What A Difference A Day Makes

March 2007 Dr. Hans Black

Since the summer of 2006 we have been living in an investment climate where few things, it seemed, could go wrong. The broad stock market, which began to rise last September in many of the industrialized countries, paled in comparison to the run-ups in many emerging markets over the past year and a half. While the spring of 2006 provided a large and fast correction, subsequent runups in such markets as China, Eastern Europe and India seemed to take speculation into the stratosphere. During the latter weeks of 2006, a variety of speculative bond instruments brought spreads down to levels never before seen. At the time we commented on this phenomenon in an essay named The End of Risk?, which essentially discussed the tremendous exaggerations in markets last fall. Again in January of this year, and particularly in an article last month called 20 Years Later, we drew parallels between the present speculation and the problems in 1987, when people believed portfolio insurance was the thing to own. These days, of course, we now have credit default insurance, which has given many the false security that they no longer need worry about the risks of potential defaults.

At the same time, signs of rampant speculation were also evident in equity markets, notably in China. Although the Chinese government tried to quiet credit markets by repeatedly raising interest rates — and more importantly raising the reserve requirements needed by banks — all hell broke loose on the exchange floor over the past few months in the run-up to the financially propitious Year of the Pig. In January, for example, volume in Shanghai was up over 500 percent from a year earlier, and according to The Economist, brokers opened 1.5 million new client accounts in the first month of this year alone.

During the last weekend of February, Asian newspapers were filled with articles about a Chinese government special task force that had been appointed to look into market excesses. For whatever reason, it took until Tuesday morning for people in China to get seriously worried. The resulting almost 10 percent plunge in the market has since snowballed and affected many markets around the world. Interestingly, as this is being written, the Standard & Poor’s 500 Index is down 5 percent in less than a week. While we will no doubt learn more about the connections of the events of the past week, we have no doubt that the closely-linked markets today, so dominated by hedge funds and all sorts of derivative players, have experienced their first real challenge during the post-September 11 period. Measurements of volatility, which had been so low for so many months, surged, reaching levels not seen since the immediate aftermath of the World Trade Center tragedy.

The debate, of course, will be whether or not this was a one-shot correction or the beginning of something more substantial. Given the excesses we have seen for so long, and particularly the almost nonchalant dismissal of all risk considerations, we believe we are probably only in the first act of a drama that will likely play itself out over the next weeks or months. It is interesting to note that the media, obviously focusing on the fact that the Dow had declined approximately 550 points on the afternoon of February 27, has gone a long way toward minimizing any concerns there might be. Indeed, the intraday rallies of February 28 were impressive, but then on March 1 we found ourselves down again over 200 points in the very early minutes of trading. One only has to look at the subprime mortgage saga, where many players have been badly hurt, to see another area where the symptoms are clear. The financial community is beginning to reassess and rediscover the concept of risk.