“Value is at best a weak
highlight increased economic risks from the end of
2007 onwards. Similarly, fi gure 5 indicates the
absurdly low level of defaults priced into credit
short-term guide to market markets prior to the credit crunch.
Once again I am conscious of the dangers of
performance. Long periods can persist
selectively presenting information. However, it does
not seem unreasonable to posit that the
when expensive securities get more
combination of a negatively-sloped yield curve and
excessively tight credit spreads and expensive
valuations at the least would have served as warning
expensive or cheap ones get cheaper”
of potential market vulnerability.
BEHAVIOURAL INFLUENCES
STATS.
If, as shown above, relatively simple models work
well in terms of anticipating periods of poor returns
for risk assets, why then did investors not react
FIGURE 4: US YIELD CURVE SLOPE AND RECESSIONS
accordingly? One explanation lies in the literature on
behavioural fi nance.
Yield curve slope (LHS)
Value is at best a weak short-term guide to
Industrial production yoy % (RHS) market performance. Long periods can persist when
4
14
expensive securities get more expensive or cheap
3 ones get cheaper. Whether it is tech stocks in the
9
2
late 1990s or credit instruments more recently,
4
professional investors whose careers and bonuses
1
o
y % change
ope
depend on index-relative returns, justify buying
e sl
0
-1 overpriced securities for fear of underperformance.
-1
oduction y
Th is mechanism is enhanced by the known
-6
Yield curv tendency of individuals to assess probabilities
-2 trial pr
-11 incorrectly, whether through overconfi dence or
-3 Indus
otherwise. So an investor may not only be sensitive
-4
-16
68 73 78 83 88 93 98 03 08
to underperforming an index but he or she may also
Recession
have incorrectly assessed the probabilities of success
and failure associated with their investments. In the
Source: Federal Reserve, Bloomberg, Russell calculations
case of credit markets, it is now clear that vast
swathes of the investment community signifi cantly
FIGURE 5: IMPLIED BREAK-EVEN DEFAULT RATE
underestimated the potential fallout from sub-
prime debt, ably assisted by the credit agencies.
Breakeven default rate
Th e representative heuristic sheds further light
High yield spread over 10 year treasury
on recent market behaviour. Th is refers to the
25
tendency of individuals to rely too much on
v
er
selective parts of their own experience. So even
ead o
20
though implied default rates were exceptionally low
15
for several years prior to recent market turmoil, few
market participants had personal experience of the
easury yield
10
previous credit crunch in the early 1990s to be able
a
t
e
and high yield spr
ear tr
to recognise it.
ault r 10 Y
5
If one’s experience is that credit spreads are
tight and in a declining trend then a continuation
e
v
en def
0
of this experience becomes the expectation; tight
eak
Br 08 credit spreads became representative of the norm
-5
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
for many investors.
Source:
Even if an investor recognises at some level that
Bloomberg, Russell calculations
his or her position is vulnerable, the pain of
26 SUMMER 2009
23-2723-27 mean variance.indd 26mean variance.indd 26 1/6/091/6/09 11:50:4411:50:44Professional Investor Summer 09.28 28 4/6/09 15:40:55
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