Divining the Next Stock Market Crash: New Fragility Index Measures Global Systemic Risk

20080227_50-stock_price_indexes"Our humanity rests upon a series of learned behaviors, woven together into patterns that are infinitely fragile and never directly inherited." -- Margaret Mead (1901-1978), American anthropolgist

When will the global stock markets decline next? That's a question investors would love to be able to answer. And now, a new index might be able to help.

By identifying periods in which financial shocks could be more likely to stretch across multiple domestic markets, researchers at Oregon State University have found a way to measure the probability of global stock market declines.

CAVEAT EMPTOR: READING THE MIND OF THE MARKET

Published online on April 5 in the Journal of Financial Economics, the study establishes a "fragility index" which identifies common systemic risk exposures across multiple national markets to ascertain periods of time in which global equity markets are more vulnerable to extensive and widespread draw-downs.

"The index may have important uses for policy makers, money managers and ultimately private investors," said Dave Berger, an assistant professor of finance at OSU and lead author of the study.

MEASURING MARKET INTEGRATION THROUGH MULTI-FACTOR MODELLING

The study is an extension of a 2008 study by Kuntara Pukthuanthong from San Diego State University and Richard Roll from the University of California, Los Angeles, which demonstrated that measuring market integration by using correlations between broad market indices is "a poor indicator of integration for a very simple reason: when there are multiple factors driving returns, such as global macro factors or even industry factors, two markets can be perfectly integrated and yet still be imperfectly correlated." The two proposed an integration measure based on a multi-factor model that goes beyond simple correlations to investigate recent global integration trends.

In the new study, Berger teamed up with Pukthuanthong to develop the 2008 integration measure to "provide an estimate of systemic risk within international equity markets."

"High levels of our risk measure indicate the probability of a global crash is greater than the probability of a local crash," state Berger and Pukthuanthong in their study's abstract. "That is, conditional on high levels of systemic risk, the probability of a severe crash across multiple markets is larger than the probability of a crash within a smaller number of markets."

HIGH FRAGILITY = EXTREME MARKET MOVEMENTS

When the fragility index is high, stock market movements are more likely to be extreme, either positively or negatively. On the other hand, when the index shows a low fragility, investors can expect minimal market movement in either direction.

"For instance, global daily returns above 1 percent, as well as losses greater than 1 percent, are both more common when the fragility index is high," according to an OSU press release. "But when the fragility index is high instead of low, the down days are by far more common. During such periods the probability of one of the bad days occurring is 33 percent—more than seven times higher than when fragility index is low, when these significant downturns occur only 4.5 percent of the time."

TO PREVENT ANOTHER CRASH, LOOK AT GLOBAL SYSTEMIC RISK

"The factors that lead to global declines can change, so we tried to create a general measure of systemic risk," Berger said. "The probability of a worldwide financial pull-back is highest during periods in which many countries share a high exposure to our factor. When exposures are high across multiple countries, then if a shock occurs it will manifest globally, and multiple markets will simultaneously decline."

The 2008 stock market crash shows how important it is to study systemic risk in global equity markets. While capitalist myopia still hampers much of the investment community, the engendering of a sustainable economy requires not only a global viewpoint, but also a cogent and useful assessment of multiple markets simultaneously. To that end, the fragility index is a step in a more clear-sighted direction.

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NOTES

Oregon State Universiy New Index Identifies Periods When Global Stock Market Might Decline. April 5, 2012. Accessed April 12. 2012.
Pukthuanthong, Kuntara and Richard Roll. Global Market Integration: An Alternative Measure and its Application. Journal of Financial Economics. Social Science Research Network. March 21, 2008. Revised November 18, 2011. Accessed April 12, 2012.
Berger, Dave and Kuntara Pukthuanthong. Market fragility and international market crashes. Journal of Financial Economics. ScienceDirect.com. April 5, 2012. Accessed April 12, 2012.
Ibid.
Ibid., 1
Ibid.

image: Stock price indexes, 2005-2008, Dow Jones Indexes, Federal Reserve Board Monetary Policy Report, February 27, 2008

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