Quantitative analysis helps explain why the global financial crisis (GFC) has passed, says Ron Bewley.
Quantitative research is designed to take some of the emotion out of decision-making. It is hard to be completely objective when, within one month, Australia was hit by the extremes of floods, cyclones and bush fires. That was followed by an uprising or riot in seemingly every North African country. To cap it all off, Christchurch was devastated by a massive earthquake. For those of us lucky enough to be able to battle on, how do we separate the natural emotion from the fact?
The model that we use in constructing equity portfolios forecasts volatility of the S&P/ASX 200 and the volatility of each of 11 key sectors.
Most researchers agree that volatility comes in clusters – some massive, like during the GFC; some just big, like the European debt crisis of early 2010. Volatility tends to revert back to some mean level after these bursts. But these so-called mean-reversion models eventually fail if they assume the mean never changes. We build possible failure into our system by including a dozen alternative models with different means! The data are used to weight these alternatives in a rigorous scientific way. We published the theory in the Journal of Forecasting (2007).
As I show in Chart 1, our three-month-ahead forecasts, which we update each month, were reasonably flat at around 10 per cent before 2008 and then jumped up out of nowhere. The forecasts climbed and climbed for several months. What these forecasts meant to us in February 2008 was that we should massively down-weight our exposure to the financials sector – before Bear Stearns – and we stayed that way throughout the GFC. Other sectors, notably property trusts, followed suit; but most sectors took some time before they became more volatile.
The volatility of the financials sector started to drop quite markedly into 2010 but had another “bump” up during the Greek debt crisis of early 2010. Now, volatility is not only back to pre-GFC levels, it got back to the lower end of those pre-GFC days in January 2011, and only kicked up a little in February as the Libya revolt unfolded.
But what about the market as a whole? I can better show that in Chart 2 with a competing model using daily data. The solid black line is the median level of volatility to which the volatility clusters have returned. In fact, the median level was the same 12 per cent for most of the previous couple of decades or so – with a brief leg down to 8 per cent in 2003-2005 – along with financials in Chart 1. The dotted lines are simple extrapolations of the solid lines, to help make a visual comparison.
The GFC stands out in all its glory in the centre of Chart 2, but I can see from the beginning of 2010, volatility has almost been at pre-GFC levels. If and when things change, our models will let us know. Being among the first to know keeps us one step ahead of the pack. Who knows what will happen even before this article is published and on your desks? I am claiming that the world of finance has been back to normal since January 2011, and so has the market. So for those of you who think that equities are still too volatile, perhaps you are listening to your heart and not your head?
Ron Bewley is executive director of Woodhall Investment Research – www.woodhall.com.au
