Jeff,

I have two quibbles: first, could you be a little more specific on why you believe that recession probability is low? I'm not seeing much to crow about across jobs data, durable goods, ISMs, you name it. (I consider sub-1% GDP equivalent enough to recession, btw.)

Second, I wonder about the St Louis Fed as an indicator of financial risk. Much of it is grounded in rates and spreads; could it be that, with short rates held low by decree, and longer rates in freefall (pending economic contraction?), this indicator is giving us a false positive as to the health of markets.

Maybe stated another way (and respectfully; I'm not trying to break your chops, Jeff), if your indicators give such a wide range of "normalcy," what are they really indicating? The current selloff has been painful and looks to worsen, but it's not reflected in the gauges and dials that you rely on for a tell.


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