Once-in-a-Century Credit Tsunami

When will the next crisis happen and what magnitude will it be?
Investor or actuary, this question puzzles our mind, isn't it?

In the Financial Analysts Journal (January/February 2010) professors Guofu Zhou and Yingzi Zhu raised a similar key question:

“Is the Recent Financial Crisis Really a ‘Once-in-a-Century’ Event?”

Actually Zhou and Zhu did research on a 'October 2008 congress quote' by Alan Greenspan:

We are in the midst of a 'once in a century' credit tsunami
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Zhou and Zhu Research
Given the fact that the Dow Jones Industrial Average (DJIA) dropped more than 50 percent, from 14,164 on 9 October 2007 to 6,547 on 9 March 2009, Zhou and Zhu answered the question whether a drop of 50% would be likely to occur once in a century.

Using daily data on the DJIA from 26 May 1896 to 19 June 2008, Zhou and Zhu estimated the long-term average DJIA-return (sample) at µ = 7.4% (excluding dividends) and the long-term volatility, known as the sample standard deviation, at s = 18.2% a year.

DowJones Industrial Average
May 1896 - June 2008
Average return: 7,4%
Standard deviation: 18.2%

On basis of the long-term data, Zhou and Zhu calculated the probability for the market to drop more than 50 percent from a high to a low over a 100-year horizon, considering two different models:

1. Random Walk Model, excluding dividend
2. Long Run Risks Model: complex dynamic simulation model, including consumption growth, dividend growth and asset prices

Here is the summarized outcome of their calculations:


As is clear on basis of the Long-Term Risks Model (LTR-Model), no matter what average return or standard deviation, the probability of a 50% draw down over a 100-year horizon is practically almost 100%.

50% draw down over an n-year horizon?
Given these results of Zhou and Zhu, we can now easily and (very) roughly approximate the probability, P(n), of a 50% draw down over an n-year horizon.


with r= P(1). We now roughly 'fit' P(n) to the results of the Long-Term Risks Model as follows:


It turns out the LTR-Models roughly corresponds with one year '50% draw downs probabilities' between r=4% and r=10% [r=P(1)].
As is clear from the table above, even over a 10-year period there's a substantial probability, somewhere between 33% and 65%, of a 50% market breakdown.

Also we can be more than 90% sure to become a witness of a market tsunami once in a lifetime......

The next market tsunami
Up to the next market tsunami, I would guess...., as tsunamis don't have a memory or allow themselves to fit into statistics or models like the ones mentioned above. Unlike natural sea-tsunamis, we - ourselves - are responsible for creating these 'financial tsunamis'.

Irrational Risk Attitude
But even if we are aware of the risk and are not responsible for creating the risk, we have an irrational risk attitude as human beings.
With the recent (2010) Haiti earthquake fresh in mind, let's take a look at the way we deal with the probability of an earthquake.

Los(t) Angeles .....................?
According to the 2007 Working Group on California Earthquake Probabilities (WGCEP 2007) the probability of a magnitude 6.7 or larger earthquake over the next 30 years striking the greater Los Angeles area is 67% (mark the similarity in our P(n) table!).

Yet we deny this reality and 'hope' for the better. Perhaps if every city would have to value the estimated fair value of this earthquake expectation in his balance sheet, things would change. However, I doubt.....

People act irrational with regard to Risk. If we can't manage it, we deny it. If we can manage it, we screw it up!

Sources
- Article Is the Recent Financial Crisis Really a ‘Once-in-a-Century’ Event?
- Wall Street Journal article, October 2008: Greenspan
- Credits: CFA Institute
- California Earthquake Probabilities
- Download Spreadsheet of tables used in this blog